Blog Post

Irrevocable Life Insurance Trusts

Michael Brennan • Dec 18, 2017

Upon death, individuals are entitled to leave their assets to chosen beneficiaries tax free so long as the total value of those assets is less than the current estate tax exclusion amount in place for the year in which the death occurs. Apart from real estate, one of the most valuable assets that many people own, or will consider purchasing during their lives is life insurance. Often, these policies can payout millions of dollars so when their value is added to the total value of all other assets in an estate, an individual can quickly approach the limit of what the IRS permits to be given away upon death tax free.

With an estate tax rate of 40%, an estate valued at more than the exclusion amount can be faced with a substantial tax bill. Because of this reality, estate planning attorneys use a number of tools and techniques to reduce the total value of what will be included in the decedent’s estate for tax purposes. Once of those tools is the Irrevocable Life Insurance Trust.

So what are Irrevocable Life Insurance Trusts and how do they work?

An irrevocable trust is a trust in which the trust creator, also known as a grantor, gives up the ability to subsequently amend or revoke the trust is any substantial way, unlike a revocable trust which may be amended freely. By electing to make a trust irrevocable, the trust creator triggers a number of advantages, particularly from tax and creditor standpoints, so they can be very beneficial in the right circumstances.

One type of irrevocable trust is the Irrevocable Life Insurance Trust (also commonly referred to as an ILIT). At its most basic, an ILIT is simply an irrevocable trust that holds a life insurance policy. That policy is usually on the life of the trust creator. Typically, ILITs are used to accomplish four main objectives:

1) They provide a means to pay estate taxes, or other debts due upon the death of the grantor. This can eliminate the potential need to sell off assets such as real estate in order to have enough cash to pay the tax bill.

2) They provide a large source of income to the beneficiaries of the trust upon the death of the grantor.

3) They shelter the value of the life insurance policy from estate taxes, which are currently imposed at a whopping rate of 40% for amounts over the exemption amount.

4) They shield a substantial asset from creditors of the grantor and generally cannot be touched to satisfy other debts unless they are the debts of the beneficiary.

Requirements for an Irrevocable Life Insurance Trust to create those benefits.

Generally speaking, the assets included in the trust, known as the trust corpus, will not be included in the gross estate of the individual creating the trust, known as the grantor, if:

1) The trust is irrevocable. This means that once it is created the grantor must give up the ability to subsequently revoke or amend its terms.

2) The grantor is not the acting trustee. This means that someone other than the grantor must ultimately be in charge of managing the trust and bear responsibility for carrying out the terms of the trust agreement.

3) The grantor has no incidence of ownership over the insurance policy. This means that the grantor must give up all rights to subsequently name a different beneficiary, remove the policy from the trust or otherwise direct in any way how the trust will operate or what will be done with the trust corpus. A minor exception to this rule is that, according to the IRS , the grantor may retain the power to remove a trustee and appoint a successor trustee. An exercise of that right is not a violation of the requirement that incidence of ownership be given up.

How is an Irrevocable Life Insurance Trust created?

During life, the grantor creates the trust by having an attorney draft an irrevocable trust agreement. The trust agreement outlines the terms of the trust, when distributions should be made and identifies the trustee and beneficiaries, among a host of other things. The grantor then funds the trust with a life insurance policy on his or her life. Existing policies owned by the grantor before the trust is created may be used, but it is simpler to use a newly purchased policy for reasons outside of the scope of this article.

Of course, it will be necessary to pay premiums on the policy. This can be done in a number of ways, but perhaps one of the easiest methods is for the grantor to make annual transfers of cash to the trust which will enable the trustee to pay the premiums. However, care must be taken in any approach, as well as in drafting the trust provisions to ensure that contributions for payment of policy premiums can be viewed as gifts of a present interest in order to maximize annual gifting exclusion amounts while creating a strong probability that the gifts will actually be used to pay the policy premiums. For more detailed reading of how this may be structured, see a previous post on Crummey Trusts.

Irrevocable Life Insurance Trusts are a relatively simple, yet effective way for individuals to leave substantial amounts of money for their loved ones when they pass away without increasing tax liability and can be used in conjunction with other estate planning tools to create a comprehensive estate plan that is specifically tailored to any number of goals and objectives.

Michael F. Brennan is an attorney at the Virtual Attorney™ a virtual law office helping clients in Illinois, Wisconsin, and Minnesota with estate planning and small business legal needs. He can be reached at michael.brennan@mfblegal.com with questions or comments, or check out his website at www.thevirtualattorney.com .

The information contained herein is intended for informational purposes only and is not legal advice, nor is it intended to create an attorney-client relationship. For specific legal advice regarding a specific legal issue please contact me or another attorney for assistance.

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