An irrevocable life insurance trust is a trust used to provide liquidity promptly after the death of an individual to pay funeral expenses, debts of the decedent, administration expenses, federal and estate tax, and any other administration expenses of the estate. The idea is that the insurance proceeds after the payment of all the expenses are available to support the spouse and children, and even grandchildren, or are available for the education of children. They are often available after the second spouse’s death to provide for children.
An irrevocable life insurance trust (ILIT) is meant to take advantage of the disparity between the gift tax and estate tax value of life insurance policies and between the sum of premiums paid to the policy and the policy proceeds. An ILIT avoids federal estate tax on the death of the surviving spouse and creates liquidity without the delay of probate. It can often be established using a minimal amount of applicable estate tax credit by either spouse.
In addition, an ILIT can ensure that family plans for use of life insurance proceeds are fulfilled to support and maintain the surviving spouse or children, or for the education or distribution for children to the terms of the trust. An irrevocable life insurance trust (ILIT) is part of an overall comprehensive estate plan. It is one of the tools that a DC trusts attorney may use or recommend in certain situations, depending on the goals and the needs of a client. It is evaluated on a case by case basis.
Generally, an ILIT is not subject to creditor’s claims against the insured, but one of the important factors is that the initial grantor must give up all incidents of ownerships of the policy by placing the policy into a trust that is irrevocable. So once the trust is funded, the grantor no longer has a right to change the terms of the policy. The grantor creates an irrevocable life insurance trust and either gifts the amount of the premium to the trust so that the trust purchases the policy or gifts the policy into the trust.
Since the insured individual is usually alive, the trustee has the discretion to distribute trust income and principal to the defendants or spouse as possible discretionary distributees, but after the death of the insured, the trust terms are similar to typical terms of a bypass trust or other trust for the support of a spouse or children. The spouse of the grantor or the insured can be the trustee or if these are warranted, there could be an appointment of a co-trustee.
Common Estate Tax Traps
Some of the estate tax traps created by the use of life insurance include the inclusion of the life insurance policy in the gross estate. Generally, when a grantor retains any incidents of ownership of a life insurance policy, to the extent the amount is receivable by the executor, they may cause inclusion of a life insurance policy in the gross estate of the grantor at death.
Also, there is a restriction on the use of insurance proceeds to pay estate taxes or administration expenses. Insurance cannot be paid to a beneficiary subject to a legally binding obligation to pay expenses of the estate, but a trustee may be authorized in the trust language to loan the proceeds to the estate or to purchase assets from the estate with no estate tax inclusion results.
Avoiding these Traps
There are a number of provisions that an estate and trust attorney can include or modify the terms of a trust to ensure the inclusion of the life insurance proceeds are not includable in the decedent’s gross taxable estate.
One of those ways is to ensure that all incidents of ownerships have been removed or turned over from the initial grantor. Another is to modify the terms of the trust to be sure that it is compliant.
There are a number of planning opportunities that an estate and trust attorney can recommend ensuring that estate tax-saving opportunities are maximized and life insurance proceeds are used as part of an overall comprehensive estate plan.