Irrevocable Life Insurance Trusts - Tax and Nontax Advantages (2023)

Creating an Irrevocable Life Insurance Trust (ILIT) can dramatically increase the liquidity of an individual’s estate and effectively leverage the value of the annual $14,000 per donee gift tax exclusion and the $5,430,000 generation-skipping transfer tax (GSTT) exemption for U.S. persons. (The annual exclusion is $14,000 in 2015. The GSTT exemption is $5,430,000 in 2015) In short, ILITs often provide an outstanding way for U.S. persons to achieve multiple estate planning goals – including substantial estate tax and GSTT savings. The following discussion provides an introduction to ILITs and the ways in which they can help preserve the estates of clients in a wide range of situations.

In simplest terms, an ILIT is an irrevocable trust, the trustee of which will own and be the beneficiary of policies on the life of the creator of the trust (the "grantor"). Married couples often create ILITs to hold "second-to-die" policies, the proceeds of which are payable on the death of the survivor. In order to succeed in passing the insurance proceeds free of estate tax, the grantor cannot serve as trustee and cannot retain any power to revoke or amend the trust or otherwise affect the policy. The grantor usually makes annual gifts of cash to the trust that the trustee uses to pay the premiums on the policy. An ILIT is usually structured so those gifts qualify for the annual $14,000 per donee gift tax exclusion. Note that an ILIT can hold any type of life insurance, including employer-provided term insurance if the insurance plan permits assignment of the policy.

Who Should Consider an ILIT?

ILITs are most often suitable for individuals or couples whose estates are likely to be subject to a heavy estate tax hit. In 2015, a U.S. person can pass up to $5,430,000 free of the U.S. estate tax. ILITs may be appropriate for those whose assets, including life insurance, will be significantly larger than the exempt amounts. An ILIT is useful primarily for two reasons. First, the proceeds of policies acquired by an ILIT are not included in the grantor's estate. Second, an ILIT can provide liquidity for those who wish to make it possible for their survivors to preserve a closely held business or other unique asset that might otherwise have to be liquidated to pay estate taxes and expenses. Another advantage is that the proceeds of life insurance are generally not subject to the federal income tax. ILITs are appropriate for individuals and couples who will not need to have access to the cash value of insurance policies to meet lifetime needs.

(Video) Brutally Honest Tips About The Irrevocable Life Insurance Trust

How an ILIT Is Created and How an ILIT Operates

Most ILITs are created by a parent (or parents) in order to provide for children and grandchildren. The grantor initially funds the ILIT with cash that the trustee uses to pay the first annual premium on a new policy on the life of the grantor. As indicated above, ILITs are usually drafted so that gifts to the trust qualify for the annual $14,000 gift tax exclusion that is allowable for each beneficiary of the trust. The policy is applied for and acquired by the trustee, who is both the owner of the policy and its designated beneficiary. In each subsequent year, the grantor transfers additional funds to the trustee to pay the annual premium. The later transfers can also qualify for the annual gift tax exclusions.

Under a slightly different approach, an existing life insurance policy may be transferred to an ILIT. However, the estate tax saving is lost if the grantor-insured does not live for more than three years following the transfer. The proceeds of a policy owned by an ILIT are included in the grantor-insured's estate if he or she retained any incident of ownership in the policy (e.g., the right to borrow against the policy, recover its cash reserves or change the beneficiary). If the grantor-insured did not retain any incident of ownership in the policy, the insurance proceeds are received by the trustee free of estate and income taxes. (As noted above, if the insured dies within three years of transferring a policy to an ILIT, the proceeds are includible in the insured’s estate for tax purposes.)

Insured Cannot Serve as Trustee of an ILIT

(Video) Irrevocable Life Insurance Trust - ILIT

The estate tax benefit of an ILIT is lost if the grantor-insured serves as its trustee. If the trust owns a policy on both a husband and wife (so-called "joint" or "second-to-die" insurance), neither spouse can serve as trustee. Subject to other planning considerations, any other individual or a corporate fiduciary may serve as trustee.

Payment of Insurance Premiums

In most cases, the grantor each year transfers enough cash to the trust to pay the annual premium. As indicated above, an ILIT can be drafted so that the annual contributions to the trust qualify for the annual gift tax exclusion. The annual exclusion is allowed if the beneficiaries (typically the children) are given the noncumulative right to withdraw the annual contribution to the trust during a limited period of time (usually 30 days) after they receive notice of the contribution. The power of withdrawal lapses if not exercised during the withdrawal period. Such a power, known as a "Crummey Power," after the name of the tax case that upheld the tax benefit, qualifies contributions to the trust for the annual gift tax exclusion. Although the grantor cannot legally prevent the beneficiaries from exercising the power, the power is almost never exercised by a beneficiary because of the greater benefits to be achieved from the policy.

Estate Tax Advantages of an ILIT

(Video) What is an ILIT? | Irrevocable Life Insurance Trust

The proceeds of life insurance policies owned by an ILIT are generally not included in the estate of the insured grantor. The potential of the exclusion is illustrated by the following example:

An unmarried person (A) owns property worth about $7,000,000. Even allowing for A’s right to transfer $5,430,000 free of U.S. estate tax, if A were to die in 2015, A’s estate would owe about $630,000 in U.S. estate tax. If A buys a $1,000,000 policy in order to fund the payment of the tax, his estate will be increased to $8,000,000, on which about $400,000 in additional tax would be due (a total of $1,030,000). A's family would receive a net of about $6,970,000.

If A instead creates an ILIT that buys a $1,000,000 policy on A’s life which has an annual premium of $28,000, the proceeds of the policy will not be includible in A’s estate. If two or more beneficiaries of the ILIT hold Crummey Powers of withdrawal, A’s annual contribution of $28,000 to the trust will not generate any gift tax liability or result in the loss of any gift exemption.

By establishing the ILIT, A can create the liquidity necessary to pay the estate tax without having to pay any gift tax. Under this scenario, A's family would receive a net of about $7,370,000 ($400,000 more than if the insurance proceeds are included in A's gross estate).

(Video) How does an Irrevocable Life Insurance Trust work?

Life Insurance Held by an ILIT Also Has an Income Tax Advantage

The buildup of cash value within a policy owned by the trustee of an ILIT is wholly free from income tax. Even more important, the life insurance proceeds ultimately received by the trustee of the ILIT are not subject to the federal income tax.

ILITs Can Hold a Policy Insuring the Joint Lives of a Married Couple

Because of the unlimited marital deduction, the estates of most couples are planned so that no estate tax is payable on the death of the first to die. Instead, the obligation to pay any estate tax is deferred until the death of the surviving spouse. The annual premium on a joint or second-to-die insurance policy is much lower than it would be if the life of each spouse were separately insured. In short, an ILIT can provide an economical way to provide tax-free funds to pay the estate tax due on the death of the surviving spouse.

(Video) ILIT - Irrevocable Life Insurance Trust -- UPDATED 2022

ILITs Can Also Leverage the Generation-Skipping Transfer Tax Exemption

Outright gifts from a grandparent to a grandchild can be subject to a combined GSTT and gift tax cost of up to 58 percent. Fortunately, however, each grandparent has a substantial GSTT exemption ($5,430,000 in 2015) that can be applied to insulate the transfer to grandchildren from the tax. Importantly, the benefit of the exemption is amplified if gifts to grandchildren are funneled through an ILIT. The possibility of sheltering far more than $5,430,000 in insurance proceeds from the GSTT exists because the exemption need only be applied against the annual transfers that are made to pay the premiums and not to the far greater value of the ultimate insurance proceeds.

© 2015 Perkins Coie LLP

FAQs

Are irrevocable life insurance trusts taxable? ›

An irrevocable life insurance trust is often used to set aside assets for certain purposes, such as paying estate taxes, because these assets themselves are not taxable.

What is the benefit of an irrevocable life insurance trust? ›

An ILIT provides a number of advantages beyond the ability to provide a tax-free death benefit. This includes protecting your insurance benefits from divorce, creditors and legal action against you and your beneficiaries. An ILIT also avoids probate and shields assets from expense and loss of privacy during probate.

How would you describe the advantages and disadvantages of life insurance in an irrevocable trust? ›

Pro: Reduce Your Estate Tax Liability. Con: Creating an ILIT Can Be Expensive. Pro: Your Heirs are Protected from Creditors. Con: An Irrevocable Trust Cannot Be Modified.

How are irrevocable trusts taxed for income tax purposes? ›

An irrevocable trust reports income on Form 1041, the IRS's trust and estate tax return. Even if a trust is a separate taxpayer, it may not have to pay taxes. If it makes distributions to a beneficiary, the trust will take a distribution deduction on its tax return and the beneficiary will receive IRS Schedule K-1.

How does an irrevocable trust avoid taxes? ›

Assets transferred by a grantor to an irrevocable trusts are generally not part of the grantor's taxable estate for the purposes of the estate tax. This means that the assets will pass to the beneficiaries without being subject to estate tax.

Do all irrevocable trusts file tax returns? ›

The trustee of an irrevocable trust must complete and file Form 1041 to report trust income, as long as the trust earned more than $600 during the tax year. Irrevocable trusts are taxed on income in much the same way as individuals.

What is the greatest advantage of an irrevocable trust? ›

An Irrevocable Trust means you can protect yourself, your loved ones and your estate against future legal action. It also means you can protect the financial future of your estate by avoiding substantial estate taxes.

What are the pros and cons of an irrevocable trust? ›

Irrevocable Trust Pros and Cons

Holding assets in an irrevocable trust can also be useful if you're trying to qualify for Medicaid to help pay for long-term care and want to avoid having to spend down assets. The downside to irrevocable trusts is that you can't change them. And you can't act as your own trustee either.

Who should be the owner of an irrevocable life insurance trust? ›

Typically, the initial Trustee of an Irrevocable Life Insurance Trust is a relative, close family friend, or a trusted advisor, such as your CPA, with the surviving spouse becoming Trustee or Co-Trustee after your death. 8.

What happens to assets in an irrevocable trust when the beneficiary dies? ›

What happens to a will or trust when a beneficiary dies? If the beneficiary of a trust or will passes away, the person who established the trust or will is required to amend their estate plan. The estate plan will still be in effect if this occurs.

Are distributions from a life insurance trust taxable? ›

Answer: Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them. However, any interest you receive is taxable and you should report it as interest received.

What is one of the main advantages of a revocable trust over an irrevocable trust? ›

Revocable, or living, trusts can be modified after they are created. Revocable trusts are easier to set up than irrevocable trusts. Irrevocable trusts cannot be modified after they are created, or at least they are very difficult to modify. Irrevocable trusts offer tax-shelter benefits that revocable trusts do not.

Who pays taxes on irrevocable trust income? ›

Grantor—If you are the grantor of an irrevocable grantor trust, then you will need to pay the taxes due on trust income from your own assets—rather than from assets held in the trust—and to plan accordingly for this expense.

Can the IRS take money from an irrevocable trust? ›

This rule generally prohibits the IRS from levying any assets that you placed into an irrevocable trust because you have relinquished control of them. It is critical to your financial health that you consider the tax and legal obligations associated with trusts before committing your assets to a trust.

What are the tax brackets for an irrevocable trust? ›

In 2022, irrevocable trusts pay tax at the top tax bracket of 37% when undistributed taxable income is $13,450. Individual beneficiaries pay tax at the top tax bracket when taxable income is $539,900 for singles and $647,850 for married individuals filing jointly.

What is the disadvantage of an irrevocable trust? ›

Some of the Cons of a Revocable Trust

Shifting assets into a revocable trust won't save income or estate taxes. No asset protection. Although assets held in an irrevocable trust are generally beyond the reach of creditors, that's not true with a revocable trust.

Can IRS touch irrevocable trust? ›

The IRS and Irrevocable Trusts

When you put your assets into an irrevocable trust, they no longer belong to you, the taxpayer (this is different from a revocable trust, where they do still belong to you). This means that generally, the IRS cannot touch your assets in an irrevocable trust.

Can a trustee withdraw money from an irrevocable trust? ›

The trustee of an irrevocable Trust cannot withdraw money except to benefit the Trust. These terms include paying maintenance costs and disbursement income to beneficiaries. However, it is not possible to withdraw money for personal or business use.

Does an irrevocable trust need to file a tax return if there is no income? ›

Q: Do trusts have a requirement to file federal income tax returns? A: Trusts must file a Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year where the trust has $600 in income or the trust has a non-resident alien as a beneficiary.

How are beneficiaries of an irrevocable trust taxed? ›

When an irrevocable trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. This form shows the amount of the beneficiary's distribution that's interest income as opposed to principal.

What happens if a trust does not file taxes? ›

A penalty of 5% of the tax due may be charged each month during which a return is not filed. This will continue to accrue up until a maximum of 25% of the tax due.

Why do people want irrevocable trusts? ›

The only three times you might want to consider creating an irrevocable trust is when you want to (1) minimize estate taxes, (2) become eligible for government programs, or (3) protect your assets from your creditors. If none of these situations applies, you should not have an irrevocable trust.

Why do people set up irrevocable trusts? ›

Irrevocable trusts are generally set up to minimize estate taxes, access government benefits, and protect assets. This is in contrast to a revocable trust, which allows the grantor to modify the trust, but loses certain benefits such as creditor protection.

Is an irrevocable trust worth it? ›

Irrevocable trusts are an important tool in many people's estate plan. They can be used to lock-in your estate tax exemption before it drops, keep appreciation on assets from inflating your taxable estate, protect assets from creditors, and even make you eligible for benefit programs like Medicaid.

Why do lenders not like irrevocable trusts? ›

Most major banks and credit unions will not lend money to an irrevocable trust. They would generally require the property in the irrevocable trust to be sold off because a property cannot simply be removed from the trust to facilitate the loan.

What assets should be placed in an irrevocable trust? ›

What assets can I transfer to an irrevocable trust? Frankly, just about any asset can be transferred to an irrevocable trust, assuming the grantor is willing to give it away. This includes cash, stock portfolios, real estate, life insurance policies, and business interests.

What type of trust is best? ›

What Trust is Best for You? (Top 4 Choices in 2023)
  1. Revocable Trusts. One of the two main types of trust is a revocable trust. ...
  2. Irrevocable Trusts. The other main type of trust is a irrevocable trust. ...
  3. Credit Shelter Trusts. ...
  4. Irrevocable Life Insurance Trust.

Can you terminate an irrevocable life insurance trust? ›

Even an irrevocable trust can be revoked with a court order. A court may execute an order that permits the dissolution of a life insurance trust if changes in trust or tax laws or in the grantor's family situation make the life insurance trust no longer serve its original purpose.

Can you change the beneficiary of an irrevocable life insurance trust? ›

That is, they cannot be normally changed or amended. So, when asking the question “can you change beneficiaries in an irrevocable trust?” the answer is generally “no” you normally cannot change the aspects of an irrevocable trust, like changing beneficiaries.

Can the creator of an irrevocable trust be a beneficiary? ›

The person who creates the Irrevocable Trust may be the beneficiary. Clients often assume that if they transfer assets to an Irrevocable Trust they give up all rights to the assets. This is not necessarily true. A very common Irrevocable Trust used for long-term care planning is an Irrevocable Income Only Trust.

Does an irrevocable trust dissolve on death? ›

After the grantor of an irrevocable trust dies, the trust continues to exist until the successor trustee distributes all the assets. The successor trustee is also responsible for managing the assets left to a minor, with the assets going into the child's sub-trust.

Does an irrevocable trust become revocable at death? ›

After the death of the grantor, a revocable trust becomes irrevocable. That means that any assets within the trust at the time of death cannot be revoked, nor can any assets be added. Nor can beneficiary designations be changed in any way. The trust's terms are simply set in stone once the grantor dies.

Do assets in an irrevocable trust get a step up in basis at death? ›

Irrevocable Trusts

The trust assets will carry over the grantor's adjusted basis, rather than get a step-up at death. Assets held in an irrevocable trust that has its own tax identification number (i.e., nongrantor trust status) do not receive a new basis when the grantor dies.

How is a life insurance trust taxed? ›

Life Insurance Beneficiaries

Trusts are not considered individuals; therefore, life insurance proceeds paid to trusts are generally subjected to estate tax. Also, the proceeds payable to a trust may not qualify for the inheritance tax exemption provided by some states for insurance payable to a named beneficiary.

What makes proceeds from life insurance taxable? ›

Under Section 85(E) of the National Internal Revenue Code, proceeds from life insurance shall be included in the computation of the gross estate of the deceased when the beneficiary is the estate, executor or administrator, whether the designation is revocable or irrevocable, and when the beneficiary is other than the ...

Is money received by a beneficiary of a trust taxable? ›

Depending on the circumstances, the income of a trust can be taxed in the hands of the Beneficiary, the Donor or the Trust.

Is a revocable trust better than an irrevocable trust? ›

When it comes to protection of assets, an irrevocable trust is far better than a revocable trust. Again, the reason for this is that if the trust is revocable, an individual who created the trust retains complete control over all trust assets.

Should I choose revocable or irrevocable? ›

Revocable and irrevocable. Revocable means that you can change who your beneficiary is anytime without getting their consent. Irrevocable, on the other hand, means that if you want to change your beneficiary you actually need their consent to do so.

What is the main difference between a revocable trust and an irrevocable trust? ›

One of the biggest differences between a revocable and irrevocable trust is your ability to make changes to the trust once it's created. You, the grantor, can modify a revocable trust, while an irrevocable trust is not as easily changed. Both types of trusts aim to protect and delegate your assets.

What is the downside of an irrevocable trust? ›

The downside to irrevocable trusts is that you can't change them. And you can't act as your own trustee either. Once the trust is set up and the assets are transferred, you no longer have control over them.

Who pays capital gains in an irrevocable trust? ›

One fundamental tax-focused decision when structuring a trust is whether the trust should be a grantor trust or a non-grantor trust. If the former, the grantor will be responsible for paying the income tax on income (including capital gains) produced by the trust assets. If the latter, the trust will pay its own taxes.

Do you pay tax on life insurance in trust? ›

How do I put a life insurance policy in trust? Writing a life insurance policy in trust means the payout goes directly to your beneficiaries and not to your legal estate, so it won't be subject to inheritance tax.

Does an irrevocable trust have to pay capital gains? ›

Although irrevocable trusts are great for distributing assets to beneficiaries, they are also responsible for paying capital gains taxes.

Why would you choose an irrevocable trust? ›

The only three times you might want to consider creating an irrevocable trust is when you want to (1) minimize estate taxes, (2) become eligible for government programs, or (3) protect your assets from your creditors. If none of these situations applies, you should not have an irrevocable trust.

Can the IRS take your irrevocable trust? ›

This rule generally prohibits the IRS from levying any assets that you placed into an irrevocable trust because you have relinquished control of them. It is critical to your financial health that you consider the tax and legal obligations associated with trusts before committing your assets to a trust.

What happens to an irrevocable trust when the beneficiary dies? ›

The state of California has an anti-lapse law that is put in place in the event that a beneficiary passes away before the decedent. With this statute, the beneficiary's share of the estate will pass down to the beneficiary's heirs or issue, rather than reverting back to the decedent's estate.

What is the capital gains tax rate for an irrevocable trust? ›

Planning for those trusts is the focus of this article. In 2022, irrevocable trusts pay tax at the top tax bracket of 37% when undistributed taxable income is $13,450. Individual beneficiaries pay tax at the top tax bracket when taxable income is $539,900 for singles and $647,850 for married individuals filing jointly.

Does a trust pay taxes after death? ›

Upon the death or incapacity of the trustor, when a revocable trust becomes irrevocable, the trust must file form 1041. Unlike an individual, trust and estate income is subject to the highest marginal tax rate once the income of the trust or estate exceeds $7,500 (I.R.C. § 1(e)).

Do beneficiaries pay tax on trust income? ›

Trust beneficiaries must pay taxes on income and other distributions that they receive from the trust. Trust beneficiaries don't have to pay taxes on returned principal from the trust's assets. IRS forms K-1 and 1041 are required for filing tax returns that receive trust disbursements.

Does an insurance trust need to file a tax return? ›

Income Tax Consequences

The trust will not file income tax returns as a separate taxable entity. As long as the trust is invested only in insurance policies, the trust will not have any taxable income, and, therefore, the grantor will not report any income.

What expenses can an irrevocable trust deduct? ›

There are some other irrevocable trust deductions that may help further reduce the tax burden to the trust or estate.
  • Investment Advisory Fees.
  • Bond Premiums.
  • Theft Losses.
  • Income Distribution.
  • Qualified Mortgage Insurance Premiums.
  • Cemetery Perpetual Care Fund.
  • Estate Taxes.
  • Charitable Deductions.

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4. Life Insurance Trust Explained w Ease of Understanding
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5. Understanding ILIT (Irrevocable Life Insurance Trust)
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