An Introduction to Irrevocable Life Insurance Trusts

Life insurance is an almost magic tool in estate planning. But because its utility is diminished in direct proportion to the taxes imposed on it and the security it provides becomes elusive, it may make sense for wealthy clients to gift it out of their taxable estates (oftentimes to an irrevocable life insurance trust (ILIT) or adult children), or, if purchasing new coverage, have it owned from the outset outside of their taxable estate (by an ILIT or adult children). That said, there are a lot fewer ILITs being created today than in the past. The primary reason for this is the much higher estate tax exemption environment that currently exists. Most people today can own life insurance without being concerned about the federal estate tax consequences of doing so. As a result, in the current estate tax environment it is generally only the ultra-wealthy that are creating new ILITs.

For ultra-wealthy clients who are looking for ways to reduce their taxable estates, gifts of life insurance offer special planning opportunities not available with other assets.

These include:

  1. Life insurance proceeds can be removed from a client’s estate at a relatively low gift tax cost. Compare this with most other property, which has the same value for gift tax purposes as it does for estate tax calculations.
  2. A gift of other assets may result in a loss of a stepped up basis to the client’s heirs.1 But a gift of life insurance does not result in such a loss in income tax savings; there is generally no income tax payable on the proceeds and the loss of a step-up in basis is no concern.
  3. Psychologically, life insurance is an easier gift for a client to part with than most other assets since it is not income producing and is generally thought of as a post death security vehicle for others.2

There are a number of advantages and disadvantages, as well as important details, to consider when helping clients understand the use of irrevocable life insurance trusts in the planning process. These include:

  1. Advantages of ownership of life Insurance by third party
  2. Disadvantages of third party ownership of life insurance
  3. Why make a gift of life insurance to an irrevocable life insurance trust?
  4. Disadvantages to ownership of life insurance by an irrevocable trust
  5. Irrevocable trust—what it is and how it works
  6. Mechanics
  7. Selection of a trustee
  8. Reducing or eliminating gift taxes on policy transfers and premium payments through Crummey powers
  9. Gift, estate, and income tax problems related to Crummey powers
  10. Reducing or eliminating gift taxes on premium payments through methods other than Crummey powers
  11. What the attorney should consider in drafting
  12. How to avoid the transfers within three years of death rule
  13. Structuring the trust for “what ifs” (increasing “control and flexibility”)
    • Designing ILITs as SLATs
  14. Allocation of the federal estate tax
  15. Income tax implications
  16. How to handle last to die (survivorship) insurance in an irrevocable trust
  17. How to handle group term life insurance in an irrevocable trust
  18. Community property issues
Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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