Ending Irrevocable Life Insurance Trusts: A Step-By-Step Guide

Irrevocable life insurance trusts (ILITs) are a valuable tool for wealthy individuals to protect their assets and provide for their heirs. However, due to changes in financial circumstances, tax laws, or family dynamics, an ILIT may no longer be necessary or desirable. While the process is complex, there are several methods for modifying or terminating an ILIT. The first step is to review the trust document for any clauses that allow for modifications or terminations under specific circumstances. Consulting with a legal expert is crucial to interpreting the trust document and exploring options for modification or termination. Court approval is often required and involves demonstrating that the termination or modification is in the best interest of the beneficiaries. Trust reformation, trust decanting, and termination by agreement are common methods for making changes to an ILIT, each with its own legal requirements and implications. It is important to consider the tax implications of undoing an ILIT, as terminating the trust may result in the inclusion of the policy in the estate, increasing estate taxes.

Allowing the insurance to lapse

It is also possible to allow a permanent life insurance policy to lapse, but this is generally not recommended, especially if the policy has a significant cash value. In this case, other options should be considered, such as surrendering or selling the policy.

If the ILIT holds a universal life policy, premium payments can be stopped, and the cash value can cover the policy expenses until it runs out. Once the cash value is depleted, the policy will lapse without any value or tax event.

However, if the ILIT holds a whole life insurance policy, premium payments must be made to keep the policy in force. Loans can be made against the policy and then re-deposited as new premiums, but this will accrue a loan against the policy, eroding its cash value over time. Allowing a whole life insurance policy to lapse with an outstanding loan may trigger a tax event if the cumulative value of the loan exceeds the premiums paid.

Therefore, if the insurance is no longer needed, allowing the policy to lapse is a viable option for term life insurance or universal life insurance policies. For whole life insurance policies, other options such as surrendering or selling the policy may be more favourable to avoid potential tax implications.

Swapping the policy for cash or other assets

The power to substitute assets is often included in ILITs to grant them grantor trust status. This power allows the grantor to swap assets of equivalent value into the trust without being considered to have "incidents of ownership" over the policy, which could cause it to be included in their estate under IRC Section 2042.

By swapping the policy for cash or other assets of equivalent value, the grantor effectively removes the life insurance policy from the ILIT without triggering a taxable event. This is because the ILIT is typically structured as a grantor trust, meaning it is treated as an extension of the grantor for income tax purposes. Therefore, exchanging the policy for cash or other assets is simply a transaction with oneself and does not create a taxable event.

It's important to note that while this strategy removes the life insurance policy from the ILIT, it does not fully unwind or terminate the trust. The ILIT will still hold the cash or other assets received in the transaction, and additional steps will be necessary to completely unwind the trust if desired.

Surrendering or selling the policy

The process of selling your life insurance is known as a life or viatical settlement. This essentially involves you exchanging ownership of the death benefit to a third-party buyer for a lump cash sum. You will receive a large amount of money and will no longer be responsible for paying insurance premiums. 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.

It is important to note that both surrendering and selling the life insurance policy can trigger a taxable gain if the surrender/sale value exceeds the premiums paid. Additionally, while surrendering or selling the policy will remove the policy from the trust, it will not fully eliminate the trust itself. The ILIT will still continue to exist, simply owning the cash proceeds from the transaction instead of the life insurance policy.

Distributing the trust assets

The trustee of an ILIT must abide by the terms of the trust and applicable state laws when distributing the assets. The trustee has a fiduciary duty to act in the best interests of the trust beneficiaries and must exercise impartiality when making distributions. The trustee cannot simply transfer the life insurance policy back to the settlor-insured to terminate the ILIT. Instead, the trustee must consider the needs of all beneficiaries, including current and remainder beneficiaries, and distribute the assets accordingly.

In some cases, the ILIT may allow the trustee to make distributions to beneficiaries before the death of the insured, especially if the beneficiaries are now adults. The trustee may have the discretion to distribute the life insurance policy itself or its cash surrender value to the beneficiaries.

If the ILIT does not permit the trustee to make distributions, it may be possible to obtain a court order to terminate the trust. This typically requires the consent of all beneficiaries and the grantor, or a court decision that modifying or terminating the trust is necessary to achieve its purposes.

It is important to note that distributing the trust assets may have tax implications. The distribution of the life insurance policy or its cash value may be considered a taxable gift, and the termination of the trust may result in the inclusion of the policy in the grantor's estate, potentially increasing estate taxes. Therefore, it is crucial to consult with legal and tax professionals before taking any action.

Going to court

Before going to court, it is important to consult with an attorney or legal advisor to discuss your specific situation and explore all possible options. There may be other strategies available to unwind an ILIT that do not involve court intervention. Additionally, it is crucial to consider the tax implications of terminating an ILIT, as there may be potential tax consequences for you or your beneficiaries.

It is worth noting that the process of going to court can be complex and costly. There may be legal fees, court fees, and other associated expenses. Therefore, it is advisable to seek professional advice and carefully consider all options before initiating any legal proceedings.

Overall, going to court to end an ILIT should be considered as a last resort, after exploring all other possible options and seeking professional advice to understand the potential consequences and costs involved.

Frequently asked questions