Crafting Financial Fortresses: The Role of Irrevocable Life Insurance Trusts
Providing Liquidity, Avoiding Taxation
Individually owned life insurance faces exposure to creditors during the owner’s life and estate taxes at death. An irrevocable life insurance trust (ILIT) keeps the policy out of reach of creditors and keeps the proceeds out of the estate. Typically, a business owner would use an ILIT to:
- provide estate liquidity
- avoid exposure to taxation
- provide income to survivors
- protect trust assets from creditors
How Does an ILIT Work?
The grantor creates the irrevocable life insurance trust during life and funds it with a life insurance policy on the grantor’s life. It may be an existing policy that the grantor gifts to the trust, or a new policy purchased by the trustee using cash that the grantor transfers to the trust for that purpose. (The grantor cannot be the trustee of an ILIT.)
The trust document authorizes the trustee to make the proceeds available to the executor upon the grantor’s death by:
- purchasing illiquid assets from the estate for a fair price, or
- making loans to the estate at a reasonable interest rate, with a set repayment schedule, using estate assets as collateral
Either way, cash flows into the estate when it is needed most to pay funeral costs, final medical bills, taxes, probate expenses, etc. However, it is important that the trustee is only authorized to make the proceeds available. Requiring the trustee to do so would make the proceeds includible in the estate, defeating the purpose of the trust.
The grantor usually gives the trustee discretion to pay premiums on the policy. This is accomplished differently depending on whether the ILIT is funded or unfunded.
In a funded ILIT, the grantor not only transfers a life insurance policy to the trust, but also transfers cash, securities, or other assets the trustee can use to pay insurance premiums. The drawback is that trust income may be taxed to the grantor if the trust can use the assets to pay premiums.
In an unfunded ILIT (the more commonly used trust), no other assets are placed in the trust beyond the life insurance policy. The grantor makes annual contributions, which the trust uses to make premium payments. The amount of the contribution (up to the annual exclusion amount) is transferred free from gift taxes. However, the annual gift tax exclusion only applies to gifts of a present interest.
To ensure that trust contributions are treated as gifts of a present interest, the grantor must use Crummey’s powers. Crummey powers provide the trust beneficiaries with the right to withdraw the contribution immediately, during a specified window of time (usually 30 days). The grantor hopes the beneficiaries won’t exercise this right, but since they are free to do so, the gift tax exclusion applies. Without the protection of the Crummey powers, the entire contribution would be considered a gift of a future interest and therefore would be taxable.
Intentionally Defective ILITs
With an ILIT, the grantor cannot keep any power whatsoever over the assets in the trust, or trust income will be taxed to the grantor. However, sometimes, the grantor chooses to pay the tax on the trust income to keep the trust assets out of the estate. This makes it an intentionally defective ILIT.
The main purpose of this arrangement is to lock in the transfer tax value of the assets placed in the trust, while still allowing the assets to increase in value free of income tax. This is helpful to the beneficiaries.
There are a number of powers that the grantor or the grantor’s spouse may retain to create an intentionally defective ILIT, including a reversionary interest, beneficial enjoyment of trust assets, certain administrative powers, the power to revoke the trust, or the power to use the income for the support of the grantor’s spouse.