Strategies & Techniques for Estate Planning


Irrevocable Life Insurance Trust (ILIT)

In most cases, life insurance proceeds pass to the named beneficiary free of any income tax. The payout from a life insurance policy is included in the "gross estate" of the policy owner for estate tax purposes at the policy owner's death and is potentially subject to federal and state estate taxes. At current federal estate tax rate, (37% to 55%) depending on what estate tax rate bracket the decedent policy owner is in, a significant portion of the life insurance proceeds would be payable to the Internal Revenue Service for federal estate tax instead of passing to the policy owner's beneficiaries.
An irrevocable life insurance trust ("ILIT") takes advantage of a purposeful loophole created by Congress. If an ILIT is created to own the life insurance policy and the proceeds of the life insurance policy are payable to the trustee of the ILIT upon the insured's death, then the proceeds are not included in the insured's estate and, therefore, are not taxable for federal estate tax purposes. This is true even though the insured gives the money to the trustee of the ILIT to pay the annual premiums of the life insurance policy.

For example, if an ILIT is created and the trustee of the ILIT purchases a $1 million life insurance policy on the life of the person creating the ILIT and the trustee of the ILIT is the beneficiary of the proceeds from the life insurance policy then, at the death of the insured, the trustee of the ILIT will receive the insurance proceeds free from estate tax. The trustee would then manage and dispose of the life insurance proceeds pursuant to the terms of the trust agreement.
For example, the terms of the trust could provide that the trustee distribute the income to the surviving spouse for his or her lifetime and then distribute the remaining principal to their children upon the death of the surviving spouse. The result is that the $1 million of life insurance proceeds is ultimately transferred to the children of the insured free of federal estate tax, state death taxes and probate costs. The $1 million is not taxed in the estate of the surviving spouse because the ILIT is set up not to qualify for the marital estate tax deduction.

Additionally, the provisions of the ILIT can provide liquidity for the estate of the insured. For example, the estate of the insured may consist of hard-to-sell assets such as real estate, an interest in business venture, closely-held stock or valuable artwork, and there is no ready cash or marketable securities to pay the federal estate tax within nine months after the death of the insured, which is the deadline for paying federal estate tax. Therefore, the terms of the ILIT can provide that the trustee be allowed to purchase assets from the estate of the insured at the fair market value for those assets. For example, if the estate of the insured owned a parcel of commercial real estate valued at $800,000 for which a buyer could not be found before the nine month deadline, then the trustee could use $800,000 from the life insurance proceeds and purchase the parcel of commercial real estate. The estate of the insured now has $800,000 to use towards the payment of federal estate tax and other administrative expenses. The ILIT now owns the commercial real estate which produces ample monthly rental income to be paid to the surviving spouse and the future appreciation of the commercial real estate will ultimately pass to the children of the insured, without estate taxes having to be paid.