Irrevocable Life Insurance Trust

The irrevocable life insurance trust (ILIT) provides an accessible means of producing estate-tax-free dollars that is without equal in terms of the potential savings measured against what the grantor has to give up in return.

Basics of Life Insurance and Estate Tax

Estate taxation of life insurance proceeds centers around ownership of the policy and payment of the proceeds. If the proceeds of a policy are paid to the insured person's estate, then they will be fully subject to tax on the insured person's death. The term "estate" in this context includes the executor of the estate, creditors of the estate, or any other beneficiary arrangement that requires the proceeds to be used to pay a debt, claim, expense, or liability of the insured person's estate.

For instance, it is not unusual for an insurance policy to be taken out on a person, either by the person's creditor or by the person himself at the request of the creditor, to cover payment of the person's debts should he die before the debt is paid off. If that happens and the policy proceeds are used to pay the debt, they will be subject to estate tax on the person's estate, regardless of who owns the policy.

This does not mean that proceeds of a life insurance policy cannot ever be used to pay the deceased person's estate taxes, as they often are. It does mean that if there is an obligation to use the proceeds for that purpose, they will be subject to a tax. However, if a beneficiary other than the "estate" receives the proceeds and decides to loan them to the estate for taxes, or if the beneficiary of the insurance policy ahs inherited other assets and does not want to sell them, certainly she can instead decide to use the insurance proceeds to pay the taxes.

The other cause of estate taxation of life insurance is ownership of the policy. Many people confuse owner with beneficiary. The beneficiary of a policy is not necessarily the owner. The owner is the one who has the right to borrow against the policy, the right to name or change the beneficiary, the right to cancel or surrender the policy, exchange the policy, etc. The tax code and regulations make it clear that if the insured person holds any of these incidents of ownership, the full policy proceeds will be included in his estate. And this can be the case even if the incidents of ownership are held by an entity that the insured controls, such as a corporation or a trust.

Note, however, that this does not automatically mean the proceeds will actually produce a tax. There could be other factors that would reduce or eliminate the taxes. For instance, is a person owns a policy on her own life under which her spouse is named as beneficiary, the proceeds are fully included in her estate on death, but there will be no tax on the proceeds, since the receipt of funds by the spouse qualifies for the estate tax marital deduction. The problem in that event is the inclusion of those funds in the estate of the surviving spouse, to the extent of those funds remaining at death. This is where the ILIT can save the day and the taxes.

ILITs

The ILIT should be irrevocable, because no one should be treated as the owner of the trust. The purpose of this is to offer the opportunity of escaping taxes not just in one estate, but in several estates. The ILIT is typically a trust for the benefit of the spouse and/or children. If the individual already has a life insurance policy, ownership of the policy can be assigned (transferred) to the ILIT. This is done by signing an irrevocable assignment form available from the insurance company or from the agent. Proper completion of the form will indicate that the ILIT will be the new owner and the beneficiary.

When an existing policy is transferred to an ILIT the tax code provides that if the insured/transferor dies within three years of the date the policy is transferred, then the proceeds of the policy will be included in his estate for tax purposes. Note that this does not mean the beneficiary will not receive the money, it merely means that the insured's estate tax return will report the proceeds as part of the estate in computing the tax.

For this reason, where the insured has a spouse, the ILIT will usually contain a fail-safe clause, providing that if the insured/transferor dies within three years of the transfer of any policy to the ILIT, then the proceeds of such policies will be held separately under the ILIT and administered for the surviving spouse in a way that will qualify for the estate tax marital deduction. This arrangement will render those proceeds tax free if the insured dies within three years and is survived by is spouse. The trade-off is that whatever is left of these proceeds will then be included in the estate of the surviving spouse. If the insured dies after the crucial three-year period, the fail-safe clause would not apply and the entire trust could provide for the family.

The three-year concern is completely avoided if the policy is purchased at the outset by the trustee of the ILIT. This way there is no policy transfer, so no three-year period to worry about.

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