Life Insurance Trust

What Is an Irrevocable Life Insurance Trust?

An irrevocable trust is a trust in which the grantor gives up all rights in the property transferred to the trust, retaining no ability to revoke, terminate or modify the trust in any material way. When the trust holds a life insurance policy—usually insuring the grantor’s life and/or a spouse’s—it’s an irrevocable life insurance trust, or ILIT. If the trust beneficiaries are given withdrawal powers, it may also be referred to as a “Crummey trust,” named after the taxpayer in a famous 1968 court case in which such withdrawal powers were approved. ILITs are used to accomplish some or all of the following objectives:

  • to help meet the liquidity needs of the grantor’s estate,
  • to help provide income for survivors,
  • to avoid estate tax on the life insurance death proceeds, and
  • to shelter property in the trust from creditors at the grantor’s death.

Funded or Unfunded?

In a funded life insurance trust, the grantor initially transfers cash or other property to the trust which the trustee uses to pay premiums. The major drawback of the funded life insurance trust is that income earned on the property inside the trust will be taxed to the grantor if it can be used to pay premiums on a policy insuring the life of the grantor or the grantor’s spouse. In an unfunded life insurance trust, the trustee relies on annual gifts from the grantor to pay premiums. These annual transfers are considered gifts to the trust beneficiaries. If the trust beneficiaries cannot “enjoy” these gifts immediately, the gifts would ordinarily be future interests. That means no annual exclusion is available to shelter the annual transfers from the federal gift tax. However, trust beneficiaries can be given special withdrawal powers—called Crummey powers—to convert their interests into present interests that qualify for the annual exclusion. Gifts in excess of the annual exclusion can be sheltered by the applicable exclusion amount for estate and gift tax.

Avoiding the Estate Tax

The trust principal—including the life insurance—generally avoids the federal estate tax if:

  • the trust is irrevocable,
  • the grantor is not the trustee,
  • the grantor-insured has no incidents of ownership in the insurance,
  • the insurance proceeds are only used to purchase estate assets or to make loans to the estate, not to pay estate costs directly, and
  • the insured must live for at least three years after transferring a policy to the trust.

The irrevocable life insurance trust is clearly an effective estate planning tool for estate owners and their advisors. It can create funds for estate liquidity and other uses precisely when they’re needed, and it keeps life insurance proceeds out of the gross estate if they would otherwise be subject to the federal estate tax.