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Irrevocable Life Insurance Trusts (ILITs) — What They Are and Why They Are GREAT!

By: Bradley R. Coppedge, Esq.

Let’s start with a brief trust primer. Virtually all trusts can be identified as one of two types. A Revocable Trust, or an Irrevocable Trust. Each is exactly what it sounds like. A Revocable Trust may be revoked or terminated after its creation, generally by the person who created it. Conversely, an Irrevocable Trust may generally not be revoked after its creation. (You may hear other terms ascribed to trusts, for example, an Inter-vivos Trust, which simply means it was created by someone during the creator’s life, or a Testamentary Trust, which was created by someone under his or her Last Will and Testament. But even each of those will either be revocable or irrevocable.)

What we will discuss is this article is a Life Insurance Trust– what they are, their general purposes, benefits and their tax structure. Most commonly they are irrevocable and are referred to as an Irrevocable Life Insurance Trust or “ILIT”. However, there are instances where a revocable life insurance trust might be used. We’ll talk about why ILITs are generally irrevocable below.

While there are countless reasons or scenarios in which an ILIT might be beneficial, some of the most common reasons to create an ILIT as part of one’s estate plan are as follows::

1) To provide creditor protection. If the life insurance policy is held in an irrevocable trust, the beneficiary will be the trust, and creditors will not be able to reach the proceeds. Thus, it protects not only from creditors of the decedent, but from future creditors so long as the proceeds remain in trust. This could include judgment creditors of a beneficiary, protection from a divorce of a beneficiary, protection from a future spouse of a beneficiary, etc. An ILIT, when properly formed, funded and operated is one of the single best creditor protection mechanisms that exist.

2) To provide estate liquidity. Particularly for individuals who have significant real estate or other non-liquid holdings, an ILIT can provide funds to loan to the estate to pay estate taxes, such that assets need not be sold at ‘fire sale’ values from the estate to pay estate taxes. In a taxable estate, the estate tax return is due 9 months after death, as are any federal estate taxes. Where a significant portion of the estate is illiquid investments such as real estate, or closely held businesses, it may be very difficult to come up with the taxes that quickly. An ILIT can greatly ease this burden. It provides options and flexibility for illiquid estates that likely do not otherwise exist.

3) To provide replacement assets. “Replacement assets” can mean several things. It can mean the replacement of the income that would be lost by virtue of the death of the insured. It can also mean the replacement of assets that might be gifted to charity under a Will or during life. (Let’s say you own as your primary asset of value 400 acres of pristine land, worth $4,000,000. You want to give it at your death to the Nature Conservancy or Land Trust for preservation, but also want to leave a meaningful inheritance to your children. An ILIT would be a great way to accomplish this).

4) To provide a continuing trust for beneficiaries. Let’s face it. Not all beneficiaries should receive his or her inheritance outright. This can be particularly true when it comes to a cash inheritance as would be received from insurance proceeds. The reasons against an outright inheritance may stem from a lack of maturity, drug or alcohol problems, foolish spending habits or countless other reasons. An ILIT allows the death benefit to go into a trust which can continue well beyond your death, with staggered payout ages for the beneficiary(ies), rather than having the proceeds payable directly to them upon the death of the decedent. (And if you have a beneficiary with special needs who receives governmental aid, keeping the proceeds in a purely discretionary trust will ensure it does not cause a loss of those benefits!).

5) To accomplish estate tax savings. I don’t generally like to use the term “loophole” when discussing tax law. But here’s the thing: ILITs are one of the few remaining loopholes in estate tax planning.

Let’s discuss how it works. (First off, I want to reiterate that the tax planning benefit of ILITs are but one of many reasons to create an ILIT, and in the majority of situations for my clients, it is not tax planning that motivates the use of the ILIT, it is instead personal planning, creditor protection planning, protection and structure for young or not-yet-mature-enough children, etc.)

So that said, here is how it works from a tax planning perspective. Let’s say you have a net worth of $12,000,000. You are in a taxable estate situation and can be expected to pay estate taxes at your death. Let’s now assume that you want (or even already have) some life insurance which you took out perhaps for one of the 4 reasons listed above. Let’s make one more assumption and assume the policy has a $3,000,000 death benefit. If you own this policy individually, then it will be included in your taxable estate for federal estate tax purposes, and would be expected to generate federal estate taxes of 40%, or $1,200,000. Now, as you may have heard it said before, life insurance is not taxable to the recipient. That is correct. However, it is included in your taxable estate, and will generate estate taxes in your estate to be paid from your other assets, even though the entire $3,000,000 passes to the named beneficiary without tax consequence to him or her.

IF, HOWEVER, you place this policy in an ILIT, then the value is not included in your estate. Saving you $1.2 million of federal estate tax in this example!! (Are there a few details to comply with? Well of course there are, but it’s really not that complex to accomplish this result with a competent attorney who specializes in estate planning).

The reason most life insurance trusts are irrevocable is a combination of all the reasons above. However, if one is trying to accomplish the estate tax savings goal by keeping the value of the policy out of the taxable estate of the decedent, then the trust must be irrevocable to accomplish this goal.

So, what about Revocable Life Insurance Trusts? When are they used? One very common usage is pursuant to a divorce. Oftentimes, when spouses get divorced, especially where they have minor children, the Court will order the non-primary custodial parent or the parent with the greater income to take out a life insurance policy, the main purpose of which is to ensure there are funds available to service child support (and/or alimony) payments to the ex-spouse if the obligor dies while payments are still due. Frequently, there will be ‘excess’ funds available under such a policy (i.e., the death benefit proceeds might often be more than the net present value of the remaining support payments). So let’s be realistic: oftentimes ex-spouse A doesn’t want to benefit ex-spouse B any more than is required by the court order. (Or, ex-spouse A may instead know that ex-spouse B is a spendthrift and that receiving a lump sum would result in its quick expenditure, which might not be beneficial for the children and their support). In these instances, provided your divorce attorney works to ensure the Order of the court will provide for it, we can create a life insurance trust to be the beneficiary of the policy, rather than the ex-spouse directly. This is not uncommon, though all too often the court orders an ILIT. Instead, what is often better for this purpose, is a revocable life insurance trust. That way, once your support obligations are satisfied, you can terminate the trust, take ownership of the policy, and use the policy for other purposes (or create a new trust for it. (If it is instead owned in an ILIT, then once your support obligations are satisfied, you can’t get the policy out—the trust is irrevocable.)

IN SUMMARY, there are countless uses for an ILIT, and the benefits they can provide are significant and meaningful. If you have questions, call me or call your estate planning attorney.