Lesson 41: Using Irrevocable Life Insurance Trusts (ILIT)

As part of our series on Federal Estate Tax Law, this lesson covers the specifics of Irrevocable Life Insurance Trusts (ILIT) and their role in managing estate taxes.

What is an ILIT?

An Irrevocable Life Insurance Trust (ILIT) is a type of irrevocable trust specifically designed to own and control a life insurance policy. Once transferred, the trust becomes the owner and beneficiary of the life insurance policy, and the policy proceeds are excluded from the insured's estate.

ILITs must be irrevocable to ensure that the life insurance proceeds are not considered part of the estate and therefore not subject to estate taxes.

How Does an ILIT Work?

Here is a simplified diagram to explain the structure of an ILIT:

classDiagram Settlor --> ILIT: Transfers Ownership ILIT --> Beneficiaries: Distributes Proceeds ILIT --> "Life Insurance Policy": Owns "Life Insurance Policy" --> ILIT: Pays Proceeds

Tax Benefits of an ILIT

ILITs offer several tax benefits, primarily by reducing the taxable estate. When the insured passes away, the life insurance proceeds are not included in the gross estate, thus minimizing estate taxes.

Example Calculation

Assume an estate without an ILIT:

$$ \text{Gross Estate} = \$10,000,000 + \$2,000,000 \ (\text{Life Insurance Proceeds}) $$

Using an ILIT:

$$ \text{Gross Estate} = \$10,000,000 \ (\text{Life Insurance Proceeds Excluded}) $$

Steps to Establish an ILIT

Consult with an estate planning attorney to draft the trust agreement.
Select a trustee who will manage the trust.
Transfer the life insurance policy to the ILIT. Note that the transfer must be completed 3 years before death to avoid inclusion in the estate.
Contribute funds to the ILIT to pay the insurance premiums.

Important Considerations

While ILITs offer significant advantages, they also come with some complexities and must be managed carefully:

Once established, the terms of an ILIT cannot be changed.
The grantor relinquishes control over the life insurance policy.
Annual exclusion gifts can be used to fund the ILIT, subject to annual gift tax exclusions.

Conclusion

Using an ILIT can be a highly effective strategy for managing estate taxes and ensuring that life insurance proceeds benefit your heirs without being diminished by estate taxes. Consult with a qualified attorney to see if an ILIT is right for your estate planning needs.

Continue exploring more on our series with Differences Between State and Federal Estate Taxes.