IRREVOCABLE LIFE INSURANCE TRUST

ATTENTION high net worth individuals and couples!
Have you been told that your life insurance benefits are “tax free”? The answer depends on the amount of your assets. If you have above average net worth, you can keep the tax man away from the death benefit proceeds of your life insurance policies with an Irrevocable Life Insurance Trust (ILIT).

THE TAXING TRUTH ABOUT LIFE INSURANCE

Upon the death of an individual, an insurance company converts the deceased person’s insurance policy into a check for a specific amount of money. That money is added to the individual’s estate and becomes subject to estate taxes. The primary benefit of an ILIT is that it enables you to place a life insurance policy inside a trust without any gift tax consequences. The insurance takes on value only upon the death of the insured, at which time the insurance company will pay the face value of the insurance policy to the trustee of the ILIT.

IS AN IRREVOCABLE LIFE INSURANCE TRUST RIGHT FOR YOU?

If the assets of your estate plus the value of any insurance exceed the federal estate tax equivalent exemption, then an ILIT should be considered. If you are obtaining insurance for the purpose of creating a legacy specifically for your heirs, to benefit a charity or other organization, or to create the liquidity for your estate to be able to pay inevitable estate taxes (without having to liquidate assets to create cash to pay taxes), you are an ideal ILIT candidate. Here is the current schedule of estate tax exemptions:
  • 2008 personal exemption: $2 million
  • 2009 personal exemption: $3.5 million
  • 2010 exemption: no limit
  • 2011 personal exemption: $1 million (unless Congress acts to change it)

An individual might establish a Life Insurance Trust to benefit their parents or their sibling or friends, or possibly a significant other or even a charity. Married couples might establish two separate Life Insurance Trusts that own policies on each of them with the other as the primary beneficiary (and their children or grandchildren as the secondary beneficiaries). Sometimes married couples might establish a special ‘joint’ Life Insurance Trust that owns a ‘survivorship’ life insurance policy that is payable at the death of the second spouse. It is common for life insurance trusts to be established by a grantor who lists business partners, friends, relatives, educational institutions, churches or non-profit charities as the beneficiaries. Such trusts are flexible and can eventually become self-funding sources of wealth for future generations.

WHAT DOES AN IRREVOCABLE LIFE INSURANCE TRUST DO?

The ILIT is a very practical tax-oriented planning tool established specifically to take ownership of an insurance policy on the life of the insured. The ILIT removes the insurance death benefit proceeds from the calculation of the taxable estate upon the death of the insured. Cash held inside of the ILIT and within the policy owned by the ILIT is generally beyond the reach of potential lawsuit creditors because the trust itself is irrevocable and all the assets that it owns are not within the legal ownership of the insured or the grantor. Such assets belong exclusively to the ILIT, which is considered a separate ‘person’ under the law and which is administered by a carefully selected trustee who operates under a strict standard of care, owing a fiduciary duty to the beneficiaries of the ILIT.

Under existing tax law and regulations, a policy owned by an ILIT pays out its death benefit at the demise of the insured payable to the ILIT 100% free of income tax AND federal estate taxes. This is the primary reason people use ILITs – to pay a large death benefit and ensure that it is not subject to either income taxes or federal estate taxes.

Policies that are issued after the formation of the ILIT automatically escape inclusion in the taxable estate. Policies that pre-date the formation of the ILIT are subject to a “three-year rule” that include the insurance death benefit in the taxable estate if death occurs within the first three years after the trust’s formation. The “three-year rule” can often be circumvented simply by working with an insurance carrier to re-issue the policy. This is referred to as a §1035 exchange, and is commonly done so the new policy post-dates the date of the ILIT. Consult with a competent professional for details.

Here are the steps to take next:


1. Contact a senior consultant at Corporate Service Center.
2. Purchase and execute the ILIT.
3. Sign the ILIT before a notary public.
4. Get the life insurance coverage issued if the ILIT is for a new policy.
5. If you are using a pre-existing policy, have the insurance company change the beneficiary designation and ownership designation on any existing policy over to the ILIT.
6. Consider using a §1035 exchange if the existing policy has cash value accumulated. Doing so can help avoid the “three-year rule” problem.
7. Have the designated trustee sign and mail a taxpayer ID application (SS4) to the IRS.