Irrevocable Life Insurance Trust

Article written by Jonathan B. Osler, Esq.

In the dark times of low estate tax exemptions, resourceful estate planners devised a number of clever methods to reduce or eliminate the estate tax exposure of their clients.  One such method, the irrevocable life insurance trust (or “ILIT,” pronounced like “eye-lit”), became an extremely popular way to soften the tax blow on beneficiaries of taxable estates.  Although ILITs once were a dime-a-dozen, their use has declined with the rising estate tax exemptions.  That said, many clients who created ILITs years ago continue to pay hefty annual premiums on the insurance policy held by the trust.  For those clients especially, it is important to understand the ILIT’s function, and to seek professional counsel to determine whether or not the ILIT’s costs outweigh its benefits in the current tax environment.

So, what is an irrevocable life insurance trust?  As the name suggests, the ILIT is a type of trust generally designed to hold life insurance. For the ILIT to work as intended, it must meet several requirements.  For example, the insurance policy must be held in an irrevocable trust (hence the name), meaning the terms cannot be changed once the trust is established.  Further, the grantor of the trust cannot serve as the trustee—the grantor’s spouse, friend, children, professional fiduciary, or some other third party must serve as the trustee.  If structured properly, the IRS will not include the value of the insurance policy in the ILIT as part of the grantor’s gross estate, and the trust’s beneficiaries will not pay any estate tax on the proceeds.  Consequently, the beneficiaries of the ILIT can use the tax-free insurance proceeds to offset the amount owed to the IRS in estate taxes.  In essence, the ILIT is a hedge against risk—one designed to reduce beneficiaries’ overall exposure to the estate tax.

Simple in theory and complicated in practice, the ILIT requires ongoing involvement on the part of the grantor, trustee, and beneficiaries.  For example, the grantor must jump through complex administrative hurdles simply to pay the premiums on the life insurance policy.  To accomplish this, the grantor gifts to the ILIT up to the annual exclusion amount ($15,000 in 2018) per beneficiary to cover the yearly premiums.  The trustee must then send something called a “Crummey letter” each year informing the beneficiaries of a specified window, usually 30 days, during which they technically have the right to withdraw the grantor’s gift to the ILIT.  The idea is that the beneficiary will leave the money in the trust, where it’s used to pay the insurance premiums; however, for the IRS to deem the gift to the ILIT tax-free, the trustee must notify the beneficiary of his or her right to withdraw the gift within the IRS-approved timeframe.  Again, although the expectation is that no beneficiary will withdraw the gift—after all, it’s in the beneficiary’s best interest that the premiums get paid—the trustee must send the Crummey letters each year, and document that the proper procedural formalities have been followed.   If the procedures above are not repeated each year and not properly documented, the IRS may include the value of the life insurance policy in the grantor’s estate, which defeats the purpose of the ILIT.  On the other hand, the upside to this arrangement is that because the grantor (indirectly) pays the premiums on the policy, there is an annual flow of cash out of the grantor’s estate; this helps to reduce the value of the estate or to slow its growth, thereby reducing estate tax liability in the long run.

You, the reader, may well have an ILIT and are wondering whether you should keep it.  Well, the answer to that question is complicated.  Your ILIT may have been an absolute necessity in the 1990s, when the estate tax exemption hovered at $600,000 for most of the decade.  But with estate tax exemptions per person exceeding $5,490,000 in 2017, and $11,200,000 in 2018, your ILIT probably seems like an anachronism—a relic of the past—and that may well be true.  However, whether you should keep your ILIT depends on a host of variables, including the current and expected value of your estate, your exposure to various personal and professional liabilities, and other considerations beyond the scope of this article.  But most importantly, we must plan for the possibility of a future reduction in the estate tax exemption; currently, the estate tax exemption will revert back to pre-2018 levels (inflation adjusted) in 2025, barring congressional action.  Thus, an ILIT that seems unnecessary today may be an invaluable part of your estate plan in just a few years.  Therefore, if you have an ILIT, you should take a moment to meet with an experienced estate planning attorney to review your current circumstances.  That will help you determine whether the ILIT remains an integral part of your comprehensive Estate Plan—one worth jumping through the hoops to maintain—or if the best long-term strategy involves terminating the ILIT.

If you have an ILIT you would like reviewed, or if you are interested in creating an ILIT, please contact our offices—we would be delighted to schedule you for a complimentary, one-on-one consultation to review your estate planning documents.   Additionally, if you are interested in learning more about estate planning in light of the recent changes to state and federal laws, please join us at one of our seminars.