Irrevocable Life Insurance Trusts: Can They Be Invaded?

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 grantor's spouse and children by holding the policy proceeds in trust after their death. The grantor creates the trust and funds it with a life insurance policy, after which they can no longer make any changes to the trust or transfer ownership of the policy. The appointed trustee is then responsible for managing the trust and its assets, including ensuring that premium payments are made through the trust account. While an ILIT offers several benefits, such as asset protection and tax savings, it also has some downsides, including the loss of control over the life insurance policy and potential gift tax implications. In certain circumstances, it may be possible to terminate an ILIT, but it is not an easy process and typically requires a court order.

Removing a policy from a taxable estate

An Irrevocable Life Insurance Trust (ILIT) is a trust that owns and controls a term or permanent life insurance policy during the insured's lifetime. It is created to reduce the value of an individual's estate and, in turn, reduce the estate tax paid on the life insurance benefits passed from the grantor to the beneficiary.

Relinquish all "incidents of ownership"

The key to removing the policy from your taxable estate is to give up 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.

Allow the insurance to lapse

If the ILIT holds a term life insurance policy that is no longer needed, the grantor can simply stop making contributions to the trust to cover premium payments. Technically, the ILIT continues to exist, but once the policy lapses, it owns no assets.

Swap the policy for cash or other assets

Some ILITs allow the grantor to retrieve a policy by substituting cash or other assets of equivalent value. This option may be preferable if the policy has a significant cash value.

Surrender or sell the policy

If the ILIT holds a permanent insurance policy, the trust might surrender it, preserving its cash value and avoiding further premium payments. Alternatively, the trust could sell the policy in a life settlement transaction.

Distribute the trust assets

Some ILITs give the trustee the discretion to distribute trust funds, including the policy's cash value, to beneficiaries. Typically, these distributions are limited to funds needed for "health, education, maintenance and support".

Go to court

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 some of these options may have tax implications for the grantor or their beneficiaries. It is always recommended to seek professional advice when considering changes to an irrevocable life insurance trust.

Allowing insurance to lapse

Allowing an insurance policy to lapse is one way to terminate an irrevocable life insurance trust (ILIT). This can be done by simply stopping contributions to the trust to cover premium payments. This method is most suitable for term life insurance policies that are no longer needed and when the ILIT holds no other assets.

Technically, the ILIT continues to exist, but once the policy lapses, it owns no assets. It is also possible to allow a permanent life insurance policy to lapse, but other options may be preferable, especially if the policy has accumulated a significant cash value.

The most common strategy for terminating an ILIT is to allow the life insurance policy to lapse by no longer making premium payments. This would render the ILIT worthless, as the insurer would eventually cancel the policy, leaving no benefits to distribute. However, allowing a policy to lapse would likely result in the loss of any premium payments made up to that point. Additionally, state trust regulations could create obstacles to letting the trust lapse.

To terminate an ILIT, state regulators may require certain conditions to be met. For example, it may be necessary to demonstrate that all parties to the trust have agreed to its termination. Alternatively, a material change that was not anticipated when the trust agreement was signed and which impacts the agreement may need to be shown. For instance, if the state changes a significant aspect of its tax law relating to estate taxation, an attorney may be able to argue successfully for the termination of the trust.

If the decision is made to terminate an ILIT by allowing the insurance policy to lapse, it is important to be prepared for a potentially lengthy and costly legal battle if a beneficiary of the trust opposes this action.

Swapping the policy for cash or other assets

The process of terminating an ILIT is not easy or fast, and it may be costly. The most common strategy is to simply allow the life insurance policy to lapse by no longer making premium payments. However, this would likely involve sacrificing the premium payments made up to that point.

The grantor of an ILIT may also consider surrendering or selling the policy. If the ILIT holds a permanent insurance policy, the trust could preserve its cash value by surrendering the policy, thus avoiding the need to continue paying premiums. Alternatively, if eligible, the trust could sell the policy in a life settlement transaction.

Another option is to distribute the trust's assets. Some ILITs give the trustee the discretion to distribute trust funds, including the policy's cash value, to beneficiaries. Typically, these distributions are limited to funds needed for "health, education, maintenance, and support".

Surrendering or selling the policy

If your ILIT holds a permanent insurance policy, the trust might surrender it, which will preserve its 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. This option is especially beneficial for older insured individuals who have experienced an adverse change in health. A life settlement transaction can provide the ILIT with a higher cash value than simply surrendering the policy.

However, it's important to note that both surrendering and selling the life insurance policy can trigger a taxable gain if the surrender or sale value exceeds the premiums paid. Additionally, the ILIT will still exist even after the policy is surrendered or sold, as it will hold the cash proceeds from the transaction.

Considerations

When considering surrendering or selling the policy, it's important to weigh the benefits of preserving the cash value and avoiding future premium payments against the potential tax implications. It's also crucial to ensure that the transaction is handled properly to maximize the benefits for the ILIT and its beneficiaries. Consulting with a professional advisor can help you navigate these considerations and determine if this is the best option for your specific situation.

Other Options

In addition to surrendering or selling the policy, there are several other options for unwinding an ILIT, including allowing the insurance to lapse, swapping the policy for cash or other assets, distributing the trust assets, or going to court to terminate the trust. The best course of action depends on the specific circumstances, the terms of the trust, and applicable state law.

Distributing trust assets

Some ILITs give the trustee the discretion to distribute trust funds (including the policy's cash value, other trust assets, or possibly the policy itself) to beneficiaries such as the grantor's spouse or children. Typically, these distributions are limited to funds needed for "health, education, maintenance and support".

If the ILIT's terms do not permit the trustee to distribute the trust's assets, it may still be possible to obtain a court order to terminate the trust. 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.

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