How To Modify An Irrevocable Life Insurance Trust

An irrevocable life insurance trust (ILIT) is a trust that owns a life insurance policy as its main asset. It is typically used to benefit the insured person's spouse and children by holding the policy proceeds in trust after their death. The main reason people create an ILIT is to save on estate taxes. While an ILIT is designed to be unchangeable once created, there are certain circumstances in which it can be terminated or altered. This paragraph will explore the conditions under which an ILIT can be changed and the options available to grantors who wish to do so.

Allowing the insurance to lapse

It is important to note that allowing the insurance to lapse may result in losing the premium payments made up to that point. Additionally, the rules governing trusts in a particular state could create obstacles to letting the trust lapse. Therefore, it is advisable to consult a professional advisor to discuss the options and their potential tax implications.

Swapping the policy for cash or other assets

The substitution should be for an asset or cash of equivalent value, which means at least the policy's cash surrender value. If there has been an adverse change in the insured's health and the insured is older, the valuation may be more akin to what the policy could be sold for in a life settlement to a third party. Since the ILIT is a grantor trust, there is no taxable event associated with the substitution to extract the life insurance policy.

Alternatively, if the ILIT doesn't have a substitution power, the grantor may be able to buy the policy back from the trust for its fair market value. This purchase would not be treated as a taxable event since the ILIT as a grantor trust is already the grantor's alter ego for income tax purposes. In addition, since the grantor is the insured who's purchasing the policy, the death benefit will remain tax-free and not be subject to the transfer-for-value rules under IRC Section 101(a)(2).

However, it is important to note that while a substitution or purchase of the life insurance policy extracts it from the ILIT and eliminates the need for future premium gifting, it doesn't fully eliminate and unwind the ILIT itself. The ILIT will still hold the cash or other substituted value proceeds from the transaction. To completely unwind the ILIT, additional steps will be required to extract all the assets from the trust.

Surrendering or selling the policy

If your ILIT holds a permanent insurance policy, the trust might choose to surrender it. This will preserve the policy's cash value but avoid the need to continue paying premiums. Alternatively, if you're eligible, the trust could sell the policy in a life settlement transaction. Surrendering a life insurance policy is a life-changing decision that affects you and your family, so you should carefully weigh the pros and cons of this option.

Pros

• Surrendering your policy is a simple and quick process. Just tell your insurance company that you'd like to surrender and let them work out the details of your policy to determine the cash surrender value you'll get back.
• Surrendering your policy means you'll get some money back, which is better than getting nothing.
• You will no longer need to keep paying premiums and can use that money for other needs.

Cons

• Surrendering your policy means you'll only get one offer from the insurance company, and their goal is to give you as little money as possible.
• There are surrender fees to consider, which can be up to 35% of the proceeds you'll get, depending on when you surrender it.
• You will lose coverage and your beneficiaries will not receive a death benefit when you die.
• You may have to pay taxes on the surrender value if earnings exceed the amount you've paid into the policy.

If you're considering surrendering your policy, it's worth looking into selling as an alternative to see how much money you could get through a life settlement. The process of selling your life insurance is known as a life or viatical settlement, and it essentially involves you exchanging ownership of the death benefit to a third-party buyer for a lump sum cash payment. Your policy's value on the secondary market is always more than its cash surrender value — five times more on average. In some cases, the sales price can be as high as 60% of the policy's death benefit.

Distributing the trust assets

The trustee of an Irrevocable Life Insurance Trust (ILIT) has a fiduciary duty to act in the best interest of the beneficiaries. One of their key responsibilities is to ensure that the benefits are properly distributed to the beneficiaries as outlined in the trust agreement. These individuals are often direct family members of the grantor, such as children or grandchildren.

The trustee can also have the discretion to provide distributions when beneficiaries attain certain milestones, such as graduating from college, buying a first home, or having a child. This can be useful in second marriages to ensure how assets are distributed or if the grantor has children who are minors.

The trustee may have the flexibility to make distributions of some or all of the trust's assets. However, the ability to terminate an ILIT is not common and may be subject to additional restrictions. The trustee may also have the power to terminate a small trust if it is no longer economical to maintain due to its size.

If the ILIT's terms do not permit the trustee to unwind the trust, it may be possible to obtain a court order to terminate it. For example, state law may permit a court to modify or terminate an ILIT if unanticipated circumstances require changes to achieve the trust's purposes or if the grantor and all beneficiaries consent.

It is important to note that the trustee must still honor the terms of the trust, and if the trust is more restrictive in preventing various "unwinding" options, the parties are still bound by those terms.

Going to court

If the terms of the trust do not allow the trustee to unwind it, it may be possible to obtain a court order to terminate the trust. This will depend on the laws of the state in which the trust is based.

In general, there are four common pathways to terminating an irrevocable life insurance trust (ILIT):

• Trustee's Power to Terminate: Some ILITs grant trustees the flexibility to make distributions of some or all of the trust's assets. Others may grant the trustee the discretion to terminate the trust altogether. However, this ability is not common and may be subject to additional restrictions.
• Trustee's Power to Terminate a Small Trust: Many trust documents allow the trustee to terminate the trust if it is no longer economical to maintain due to its small size. This may be applicable for an ILIT owning a term insurance policy with no cash value.
• Consent Termination by Grantor and Beneficiaries: Most states allow trusts to be terminated with the mutual consent of the trust beneficiaries and the grantor. However, this requires the affirmation of all beneficiaries, including minor children, and can be difficult to obtain.
• Beneficiary-Directed Court Termination: If the beneficiaries wish to terminate the trust but the grantor does not consent, they may seek a court order to terminate or modify the trust. This typically requires the agreement of all beneficiaries and is only approved by the courts if the original purpose of the trust is no longer achievable or if other factors substantially outweigh the original purpose.

While an ILIT is designed to be irrevocable, it is not entirely unchangeable. With the right trustee and legal maneuvering, it is possible to modify or terminate the trust in certain circumstances. However, it is important to remember that this is not a simple process, and obtaining a court order can be costly and time-consuming.

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