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 IRREVOCABLE LIFE INSURANCE TRUSTS
If you own a substantial life insurance policy and want the proceeds to pass to your beneficiaries tax-free, then you may need an Irrevocable Life Insurance Trust (“ILIT”). An ILIT is a trust which owns life insurance policies, and thus removes the insurance proceeds from your taxable estate.
Even with a Revocable Living Trust, an estate over $2 million ($4 million for couples) will face federal estate taxes at rates starting at 41% to as high as 46%. If you own a life insurance policy, the proceeds will be added to your taxable estate upon death, subject to federal estate taxes. If the policy is owned by an ILIT, it will pass to your heirs tax-free. Life insurance proceeds pass to a beneficiary outside of probate, but without an ILIT, are still includable in your taxable estate.
An ILIT is irrevocable, which means that it cannot be changed once it has been created. The ILIT is established and then funded with one or more life insurance policies. The ILIT is named as beneficiary of the policy, but the terms of the ILIT determine who will actually receive the policy proceeds. At convenient annual intervals you (the insured) will transfer money to the ILIT for the trustee (someone other than you or in your immediate family) 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 $12,000 annual gift tax exclusion. To create this real access to the transferred funds, the trustee writes a letter to the beneficiaries if they are adults or their parents or guardians, if they are minors, to notify them that the transfer has taken place and that they are entitled to the funds if they so choose to receive them. The beneficiaries have a short time in which to exercise this right, usually between 30 and 60 days. If they do not elect to take the funds, the funds will be used to pay the insurance premiums. 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.
Thus, an ILIT will increase the liquidity of the estate without requiring the forced sale of illiquid assets; it will increase the size of the estate without increasing estate taxes; it will allow for transfers out of the estate with minimal or no gift tax consequences; and it will provide for ongoing management of assets under the terms of the trust.
There are a couple caveats to remember when using ILITs: (1) 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; and (2) The transfer of an existing life insurance policy to an ILIT may result in the policy proceeds being included in the taxable estate if the death of the policyholder occurs within three (3) 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. |
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