How an ILIT is Like a Country Song, but Backwards

What do you get when you play a country song backwards?  Your dog, job and trailer back.  This joke actually has some interesting parallels to one of the best estate planning and asset preservation strategies that you may have never heard of – the ILIT.

If your estate is greater than the current estate/gift tax exemption, the legacy you leave for your beneficiaries may become a nightmare to manage and will be greatly reduced if you do not plan properly. State and federal estate taxes can reduce the assets you have worked to preserve for your family by as much as 60%. Without proper planning, your beneficiaries may need to immediately liquidate  closely held assets to cover such a tax bill that. For example, if you have a business and real estate assets that exceed the gift tax exemption by $5 million, your beneficiaries may need to come up with $3 million to cover the estate tax burden you left them. If they do not have that amount in cash, they may need to conduct an immediate fire sale of the family business, real estate or sentimental heirlooms just to pay Uncle Sam.

One way to avoid this tax burden is an Irrevocable Life Insurance Trust (“ILIT). An ILIT can be designed to provide needed liquidity and a host of other benefits as well.  Generally, an ILIT is an extremely useful estate-planning tool for high-net-worth individuals and estates that need a flexible source of liquidity upon the death of the insured party. An ILIT is a separate, irrevocable entity that owns and controls a life insurance policy that covers the life of a separate insured person or multiple people. An ILIT is responsible for managing the policy and distributing the proceeds after the death of the insured person, and because it’s a separate entity, the ILIT death benefit proceeds are not included in the taxable estate of the insured party. An ILIT can include one or several policies, including individual second to die policies.  Second to die life insurance covers two separate lives and is only distributed when both individuals have passed.

An ILIT is comprised of several important parties: the grantor(s), the trustee(s), and beneficiary(ies). The grantor is the individual who establishes and funds the ILIT. Because an ILIT is irrevocable, all material transfers to the ILIT are permanent, and the grantor is essentially giving up control of the ILIT to the trustee. The trustee manages the ILIT for the grantor, and the ILIT beneficiaries receive the insurance death benefit distributions after the death of the grantor (or covered person if different than grantor).

There are some very important considerations to keep in mind when forming and managing the ILIT. It is essential that the ILIT grantor avoid any incidental ownership in the life insurance policy that is owned by the ILIT – it must remain completely separate from the grantor. The ILIT premiums should be paid from a checking account that is owned by the ILIT (and not the grantor). Additionally, if a grantor attempts to transfer an existing life insurance policy to the ILIT, there is a three-year look-back period, meaning that if the grantor dies within three years of the transfer, the entire ILIT death benefit could be included in the grantor’s taxable estate. There can also be gift tax considerations if the life insurance policy being transferred to the ILIT has significantly appreciated. The insurability of the grantor and the issuance of a policy in the name of the trust may add some layers of complexity to the ILIT process.

ILITs can serve a multitude of estate planning purposes, including the following:

Minimizing Estate and Gift Taxes

Generally, the proceeds of a normal life insurance policy are included in the taxable estate of the insured party when they die. Thus, while the proceeds of a life insurance policy are not taxable to the beneficiaries, the value of the estate in excess of the gift tax exemption is taxable. In 2021 the gift tax exemption is $11.7 million, but that figure has the potential to be significantly reduced by proposed legislative changes. Under at least one proposal, the gift tax exemption could be reduced to $1 million. Hypothetically, if the gift tax exemption is $1 million and you leave a business and real estate assets worth $5 million and an insurance policy that yields a death benefit of $1 million, your estate will be valued at $6 million, $5 million of which can be taxed at up to 60% and your beneficiaries would then need to find a way to pay $3 million in taxes. However, if you have a life insurance policy owned by an ILIT with adequate coverage to pay the estate taxes based on the value of your estate, the death benefit distributions would be separate from your estate and thus exempt from state or federal estate taxes (saving your beneficiaries the $3 million tax bill and allowing them to avoid a chaotic and upsetting fire sale).

ILITs can also reduce or eliminate gift tax consequences altogether since contributions by the grantor can be used to pay insurance premiums and are considered gifts to the beneficiaries of the ILIT. Grantors can gift $15,000 annually, and currently up to $11.7M during their lifetimes to ILIT beneficiaries without gift tax consequences.

Government Benefits

ILITs can protect the eligibility of beneficiaries who are receiving government benefits, such as Social Security disability or Medicaid, by managing how distributions from the trust are classified and used by the beneficiary.

Asset Protection

ILITs can provide excellent asset protection for large estates, making it almost impossible for creditors to reach the assets held by the ILIT. Distributions from the ILIT can be protected from creditors of the ILIT beneficiaries, but this will require some strategic planning by the grantor and trusted advisors.

Retained Financial Control

ILIT grantors can give the trustees discretionary control over the timing and amount of distributions to beneficiaries. ILIT proceeds can be paid out immediately, or grantors can specify when and how much of the ILIT benefit their beneficiaries will receive. Trustees can also be provided with the discretion to make distributions when beneficiaries attain predetermined goals, such as school graduation, starting a business, purchasing a home, or having a child. This strategic planning can be useful in ensuring the your beneficiaries use the insurance proceeds for meaningful purposes, as well as protecting children who are minors or who are from prior marriages.

Tax and Legacy Planning

The cash value and death benefit of a life insurance policy are free from taxation, so there are no tax issues with having a policy owned in an ILIT.  This can be important when it comes to tax planning for large estates with multiple generations. In addition to estate tax, generation skipping tax (GST) can impose a 40% tax on younger generations. Since ILIT proceeds are excluded from the grantor’s taxable estate, multiple generations may be able to avoid the GST.

The Take Away

Break out the six string and fire up the fiddle! ILITs can provide your estate with necessary liquidity, asset protection, and estate/gift tax mitigation that will enable your heirs to keep the dog, house and family business, and then some. The estate planning/asset protection group at Johnson Fistel would be happy to help you explore the benefits of adding an ILIT to your comprehensive and integrated estate plan.


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