An Irrevocable Life Insurance Trust, also known as an “ILIT” is an estate planning tool designed to minimize income and estate taxes, and to provide cash to pay estate taxes and expenses of administering an estate, without the need to liquidate non-liquid assets. The ILIT is used to hold a life insurance policy or policies outside of an estate.
If you own a life insurance policy, the Internal Revenue Service (“IRS”) will add the amount of the life insurance benefit to the amount of your taxable estate and calculate the tax based upon that value. This may seem unfair since the death benefit is usually not paid to your estate, but to someone else instead.
The ILIT (if properly prepared) creates a separate legal entity from the insured’s estate. Using an ILIT, the life insurance is not a part of the person’s estate and therefore is not subject to estate tax.
You should consider having an ILIT if you meet either of these two conditions:
The value of everything you own (called your “estate”), including the death benefit of your life insurance policies, will be over $1,000,000 at the time of your death if you are single, or over $2,000,000 at the time of your death if you are married and if you have a revocable living trust; or
Your estate consists of a business or other substantial assets that cannot be easily liquidated (converted to cash).
If the size of your estate is over a certain amount, there may be taxes that must be paid to the IRS. The IRS wants payment in cash. If your estate does not include sufficient cash to pay the taxes, something will have to be liquidated (sold).
An ILIT holding sufficient amounts of life insurance will provide the cash needed to pay estate taxes and the expenses of administering your estate.
To work, an ILIT must involve the creation of an irrevocable trust. This means that a trust is created, and the trust cannot be revoked, modified or changed after it is created. Thoughtful care and planning must go into the creation of the trust.
Additionally, neither you nor your spouse can serve as trustee. In order to exclude the ILIT from your estate, you may not have any “incidents of ownership.” After the trust is created you cannot control it.
The trust can be created so that life insurance is obtained with a single premium, or with premiums paid over a period of time. If premiums are paid over a period of time, a special method is used to fund the ILIT. This method involves the use of certain legal powers, named after the people who sued the IRS to establish this legal right. The power is called the “Crummey” power, named after Mr. and Mrs. Crummey.
Using the “Crummey” power, money is gifted to the trustee who in turn pays the insurance company. Sometimes you can make an arrangement to deposit funds into the trustee’s bank account with an automatic debit being made to the insurance company. This way, the trustee has minimal involvement during your life. Whenever a gift is made, the trustee must send a special letter, called a “Crummey letter,” to the beneficiaries of the trust.