UNDERSTANDING ILITS

Understanding Irrevocable Life Insurance Trusts (ILITs)

Life insurance is often used in estate planning to create liquidity at death. When structured properly, it can provide funds to pay estate taxes, equalize inheritances, or support family members.

However, if an individual owns a life insurance policy on their own life, the death benefit may be included in their taxable estate. For individuals with large estates, this can reduce the effectiveness of life insurance as a planning tool.

One commonly used solution is an Irrevocable Life Insurance Trust (ILIT).

An ILIT is a trust designed to own and control a life insurance policy, allowing the death benefit to pass outside the insured’s taxable estate while also providing structure around how those proceeds are distributed.


What Is an ILIT?

An ILIT is a trust created during the grantor’s lifetime that owns a life insurance policy on the grantor’s life. Because the trust, not the insured, owns the policy, the death benefit can generally be excluded from the insured’s estate for estate tax purposes.

A typical ILIT structure involves three parties:

Grantor
 The individual who creates the trust and whose life is insured.

Trustee
 The person or institution responsible for administering the trust and managing the policy.

Beneficiaries
 The individuals who will ultimately receive the proceeds from the trust.

When the insured dies, the life insurance proceeds are paid to the trust. The trustee then distributes the funds according to the trust’s terms.

This structure allows the trust to act as a separate legal owner of the insurance policy, which can be important for estate tax purposes.


Why ILITs Are Used

ILITs are most commonly used in estate planning to address the issue of liquidity at death.

Many families hold wealth in assets that are difficult to sell quickly, such as:

When estate taxes or other expenses arise, heirs may be forced to sell assets under time pressure.

Life insurance held inside an ILIT can provide a source of funds that may be used to:

Because the policy is owned by the trust rather than the insured, the proceeds may avoid being included in the taxable estate.


Advantages of an ILIT

When properly structured and administered, ILITs can offer several planning benefits.

Estate tax planning

Life insurance owned directly by the insured is typically included in the estate for tax purposes. An ILIT can help remove the policy from the estate.

Liquidity for the estate

Insurance proceeds can provide immediate funds to help cover estate taxes or other obligations.

Control over distributions

Trust terms can control how and when beneficiaries receive funds. This can be useful when beneficiaries are minors or when a grantor wants to structure long-term distributions.

Asset protection

Depending on how the trust is structured and the laws of the governing state, assets held in trust may offer some protection from creditors or other claims against beneficiaries.


Potential Drawbacks and Limitations

ILITs are not appropriate for every situation. Several factors should be considered before establishing one.

Irrevocability

As the name suggests, the trust is generally irrevocable. Once established, the grantor typically cannot change the trust terms or reclaim ownership of the policy.

Administrative responsibilities

The trust must be administered properly to preserve its tax treatment. Failure to follow proper procedures can undermine the planning.

Funding obligations

Premium payments must be made regularly to maintain the insurance policy.

Legal and administrative complexity

ILITs require coordination between legal, tax, and insurance professionals. Poor administration can create tax complications.

Funding an ILIT

An ILIT can obtain life insurance in several ways.

Purchasing a new policy

The trust is established first, and the trustee applies for and purchases a new life insurance policy on the grantor’s life. Because the trust is the original owner and beneficiary, the policy is generally not included in the grantor’s taxable estate.

Transferring an existing policy

An existing life insurance policy can also be transferred to the trust. However, this approach may trigger the three-year inclusion rule. If the insured dies within three years of transferring the policy, the death benefit may still be included in the insured’s estate for tax purposes.

Selling an existing policy to the ILIT

In some cases, the trust may purchase an existing policy from the grantor for its fair market value rather than receiving it as a gift. When structured properly, a bona fide sale can avoid the three-year inclusion rule because the policy is no longer treated as a transferred gift.

This approach requires careful valuation of the policy and attention to other tax considerations, including potential transfer-for-value rules, and should generally be implemented with guidance from experienced estate planning professionals.

In all cases, the trustee must ultimately be both the owner and beneficiary of the policy to ensure the proceeds are administered according to the trust terms and remain outside the insured’s estate.


Understanding Crummey Powers

Many ILITs rely on a mechanism known as a Crummey power.

Normally, gifts to a trust do not qualify for the annual gift tax exclusion because the beneficiaries do not have an immediate right to the funds.

Crummey powers address this issue by giving beneficiaries a temporary right to withdraw contributions made to the trust. This temporary withdrawal right allows the contributions to qualify for the annual gift tax exclusion.

In practice, beneficiaries typically do not exercise the withdrawal right, allowing the trustee to use the contributions to pay life insurance premiums.


The Role of Crummey Notices

To ensure that contributions qualify for the annual exclusion, beneficiaries must be formally notified of their withdrawal rights.

These notifications are commonly referred to as Crummey notices.

The trustee sends written notice to beneficiaries each time a contribution is made to the trust, informing them of:

Proper documentation of these notices is an important part of ILIT administration.


Common Administrative Pitfalls

Several issues frequently arise in the administration of ILITs.

Failure to send Crummey notices

If notices are not sent, contributions may not qualify for the annual gift tax exclusion.

Improper funding

Premiums should generally be paid by the trustee after contributions are made to the trust. The ongoing performance of the policy should be periodically reviewed by a life insurance professional.

Poor recordkeeping

Trustees should maintain records of contributions, notices, and premium payments.

Failure to follow these procedures can weaken the tax treatment of the trust or create disputes among beneficiaries.


Final Considerations

Irrevocable Life Insurance Trusts are a widely used planning tool in estate and tax planning.

When properly structured and administered, they can:

However, they require careful planning and ongoing administration. For this reason, ILITs are typically implemented as part of a broader estate planning strategy coordinated among attorneys, tax advisors, and insurance professionals.