Advantages of an Irrevocable Life Insurance Trust

Multi-millionaires have always had favorite ways of passing money to their heirs with minimal tax obligations. One of those ways, an Irrevocable Life Insurance Trust (ILIT), has been especially attractive because it combines three types of tax benefits: lifetime reduction of income tax, estate tax planning, and avoidance of income tax on assets passed to heirs. Also, an ILIT can be designed to provide assets for multiple beneficiaries with continuing professional management. Just in the past decade of so, the financial services industry has made ILITs available to people of modest wealth, in addition to the very rich.

How an ILIT Works

In concept, an ILIT is relatively simple. The person who sets up the trust (the grantor) is insured under a permanent life insurance contract owned by an irrevocable trust. In such a trust, the grantor gives up ownership and control. Premiums on the life insurance typically are paid by the grantor through annual gifts. These gifts have no estate tax consequences if they are $12,000 or less per beneficiary per year (as of 2007) and made under a “Crummey power” written into the trust document.

At the grantor’s death, the life insurance pays a death benefit that is income tax free. Because the grantor has given up rights of ownership, the life insurance proceeds generally are not included in the grantor’s estate for estate tax purposes. Virtually all of the death benefit can pass to heirs without tax erosion. Also, the trust can continue to hold money after the grantor’s death and manage it for the future benefit of heirs, using investment strategies that the grantor selects at trust creation. An ILIT can be especially useful in providing for the future care of minor children, and even children yet unborn, when it utilizes professional management after the grantor’s death.

Trust Documents Must Be Customized

ILITs are not for everyone because they require enough confidence and self-sufficiency to give up ownership and control of what may become a significant asset. Also, they aren’t boilerplate trusts that can be set up with fill-in-the-blank forms. Each ILIT trust document should be custom designed, because the grantor must give up control to a third-party trustee – either an experienced individual or a professional trust company (corporate trustee). Specific instructions must be written in the document for the trustee to follow in such important matters as how life insurance proceeds will be managed after the grantor’s death and whether the trustee can exercise discretion.

For example, if the trust is designed to benefit four grandchildren, can the trustee pay out more money to those needing help with college expenses? Can the trustee make discretionary payments or arrangements to provide for a beneficiary with special needs, such as a learning-disabled child? The grantor can be specific in giving instructions during the trust design process, but may have limited flexibility to influence the trustee later.

Several complex areas may require professional attention. For example, the law requires that the life insurance be held in the trust for at least three years after the insured transferred it if the insurance benefit is to escape estate tax at the owner’s death. If the ILIT is the applicant for the policy, and owner from inception, then the three year rules does not have to be met for the proceeds to be excluded.

Yet another complex area involves the Crummey powers that should be written into the trust document, if the annual premiums are to avoid gift tax consequence. Using these powers, named after a landmark legal case, the life insurance premiums that the donor pays each year can qualify for the annual gift tax exclusion (currently $12,000 per person) if they are of a “present interest.” The Crummey court case held that premiums are of a present interest if beneficiaries have even a temporary right to withdraw them. In practice, beneficiaries who are granted Crummey powers rarely withdraw premiums, but they must be legally notified of this right periodically.

The Choice of Insurance

Another important issue is the type of insurance that will fund the program. When a married couple wants to leave a legacy, professionals may recommend a “survivorship policy” that pay a death benefit at the second death. Seek the advice of a financial professional to discuss the various types of life insurance products that may be appropriate for funding an ILIT.

If you are interested in setting up an ILIT, you probably will need at least two financial professional to assist you. One is a trust attorney capable of drafting your document. Unless you already have a personal attorney competent in this area, it’s best to seek a specialist who keeps up to date with issues such as Crummey powers. The second financial professional you may need specializes in helping you implement the trust and select solutions and vendors, including life insurance program and professional trust company. This financial professional should have the advanced training represented by a professional designation such as Chartered Life Underwriter (CLU), Chartered Financial Consultant (ChFC) or Certified Financial Planner (CFP).

If you think an ILIT may make sense for your planning and estate wishes, now is the best time to talk to a professional. Remember the three-year rule, and the fact you can avoid it and have optimum estate tax consequences by having the ILIT apply for the policy as owner from the very beginning of coverage. Also, think about how much better you will feel once you have a well conceived plan in place for the rest of your lifetime, and beyond.

Comments

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Irrevocable life insurance trust might be the best kind of life insurance to purchase. Seeing all of the benefits above that we can't see for sure from other types of life insurance.