Irrevocable Life Insurance Trusts
Hi, thank you for tuning into today's Emerald GEM, which stands for Get Educated in Minutes. I'm Dolly Donnelly, Director of Wealth Strategies for Wilmington Trust's Emerald Family Office and Advisory, and your host for today's podcast. In today's GEM, I'm going to answer the question, what is an irrevocable life insurance trust and when should I consider using one?
Before we turn to discuss personal Life Insurance Trust, specifically, let's briefly review common reasons why high net worth and ultra-high net worth individuals own life insurance policies to help frame their importance. At the most basic level, purchasing life insurance is intended to mitigate risk occurring from death.
While the type of risk to be mitigated can vary depending on factors such as a person's stage of life or financial situation, common risks that life insurance is designed to mitigate include replacing income in the event of a premature death, ensuring that there is a legacy for heirs, and providing a source of liquidity for the payment of estate taxes.
Now for those focused on the last of those risks, providing a source of liquidity for estate taxes, it can be particularly beneficial to consider using an irrevocable life insurance trust to own their life insurance policies. Those who fall in this category often include owners of closely held businesses, whose estates may not otherwise include sizable liquid assets.
In the absence of sufficient liquidity available at death, high net worth and ultra-high net worth business owning clients potentially could leave an estate tax burden that has to be satisfied through a sale of the business under less-than-optimal conditions in order to raise the necessary funds for taxes.
Moreover, mitigating the risk of estate taxes also could become significant for an even greater number of individuals if the sunset of the Tax Cuts and Jobs Act estate tax exemption occurs as scheduled under existing law on January 1, 2026, and the federal estate tax exemption decreases from over 13 million per person to approximately 7 million per person adjusted annually for inflation.
So with those considerations in mind, what is an irrevocable life insurance trust? At the most basic level, an irrevocable life insurance trust, often referred to as an ILIT, is a type of trust designed to hold life insurance policies so that upon the death of the trust creator, also known as the trust grantor, who also usually is the insured, the proceeds of the life insurance policies are not included in the grantor's taxable estate.
In contrast, in the absence of an ILIT, when a life insurance policy is owned by the insured individually, the proceeds payable on the insured's death are includable in that person's taxable estate. This essentially results in the proceeds, which were intended to be a source of payment for estate taxes, further increasing the amount of estate taxes owed and reducing the benefit that they were intended to provide.
By way of example, with the highest marginal tax rate for federal estate taxes reaching 40 percent in 2024, that has the possibility of leaving only 60 cents for every dollar of life insurance death benefit available for the payment of taxes. On the other hand, when held in a properly structured and administered ILIT, none of the death benefits payable on the trust owned life insurance policies are subject to estate taxes.
As a result, for high net worth and ultra-high net worth individuals with taxable estates, the use of a properly structured ILIT to own life insurance policies can be an important way to ensure that the proceeds truly are there to pay estate taxes rather than adding to your estate tax burden. To achieve those benefits, the ILIT must be properly structured and administered.
Like many other types of irrevocable trusts, an islet must be structured so that the trust assets are not deemed to be included in the grantor's estate. This means that the grantor should not have the right to change or terminate the trust, and the grantor must relinquish control over the assets contributed to it, such as a life insurance policy.
Consequently, in addition to having the trust own and be the beneficiary of the policy, the grantor should not possess incidents of ownership over the policy. For example, the grantor should not have the power to change the policy's beneficiaries, surrender or borrow under the policy.
The grantor also should not serve as trustee of the ILIT. An additional provision that is often important to include in an ILIT is called a Crummey1 withdrawal right. Crummey in this context isn't a comment on the merits of the provision, but rather the name of an important case that provides a path for allowing contributions to be made to the trust to qualify for the contributor's annual gift tax exclusion.
These provisions can be particularly important in the case of ILITS so that the grantor can make use of his or her annual gift tax exclusion, $18,000 per person annually in 2024, to contribute money to the trust to be used towards premium payments. In order for a gift to qualify for the annual gift tax exclusion, the gift must be deemed a gift of a present interest.
In most trusts without Crummey withdrawal rights, the beneficiaries of the trust don't have a present interest in, or an immediate right to access, the funds contributed to the trust. As a result, contributions to such trusts wouldn't qualify for the annual gift tax exclusion. Instead, a Crummey withdrawal right is a provision that results in specified beneficiaries, the withdrawal right holders, having a present interest because they have the right to withdraw contributions made to the trust for a limited period.
That said, despite having a legal right to withdraw the contributions, there often is an expectation that withdrawal right holders typically would not actually exercise such rights. Crummey withdrawal rights generally can be given to trust beneficiaries with current income or vested remainder interest in the trust.
While Crummey withdrawal rights can be a powerful tool for funding premium payments without using the Grantor's Lifetime Gift Exemption, there are additional requirements that come along with such rights. Perhaps most importantly, the trustee will need to provide holders of Crummey withdrawal rights with timely written notice of contributions made to the trust and keep sufficient documentation that such notice was provided throughout the period the policy exists.
In cases where a grantor does not have enough Crummey withdrawal right holders and associated annual exclusion gifting available to fund the payment of premiums, other strategies can be used to pay policy premiums. These may include using some of the grantor's lifetime gift tax exemption to seed the trust with funds or other income producing assets to be used to pay premiums, as well as evaluating the policy itself to see if there is any built up cash value that could be applied towards premium payments.
Care also should be given in deciding what type of life insurance policy to hold within an ILIT. First, if thinking of transferring an existing life insurance policy to an ILIT, it is important to note the requirement that the insured survive three years from the date of transfer to the ILIT.
Otherwise, the proceeds of the policy will be included in the insurer's estate. Additionally, for married couples, it may be advantageous to consider purchasing a second to die policy rather than policies on each spouse's individual life. Because estate taxes are not payable on assets left to a surviving spouse, most well-planned married couples will not need to pay estate taxes until the death of a second spouse.
Policy benefits and costs also can vary depending on the type of life insurance policy purchased, from term to permanent policies, and varieties within permanent offerings such as universal and whole life policies. Regardless of the type of policy ultimately chosen, policies should be routinely monitored to ensure that they are performing as intended.
As with other trusts established for the benefit of heirs, an ILIT that directs the proceeds of the life insurance policy to be held in continued trust for the benefit of a spouse, children, or future generations may provide increased asset protection, preserve family wealth, and help pass along the legacy desired by the grantor.
Thanks again for joining us today. Please contact your Wilmington Trust advisor if you have any questions about irrevocable life insurance trusts or when to use one. We would be glad to help you. See you next time.
[1] Crummey v Commissioner, 397 F.2d 82 (9th Cir. 1968).
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