Question 34: What Is an ILIT?
ILIT stands for Irrevocable Life Insurance Trust. This is an estate planning technique, often used to ensure that life insurance proceeds will not be subject to federal estate tax. The ILIT is used to hold a life insurance policy or policies outside of an estate.
If you own a life insurance policy, the Internal Revenue Service will add the amount of the life insurance benefit to the amount of your taxable estate and calculate the tax based upon that value. This may seem unfair since the death benefit is usually not paid to your estate, but to someone else instead.
The ILIT, if properly prepared, creates a separate legal entity from your estate. Since the life insurance will be part of the ILIT and not part of your estate, it will not be subject to estate tax.
Why Should I Consider Having an ILIT?
You should consider having an ILIT if you meet either of these two conditions:
- The value of everything you own (called your “estate”), including the death benefit of your life insurance policies, will be over $5.49 million at the time of your death if you are single, or over $10.98 million at the time of your death if you are married and if you have a properly drafted Will or Revocable Living Trust that utilizes both spouses applicable exclusion amounts ($10.98 million in 2017); or
- Your estate consists of a business or other substantial assets that cannot be easily liquidated (converted to cash). If the size of your estate is over a certain amount, there may be taxes that must be paid to the IRS. The IRS wants payment in cash. If your estate does not include sufficient cash to pay the taxes, something will have to be liquidated (sold). An ILIT holding sufficient amounts of life insurance will provide the cash needed to pay estate taxes and the expenses of administering your estate.
How Does an ILIT Work?
To work, an ILIT must involve the creation of an Irrevocable Trust. This means that a Trust is created, and the Trust cannot be revoked, modified or changed after it is created. Thoughtful care and planning must go into the creation of such a Trust.
Additionally, neither you nor your spouse (if also an insured) can serve as Trustee. In order to exclude the ILIT from your estate, you may not have any “incidents of ownership.” After the Trust is created you cannot control it. Trustees are most often the beneficiaries of the Trust or a financial advisor.
The Trust can be created so that life insurance is obtained with a single premium, or with premiums paid over a period of time. If premiums are paid over a period of time, a special method is used to fund the ILIT. Using a Crummey power, money is gifted to the Trustee who in turn pays the insurance company. Whenever a gift is made, the trustee must send a special letter, called a “Crummey letter,” to the beneficiaries of the Trust letting them know that they have the opportunity to remove their portion of the gift within a specified period of time. When they don’t exercise their option, your Trustee will use the money to pay your insurance premium.
Benefits of an ILIT
Even with a properly drafted Will or Revocable Living Trust, an estate over $5.49 million ($10.98 million for couples) will face federal estate taxes at rates of 40 percent. If you own a life insurance policy, the proceeds will be added to your taxable estate upon death, subject to federal estate taxes.
At convenient annual intervals you will transfer money to the ILIT for the Trustee to use to pay the insurance premiums. Ordinarily this money would be subject to gift taxes, but if the beneficiaries of the ILIT have real access to these funds, the transfer will qualify for the $14,000 annual gift tax exclusion. When the benefits of the ILIT are explained, beneficiaries almost never demand disbursement.
Upon your death, the policy proceeds are paid to the ILIT, and are not a part of your estate. The funds can be used to increase the liquidity in the estate by purchasing estate assets for cash, they can be “loaned” to the estate to pay off liabilities, they can be held in Trust for the beneficiaries, or they can be distributed pursuant to the terms of the ILIT.
The ILIT provides you control over how proceeds from your life insurance policy are spent. With the ILIT, you control who receives the proceeds, and how they receive it. Whatever distribution strategy makes most sense for you and your loved ones; the ILIT gives you the opportunity to put it into effect.
Since the cash value of the insurance policy is held by the ILIT, it is typically out of reach of your creditors.
Caveats of an ILIT
There are a couple caveats to remember when using ILITs:
- The ILIT is a taxable entity that must file its own separate tax returns each year. However, the returns are generally simple and can be handled easily by an accountant.
- The transfer of an existing life insurance policy to an ILIT may result in the policy proceeds being included in the taxable estate if your death occurs within three years of the transfer. The recommended approach is to have the ILIT acquire a new policy and then the three-year restriction would not apply.
Estate planning is a complex process. Although an ILIT is easy to understand, the failure to follow specific IRS rules could be costly to your estate. For this reason, it’s important to have a qualified estate planning attorney working on your side.