Terminating Irrevocable Life Insurance Trusts: Is It Possible?

Irrevocable life insurance trusts (ILITs) are a popular tool for avoiding estate tax on death benefits paid out under life insurance policies. However, with the increase in the estate tax exemption, many ILITs are no longer necessary. So, what are the options for those who have an ILIT they no longer need?

While an ILIT is typically irreversible by design, it is possible to terminate one in certain circumstances. The specific options available depend on the terms of the trust and applicable state law.

One option is to allow the insurance to lapse by stopping premium payments. This works best for term life insurance policies with no cash value. Another option is to swap the policy for cash or other assets of equivalent value, if permitted by the ILIT. Alternatively, if the ILIT holds a permanent insurance policy, it could be surrendered or sold.

If the ILIT gives the trustee the discretion to distribute trust funds, they may be able to distribute the policy or its cash value to the beneficiaries. If the ILIT's terms do not allow the trustee to unwind the trust, it may be possible to obtain a court order to terminate it, especially if all beneficiaries and the grantor consent.

While it is possible to terminate an ILIT in certain situations, it is important to carefully consider the context and potential tax implications before making any decisions.

Allowing the insurance to lapse

If the ILIT holds a universal life policy, you can stop making premium payments and let the cash value cover the policy expenses until it runs out. When the cash value is depleted, the policy will lapse with no value and no tax event. However, if the ILIT holds a whole life insurance policy, you must make premium payments to keep the policy in force. While you can take out loans against the policy and re-deposit them as new premiums, this will accrue a loan against the policy, eroding its cash value and hastening its demise. Lapsing a whole life insurance policy with a loan may trigger a tax event if the cumulative value of the loan is greater than the premiums.

Therefore, if you unequivocally do not want to continue the life insurance or make ongoing premium payments, allowing the insurance to lapse is an option. However, it is important to consider the potential tax implications and consult with a professional advisor before making any decisions.

Swapping the policy for cash or other assets

The power to substitute replacement assets of equivalent value into a trust under IRC Section 675(4) is often used as one of the key powers to make an ILIT into a grantor trust in the first place. Revenue Ruling 2011-28 affirmed that the power of substitution is not treated as an "incident of ownership" that would cause the life insurance to be included in the decedent's estate under IRC Section 2042.

Accordingly, one of the most straightforward ways to extract a life insurance policy out of an ILIT is to simply swap out the life insurance policy for an asset of equivalent value (e.g., cash). Notably, the substitution should still be for an asset (or cash) of equivalent value, which at a minimum means the policy's cash surrender value. If there's been an adverse change of 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. On the plus side, since the ILIT is a grantor trust, there's no taxable event associated with the substitution to extract the life insurance policy.

Alternatively, if the ILIT doesn't have a substitution power, it may be feasible for the grantor to buy the policy back from the trust for its fair market value. Here again, the 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, while a substitution or purchase of the life insurance policy does extract it out of the ILIT, 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. Completely unwinding the ILIT will require additional steps to extract all of the assets out of the trust.

Surrendering or selling the policy

If your irrevocable life insurance trust (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. Surrendering a life insurance policy means cancelling the policy and receiving its surrender value, which is the cash value minus any surrender fees. Surrendering your policy cancels your life insurance immediately. Your insurer will terminate the coverage and send you a check for the policy's cash surrender value.

Alternatively, if you’re eligible, the trust could sell the policy in a life settlement transaction. 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 cash sum. You receive a large amount of money and are no longer responsible for paying insurance premiums, and upon your eventual passing, the buyer collects the death benefit associated with your policy. Life settlements are generally intended for older people who are in declining health.

The alternative for permanent life insurance policies with cash value is simply to proactively surrender the policy instead, which both eliminates the need for any new premiums and preserves the existing cash value (rather than letting the permanent policy lapse by eroding the cash value down to $0 for life insurance coverage that ostensibly was no longer needed anyway). For policyowners who are at least 60 years old, another option is to sell the life insurance policy, rather than merely surrender it, as life settlement transactions can sometimes pay even more to the policyowner than just the cash value alone. Notably, a life settlement transaction generally only works for those who are older (age 60+ or more commonly 65+, and thus have a shorter life expectancy and nearer-term payout potential for the life settlements buyer). Furthermore, there’s rarely any material payment from a life settlement transaction above the cash value (especially after transaction costs) unless the insured has also had a material (and adverse) change in health. Still, for older insured individuals who have had an adverse change in health, a life settlement transaction may provide the ILIT far more cash than “just” surrendering. Though, of course, if there’s been a material adverse change in health, the implied rate of return for holding the life insurance policy may make it even more compelling to keep after all!

Nonetheless, for those who unequivocally do not want to continue the life insurance, and/or no longer want the commitment of making ongoing premium payments (even if technically they may have a good return on investment to the ILIT and its beneficiaries), surrendering the policy or selling it as a life settlement is another option. In fact, it’s sometimes even feasible for term insurance policies to be sold in a life settlement (despite otherwise having no cash value) if they can be converted to a permanent insurance policy and the insured is older with an adverse change in health (and at that point, any life settlements purchase value is better than allowing the term policy to simply lapse with a value of $0).

The caveat, however, is that both surrendering and selling the life insurance policy can also trigger a taxable gain (to the extent the surrender/sale value exceeds the premiums paid), and once an ILIT’s life insurance policy is surrendered or sold, the ILIT again may no longer need to deal with premium gifts and Crummey notices, but as in the case of a substitution or sale back to the grantor, the ILIT will still continue to exist… simply owning a pile of cash, instead of the life insurance policy the cash came from!

Distributing the trust assets

One option is to allow the insurance policy to lapse. This is possible if the ILIT holds a term life insurance policy that is no longer needed and has no other assets. The grantor simply stops making contributions to the trust to cover premium payments. 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 a significant cash value.

Another option is to swap the policy for cash or other assets. Many ILITs permit the grantor to retrieve a policy by substituting cash or other assets of equivalent value. This allows the grantor to access the policy's cash value by swapping it for illiquid assets.

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 if the grantor is eligible.

Some ILITs give the trustee the discretion to distribute trust funds, including the policy's cash value, other trust assets, or the policy itself, to beneficiaries. 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 unwind the trust, it may be possible to obtain a court order to terminate it. 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.

Going to court

The exact rules and conditions under which a trust can be terminated will vary by the terms of the trust itself, and/or the state in which the ILIT is based. In general, there are four common pathways to terminating an 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. Although the ability to terminate an ILIT is uncommon and may be subject to additional restrictions, it is a possibility that merits reading the trust document to find out.
• Trustee's Power to Terminate a Small Trust: Many trust documents have a provision that allows the trustee to terminate if it is no longer "economical" to maintain the trust because it is too small. This may be feasible 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 by the mutual consent of the trust beneficiaries and the trust’s original grantor. However, this requires the affirmation of all (current and even distant remainder) beneficiaries, which may be difficult or impossible if some are uncooperative, hard to reach, or minors. The grantor must also give consent, which makes a consent termination impossible if the grantor won't cooperate or has already passed away.
• Beneficiary-Directed Court Termination: The most costly pathway to terminate is when beneficiaries wish to do so but the grantor will not or cannot consent. A court termination still requires all beneficiaries to agree and the courts will generally not approve a termination that would violate a "material purpose" of the trust.

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