An irrevocable life insurance trust (“ILIT”) is exactly as it sounds. It is an irrevocable trust designed to hold one or more life insurance policies. A properly drafted ILIT provides the owner of a life insurance policy with several estate planning benefits, including estate tax avoidance and liquidity for estate tax obligations.
An ILIT is a special type of trust that holds and owns a life insurance policy usually on your life or the life of your spouse. It’s designed to remove the policy from your taxable estate, help control how the death benefit is used, and potentially reduce estate taxes. An ILIT is “irrevocable” in the sense that it cannot generally be modified after it is created. An ILIT may be funded with either an existing life insurance policy or with assets to purchase a life insurance policy. The settlor, also known as the creator of the trust, may fund the insurance policy premiums through periodic contributions to the ILIT.
It’s important to note, however, that such periodic contributions to an irrevocable trust generally do not qualify for the federal annual gift tax exclusion because they are considered gifts of future interest. To avoid this designation, the settlor must provide the trust beneficiaries with a “Crummey Notice.” A Crummey Notice notifies the trust beneficiaries of each periodic contribution to the ILIT. It also notifies them of their “Crummey Power.” A Crummey Power is a temporary right to withdraw the contribution—usually for 30 days—when the contribution is made to the trust. Periodic contributions to the ILIT accompanied with a Crummey Notice to the trust beneficiaries are generally eligible for the federal annual gift tax exclusion. Thus, even if you do not have enough federal applicable credit to shelter the transfers from gift tax, such transfers won’t be subject to federal gift tax under the annual gift tax exclusion. A failure to provide a Crummey Notice to the trust beneficiaries may result in adverse tax consequences to the person who made the contribution, such as reduction in their applicable credit.
The beneficiaries of the ILIT are designated by the settlor of the ILIT, but it’s important that the ILIT itself is designated as the sole beneficiary of the life insurance policy. That way, upon the death of the insured, the insurance company distributes the insurance proceeds directly to the ILIT. The trustee of the ILIT then distributes the death benefit in accordance with the terms of the trust documents. The terms of the ILIT contain the settlor’s explicit instructions to the trustee on how to distribute the insurance proceeds after the insured’s death. Thus, an ILIT allows the settlor to control how the death benefit is used.
Additionally, by designating the ILIT as the sole beneficiary and owner of the life insurance policy, the death benefit is removed from the insured’s estate. Typically, if the decedent had ownership over the life insurance policy at their death, the proceeds from the policy are included in the decedent’s taxable gross estate. In Minnesota, estate taxe generally applies to individual estates worth more than $3 million. The inclusion of life insurance proceeds often forces individuals over this mark and subjects their excess value to estate tax. By transferring ownership of the life insurance policy to the ILIT, the settlor minimizes their taxable estate and ultimately may reduce estate taxes. However, to effectively relinquish ownership and control of the life insurance policy in the eyes of the Internal Revenue Service, the ILIT must be irrevocable, meaning the settlor cannot alter or modify the terms of the ILIT after its creation. A properly drafted ILIT ensures that the proceeds from a life insurance policy avoid estate taxes while also being distributed in accordance with the settlor’s explicit instructions.
ILITs are often used by the settlor to provide their estate with necessary liquidity to meet other estate tax obligations. Many estates include illiquid assets such as real property, interest in a closely held business, or other property that cannot be readily sold for cash. Regardless of the asset type, the Internal Revenue Service and Minnesota Department of Revenue assess a tax on all property, real or personal, tangible or intangible, owned by a person at death. For example, if the decedent’s estate consisted of minimal cash and a high value family farming business, the decedent’s estate could face significant estate tax obligations and not enough cash to satisfy such obligations. In this scenario, the estate must sell all or a large portion of the family business to satisfy the estate tax obligations. An ILIT can help solve this liquidity issue. After the trustee receives the life insurance proceeds, the trustee can use the proceeds to purchase illiquid assets from the insured’s estate so that the estate can satisfy its tax obligations. The estate is still forced to sell the family business, but now, the family business is held by the ILIT and distributed to the beneficiaries of the ILIT—usually the settlor’s children. Thus, keeping the family business within the family.
Irrevocable life insurance trusts, if properly drafted, are highly effective estate planning tools that provide several benefits including estate tax avoidance and liquidity for estate tax obligations. For further guidance and information on whether an ILIT is the proper estate planning tool for your estate planning goals, contact an attorney or other estate planning professional.
