Irrevocable Life Insurance Trusts (ILIT) and Estate Planning

Written by: Bennie A. Wall

Posted on: April 26, 2024

Building Blocks for Life Insurance Taxable Estate

In the intricate world of estate planning, where the twin goals of preserving wealth and minimizing tax liability converge, the Irrevocable Life Insurance Trust (ILIT) stands out as a formidable tool. Often misunderstood and underutilized, the ILIT offers high-net-worth individuals, small business owners, and family businesses a unique array of benefits that extend far beyond the conventional insurance policy. This blog post aims to demystify ILITs, address common misconceptions, and showcase how they can be strategically implemented to safeguard intergenerational wealth and business continuity.

While life insurance policies owned by an individual are a great tool to ensure income tax free liquidity at the death of the owner, one must be aware that the death benefit will be includable in the value of the decedent’s gross estate. This direct ownership means the policy’s benefits are included in the estate’s total value, potentially pushing it above the estate tax exemption threshold, thereby increasing the estate’s tax liability. This oversight underscores the importance of considering ownership and beneficiary designations in the context of broader estate planning goals; this is where utilizing an Irrevocable Life Insurance Trust can be paramount.

Unpacking the Benefits of an ILIT

At its core, an ILIT is designed to exclude life insurance proceeds from the taxable estate of the insured, thereby offering an estate tax-free benefit to the heirs. This mechanism not only provides liquidity to cover estate taxes and other associated expenses without the need to liquidate high-value assets (like a farm or family business) but also allows for the strategic leveraging of the annual gift tax exclusion to cover premium payments. Furthermore, an ILIT can serve as a robust asset protection vehicle for trust beneficiaries, shielding them from divorce, creditors, and potentially their own bad decisions.

Dispelling a Common Misconception

The notion that ILITs are rigid and unalterable is one of the most prevalent misconceptions that deters individuals from considering this planning tool. While it’s true that an ILIT is an irrevocable trust, there are certain powers that the trust’s creator may retain that can change the trust in certain circumstances. Furthermore, the trust’s creator can incorporate a trust protector into the ILIT to allow more flexibility. Any trust protector provisions or retained powers MUST be carefully considered and drafted to ensure they do render the ILIT ineffective.

A Real-Life Case Study

Consider the case of Ken, the owner of a $7 million business he built from the ground up, who dreams of a leaving a lasting legacy for generations to come. However, the looming concern is that his heirs may face the dilemma of selling the business to cover hefty taxes or resorting to taking out significant loans against the business. Since Ken has put so much into this business, he only has about $3,000,000 in liquid assets outside of the business. The estate’s lack of liquidity to meet potential tax obligations in the future adds complexity to the situation.

The Issues: With a federal estate tax exemption of $13.6 million in 2024 scheduled to plummet at the end of 2025 (estimated to be between $6.8 million and $7 million), Ken is concerned that his will exceed future exemption amounts. This fear is compounded when Ken considers the reasonable growth of his business over the next ten years. Anticipating a 14% annual growth rate, the business could soar to $28 million within a decade. Even if his federal estate tax exemption grew to $10 million with inflation adjustments over the decade, his family would still have at least $18 million of his estate subject to a potential 40% tax bite, which would leave his estate with a $7.2 million federal tax bill and no liquid assets to cover it. This bill could be even higher if Virginia reinstates its estate tax by passing HB1414 that was introduced in 2024. Ken is very uncomfortable with this uncertainty around the actions of future legislature, both state and federal. He comes to Carrell Blanton Ferris & Associates for help.

Our Solution: A comprehensive estate plan evaluation. We present several options to Ken, his financial advisor, and his CPA. Each varying in complexity and various benefits. Our main goal is to guide Ken to help him protect his family and preserve his legacy. Ken values simplicity in planning above all else, and he and his advisors elect to use an Irrevocable Life Insurance Trust. With his particular planning goals, he is able to gift enough to the trust each year to obtain a $15 million dollar life insurance policy while remaining under his annual gift threshold. Upon his passing, the ILIT plans to use the proceeds paid from the insurance policy to acquire shares in the business, furnishing the necessary liquidity for taxes. The trustee safeguards these shares for descendants based on Ken’s directives, shielding them from the beneficiaries’ creditors, ex-spouses (aka outlaws), and even imprudent decisions. His ILIT structure is designed to effectively shield the underlying assets and their appreciation from future estate taxes at his children’s death, ensuring a smooth financial path for forthcoming generations.

ILITs in the Modern Estate Planning Arsenal

As Ken’s case demonstrates, Irrevocable Life Insurance Trusts represent a pivotal component in the estate planning arsenal for those seeking to mitigate tax burdens, protect assets, and ensure the seamless transfer of wealth across generations. By combining life insurance with a trust structure, individuals can enact a proactive strategy that addresses both immediate and long-term financial objectives. Despite common myths, when designed with precision and foresight, an ILIT offers unparalleled benefits – serving as a testament to the owner’s legacy while securing a future for heirs untethered by unnecessary fiscal strain.

Crafting Your Legacy with ILITs

Before integrating an ILIT into your estate plan, it’s imperative to conduct a comprehensive assessment of your financial landscape, alongside a forward-looking analysis of potential tax law shifts and personal financial projections. Consulting with experienced estate planning professionals can illuminate the path toward establishing an ILIT that aligns with your goals, or assessing whether another tool (like a Spousal Lifetime Access Trust or Qualified Self Settled Spendthrift Trust) will work better, all and all providing peace of mind that your legacy and beneficiaries are well protected.

Let our experienced team be your guide. At Carrell Blanton Ferris & Associates, our estate planning attorneys have access to top-tier resources built on our 30-year legacy. We are committed to establishing a lasting practice that will support you and your family for generations. Reach out to the office nearest you to discover how you can begin working with our team today.

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