What Is An Irrevocable Life Insurance Trust

estate planning lawyer

An irrevocable life insurance trust, commonly called an ILIT, is a trust specifically designed to own life insurance policies on your life and keep the death benefit proceeds outside of your taxable estate. When you die, the trust receives the insurance payout tax-free and can use those funds to pay estate taxes, provide for beneficiaries, or accomplish other financial goals without the proceeds being subject to federal estate taxes.

Our friends at Theus Law Offices use ILITs regularly for clients whose estates exceed or approach federal or state estate tax exemptions. An estate planning lawyer experienced with insurance trusts can help you determine whether an ILIT makes sense for your situation and structure the trust to accomplish your specific objectives.

The Estate Tax Problem With Life Insurance

If you own a life insurance policy on your own life, the death benefit is included in your taxable estate even though the proceeds pass directly to beneficiaries outside of probate. This inclusion can push estates over exemption thresholds or increase estate tax liability significantly.

For example, a $5 million estate combined with a $2 million life insurance policy creates a $7 million taxable estate. If estate tax applies, nearly $800,000 might go to taxes instead of beneficiaries, assuming a 40% estate tax rate on amounts exceeding the exemption.

The irony is that life insurance intended to provide for your family or pay estate taxes actually increases estate tax liability when you own the policy. ILITs solve this problem by removing policy ownership from you entirely.

How ILITs Work

You create an irrevocable trust and name an independent trustee, typically a family member, friend, or professional trustee. The trustee applies for and purchases a life insurance policy on your life, or you transfer an existing policy to the trust.

Since the trust owns the policy rather than you, the death benefit isn’t included in your taxable estate when you die. The trust receives the insurance proceeds and distributes them according to instructions in the trust document.

You cannot serve as trustee because that level of control would include the policy proceeds in your estate. The trustee must be truly independent with discretion over trust decisions.

The trust is irrevocable, meaning you cannot modify or revoke it after creation. This permanence is necessary for estate tax exclusion. Any ability to change the trust or reclaim the policy would give you too much control and defeat the tax benefits.

Funding Premium Payments

Life insurance requires ongoing premium payments. Since the trust owns the policy but typically has no income, you make annual gifts to the trust to cover premiums.

These gifts would normally trigger gift tax consequences. However, Crummey withdrawal powers convert the gifts into present interest gifts that qualify for the annual gift tax exclusion.

Here’s how it works: The trust gives beneficiaries a limited time right, usually 30 to 60 days, to withdraw contributed amounts. The trustee notifies beneficiaries of their withdrawal rights through Crummey letters. Beneficiaries almost never exercise withdrawal rights, leaving the funds in the trust for premium payments.

ILIT premium payment process:

  • You gift money to the trust annually
  • Trustee sends Crummey notices to beneficiaries
  • Beneficiaries have limited time to withdraw funds
  • Beneficiaries don’t withdraw, leaving funds for premiums
  • Trustee pays insurance premiums from trust funds
  • Gifts qualify for annual exclusion due to withdrawal rights

According to the Internal Revenue Service, Crummey powers must be genuine rights with real withdrawal opportunities, not illusory provisions that beneficiaries cannot actually exercise.

The Three-Year Rule

If you transfer an existing policy to an ILIT and die within three years, the death benefit is pulled back into your taxable estate. This three-year look-back rule prevents deathbed transfers from achieving estate tax savings.

Having the ILIT trustee purchase the policy originally avoids this issue entirely. No transfer occurs because you never owned the policy. The trust is the initial and only owner.

If you must transfer an existing policy, understand that the estate tax benefits don’t materialize unless you survive three years after the transfer.

Using Death Benefits For Estate Liquidity

ILITs commonly provide liquidity for estate tax payments. The trust receives death benefits and can loan money to the estate or purchase assets from the estate, providing cash for tax payments without forcing fire sales of valuable property or businesses.

The trust might purchase a business interest from the estate at fair market value, giving the estate cash for taxes while transferring the business to intended beneficiaries through the trust structure.

Alternatively, the trust can loan funds to the estate for tax payments. The loan must carry adequate interest and be properly documented, but it provides needed liquidity while keeping wealth in the family.

Distribution Provisions

The trust document specifies how death benefits should be distributed. You might direct immediate distribution to beneficiaries, staged distributions at different ages, discretionary distributions based on needs, or continuing trust protection for beneficiaries’ lifetimes.

Continuing trusts protect proceeds from beneficiaries’ creditors, divorcing spouses, and poor financial decisions. The trustee manages funds and makes distributions according to standards you establish.

For example, the trust might provide for each child’s health, education, maintenance, and support with discretionary distributions for other purposes. This gives the trustee flexibility while providing guidance about your intentions.

Dynasty Trust Features

ILITs can be designed as dynasty trusts that benefit multiple generations. The death benefit stays in trust, with income and principal distributed to children, then grandchildren, then great-grandchildren for as long as state law permits.

This multigenerational approach removes substantial wealth from transfer taxation indefinitely. Each generation benefits from the trust without the assets ever passing through their taxable estates.

Dynasty planning requires careful drafting and works best in states with favorable trust laws and no state estate taxes.

Choosing A Trustee

The trustee manages the ILIT, pays premiums, sends Crummey notices, files trust tax returns, and distributes proceeds after your death. This is a significant responsibility requiring financial knowledge and attention to detail.

Family members can serve if they’re responsible and understand fiduciary duties. Professional trustees including banks, trust companies, or attorneys bring experience but charge annual fees.

Some people name family members as co-trustees with professionals to combine personal knowledge of family circumstances with professional administration capabilities.

Second-to-Die Insurance

Married couples often use second-to-die or survivorship life insurance in ILITs. These policies insure both spouses and pay benefits only after the second spouse dies.

Second-to-die policies cost less than insuring each spouse separately and align with estate tax timing. Unlimited marital deduction typically eliminates estate taxes at the first spouse’s death. Taxes become due when the second spouse dies, which is exactly when the policy pays.

Tax Reporting Requirements

ILITs are separate taxpayers and must obtain tax identification numbers. The trust files annual income tax returns even if it has minimal income from premium overpayments or invested funds.

Gift tax returns must be filed for years when contributions to the trust exceed the annual gift tax exclusion. Even if no tax is owed due to Crummey powers, the returns document the gifts and withdrawal rights.

Policy Ownership Verification

Insurance companies maintain ownership records and must be notified of policy ownership by the trust. The application should list the trust as owner and beneficiary from inception, or transfer forms must properly document ownership changes.

Keep documentation proving the trust owned the policy and that you had no incidents of ownership. This evidence protects against IRS arguments that proceeds should be included in your estate.

Modification Limitations

The irrevocable nature of ILITs limits flexibility. You cannot change beneficiaries, alter distribution terms, or retrieve the policy if circumstances change.

Some modern ILITs include trust protector provisions giving an independent party limited powers to modify the trust in response to changed circumstances or tax law changes. These powers must be carefully drafted to avoid giving you indirect control that would defeat tax benefits.

When ILITs Make Sense

ILITs benefit people with estates approaching or exceeding estate tax exemptions, substantial life insurance coverage needed for family security or business purposes, desire to protect insurance proceeds from beneficiaries’ creditors or poor decisions, and multigenerational wealth transfer goals.

The strategy makes less sense for people with small estates unlikely to face estate taxes, minimal life insurance needs, health issues preventing policy qualification, or preference for simplicity over tax optimization.

Professional Guidance

ILITs involve tax law, trust law, insurance regulations, and annual compliance requirements. Improper drafting or administration can result in losing intended tax benefits while bearing the costs and inflexibility of irrevocable trusts.

We help clients evaluate whether ILITs fit their situations and design trusts that accomplish their goals while maintaining compliance with complex tax rules. Life insurance represents significant financial resources that deserve thoughtful planning to maximize benefits for your family. Whether you’re considering an ILIT for the first time or reviewing an existing trust for proper administration, take time to understand how these powerful planning tools work and whether they serve your specific estate planning objectives.

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