What is an irrevocable life insurance trust (“ILIT”) and why would it be useful to me? This article explores the advantages and disadvantages of “ILIT”. The author concludes that an ILIT is both a cost effective and powerful tool for providing liquidity, paying estate tax, avoiding the Generation Skip Transfer Tax (GSTT), protecting beneficiaries from creditors and, for property owners, business, keep a business in the family. An ILIT is an irrevocable trust that has life insurance. Its primary purpose is to keep life insurance proceeds out of the settler’s estate. But it can also have a number of other purposes. Below are five reasons why one might consider an ILIT:
First, an ILIT is an attractive alternative to other estate planning strategies that involve transferring substantial amounts of assets out of one’s estate. Grantor Retained Annuity Trusts (GRATs), Charitable Master Trusts (CLTs), and other trust arrangements can involve the transfer of valuable business or income-generating assets that most, if not all, would hesitate to transfer out of your home. control (not to mention that ILIT usually costs less). However, transferring a life insurance policy is easier: while premiums must be paid, proceeds are only paid to beneficiaries upon death. Therefore, there is no great fear that the transfer of the policy will deprive the holder of the benefit of it.
Second, and more importantly, an ILIT that is properly structured provides liquidity. In an estate laden with illiquid real estate assets, an ILIT can be essential to pay off a large estate tax bill without selling assets. Consider the example of Robert and Sally Colmery. Throughout their lives, Robert and Sally amassed a small real estate empire throughout California, including a house in Palo Alto ($3,000,000), a vacation home in Tahoe ($1,000,000), and three rentals in San Mateo (along with a value of $2,500,000). Robert’s liquid assets were mostly spent at the end of his life, in the amount of $150,000. At the end of your and Sally’s lives, $3,150,000 of the estate will be subject to federal estate tax at a rate of 45%, and Robert and Sally’s children, Peter and Ruth, will not have enough cash to cover the account unless to sell some of the properties.
Now suppose that Robert establishes a qualified ILIT with a second-to-die insurance policy that names his children, Peter and Ruth, as remaining beneficiaries, and pays the premiums using his $13,000 annual gift tax exclusion. Robert structures the payment of the premiums with the help of an attorney so that they do not generate any gift tax using something called “rudepower of attorney. At the time of the second spouse’s death, the proceeds from the life insurance policy will pass free of estate taxes. As a result, Peter and Ruth are not required to sell the real estate when they inherit.
Third, an ILIT can be used to take advantage of the insured’s GSTT exemption. Any time we would like to give to our grandchildren or to people separated by 2 or more generations, the IRS imposes a second layer of taxes called the GST tax. However, there is an exemption of $3.5 million (in 2009) to which transfers to a trust can be allocated at the time of such transfer. If amounts transferred to a trust appreciate, the ratio of GSTT-exempt assets to non-exempt assets will remain constant. As a result, if the entire transfer to ILIT is allocated through the GSTT exemption (resulting in an inclusion rate of zero), all GST tax may be eliminated on the final distribution, even if the trust enjoys income. considerable over the years.
For example, suppose Robert establishes a generation-jumping ILIT. The ILIT uses life insurance proceeds to be invested in securities. All net income is payable to Peter and Ruth over their lifetimes, with remaining interest to Peter and Ruth’s children. Normally, Peter and Ruth’s children would be responsible for GST tax at the maximum applicable federal rate when they drink. However, if the ILIT is set up so that the inclusion ratio of the assets subject to the GSTT is zero, Peter and Ruth’s grandchildren will not pay GST taxes. If ILIT assets grow at a modest rate, the grandchildren would take potentially significant amounts without incurring any additional GST or estate tax liability.
Fourth, Robert can also protect his children and grandchildren from future creditors by including a wasteful provision in the trust document and giving the trustee discretion to make distributions to beneficiaries. If the ILIT is established with investments or cash that Robert does not need access to, the amounts can be protected from Peter and Ruth’s creditors.
Fifth, while ILIT is not modifiable, it can be structured so that beneficiaries have incentives to engage in positive behavior. The trustee may be instructed not to make distributions until the beneficiaries reach a certain age, or unless they have demonstrated positive behavior. For example, they may be ordered to withhold funds that would pay for a drug, gambling, or other addiction. The trustee may be ordered to pay for education, business planning, or other positive expenses that the beneficiaries may require.
The settler must be cautious when establishing an ILIT. Please note the following caveats: (1) there must be no property incidents by the owner/insured within 3 years of purchasing the policy; (2) The reciprocal trust doctrine may return policy proceeds to the estate (ie, when two spouses establish life insurance policies with each other at the same time); (3) Gift tax consequences may result with ILIT funded. Consider using the annual gift tax exemption with an unfunded ILIT. In conclusion, ILIT is a powerful and profitable estate planning strategy. Often more attractive to individuals than strategies that require the transfer of income-generating assets, ILIT can ensure that estate taxes are paid; that the beneficiaries are provided in accordance with the wishes of the principal; and that GST, inheritance or gift taxes be reduced or eliminated.
If you have questions about an ILIT, contact our Palo Alto living trust attorneys, serving Palo Alto, Menlo Park, Redwood City and surrounding areas.
WARNING: While we would love your business, we cannot represent you as an attorney until we can determine that there is no conflict of interest between you and any of our existing clients. We ask that you not send us any information (other than that requested on the “Contact Us” page) about any matter that may involve you until you receive a written statement from us that we will represent you.
DISCLOSURE UNDER TREASURY CIRCULAR 230: United States federal tax advice, if any, contained on this website and associated websites may not be used or relied upon in the endorsement, marketing, or recommendation of any entity, investment plan, or arrangement, nor is such advice intended or written to be used, and may not be used, by a taxpayer for the purpose of avoiding federal tax penalties.