Life Insurance Trusts
An irrevocable life insurance trust (ILIT) is typically used to own and control one or more term or permanent life insurance policies while the insured is alive, and then determine how the proceeds will be paid out upon the insured’s death. An ILIT can own both individual and second to die life insurance policies. Once established and funded, an ILIT can serve many purposes:
Minimizing Estate Taxes
If the same person is the owner and the insured under a life insurance policy, the death benefit of that policy will be included in the owner’s gross estate. However, when life insurance is owned by an ILIT, the proceeds from the death benefit would not be part of the insured's gross estate and thus not subject to state and federal estate taxation.
Providing Liquidity to an Estate
If properly drafted, the ILIT can provide liquidity to help pay estate taxes, as well as other debts and expenses of an estate, by purchasing assets from the grantor’s estate or through a loan. Also, lifetime gifts can help reduce a taxable estate by transferring assets into the ILIT.
Avoiding Gift Taxes
A properly drafted and funded ILIT avoids gift tax consequences because contributions by the grantor are considered gifts to the beneficiaries. In 2022, an individual may give up to $16,000 a year to anyone, including an ILIT. There is no limit to the total number of such tax-free gifts a person may make. One could also give someone more than $16,000 a year free of gift tax by filing a gift tax return and applying the unused portion of one’s lifetime estate tax exemption to that gift.
Protecting Government Benefits
Having the proceeds from a life insurance policy owned by an ILIT can help protect the benefits of a trust beneficiary who is receiving government aid, such as Social Security disability income or Medicaid. The ILIT trustee could control how distributions from the trust are used so as not to interfere with the beneficiary's eligibility to receive government benefits.
Depending on how much cash value or death benefit there is in the life insurance policy held by the ILIT, some or all of that value or benefit may be protected from creditors of the ILIT’s grantor and/or beneficiary. The creditors may, however, attach any distributions made from the ILIT.
Depending on the grantor’s wishes, the trustee of an ILIT can have discretionary powers to make distributions and control when beneficiaries receive the proceeds of the policy. The trustee could also be given the discretion to provide distributions when beneficiaries attain certain milestones, such as graduating from college, buying a first home, starting a business, or having a child.
The generation-skipping transfer tax imposes a significant tax on both outright gifts and transfers in the trust to or for the benefit of unrelated persons who are more than 37.5 years younger than the donor or to related persons more than one generation younger than the donor. An ILIT helps leverage the ILIT grantor’s generation-skipping transfer (GST) tax exemption by using gifts to the trust to buy and fund a life insurance policy. Because the proceeds from the death benefit are excluded from the grantor’s estate, multiple generations of the family - children, grandchildren, and great-grandchildren - may benefit from the ILIT's assets free of estate and GST tax.
As with all irrevocable trusts, ILITs have a separate tax identification number and a very aggressive income tax schedule. However, the cash value accumulating in a life insurance policy is free from taxation as is the death benefit. Thus, if properly designed, there likely would be no tax issues with having a policy owned in an ILIT. ILITs are a powerful tool that should be considered in many wealth management plans.
Contact Collins Law today to learn whether an ILIT could benefit you.