PROTECT YOUR LIFE INSURANCE with an ILIT

By Nathaniel E. Clement, J.D.

This article discusses the "ILIT" - an irrevocable life insurance trust.

An ILIT is a trust formed by the person who intends to purchase a life insurance policy. It could be a trust formed by a person who already owns a life insurance policy.

First of all, what is a "trust?" A trust is, simply, a device that let's a grantor (trustmaker) make a gift with strings attached. If a trust is revocable (for example, a revocable living trust), the grantor retains complete - 100% - control over the trust and, for tax purposes, property placed in the trust is considered still owned by the grantor. This is not so with an ILIT. Property contributed to an ILIT (properly structured) is a gift for tax purposes to the beneficiaries of the trust and, therefore, is NOT considered "owned" by the grantor.

The property that is contributed/gifted to the ILIT is either (i) an existing life insurance policy, or (ii) cash, which will be used by the trustee of the ILIT to pay for a new life insurance policy.

There are two other important trust terms that you must understand.

The first term is "trustee." A trustee is a person appointed by the grantor (by means of the trust agreement) to be the chief operating officer of the entity.

The second term is "beneficiary." Every trust must have one or more beneficiaries, which can be any person(s), a charity, or another legal entity, such as a partnership or even another trust. For an ILIT to work properly, the grantor must not name himself/herself as a beneficiary, but it is all right to name a spouse as a beneficiary. (This is a totally different concept from a revocable living trust where the grantor is named as a beneficiary.)

Under a trust arrangement, a grantor makes a gift to beneficiaries with strings attached, it being the trustee's job to carry out or administer the restrictions set forth in the trust agreement. A trustee has a "fiduciary" duty under state law to faithfully, honestly, and competently carry out these instructions. If an ILIT says that the trustee is permitted to use the cash value of the policy for the needs of the beneficiaries, that means the trustee must be competent enough to make value judgments and to balance the needs of possibly competing interests. A trustee has a duty to all of the beneficiaries - not just one beneficiary. However, an ILIT may be drafted to state that the "needs of my spouse are more important than the needs of my children." This gives the trustee the authority to use the cash value of the policy - or the death proceeds after the grantor's death - for the primary benefit of the spouse and only thereafter for the benefit of others.

The common goal of ILIT planning is to mimic as closely as possible the advantages of personal ownership of the life insurance policy but without the negative aspects of personal ownership. We want to say to clients something like this: "We recommend that you use an ILIT as the ownership device for the life insurance that we have recommended to you. Here's why: it will protect the property (cash value and death proceeds) from divorce, lawsuits, mismanagement and spendthrift behavior; it will not interfere with tax-free accumulation of cash value in the policy during your lifetime; the ILIT will still enable you to have access to the cash value during your lifetime - and, as always, distributions of cash value to you or the beneficiaries will be tax-free. The ILIT will give you and your family enormous tax advantages that outright and personal ownership will not permit: An ILIT will protect the proceeds of the life insurance from the estate tax. Finally, when you - the insured - pass away, the ILIT will ensure that 100% of the proceeds are used exactly as you wish, with the type of controls that you desire."

If all this sounds too good to be true, this is one case where it actually is true. All of the above can be obtained with ILITs that are properly structured and properly administered. Some clients ask "why doesn't the Congress just outlaw ILITs?" or "How do we know the IRS won't make them illegal?" The answer is that trusts are governed by state law - not federal law. A properly drafted ILIT is not "owned" by the grantor under state law. However, the ILIT must also carefully comply with Congress' statutes and the regulations of the IRS concerning "incidents of ownership." The slightest incident of ownership can be fatal from an estate tax standpoint; but a well-drafted ILIT and a properly administered ILIT will deny incidents of ownership.

One of the nice things about ILITs is that when the death proceeds pay out into the trust, the property can be held in a protective trust for the benefit of the beneficiaries in an order of priority. For example, a single-life ILIT can hold the proceeds in trust for the lifetime of the surviving spouse (without her being the "owner" of the funds) and then direct the balance, at her death, to the children in any manner that the grantor has directed in the trust agreement. Often this will be in protective trust shares for the children. In the example just shown, the surviving spouse does not "own" the assets of the ILIT. This concept of use without ownership is one of the most important tax principles in estate planning. Use without ownership is what makes the Family Trust in a good estate plan save over $500,000 in estate taxes.

The "use without ownership" concept in an ILIT can be extended to even the next level of beneficiaries - the children who take the property after both parents have passed away. In an ILIT it is possible to have the property in the trust be forever free of the U.S. estate tax - to do this, the trust agreement must never allow a beneficiary to acquire ownership for tax purposes. It is the use without ownership concept that makes the ILIT such a powerful planning tool.

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