- Who should consider an ILIT.
- How ILITs work.
- The tax and other benefits of ILITs.
What is a Trust?
A trust is a legal arrangement in which you can have your assets managed by a third party. The third party will ensure that the assets eventually get distributed to designated beneficiaries. Trusts can hold assets ranging from cash, investment accounts, properties, and cars.
- The grantor is the individual who sets up and puts their assets into the trust.
- The beneficiary is a person or people who receive some or all the trust’s assets.
- The trustee is the third-party organization that operates the trust.
Normally, the assets are distributed to the beneficiaries upon the death of the grantor. Using a trust allows you to avoid your assets going through the probate system, which is a part of the US court system that determines whether your will is valid and then distributes your assets.
What Types of Trusts are There?
There are two main types of trusts:
- Living, or Revocable.
While you are alive, you can modify the beneficiaries and assets in a living or revocable trust. You can even name yourself as a trustee, and you can also list a successor trustee if you can no longer manage the trust.
With an irrevocable trust, you cannot modify the beneficiary and assets in the trust. The advantage of this type of trust is that it may help reduce your estate taxes. Since the assets in an irrevocable trust belong to the trust and not to you, this can reduce tax liability. Additionally, irrevocable trusts are more likely to be protected from creditors’ claims than revocable trusts.
Taxation and Trusts
People who own large estates may own federal estate taxes when they die. In 2020, the federal estate tax applied when assets exceeded the following at the time of death:
- $11.58 million per individual.
- $23.16 million per couple.
The federal estate tax rate can be up to 40%. Some states charge a separate estate tax that people must pay in addition to the federal estate tax.
Inheritance taxes are levied on people who inherit money. Inheritance tax is charged in only certain states.
If the assets in the trust accrue income, the legal owner may owe income or capital gains taxes. This tax is levied on the direct owner of the assets.
It is important to obtain life insurance as part of your estate planning journey for the following reasons:
- Replace your earnings upon death.
- Provide funds to pay debts, expenses, and taxes upon death.
- Facilitate satisfaction of gifts.
- Ensure non-liquid assets pass to beneficiary.
If the grantor owns the life insurance outright, your insurance policy’s death benefits could be included in the estate and could be taxable. To avoid this issue, it is possible to give the ownership of a life insurance policy to an Irrevocable Life Insurance Trust (ILIT).
An Overview of Irrevocable Life Insurance Trusts (ILITs)
ILITs are created to own life insurance policies while the insured party is still alive. This means that an ILIT is the primary beneficiary of your insurance policy’s death benefits. Once you die, your life insurance’s death benefits are deposited into your ILIT in trust and then given to the individuals you’ve named as your trust’s beneficiaries.
The primary purpose of an ILIT is to remove the value of life insurance proceeds from the insured grantor’s estate for estate tax purposes. Because the trust is the primary beneficiary of the policy, the individual avoids estate taxes when they die.
Additionally, an ILIT may be beneficial if you expect your estate to have a large tax liability and you need the liquidity pay for it.
The funds from an ILIT are transferred in regular incremental payments to your named beneficiaries, instead of them receiving one lump sum payment. This helps reduce tax liability.
Like irrevocable trusts, ILITs cannot be changed after their creation. You cannot serve as a trustee of your own ILIT, but you can name your spouse, a family member, friend, financial institution, or an attorney as its trustee.
ILITs offer state tax considerations, protection from beneficiaries carelessly spending their payouts, and protection from courts and creditors having access to the assets.
Benefits of ILITs
If structured correctly, you can avoid including policy proceeds in your estate for estate tax purposes. Additionally, ILITs are beneficial because they:
- Provide for the income needs of trust beneficiaries.
- Protect trust assets from creditor claims.
- Allow for flexible management and distribution of trust assets.
- Enhance the grantor’s planning goals.
What Happens to ILITs Upon Death
When the grantor dies, the proceeds from their life insurance policy typically either:
- Get transferred to the ILIT or get distributed to the beneficiaries free of transfer tax, or
- Get used by the trustee to purchase assets from the estate or are used to pay down estate taxes without liquidating assets. This is usually done when an estate’s assets are mostly not liquid, and:
- The assets may not be liquidated quickly enough to pay the estate taxes due upon the grantor’s death, and
- The grantor prefers that the assets are transferred in kind to the beneficiaries.
Incidents of Ownership for ILITs
Someone has incidents of ownership if they have the right to do the following to a life insurance policy:
- Change the beneficiaries.
- Surrender or cancel it.
- Assign it.
- Revoke its assignment.
- Pledge it for a loan.
- Get a loan from the insurance company against the policy’s surrender value.
To form an ILIT, the grantor must give up all their control and incidents of ownership over their insurance policy.
ILITs must be irrevocable. The grantor must relinquish control of the assets transferred to the ILIT, and they cannot gain any economic benefit from the underlying insurance policy.
If the grantor transfers an insurance policy that they already own, they must outlive the transfer by at least three years so that the proceeds are not included in their gross estate for tax purposes.
The trustee must follow complex administrative rules, send out notices every time the trust is funded, pay insurance premiums on time, and maintain accurate records of all notices sent and received and of the trust’s tax characteristics.
Types of Insurance Used in ILITS
Three types of life insurance can be used in ILITs. These include:
- Term life insurance.
- Universal life insurance.
- Whole life insurance.
Term life insurance lasts for a specific period before it expires. This policy type can be beneficial because its premium payments are lower than the other two types of policies. Time life insurance can be used for an ILIT to replace the grantor’s income for their spouse and family after their death.
Whole life insurance remains effective for the insured party’s lifetime. Fixed premiums are paid over the course of the grantor’s whole lifetime, or for a specific number of years. As premiums are paid, these policies accumulate a guaranteed cash value. Premiums are often substantially higher than under a term life insurance policy.
Universal life insurance is permanent, but more flexible than whole life insurance. Policy owners can reduce the death benefit or increase it with a medical exam. This insurance policy gains a cash value over the insured person’s lifetime. Usually, the owner can change the amount or frequency of premium payments if they make larger payments earlier on, or if they make one lump sum payment.
Owner and Beneficiaries of an ILIT
The ILIT is always the owner and beneficiary of its insurance policy, regardless of which policy type is chosen. If an existing policy Is transferred to an ILIT, the owner and beneficiaries on the policy must be changed.
If a new insurance policy funds an ILIT, the grantor must not have an ownership interest in the policy. The trustee should purchase the policy in the name of the trust and list the trust as its beneficiary. All premium payments should be made from the trust.
The individuals who are designated to receive the insurance policy proceeds at the grantor’s death are its beneficiaries. Typically, a trust’s beneficiaries include the grantor’s:
- Surviving spouse.
- Additional family members or friends.
- Charitable organizations.
Trustees for the ILIT
The grantor should never be the trustee of the ILIT, or else they could miss out on estate tax benefits. If the grantor never has or relinquishes control over the life insurance policy, the policy’s proceeds are excluded from the estate for tax purposes.
Trustees of ILITs have the following responsibilities:
- Paying insurance premiums on time using the appropriate funds.
- Ensuring beneficiaries know about their withdrawal rights and they have appropriate time to use those rights.
- Choosing life insurance policies.
- Managing the assets of the trust.
- Investing trust assets after the policies are paid out.
- Distributing the trust assets according to the trust’s terms.
- Cooperating with the trust’s beneficiaries.
- Filing required income tax returns.
- Maintaining all insurance documents and performing accounting for the trust assets.
Withdrawal Rights and Gift Tax
Beneficiaries have a limited time, often 30-60 days, to withdraw a certain amount of money from an ILIT each time a grantor contributes to it. Once the withdrawal period is over, the trustee can use the trust’s cash to pay insurance premiums.
There can be no requirement that beneficiaries do not exercise their withdrawal rights, or else the ILIT would lose its tax exclusion.
To ensure that withdrawal rights do not trigger a gift tax, all gifts to an ILIT must be:
- Present interest gifts.
- Of equal or lesser value to the annual exclusion amount.
Grantors must file gift tax returns if:
- The beneficiary has withdrawal rights to a gift, but their share of the gift exceeds the federal gift tax annual exclusion amount.
- The beneficiary does not have withdrawal rights to a gift, or there are not enough beneficiaries with withdrawal rights to a gift to cover the entire gift amount.
ILITs can shield life insurance policies from estate taxes by:
- Protecting the proceeds from estate taxes.
- Keeping the value of the gross estate below the estate tax threshold by removing the proceeds.
If an ILIT is not correctly structured or administered, then policy proceeds may still be subject to estate tax and included in the gross estate of the grantor. This can happen in a variety of circumstances, including:
- The grantor retains ownership of the insurance policy or does not correctly name the ILIT as the policy’s beneficiary.
- The grantor transfers ownership of an existing life insurance policy to the ILIT but dies within three years of that transfer.
When married, the grantor can avoid issues by designating that any insurance proceeds which are included in the grantor’s gross estate for federal estate taxes should be distributed to a marital trust for the spouse. This will allow this portion to avoid estate taxes upon the grantor’s death.
ILITs do not generate income unless they hold funds in an interest-bearing account or some other income-generating asset.
Because the ILIT is a grantor trust, it is usually not necessary to obtain a separate tax identification number. However, after the grantor’s death, the ILIT becomes a separate taxable entity and must have a distinct Tax Identification Number, which is then used to file income tax returns for the trust. This number may be applied and obtained by the trustee on behalf of the trust.
Usually, ILITs should consider:
- Using a non-interest-bearing account to avoid filing annual income tax returns for the trust, or
- Having the grantor write a check for insurance premiums. The trustee should endorse the check to the insurance company at the appropriate time so that no trust account is necessary, or
- Including trust income on the grantor’s annual income tax returns.
For an ILIT to achieve its purpose of avoiding estate tax, the grantor must relinquish all the grantor’s rights, incidents of ownership, and powers to the life insurance policy in the ILIT. To do this, the grantor cannot have the power to amend, revoke, terminate, or otherwise alter the trust agreement.
However, sometimes there is an unanticipated change or a compelling reason to modify the trust. Trust decanting allows the trustee to take the assets from one trust, distribute them to a new trust, and create new provisions that better suit the goals of the grantor and the needs of the beneficiaries.
ILITs can help individuals with large estates to save big on their estate taxes while protecting the needs of their loved ones. For help setting up an ILIT, please contact your experienced Chugh CPAs, LLP professional.