Irrevocable Life Insurance Trusts: Audit Frequency And You

Irrevocable Life Insurance Trusts (ILITs) are a common estate planning strategy used to minimise estate taxes on an individual's assets after their death. ILITs are the owner and beneficiary of a life insurance policy, and the proceeds from this policy are distributed to beneficiaries according to the insured's wishes. While ILITs are a useful tool for estate planning, it is unclear how often they are audited.

How do irrevocable life insurance trusts work?

An Irrevocable Life Insurance Trust (ILIT) is a legal arrangement that seeks to minimise an individual's current tax burden and the impact of taxes on their estate after their death. It does this by transferring assets from the individual to the trust and using a life insurance policy to distribute the proceeds to beneficiaries when the individual dies.

ILITs are trust structures set up between three legal parties: the grantor, the trustee, and the beneficiary/beneficiaries. The grantor creates and funds the trust. The trustee manages the trust and pays the annual insurance premiums. The beneficiaries receive the trust assets upon the grantor's death.

By creating an ILIT, the grantor removes taxable assets from their estate and transfers them to a separate legal entity (the trust). The trustee uses these assets to purchase a life insurance policy in the grantor's name and continues to pay the premiums. When the grantor dies, the policy's death benefit is paid directly to the trust, which then distributes the proceeds to the named beneficiaries.

ILITs are a powerful planning tool that serves as an important wealth transfer mechanism in many well-crafted estate plans. They are particularly beneficial for affluent families with sizable estates or those with loved ones who have special needs and will require ongoing care.

One of the main benefits of an ILIT is its ability to minimise estate taxes. When life insurance is owned by an ILIT, the proceeds from the death benefit are not part of the insured's gross estate and are therefore not subject to state and federal estate taxation.

Another advantage of ILITs is their ability to avoid gift taxes. Contributions made by the grantor to the trust are considered gifts to the beneficiaries, and as such, they avoid gift tax consequences.

ILITs can also help protect government benefits for beneficiaries who are receiving government aid, such as Social Security Disability Income or Medicaid. The trustee can carefully control how distributions from the trust are used, ensuring that the beneficiary's eligibility for government benefits is maintained.

While ILITs offer several benefits, it is important to consider the downsides as well. The main disadvantage is that ILITs are irrevocable. Once the trust is established, it cannot be modified or terminated without legal action or the consent of the beneficiaries. Therefore, individuals should carefully consider the implications of establishing an ILIT before setting one up.

What are the pros and cons of an irrevocable life insurance trust?

An Irrevocable Life Insurance Trust (ILIT) is a trust that owns and controls a term or permanent life insurance policy or policies. It is created during the insured's lifetime and can manage and distribute the proceeds that are paid out upon the insured's death. ILITs are often used to minimise estate taxes and avoid gift taxes, as well as protect government benefits and provide tax considerations.

Pros:

• Minimising Estate Taxes: The proceeds from the death benefit are not part of the insured's gross estate and are thus not subject to state and federal estate taxation.
• Avoiding Gift Taxes: Contributions by the grantor are considered gifts to the beneficiaries, avoiding gift tax consequences.
• Protecting Government Benefits: ILITs can help protect the benefits of a trust beneficiary who is receiving government aid, such as Social Security disability income or Medicaid.
• Tax Considerations: Irrevocable trusts have a separate tax identification number and an income tax schedule. The cash value accumulating in a life insurance policy is free from taxation, as is the death benefit.
• Asset Protection: When the policy is held in an ILIT, any excess value above the state limits is generally protected from the creditors of both the grantor and the beneficiary.
• Legacy Benefits: Transferring ownership to a trust can make it easier for beneficiaries to qualify for Medicaid and other government assistance programs.
• Protection Beyond Taxes: ILITs can protect insurance benefits from divorce, creditors, and legal action against the grantor and beneficiaries. They also avoid probate and shield assets from expense and loss of privacy during probate.
• Liquidity: ILITs can provide liquidity to pay estate taxes and other debts and expenses.

Cons:

• Irrevocability: ILITs are irrevocable, meaning they cannot be altered or undone after they are created. This could cause issues if the grantor unexpectedly needs assets that have been put into the trust.
• Loss of Control: The grantor loses control of the assets, including who the trust beneficiaries are and the circumstances under which they receive the assets.
• Cost: Setting up and maintaining an ILIT may require professional fees and the filing of a gift tax return.
• Tax Burden for Descendants: While ILIT assets are not taxed as part of the grantor's estate, they are taxed as part of the beneficiaries' estates, leaving a bigger tax burden for descendants.

How to set up an irrevocable life insurance trust

An irrevocable life insurance trust (ILIT) is a legal arrangement that helps to minimise an individual's current tax burden and the impact of taxes on their estate. It does this by transferring assets from the individual to the trust, and using a life insurance policy to distribute the proceeds when the individual passes away.

• Understand the implications: Before setting up an ILIT, it is important to fully consider the implications of establishing one. ILITs are irrevocable, meaning that once the trust has been established, it cannot be changed or altered. This means the grantor will no longer have access to the assets put into the trust.
• Check insurance eligibility: Before starting the process of establishing an ILIT, individuals should first determine if they are healthy enough to go through the underwriting process.
• Ensure liquidity: Individuals should work with a financial advisor to confirm that funding the life insurance premiums will not affect their day-to-day standard of living.
• Work with experts: ILITs are complicated legal instruments, so it is important to work with experts in the field to make sure the trust is set up and funded appropriately. Consult a tax attorney, trust officer, or financial professional to see if an ILIT is the right choice for you.
• Apply for coverage: The trust will apply for coverage on the grantor and the insurance company will provide an offer.
• Work with estate planning professionals: The grantor then works with estate planning professionals and lawyers to establish the ILIT. The lawyers will draft the trust documents.
• Transfer ownership of a life insurance policy: Funding a life insurance trust typically involves transferring ownership of a life insurance policy to the trust. This can be done by purchasing a new policy and naming the trust as the owner and beneficiary, or by transferring an existing policy to the trust.
• Fund the trust: In addition to a life insurance policy, the trust can also be funded with various assets, including cash, stocks, bonds, and other investments.
• Consider the type of life insurance policy: Permanent life insurance policies, such as whole life or universal life, are often preferred for funding trusts. These policies provide a guaranteed death benefit and can accumulate cash value over time, making them a reliable choice. Term life insurance policies may not be as suitable as they expire after a certain period, potentially leaving the trust unfunded if the term ends before the insured person passes away.

By following these steps, individuals can set up an ILIT to minimise their tax burden and effectively manage their estate.

When might an irrevocable life insurance trust be unnecessary?

An irrevocable life insurance trust (ILIT) is a legal arrangement that seeks to minimise an individual's current tax burden and the impact of taxes on their estate after their death. While ILITs are a powerful tool for estate planning, there are certain scenarios in which setting up an ILIT may be unnecessary.

Firstly, ILITs are typically used by ultra-high-net-worth individuals and couples whose assets exceed the lifetime exemption. As of 2024, the lifetime exemption for an individual is $13.61 million, doubled for married couples. Therefore, if an individual's or couple's assets do not exceed this threshold, an ILIT may be unnecessary. It is important to note, however, that the lifetime exemption is subject to change. For example, in 2025, the exemption is expected to increase to $13.99 million for individuals, while in 2026, it is set to be reduced to a lower level, which may increase the demand for ILITs.

Another scenario in which an ILIT may be unnecessary is when an individual does not own any life insurance policies or does not intend to purchase one. ILITs are specifically designed to hold and manage life insurance policies during the insured's lifetime. Therefore, if an individual does not have or want a life insurance policy, there would be no need to set up an ILIT.

Additionally, ILITs are often used to protect the eligibility of beneficiaries who are receiving government benefits. Therefore, if the intended beneficiaries of an estate do not require ongoing government assistance, such as Social Security Disability Income or Medicaid, an ILIT may be unnecessary.

Furthermore, one of the primary benefits of an ILIT is its ability to minimise estate taxes. However, if the value of an individual's estate is below the estate tax exemption threshold, they may not need an ILIT for tax minimisation purposes. It is important to consider both federal and state-level estate tax thresholds, as they can vary.

Lastly, ILITs can be complex and costly to set up and maintain, requiring professional fees and the involvement of legal and financial experts. Therefore, for individuals with simple estate planning needs or limited assets, an ILIT may be unnecessary, and other, more straightforward estate planning strategies may be more appropriate.

How do irrevocable life insurance trusts differ from revocable trusts?

Irrevocable life insurance trusts (ILITs) are a type of trust that is the owner and beneficiary of a life insurance policy covering an individual or couple. They are typically used by wealthy individuals and couples to minimise estate taxes and protect assets from creditors. The key difference between an irrevocable life insurance trust and a revocable trust is that an ILIT cannot be altered or amended once it has been established, whereas a revocable trust can be modified at any time by the grantor.

An ILIT is created during the insured's lifetime and 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 parties involved in an ILIT are the grantor (who creates and funds the trust), the trustee (who manages the trust), and the beneficiaries.

A revocable trust, on the other hand, is a trust that can be changed at any time. The grantor of a revocable trust can modify the terms, add or remove beneficiaries, and change stipulations on how the assets within the trust are managed. Revocable trusts are also known as living trusts.

The main advantage of an ILIT is that it offers tax benefits and protects assets from creditors. By transferring ownership of a life insurance policy to an ILIT, the proceeds of the policy are no longer considered part of the individual's estate and are therefore not subject to estate taxes. Additionally, the assets in an ILIT are generally protected from the creditors of both the grantor and the beneficiary.

The main disadvantage of an ILIT is that it cannot be modified once it has been established. This means that the grantor gives up control over the assets in the trust and cannot make changes without the consent of the beneficiaries or court approval. In contrast, the assets in a revocable trust are still owned by the grantor and are therefore not protected from creditors or lawsuits.

In summary, the main difference between irrevocable life insurance trusts and revocable trusts is that ILITs are irrevocable and offer tax benefits and asset protection, while revocable trusts can be modified at any time but do not provide the same level of tax and asset protection.

Frequently asked questions