238 / How can an irrevocable life insurance trust (ILIT) be terminated?

In most situations, termination procedures are predicated upon the trust language coupled with any applicable specific state regulations, but there are some general guidelines that can be followed when a grantor wishes to terminate an ILIT. There are many reasons to terminate an ILIT, such as when the life insurance policy has become too expensive to maintain or the policy has lapsed. The grantor may also wish to terminate if he or she is no longer satisfied with the terms of the trust, or if the federal estate tax exemption has increased substantially since the trust was created (or the grantors estate has decreased) and as a result, no estate tax issues exist to warrant continuation of the ILIT.

A grantor can ensure that his or her ILIT can be terminated by including terms in the governing trust document to terminate it. To allow for flexibility in terminating the trust, the governing instrument may contain a provision enabling the trustee or a “special” trustee to terminate it for specified reasons. This type of provision should be coupled with trust language outlining the provisions of termination. Even with this language, there is no guarantee that a court would agree that the ILIT should be terminated if the termination was challenged.

There are also tax considerations to be weighed when terminating an ILIT. Generally, the proceeds of a life insurance policy that are received due to the death of the insured are not taxable. But if the policy is sold during the insured’s lifetime, tax liability may arise under the transfer for value rule unless one of the exceptions to the rule can be satisfied (see Q 279 for more information on the transfer for value rule).¹