Estate planners usually encounter some form of insurance when examining a client’s schedule of assets. The primary utility of life insurance in the tax planning context is the opportunity it provides to transfer future benefits at a reduced present cost. An irrevocable life insurance trust (ILIT) is a useful estate planning device used to manage life insurance policies and dispose of policy proceeds. ILITs are very popular because of their enormous transfer tax savings.
When the insured is the owner of a life insurance policy, the proceeds of the policy will be subject to estate tax when the insured dies. Rather than the insured being the owner of a life insurance policy, an ILIT serves as the owner and beneficiary of the policy.
An ILIT is an irrevocable, non-amendable trust established for the purpose of being the owner and beneficiary of one or more life insurance policies. When properly drafted, the ILIT allows the proceeds of the life insurance policy held in the trust to avoid estate taxation.
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Although transfer tax savings is the primary reason for creating life insurance trusts, there are also non-tax advantages of holding a life insurance policy in trust. The trust provides liquidity for taxes, financial support for the insured’s beneficiaries, spendthrift protection and can even provide meaningful advantages when planning for elective share rights of a surviving spouse.
An ILIT is usually established by formation of the trust, followed by the contributor (usually the insured) assigning an existing insurance policy to the trust or the trustee of the trust buying a policy directly from an insurance company. The insured retains no benefits in the trust.
If the trust only contains a life insurance policy or policies, during the insured’s lifetime, premiums are typically paid by the insured making annual gifts to the trustee of the trust in an amount sufficient for the trustee to pay the premiums of the life insurance policy. At the insured’s death, the insurance company pays the policy proceeds to the trust, and the trust assets are then administered and distributed in accordance with the terms of the trust instrument.
If the insured’s estate is in need of liquidity, the trustee may lend money to the insured’s estate or use the proceeds to purchase assets from the insured’s estate, provided the trustee has such authority under the trust instrument.
Establishing the Trust
Establishing an effective life insurance trust always begins with a properly drafted trust instrument. Immediately thereafter, the life insurance policy should be transferred to the trust and consideration should be given to the ongoing trust administration issues such as income tax reporting and payment of premiums.
Although these tasks may appear basic and rudimentary, they are critical to the success of the trust and for the estate, gift, and generation-skipping transfer tax benefits to be realized.
Purchase or Assignment of a Life Insurance Policy
The main purpose of creating an insurance trust is for the trust to hold life insurance. The trust can acquire ownership of the life insurance policy by either purchasing a policy or by the grantor transferring an existing policy to the trust by gift. Once the trust becomes the owner of a life insurance policy, it should immediately name itself as the beneficiary of the insurance policy.
If the trust is the applicant, owner and beneficiary of the life insurance policy from the outset, none of the death benefits will be included in the grantor’s gross taxable estate because the grantor has no “incidents of ownership” over the policy.
In cases where an existing policy is transferred to the trust by the grantor, the grantor must survive for three years after the insurance is transferred to achieve estate tax exclusion.
Funded v. Unfunded Trust
An ILIT may be funded or unfunded.
A funded trust contains assets other than life insurance policies. The assets are often investment accounts held to produce sufficient income to pay the insurance premiums. Funding the trust has the additional benefit of allowing future appreciation of the assets to be sheltered from estate taxation.