Irrevocable Life Insurance Trust

<div class="Section1">An irrevocable life insurance trust (ILIT) is a trust funded primarily by life insurance which cannot be modified, amended or revoked without the permission of the beneficiary. It is mechanism used in estate planning in which a grantor effectively removes all of his rights of ownership to the assets of the trust.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     https://www.irs.gov/tax-professionals/tax-code-regulations-and-official-guidance.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The irrevocable life insurance trust is created during the grantor’s life. The trustee purchases a policy on the life of the grantor. The trust should be the owner and premium payor of the policy and the grantor/ insured should have no ownership interests in the life insurance policy. The beneficiaries of the trust are often family members of the grantor—a spouse, children, grandchildren, and spouses of children and grandchildren.<br /> <br /> Because the trust is funded with a life insurance policy on the grantor’s life, funding may be accomplished using an existing policy that the grantor gifts to the trust. Unless the insurance policy is paid up, the trustee will have to pay the annual premiums. The grantor usually makes annual transfers of cash to the trust so that the trustee can pay the premiums.<a href="#_ftn1" name="_ftnref1">¹</a> These annual transfers are gifts, meaning that the gift tax annual exclusion may be available to shelter the annual cash transfers from the federal gift tax up to the annual exclusion amount ($19,000 for 2025).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.    IRC § 677.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.    https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes.<br /> <br /> </div>

<div class="Section1"><br /> <br /> When funding an ILIT, various forms of life insurance can be used that will minimize both income taxation and estate taxation at death. The first type of life insurance is term life insurance. This can be in the form of annual renewable term, decreasing term or level premium term, but the primary distinguishing feature of term life insurance is that it will only last for a designated amount of time. It is rare to fund an ILIT with this type of insurance because of the short duration of the policies, which makes it possible that the grantor will outlive the funding mechanism of the trust.<br /> <br /> Whole life insurance is more commonly used to fund an ILIT. Whole life insurance can be in the form of single premium whole life insurance (in which a lump sum payment is paid upfront) or a policy on which premiums are paid on a permanent basis until the policy is “paid up.” There is a buildup of cash value in the policy which varies by insurance carrier and by year. Depending upon the chosen policy, universal life insurance and indexed universal life insurance have a unique feature which allows the premiums to be paid on a level (equal) basis, or the premiums can be adjustable. This type of policy always carries a cash value that is built up within the account, and this cash value is typically linked to a particular fixed rate or index option(s).<br /> <br /> Variable life insurance is another type of insurance that can be used to fund an ILIT. Variable life insurance premium structures are similar to the universal and indexed universal life policies, but variable life insurance policies are distinguished by the cash build-up, which is dependent upon the performance of the investment portfolio of the insurance company.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 7702.<br /> <br /> </div>

<div class="Section1"><br /> <br /> An ILIT can present many advantages to individuals who possess significant amounts of life insurance. One of the primary benefits is that the ILIT strategy can help reduce estate tax liability, as discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="232">232</a>, as it removes life insurance from the decedent&rsquo;s gross estate. Further, the ILIT strategy may reduce the amount of insurance coverage needed by the insured, since his or her estate tax bill will be lowered due to funding through an ILIT.<br /> <br /> Creating an ILIT also helps the insured protect the cash value of the life insurance policy from creditors. In an ILIT, the grantor no longer legally owns the assets or controls the trust. Due to this loss of ownership and control, a future creditor cannot satisfy a judgement against assets held in an ILIT.<br /> <br /> Another advantage of an ILIT is that it can allow the grantor to control when, how and why the beneficiaries receive the proceeds of the life insurance policy. This is set out in the trust documents. Upon the insured&rsquo;s death, the life insurance proceeds will pay to the trust. The trust documents will then detail the disbursement of the funds.<br /> <br /> An ILIT will also help protect the benefits of a beneficiary who is receiving government aid, and prevents the court from controlling insurance proceeds if a beneficiary is incapacitated. This can be accomplished by naming the trust as the beneficiary of the insurance policy. Most insurance companies will not knowingly pay to an incompetent or disabled person, but if the trust is the beneficiary, the trustee can use the funds to provide for that individual without court interference.<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> An ILIT may be either &ldquo;funded&rdquo; or &ldquo;unfunded.&rdquo; In a funded trust, the trust owns income-producing assets, such as securities, in addition to the life insurance policy. Income generated by these underlying investment assets may be used to pay the insurance premiums. The grantor not only transfers the life insurance policy to the trust, but also transfers other property to the trust from which the premium payments may be made. The major drawback of the funded life insurance trust is that the trust income may be taxed to the grantor if it can be used to pay premiums on a policy on the life of the grantor or his or her spouse.<br /> <br /> In an unfunded trust, the only asset owned by the trust is the life insurance policy. The trustee has no other property in the trust with which to pay premiums, and is dependent on annual cash gifts from the grantor. This results in the need to transfer funds into the trust to be used to pay the premiums on the policy. Gifts of premium dollars to the trust by the grantor may be sheltered from gift tax using the annual gift tax exclusion. Gifts to an unfunded trust, however, will be considered present interest gifts, qualifying for the annual gift tax exclusion only to the extent that the trust beneficiaries are given immediate withdrawal rights with respect to the amounts transferred to the trust (<em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="236">236</a> on gifting as a method for funding an ILIT).<br /> <br /> </div><br />

<div class="Section1"><br /> <br /> Typical parties to an irrevocable life insurance trust include a grantor, trustees and beneficiaries. The grantor typically creates and establishes the funding mechanism for the trust. In the case of an ILIT, the funding source would be a life insurance policy.<br /> <br /> Gifts or transfers made to the ILIT are permanent, and the grantor relinquishes control over transferred assets to the trustee. The trustee manages the ILIT and is the individual holding the property in trust. Beneficiaries are those entitled to receive the benefits of the trust.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Restatement (Second) of Trusts § 3 (1959).<br /> <br /> </div>

<div class="Section1"><br /> <br /> While life insurance proceeds are an income tax-free benefit,<a href="#_ftn1" name="_ftnref1">¹</a> they are includable in the insured’s estate for estate tax purposes if the proceeds are payable: (1) to the estate, either directly or indirectly; or (2) to named beneficiaries, if the insured possessed any incidents of ownership in the policy at the time of death.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> For individuals with a large estate tax liability, using insurance proceeds can worsen this tax burden by inflating the insured’s gross estate for federal estate tax purposes.<a href="#_ftn3" name="_ftnref3">³</a> Using an ILIT can allow death proceeds from the life insurance to pass into the trust, where funds can be distributed income tax-free to the trust beneficiaries as directed by the trust documents. By avoiding the insured’s estate, insurance proceeds in an ILIT do not increase the estate of the decedent, thus avoiding additional estate tax.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 101(a)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 2042.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 2206.<br /> <br /> </div>

<div class="Section1"><br /> <br /> The role of a trustee is extremely critical in an ILIT if the tax advantages of the structure are to be realized. The integrity of the individual or the institution must be a primary priority because of their role as fiduciary and controller of the trust. The trustee can be the trust creator or family members, unrelated person(s), an institutional or corporate trustee such as a trust department of a banking institution or any combination of the these options. When choosing a trustee, it is important to consider the experience, knowledge and expertise of the trustee.<br /> <br /> The trustee should be one with the experience and capacity to handle the types of investments contained in the trust, and must have the necessary skills to sufficiently administer the trust for the benefit of the trust beneficiaries.<br /> <br /> Choosing the appropriate trustee also dictates whether the income from the trust will be treated as taxable income to the grantor. This can occur because the trustee has a relationship with the grantor that is prohibited by statute or because the trustee administers the trust in a way designed to circumvent tax regulation and benefit the grantor.<a href="#_ftn1" name="_ftnref1">¹</a> This problem will occur if the trustee is considered to be related or a subordinate party to the grantor.<a href="#_ftn2" name="_ftnref2">²</a> However, this problem will not occur if the related or subordinate party is also considered to be an adverse party. An adverse party is one that has a beneficial interest in the trust, one who has the power of appointment over trust assets or one whose interest would be adversely affected by the exercise or the non-exercise of a power held by the non-adverse party.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 671(a), Rev. Rul. 2004-64, 2004-2 CB 7.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 674(c).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 672(a-b).<br /> <br /> </div>

<div class="Section1"><br /> <br /> Gifts made to an ILIT typically come in the form of the grantor paying premiums on the life insurance policy, and must be made correctly in order to avoid creating gift tax liability. If the amount of the premiums is directly transferred to the trustee in cash, gift tax liability can arise. A grantor can make annual tax-free gifts up to annual gift tax exclusion amount ($19,000 in 2025, or $38,000 for spouses that consent to gift splitting)<a href="#_ftn1" name="_ftnref1">¹</a> to each beneficiary of the trust.<br /> <br /> For the premium payments to qualify for the annual gift tax exclusion amount, rather than the grantor making a gift directly to each beneficiary to pay the premiums, the funds are given to the trustee for the benefit of each beneficiary.<a href="#_ftn2" name="_ftnref2">²</a> The trustee then notifies each beneficiary that a gift has been received on their behalf and the trustee pays the premium on the insurance policy. To avoid gift tax liability, it also is crucial that the trustee, using what is known as a “<em>Crummey</em>” letter,<a href="#_ftn3" name="_ftnref3">³</a> notify the beneficiaries of the trust of their right to withdraw a share of the contributions within a 30-day period. After 30 days have expired, the trustee can then use the contributions to pay the insurance policy premium. The <em>Crummey</em> letter qualifies the transfer for the annual gift tax exclusion by making the gift a present interest gift (rather than future interest gift) thus avoiding the need in most cases to file a gift tax return.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     <em>See</em> IRS FAQ, available at https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Let. Rul. 9809032.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     <em>Crummey v. Commissioner</em>, 397 F.2d 82, 68-2 U.S. Tax Cas. (CCH) ¶ 12541, 22 A.F.T.R.2d (P-H) ¶ 6023 (9th Cir. 1968).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     Treas. Reg. § 25.2512-6(a).<br /> <br /> </div>

<div class="Section1"><br /> <br /> 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.<br /> <br /> 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 &ldquo;special&rdquo; 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.<br /> <br /> 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&rsquo;s lifetime, tax liability may arise under the transfer for value rule unless one of the exceptions to the rule can be satisfied (<em><em>see</em></em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a> for more information on the transfer for value rule).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101.<br /> <br /> </div></div><br />