Borrowing From Irrevocable Life Insurance Trusts: Can Grantors?

Irrevocable life insurance trusts (ILITs) are a popular estate planning tool used to avoid estate tax on the death benefits paid out under life insurance policies. When an insured person dies, the proceeds from their life insurance policy are normally subject to estate tax. However, if the insurance policy is owned by an ILIT, the proceeds are exempt from this tax. This is because the trust, rather than the insured, owns the policy.

In this context, the grantor is the person who creates and funds the trust. They can be the insured person, but this is not always the case. The grantor cannot borrow from the cash value of the life insurance policy. However, they can give the trustee the right to borrow and distribute or spend the funds on the designated beneficiaries.

Grantor relinquishing incidents of ownership

Grantor trust rules are guidelines in the Internal Revenue Code (IRC) that outline certain tax implications of a grantor trust. A grantor trust agreement dictates how assets are managed and transferred after the grantor's death. State laws determine if a trust is revocable or irrevocable. A grantor trust is one in which the individual who creates the trust is the owner of the assets and property for income and estate tax purposes.

A grantor can relinquish control of the trust, making it irrevocable. This type of trust can't be amended or cancelled without the permission of all beneficiaries. The trust pays taxes on the income it generates and requires a tax identification number (TIN).

An irrevocable life insurance trust (ILIT) is a trust created during the insured's lifetime that owns and controls a term or permanent life insurance policy. The trust can also manage and distribute the proceeds that are paid out upon the insured's death, according to the insured's wishes.

The key to removing the policy from the grantor's taxable estate is to relinquish all "incidents of ownership." This means that the grantor cannot retain the power to change beneficiaries, assign, surrender or cancel the policy, borrow against the policy's cash value, or pledge the policy as security for a loan.

Once the insured gives up these rights, they can no longer borrow from the cash value of the life insurance policy. However, the trustee may have the power to borrow and distribute or spend the funds on any of the designated beneficiaries.

Trustee borrowing and spending

Trustees can borrow and spend from an irrevocable life insurance trust (ILIT) under certain conditions. The trust agreement typically authorises the trustee to borrow funds from the insurance company and pledge the trust policies as security. This strategy can be used to pay all or part of the premiums due on certain policy types. Trustees can also borrow from the cash value of the life insurance policy if the grantor has given them the right to do so. This right must be explicitly stated in the trust's written instructions.

The trustee can also distribute the borrowed or withdrawn funds to the designated beneficiaries. The grantor may set conditions for distributing funds, such as withholding funds from a beneficiary with a substance abuse problem or who drops out of school. The trustee can also be given the power to remove beneficiaries under certain circumstances, such as divorce in the family.

In addition, the trustee can have discretionary powers to make distributions and control when beneficiaries receive the proceeds of the policy. The trustee may decide to provide distributions when beneficiaries attain certain milestones, such as graduating from college, buying their first home, or having a child. The trustee can also distribute funds for the beneficiary's support.

To ensure that the ILIT achieves the grantor's objectives, they may appoint a "trust protector". This person has the power to remove the trustee, amend the trust, or take other necessary actions in light of changing laws or circumstances.

ILIT estate-planning strategy

An Irrevocable Life Insurance Trust (ILIT) is a trust created during the insured's lifetime that owns and controls a term or permanent life insurance policy. It is a common estate-planning strategy used by those with large taxable estates. By making the trust the owner and beneficiary of the life insurance policy, the insured removes the insurance proceeds from their taxable assets.

Minimizing Estate Taxes

ILITs are often used to minimize estate taxes. When a life insurance policy is owned by an individual, the death benefit is typically included in their gross estate and subject to estate taxation. However, when the ILIT owns the policy, the proceeds are not considered part of the insured's estate, thereby reducing the tax burden.

Avoiding Gift Taxes

Properly structured ILITs can help avoid gift tax consequences. Contributions made by the grantor are considered gifts to the beneficiaries, and the trustee can notify the beneficiaries of their right to withdraw these gifts for a specified period (usually 30 days) using a "Crummey letter." This qualifies the transfer for the annual gift tax exclusion, avoiding the need to file a gift tax return in most cases.

Protecting Government Benefits

ILITs can help protect the benefits of trust beneficiaries who are receiving government aid, such as Social Security disability income or Medicaid. The trustee can manage distributions carefully to ensure they do not interfere with the beneficiary's eligibility for government assistance.

Tax Considerations

Irrevocable trusts have their own tax identification number and are not subject to taxation on the cash value accumulating in the life insurance policy or the death benefit. However, if the proceeds remain in the trust after the death benefit is paid, any investment income earned may be taxed if it is not distributed to the beneficiaries.

Flexibility for Heirs

ILITs provide flexibility for heirs by offering a source of cash to settle estate taxes and other debts. This can help avoid the need to sell real estate, stocks, or family businesses to raise funds, preserving the assets as intended by the deceased and their family.

Protection from Creditors and Divorce

ILITs can also protect insurance benefits from creditors, legal action, and divorce. This ensures that the benefits are preserved for the intended beneficiaries and are not diverted to other purposes.

Considerations for Grantors

It is important to note that ILITs are irrevocable, meaning the grantor gives up certain rights and cannot make changes once the trust is established. The grantor must relinquish all "incidents of ownership," including the power to change beneficiaries, assign or cancel the policy, or borrow against the policy's cash value. This loss of personal use and flexibility of the policy is a trade-off that grantors should carefully consider.

In conclusion, ILITs are a powerful tool in estate planning, particularly for individuals with large taxable estates. They offer tax advantages, flexibility for heirs, and protection for beneficiaries. However, grantors should be aware of the irrevocable nature of the trust and the associated loss of personal control over the insurance policy.

Beneficiary borrowing

Beneficiaries can borrow from the cash value of a life insurance policy through the trustee. However, this right must be explicitly stated in the written instructions for the trust. If the grantor did not set up this provision when the trust was originally created, the beneficiary cannot borrow from the cash value.

The grantor of an irrevocable life insurance trust (ILIT) cannot borrow from the cash value of the life insurance policy. However, they can give the trustee the right to borrow and distribute or spend the funds on any of the designated beneficiaries. The trustee can also be given the power to assign, surrender, or cancel the policy, or pledge it as security for a loan.

The primary purpose of an ILIT is to reduce the value of an individual's estate, thereby lowering the estate tax paid on the life insurance benefits passed from the grantor to the beneficiary. The trust is the owner and beneficiary of the policy, and the proceeds of the life insurance policy are paid to the trust as beneficiary to be distributed in accordance with the trust agreement.

ILITs are typically used by those with large taxable estates. By making the trust the owner of the life insurance policy, the insured removes the insurance proceeds from their taxable assets. The grantor of the trust pays the insurance premiums each year by gifting to the trust. As long as the premiums remain below a certain amount (for example, $13,000 in one source), the grantor can use the annual gift exclusion to avoid taxes.

Grantor trust rules

Taxation of Grantor Trusts

Powers of the Grantor

Grantors have the power to change the beneficiaries, investments, and assets held within the trust. They can direct a trustee, who is responsible for managing the assets and distributions to the beneficiaries, to make alterations. Grantors can also revoke or undo their revocable trusts, giving them greater flexibility and control. However, if a grantor relinquishes control and makes an irrevocable trust, it cannot be amended or cancelled without the permission of all beneficiaries.

Conditions for Irrevocable Trusts

According to the grantor trust rules outlined by the IRS, an irrevocable trust may be treated as a grantor trust if certain conditions are met. These conditions include the grantor retaining powers such as:

• A reversionary interest of more than 5% of the trust property or income
• The ability to revoke the trust and return its assets to the grantor
• The power to distribute income to the grantor or their spouse
• Power over the beneficial interests in the trust
• Administrative powers that allow the grantor to benefit

Benefits of Grantor Trust Rules

Frequently asked questions