What is an Irrevocable Life Insurance Trust (ILIT)?

Adam Keilen Estate Planning

The Goal of an ILIT is to Avoid Inclusion in the Insured’s Gross Estate: For a typical life insurance policy, the death benefit proceeds are includible in a decedent’s gross estate for estate tax purposes. IRC 2042. Further, in Michigan, the cash value of a life insurance policy is not protected during the insured’s lifetime from the insured’s creditors. MCR 3.101(G)(1)(a) allows the garnishment of all tangible and intangible property belonging to a principal defendant which is in the possession of the garnishee defendant, which included cash value of life insurance. Life insurance proceeds are not exempt. However, a properly drafted and funded ILIT excludes the death benefit proceeds of a life insurance policy (held by the ILIT) from the insured’s gross estate for estate tax purposes upon the insured’s death, and the cash value of the life insurance policy is protected from the insured’s creditors during his or her lifetime.

Who Needs an ILIT:

Insured with Taxable Estate: ILITs are typically used when the insured has a gross estate in excess of his or her federal estate tax exemption equivalent. In 2015, the federal estate tax exemption equivalent is $5,430,000.

Insured is Concerned with Asset Protection: Even for the insured who does not have a taxable estate, an ILIT can benefit those concerned with creditor protection. This includes those in a profession with malpractice liability (for example, doctors, dentists, accountants, lawyers, etc.), business owners, and those who are highly leveraged.

Control of the ILIT: To avoid estate taxation in the insured’s estate, there must be certain restrictions on the insured’s access to and control over the life insurance policy during the insured’s lifetime. The ILIT must be crafted such that the insured does not possess or retain any incidents of ownership over the policy, or possess any powers over the ILIT or the trustee that would result in the ILIT assets and death benefit proceeds being included in the insured’s gross estate for estate tax purposes. An ILIT must be drafted in such a way as to not give the insured the power to:

  • Change the beneficiary;
  • Surrender or cancel the policy;
  • Assign the policy or revoke an assignment;
  • Pledge the policy for a loan;
  • Borrow against the policy;
  • Change the time or manner of enjoyment of the policy; or
  • Holding a reversionary interest in the policy or proceeds greater than 5%.

Three-Year Transfer Rule: If an existing life insurance policy is transferred to an ILIT, the death benefit proceeds are includible in the insured’s estate for 3 years from the date of the transfer. IRC 2035. This can be avoided by having the ILIT purchase the policy for actual cash value (full consideration).

Leveraging GST and Gift Tax Exemptions: An ILIT allows the insured to leverage the use of his or her GST and gift tax exemptions because these exemptions need only be allocated to the premiums paid. Allocation of GST and gift tax exemption to these gifts will fully exempt the full death benefit proceeds received on the policy from estate tax and GST tax.

Downside of Irrevocability: The irrevocability of an ILIT can limit the flexibility of the policy and its uses, especially during the insured’s lifetime. Further, the insured may be concerned with irrevocably naming beneficiaries of their estate and the terms for inheritance.

Who Shall Serve as Trustee: It is permissible for the insured’s spouse to serve as trustee without causing estate tax inclusion in either of their estates. Additionally, careful drafting should be taken to not trigger inclusion by giving the insured the unfettered right to remove and replace the trustee. Limiting trustee replacement to a professional trustee or an individual who is not related or subordinate to the insured under IRC 672(c) would be best.

Avoid Reciprocal Trusts: Reciprocal trusts created by spouses for each other result in estate tax inclusion under IRC 2036. To avoid this rule, the dispositive terms of the trusts must contain meaningful differences. Areas to consider having meaningful differences include selection of trustees, distribution standards and timing, ages of distribution to beneficiaries, lifetime and testamentary powers of appointment, and permissible beneficiaries.

Payment of Premiums: Typically an ILIT will only own an insurance policy. When premiums become due, the ILIT must generate the cash to pay the premium.  To avoid estate tax inclusion, it is critical that the insured not pay the premiums directly to the insurance company. The insured may, however, make cash gifts to the ILIT so that the Trustee may pay the premiums. Contributions to the trust should be from a non-beneficiary to avoid estate taxation under 2036 (transfer with a retained life estate). Thus, if husband creates an ILIT for the benefit of his wife and children, he should write a check from an account in his name alone, and not from a joint account.