Introduction
In estate planning, an Irrevocable Life Insurance Trust (ILIT) is a powerful tool for reducing estate tax liability and securing the financial future of beneficiaries. Contrasted with a revocable trust, an ILIT is irrevocable, used primarily for estate tax purposes, and requires thoughtful planning, particularly when working with a life insurance company to transfer an existing policy or establish a new policy.
This structured approach helps ensure a smooth transfer of assets, providing essential benefits to loved ones while minimizing tax burdens. This may be best illustrated using an example.
Imagine Mark, a single parent of two young daughters, ages 9 and 11. He has an estate currently valued at $30 million and plans to purchase a life insurance policy with a $5 million death benefit, Mark’s total estate value reaches $35 million. This amount exceeds the federal estate tax exemption, making his estate vulnerable to estate taxes. To protect his estate’s value for his daughters, Mark establishes an irrevocable life insurance trust (ILIT). The ILIT assumes ownership and is the designated beneficiary of the life insurance policy, effectively reducing Mark’s federal and state estate tax exposure while safeguarding the life insurance proceeds for his children.
What is an ILIT?
An ILIT, or irrevocable life insurance trust, is a specialized estate planning tool often utilized by high-net-worth individuals. This type of trust manages life insurance policies—whether term life insurance, whole life insurance, or other types of insurance—during the grantor’s lifetime, and ultimately distributes the life insurance proceeds upon their death free of additional estate tax.
An ILIT is usually established to manage a single life insurance policy, but the trust can vary depending on the individual’s estate planning needs. To create an ILIT, the grantor transfers ownership of a life insurance policy into the trust, removing it from their gross estate. This transfer may require a gift tax return. The trustee, appointed by the grantor, takes control of the policy, handling life insurance premiums, collecting the death benefits, and distributing payouts to beneficiaries as directed in the trust document.
This structure keeps the life insurance policy payout outside the grantor’s taxable estate, thus reducing estate tax liability. As for whether it can hold other assets, while an ILIT can include other trust assets, such as an annuity, the downsides generally outweigh the benefits, so it’s best to consult with an expert attorney to see if such a structure makes sense for your situation.
For example, Mark’s sister, named as trustee, must keep the ILIT’s finances separate from Mark’s other assets, ensuring the integrity of the trust and avoiding any incidents of ownership that might pull the policy back into his taxable estate. As trustee, she would oversee premium payments from a separate ILIT-owned checking account, ensuring no overlap with Mark’s accounts.
How is an Irrevocable Life Insurance Trust Established in Arizona?
To establish an ILIT in Arizona, the grantor and trustee enter into a formal agreement, drafted by an estate planning attorney, to administer a life insurance policy for the benefit of the beneficiaries of the trust. Then, the life insurance policy is transferred to the trust which is treated as a separate legal entity for tax purposes. Once an ILIT is established, the grantor cannot change, modify, or dissolve it.
In establishing an ILIT, the grantor must undergo medical examination procedures to confirm insurability, followed by the drafting and signing of the trust document. The attorney typically advises against filing the life insurance application until certain steps are complete: making an initial gift to the ILIT to cover the first premium payment, opening a trust-owned checking account, and issuing Crummey withdrawal notices to beneficiaries, who receive the right to withdraw the gift temporarily. Only after these steps does the grantor apply for life insurance, designating the ILIT as the policy’s owner and primary beneficiary.
The transfer of ownership requires surrendering all control over the life insurance policy, so it is essential to choose a trustworthy and competent trustee. In many cases, people select a corporate fiduciary, a trusted financial advisor, or a family member not named as a beneficiary. This arrangement maintains the ILIT’s recognition as a separate legal entity for tax purposes and avoids conflicts of interest or IRS scrutiny.
Why Not Directly Transfer the Life Insurance Policy?
You might be wondering why you can’t simply transfer ownership of a life insurance policy directly to a beneficiary. The answer is that while you can, people choose to create an ILIT so they maintain some control over it while alive, and/or they don’t trust the beneficiaries to manage the policy (perhaps they are minors or spendthrifts).
Life Insurance Policy Transfers within 3 Years of Death
The Internal Revenue Code (IRC) Section 2035 stipulates that any transfer of ownership made within three years of the grantor’s death subjects the death benefit to estate tax as if the policy remained in the estate. This three-year lookback period is intended to prevent last-minute transfers, commonly known as “deathbed transfers.” As such, planning is necessary to ensure the life insurance policy is removed from the taxable estate.
Potential Benefits of an ILIT
An ILIT offers multiple financial and tax-related benefits, including estate tax mitigation, asset protection, and control over distributions, and even allows for the possibility of receiving government benefits for special needs beneficiaries. Here are some other benefits:
- Estate Tax Mitigation: The primary purpose of funding an ILIT with a life insurance policy is to reduce estate taxes. By excluding the policy from the taxable estate, the grantor can avoid federal and state estate taxes on the life insurance proceeds. In Mark’s case, the ILIT removes the $5 million death benefit from his taxable estate, reducing his estate tax burden.
- Asset Protection: Since the ILIT owns the life insurance policy, its cash value and death benefit are generally protected from creditors. In some states, like Florida, this protection may extend even further, shielding the entire life insurance payout from creditors.
- Control Over Distributions: The ILIT allows the grantor to specify the terms of the trust, including how and when distributions are made. Mark, for instance, can dictate that life insurance proceeds are distributed to his daughters in increments or held until they reach a certain age. This structure also allows the trust to offer liquidity to the estate, covering necessary expenses like probate fees, estate taxes, or debts, if needed.
- Wealth Transfer to Family Members: ILITs offer an efficient way to transfer wealth to loved ones with reduced tax implications. Through the ILIT, Mark can ensure his daughters receive life insurance death benefits without the policy being subject to federal estate tax. Additionally, by utilizing the annual gift tax exclusion, Mark can gift amounts to the trust to pay premiums, further reducing his taxable estate over time.
- Avoidance of Gift Taxes: Properly structured, an ILIT avoids gift tax liability. The typical ILIT is structured as a Crummey trust which qualifies for the annual gift tax exclusion. The premium payments would be structured to be lower than this limit, reducing overall gift tax liability and allowing the policy’s cash value to grow outside his estate.
- Government Benefits Protection: If Mark’s daughters might need government benefits like Medicaid or Social Security disability income, the ILIT can be structured so distributions do not affect their eligibility. This feature is particularly beneficial when planning for special needs beneficiaries.
Potential Drawbacks of an ILIT
Despite the advantages, it’s essential to consider certain drawbacks associated with ILITs:
- They’re Irrevocable: Once established, an ILIT is irrevocable, meaning it cannot be changed, amended, or dissolved without court involvement or tax implications. This immutability requires thoughtful planning from the grantor. Mark, for instance, cannot alter the life insurance policy terms, change beneficiaries, or reclaim ownership of the policy after the ILIT’s establishment. This inflexibility requires a good planner to make sure the grantor’s wishes are carried out.
- Lookback Period: If Mark transfers an existing life insurance policy to the ILIT within three years of his death, the death benefit may be included in his taxable estate. The three-year rule applies under IRC Section 2035, emphasizing the need to plan an ILIT transfer well in advance.
- Complexity and Compliance: ILITs are sophisticated trusts that must be carefully structured to achieve the intended estate tax benefits. For example, the annual contributions Mark makes to cover premiums must qualify under the annual gift tax exclusion and beneficiaries must be provided with withdrawal rights to meet IRS guidelines.
Federal and State Estate Tax Exemptions
As of 2024, the 2025 federal estate tax exemption stands at $13.99 million per individual and $28.98 million for married couples. Many estates fall under these thresholds, allowing individuals to avoid federal estate tax. However, the current exemption levels are expected to sunset in 2026, meaning the estate tax exemption may be significantly reduced. In some states, including New York, state estate taxes apply in addition to federal estate taxes, further complicating estate planning for high-net-worth individuals.
An ILIT can provide protection against potential future changes to both federal and state estate tax exemptions. For instance, Mark’s $5 million life insurance death benefit will remain outside his taxable estate regardless of exemption changes, shielding his daughters from increased estate tax liability.
ILIT and Income Tax
Income tax implications can arise when an ILIT generates cash value within certain types of life insurance, such as whole life insurance policies. The trust’s cash value grows tax-deferred, and beneficiaries receive life insurance payouts income tax-free. Additionally, if structured correctly, the ILIT may avoid the grantor’s income tax liability as the trust is treated as a separate tax entity under IRS rules.
Contacting an Estate Planning Attorney
Due to their complexity, ILITs require professional guidance to ensure compliance with tax regulations and to achieve desired financial outcomes. At Copper State Estate Planning, we specialize in high-net-worth estate planning, asset protection, and irrevocable trusts. Contact our legal team to discuss your life insurance policies, estate tax exposure, and asset protection goals. By leveraging an ILIT and other advanced estate planning tools, we can help secure your
