An irrevocable life insurance trust, often referred to as an ILIT, is an irrevocable, non-amendable trust that serves as both the owner and the beneficiary of a policy on the life of an individual. When the insured individual dies, the death benefit is paid to the trustee of the irrevocable life insurance trust to be used for the benefit of the trust beneficiaries.
The beneficiaries of an irrevocable life insurance trust can vary depending on the desire of the client. If the client is married, the client’s spouse and children are often named as beneficiaries of the trust. Some trusts are formed to hold a “second-to-die” life insurance policy that pays out upon the death of the second spouse, in which case the children of the marriage would be the most likely beneficiaries.
Irrevocable life insurance trusts are used primarily in two situations: (1) excluding the proceeds of the policy from estate taxation so that estate tax is avoided altogether and (2) providing liquidity to pay the estate tax at the death of the insured. Each of these purposes are described in more detail below.
Using an Irrevocable Life Insurance Trust to Avoid Estate Tax on Life Insurance Proceeds
The United States Treasury Department taxes the transfer of wealth at death. This tax, known as the estate tax or the death tax, applies to the transfer of the “taxable estate” of a deceased person. It applies regardless of whether the deceased person left a will nor died without a will. If a person’s estate is of significant value, it will be subject to the estate tax.
The estate tax is not a concern for most people since their estates are small enough to fit within the applicable federal exemption from estate tax. Those who are subject to estate tax, particularly married couples or charitably-minded individuals, can save millions by engaging in pre-death estate planning. However, even among these groups, many people do not consider the fact that life insurance proceeds are included in a person’s taxable estate for estate tax purposes. The inclusion of life insurance proceeds in a person’s taxable estate can result in the loss of almost half of the insurance proceeds to the IRS in the form of estate taxes.
Let’s look at a simplified example. Say that the estate tax exemption in effect for a given year is $2 million. Mark and Mindy are a young couple with three school-age children. Mark’s hard assets consist of a home worth $350,000, automobiles worth $50,000, and personal belongings worth another $50,000. His financial accounts are worth about $150,000. When we add these up, we see that Mark’s estate appears to be well within the $2 million exemption amount:
Home $350,000
Automobiles $50,000
Personal Belongings $50,000
Financial Accounts $150,000
Total Net Worth $600,000
Looking at his financial profile, we can assume that the estate tax will not be an issue for Mark, right? Here’s the problem: Mark also has a life insurance on his life in the amount of $3,000,000. He intends for this to provide for his children after his death and to help pay for his their college expenses. But he hasn’t factored in the value of the life insurance proceeds. Taking the life insurance proceeds into account, their financial profile would look like this:
Life Insurance Proceeds $3,000,000
Home $350,000
Automobiles $50,000
Personal Belongings $50,000
Financial Accounts $150,000
Total Net Worth $3,600,000
This means that Mark’s total net worth for estate tax purposes will exceed the $2 million estate tax exemption by $1.6 million. Assuming a 45 percent estate tax rate, Mark’s estate will pay $720,000 in estate taxes at his death. That’s $720,000 less that gets passed on to help raise his children and send them through college. This is not what Mark intended.
This problem can be avoided through the use of an irrevocable life insurance trust. If structured property, the life insurance trust will be the owner of the life insurance policy, taking it out of the taxpayer’s taxable estate and thus exempting it from estate tax. This is due to the provisions in the Internal Revenue Code provides for exclusion of the policy if the insured doesn’t retain any “incidents of ownership” in the policy.
In the example above, if Mark created an irrevocable life insurance trust with an independent, third-party trustee to purchase a life insurance policy, the $3,000,000 death benefit would not have been included in his taxable estate, saving him $720,000.
This estate-tax saving feature makes irrevocable life insurance trusts a good planning tool to help people avoid estate tax and pass more money to their intended beneficiaries.
Irrevocable Life Insurance Trusts for Estate Tax Liquidity
The estate tax is especially problematic for individuals that own illiquid but valuable assets. Common examples of these types of asset include land and stock in a closely-held business. These assets can present a real liquidity problem by triggering a large estate tax at the death of the owner while not providing sufficient liquid funds to pay the tax. For example, the owner of a family business will usually be reluctant to force the beneficiaries to liquidate the family business in order to pay estate tax. Likewise, those involved with large tracts of family-owned land will not usually want to see the land broken up and sold in a “fire sale” situation in order to provide liquidity to pay the estate tax.
One way to address these concerns is to ensure that there is cash available to pay any estate tax liability at the owner’s death. Since the estate tax is triggered by the owner’s death, it makes sense to have a source of liquid cash that becomes available at the same time. And the most common source of cash at the death of the owner is life insurance. A life insurance policy on the life of the owner is often the best fit for providing liquidity at the death of the owner.
So what do trusts have to do with this? Why doesn’t the owner just go out and buy a life insurance policy in an amount sufficient to cover the anticipated estate tax liability? The problem is that, as noted above, life insurance policies on an individual can actually increase his or her estate taxes. If a taxpayer owns a life insurance policy, the death benefit will be included in the owner’s estate.
One way to address this concern is through the use of an irrevocable life insurance trust designed to own the policy. This technique provides the estate with liquidity to pay the estate tax while excluding the policy proceeds from the taxpayer’s estate. The ILIT can be a great tool to help solve the liquidity crisis caused by the estate tax.
Like most planning techniques, ILITs are not a good fit for everyone. There are some drawbacks that may make them unsuitable for some individuals. Perhaps the most common disadvantage is that, by vesting ownership of the property in the ILIT, the insured/client loses control of the policy, forfeiting any right to make decisions regarding the policy. This can often be mitigated by drafting the document carefully to provide for various contingencies and by allowing individuals other than the insured/client to make decisions in reaction to changed circumstances.
Note: For 2010, the concepts discussed in this article require special planning. For more information, see our Section on Estate Planning in 2010.