An irrevocable life insurance trust (ILIT) is created with a life insurance policy as its asset. As the name suggests, the trust grantor cannot, in any way, modify, amend, or rescind the trust or reclaim its property after its initial creation. When the life insurance policy is placed in the trust, it is the trust, not the insured person who now owns the policy. The trust’s management, for policy beneficiaries, is the responsibility of the trustee upon the death of the insured.
An ILIT is a preferred vehicle to set aside cash proceeds without estate taxes since the assets themselves are not taxable, and even allows for some controls as to how your assets are used after your death. Proper ownership and execution of the trust are crucial if the tax avoidance strategy is to be successful. An ILIT must have the life insurance policy transferred to the trust at least three years before the death of the insured person. There are some techniques to circumvent the rule; for example, a new policy can be taken out with the spouse as the owner, and then placed in the trust. Gift taxes can be avoided by implementing the Crummey letter, which changes the eligibility status of a taxable gift to a gift-tax exclusion status. The legal mechanisms of an ILIT provide freedom from inclusion in the gross estate of the insured to minimize estate taxes and avoid gift taxes.
There are other benefits to creating an ILIT besides estate tax avoidance. The grantor of the irrevocable trust has controls as to how the beneficiaries will spend the money through trust document instructions and the appointed trustee who supervises the distribution of the trust’s assets. Creating detailed trust asset dispersion instructions is typical in the case of minor beneficiaries and in the case of adults who have a history of alcohol or substance abuse or are known to have reckless spending habits, or any beneficiary with special needs or in recipe of government benefits. In all of these cases, asset dispersion instructions prevent the disastrous consequences of a beneficiary who is unable to manage their finances properly. Some trusts instructions help guide the life of a beneficiary by awarding distributions based on milestone events or achievements such as graduating from college, buying a first home, or for the birth of a child. ILITs are a strategic tool in the case of second marriages to protect how assets are distributed if the trust grantor has children from a previous marriage who are minors or who require financial protection or inheritable assets.
If a trust beneficiary is receiving government aid, like Medicaid, or income from Social Security disability provisions, the trustee can control distributions from the trust to avoid potential interference with eligibility requirements of the beneficiary receiving government benefits. The trust also protects the beneficiaries in the event of future litigation (including divorce) because ILITs are technically not owned by the beneficiary. Therefore, courts cannot connect the trust assets to the beneficiary, protecting them from creditors or other impending lawsuits seeking damages. However, creditors can go after the distributions already made from the ILIT.
Finally, an ILIT can aid in legacy planning by avoiding the generation-skipping transfer tax (GST). This federal tax consequence occurs when there is a gift or inheritance of property to a beneficiary who is 37 ½ or more years younger than the donor. While the threshold for this tax only applies when the amount transferred exceeds 14.4 million dollars per person, it is an essential tool for well-funded estates as the GST tax rate is a flat 40 percent.
The paperwork necessary to create an ILIT is highly complex, and there are strict drafting and procedural guidelines to follow to comply with IRS rules. Identifying a lawyer and a tax specialist who is well versed in the creation of this trust type is crucial to success because once the life insurance policy funds the trust, it will not change. There are legal and financial benefits to the heirs of an ILIT as well as to the original grantor. Asset protection, favorable tax situations, and assurance that benefactor’s wishes will be carried out by the trustee regarding fund dispersion are some of the advantages an ILIT can bring to legacy planning.
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