What is an Irrevocable Life Insurance Trust (ILIT)?

For individuals with large estates and sizable life insurance policies, an irrevocable life insurance trust can provide considerable benefit. What is an irrevocable life insurance trust? Here’s an overview of how this estate planning tool works. 

What is an Irrevocable Life Insurance Trust (ILIT)?

An irrevocable life insurance trust (or ILIT) is an irrevocable trust created during your lifetime. Because it is irrevocable, it cannot be altered or undone once created. This trust owns and controls one or more term or permanent life insurance policies. Upon your death, it can also manage and distribute the policy proceeds according to your wishes.

The main purpose of a life insurance trust is to avoid estate taxes on the policy benefits. 

An ILIT can own both individual and second-to-die insurance policies. Second-to-die policies insure two lives and pay a death benefit only upon the second death.

How Does an ILIT Work?

Once you create an ILIT, the trust acts as the owner of your life insurance policies. The death benefits are no longer considered part of your estate for tax purposes. Assets in the trust will not be subject to probate, meaning your heirs will not have to go through the California probate court to receive the death benefit.

Here’s a breakdown of how the ILIT process works:

1. Set up an irrevocable trust.
2. Transfer your existing life insurance to the trust, or have the trust “buy” a new policy. Then fund the trust so it can pay the premiums on your behalf.
3. When you die, the policy pays the life insurance death benefit to the trust, which is the beneficiary of the life insurance policy. The benefit is excluded from your taxable estate. 
4. The ILIT distributes the death benefit to your trust beneficiaries according to your wishes, as outlined in the trust. 

Crummey Powers

One last thing to understand is the importance of adding Crummey powers to your irrevocable life insurance trust. When you fund the trust, the money you transfer into it for premium payments is considered a gift by the IRS and is subject to a gift tax. But you can avoid gift taxes on up to $16,000 in annual gifts by adding “Crummey powers” to your trust. 

Crummey powers are a provision in certain irrevocable trusts that permit trust beneficiaries to withdraw gifts you make to the trust for a set period of time. Generally, you do not want the beneficiaries to make withdrawals as those funds are used to pay the premiums on the policy, but they need to be given the option to make such withdrawals.

Be sure to work with an experienced estate planning attorney who can include these provisions in your trust.

Who Benefits from ILITs?

Who benefits most from an irrevocable life insurance trust? An ILIT may be most appropriate for the following types of people:

• Individuals with large estates: ILITS are best suited for high-net-worth individuals whose assets will be subject to high federal estate taxes. For 2022, the estate tax exemption amount is $12.06 million per individual; in 2023, it will increase to $12.92 million.
  
• Business owners: If the bulk of your assets are in a business, there may not be enough cash to pay estate taxes and other expenses, forcing your heirs to sell the business. An ILIT can provide the immediate cash your heirs may need to pay estate taxes and trust administration expenses so they can avoid this difficult position.
• Individuals who want to equalize inheritances: If your estate contains a large asset that can’t be evenly distributed between multiple beneficiaries, like a family business, then the ILIT can help equalize the inheritance. One child can receive the family business and the other child can receive the proceeds from the ILIT to make the inheritance equal.

Disadvantages of an ILIT

An ILIT can provide multiple advantages, but be aware of the following disadvantages and risks: 

1. Cost: The cost of creating an ILIT includes paying an estate planning attorney to draft the trust. You may also need to file a gift tax return the year you fund the trust and possibly in future years. 
2. Inflexibility: An ILIT is irrevocable and cannot be changed or undone. It lacks the flexibility of a revocable trust. 
3. Lookback period: If you die within three years of transferring a life insurance policy into an ILIT, the IRS will count the death benefit as part of your estate for tax purposes.
4. Tax Risk: If you’re using a permanent life insurance policy, be careful to avoid contributing more than the federal limit to the cash value of the policy. If you do, the IRS will consider your policy a modified endowment contract and tax it at a higher rate.

How to Set Up an ILIT

You’ll need to decide who will serve in the following roles to set up your ILIT: 

1. The grantor: The insured individual whose death prompts the death benefit payout. 
2. The trustee: The administrator of the trust; this person cannot be the same as the grantor.
3. The trust beneficiaries: The recipients of the funds from the trust.

Once you set up your trust, you can purchase a life insurance policy through the trustee if you don’t already own life insurance. You are the insured, and the trust is the policyholder. The trust will make the premium payments, not you.

If you already have a life insurance policy, you can transfer it to the trust with a change of ownership form. Contact your insurance company to make the ILIT the owner of your policy. Remember that to successfully get the tax benefits of a life insurance trust, it must be set up at least three years before you die because of the IRS look-back period. 

When setting up an ILIT, be sure to consult with an experienced estate planning attorney who can help you consider all of the tax implications and draft the trust appropriately. 

If you have any questions about irrevocable life insurance trusts, feel free to contact our office.

Law Offices of Daniel A. Hunt

The Law Offices of Daniel A. Hunt is a California law firm specializing in Estate Planning; Trust Administration & Litigation; Probate; and Conservatorships. We've helped over 10,000 clients find peace of mind. We serve clients throughout the greater Sacramento region and the state of California.