An Irrevocable Life Insurance Trust, or ILIT, is a vehicle to gain various financial advantages. Primarily, the ILIT is used as a tax shelter. This was much more common in the past when the estate tax exemption was much lower. For example, twenty years ago both the Federal and Minnesota estate tax exemption was a mere $675,000. If a person purchased life insurance, then its payout would likely push the estate above the exemption amount. Today the Federal exemption is $11.58 million. It is much less likely that life insurance will push an estate over the limit. However, there are other reasons to use an ILIT.
Before we get to that, what is an ILIT?
An Irrevocable Life Insurance Trust is just that: an irrevocable trust that holds a life insurance policy as its primary or only asset. To form an ILIT, the Grantor forms an irrevocable trust. The Grantor's spouse, children, or other person is listed as the beneficiary of the trust. Someone other than the Grantor is listed as the Trustee (person who administers the trust). Then annually, the Grantor pays money to the ILIT, and the ILIT uses this money to pay the premium on the life insurance.
This last part is important: because the ILIT owns the life insurance policy, it must be the one to pay the premium. The Grantor's paying the money to the ILIT is done in one of two ways. First, the Grantor could make annual payments to the ILIT using the annual gift tax exclusion, which is currently $15,000 per year. Second, the Grantor could avoid using the gift tax exclusion by treating the ILIT as a Crummey Trust. Basically, the Grantor would give notice to all the beneficiaries that for thirty days they have a right to the money in the ILIT. After 30 days, the ILIT can use the funds to pay the insurance premiums.
What are the reasons to use an ILIT?
The Federal estate tax exemption is less of an incentive to use an ILIT these days. But there are other reasons that make them relevant today. First and foremost, the Minnesota estate tax exemption is only $3 million. A sizeable amount to be sure, but not untenable in this day and age.
The structure of the trust can be advantageous as well. If structured properly the trust can be used to control how, when, and to whom distributions are being made. For small children, this is invaluable, as a lump sum of $500,000 to an 18 year old might not be a great idea! Instead, payments can be doled out over time and only for specific purposes (e.g., health, education, maintenance, and support).
As an irrevocable trust, the ILIT avoids Probate. While not a terrible burden in Minnesota, it does speed access to funds for the beneficiaries. It also preserves privacy of the estate (or rather, funds not in the estate).
There are other reasons that an ILIT may be useful in this day and age, but one sticks out above the rest. While the federal estate tax exclusion is currently $11.58 million, that is due to sunset in 2026. When that happens, it will drop to $5 million per person. And, with every new administration, there is a chance that the estate tax exemption will be cut even more. It is not out of the realm of possibility that the exemption could be dropped to a mere $1 million. If that happens, we can expect to see a resurgence of various estate planning strategies, including use of the ILIT.
What are some of the downsides of using ILITs?
There are three primary downsides to the ILIT. The first downside of the ILIT is in the name: it is an irrevocable trust. This means that the policy is stuck in the trust, and the terms of the trust cannot be altered. Second, there is the administrative burden of managing the trust and sending out Crummey letters every year. Third is the IRS's three year rule. Under Section 2035 of the IRS Code, once the insurance policy is transferred into the ILIT, the Grantor must live at least three years more. Otherwise, the life insurance is clawed back into the estate and the tax credit shelter fails.
The ILIT is an interesting beast. There are some distinct advantages to using one to shelter funds and control distributions. And in the future, this may become even more relevant with the sunset of the federal estate tax exemption. In any event, they are a viable tool for estate planning that need not be overlooked. If you want to know if using an ILIT is right for your estate plan, contact Signature Law for a free consultation.