Irrevocable Life Insurance Trusts - 5 Reasons
First - what is an Irrevocable Life Insurance Trust (ILIT)? This special type of trust is set up to keep life insurance proceeds out of the estate. But there are other benefits; a recent article on JD Supra by the attorney John C. Martin covered ILITs (Irrevocable Life Insurance Trusts) and described key benefits. Here are some excerpts:
First Reason: No Loss of Control over Income-Producing Assets
First, an ILIT is an attractive alternative to other estate planning strategies that involve transferring substantial amounts of assets out of one’s estate. Grantor Retained Annuity Trusts (GRATs), Charitable Lead Trusts (CLTs), and other trust arrangements may involve the transfer of valuable income producing or business assets that most if not all would be hesitant to transfer out of their control (not to mention that the ILIT usually costs less). Yet, transferring a life insurance policy comes more easily: While premiums must be paid, the proceeds are only payable to beneficiaries upon death. Thus, there is not a great fear that transferring the policy would deprive the owner of its benefit.
Keep in mind that this benefit is psychological. The person setting up the trust is paying premiums, so there is a cash flow impact. And if your circumstance doesn’t have a high cost associated with other trust options surrounding ‘loss of control’ this benefit may not make sense.
Second Reason: Liquidity Creation
Second, and most importantly, an ILIT that is structured properly provides liquidity. In an estate laden with illiquid real estate assets, an ILIT can be essential in order to pay a large estate tax bill without selling off assets. Consider the example of Robert and Sally Colmery. Over their lifetimes, Robert and Sally accumulated a small real estate empire throughout California, including a Palo Alto home ($3,000,000), a vacation home in Tahoe ($1,000,000) and three rentals in San Mateo (together worth $2,500,000). Robert’s liquid assets were mostly spent by the end of his life, amounting to $150,000. At the end of his and Sally’s life, $3,150,000 of the estate will be subject to the federal estate tax at a rate of 45%, and Robert’s and Sally’s children, Peter and Ruth, will not have sufficient cash to cover the bill unless they sell off some of the properties.
Now let’s assume that Robert establishes a qualifying ILIT with a second-to-die insurance policy naming his children, Peter and Ruth, as remainder beneficiaries, and pays the premiums by using his $13,000 annual gift tax exclusion. Robert structures the payment of premiums with the help of an attorney so that they do not trigger any gift tax by using something called a “Crummy” power. At the time of the second spouse’s death, the proceeds of the life insurance policy will pass estate tax-free. As a result, Peter and Ruth are not forced to sell off the real estate when they inherit.
“Crummy” refers to a clause embedded in the irrevocable trust, which uses the gift tax annual exclusion to keep the proceeds of the trust from being taxed. Crummy provisions are complicated and should be set up by a skilled attorney
Third Reason: Leveraging the Generation-Skipping Transfer Tax Exemption
Third, an ILIT can be used to leverage the insured’s GSTT exemption. Whenever we would like to give to our grandchildren or to individuals removed by 2 or more generations, the IRS imposes a second layer of tax called the GST tax. However, a $1 million exemption exists to which transfers to a trust can be allocated at the time of such transfer. If the amounts transferred to a trust appreciate, the ratio of assets exempt from GSTT to non-exempt assets will remain constant. As a result, if the entire transfer to the ILIT is allocated to the GSTT exemption (an inclusion ratio of zero), all GST tax can be eliminated at the final distribution, even if the trust enjoys considerable income over the years.
remember Robert in the example above? Here he sets up a ILIT that benefits not only his children Peter and Ruth, but also their descendants.
For instance, let’s say that Robert sets up a generation-skipping ILIT. The ILIT directs the proceeds from the life insurance to be invested in securities. All net income is payable to Peter and Ruth over their lifetime, with a remainder interest to Peter and Ruth’s children. Normally, Peter and Ruth’s children would be liable for GST tax at the maximum applicable federal rate when they take. However, if the ILIT is set up so that the inclusion ratio of assets subject to GSTT is zero, Peter and Ruth’s grandchildren will pay no GST tax. If ILIT assets grow at a modest rate, the grandchildren would take potentially significant amounts without incurring any additional GST or estate tax liability.
Fourth Reason: Protecting Beneficiaries from Creditors
Fourth, Robert can also protect his children and grandchildren from future creditors by including a spendthrift provision in the trust document and granting discretion to the trustee in giving distributions to the beneficiaries. If the ILIT is set up with investments or cash that Robert doesn’t need to access, the amounts can be shielded from Peter’s and Ruth’s creditors.
Many advisors caution you to think carefully when putting restrictions on trust proceeds. Benefit number 4 and 5 are both founded on these restrictions, and apply to more trust types than just ILITs. See my post Inheritance with Strings Attached.
Fifth Reason: Encouraging Responsibility
Fifth, while the ILIT is non-amendable, it can be structured so that beneficiaries are incentivized to engage in positive behavior. The trustee may be given directions to not make distributions until the beneficiaries reach a certain age, or unless they have demonstrated positive behavior. For instance, they can be directed to withhold funds that would pay for a drug addiction, gambling, or otherwise. The trustee can be directed to pay for the education, business planning, or other positive expenditures that the beneficiaries may require.
Practicing attorney John C. Martin’s article first appeared on the JDSupra website dated April 20, 2009
One Response to “Irrevocable Life Insurance Trusts - 5 Reasons”
da best. Keep it going! Thank you
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