Five Ways That an ILIT Can Turbo Charge Your Estate Plan
What is an irrevocable life insurance trust (“ILIT”) and why would it be useful to me? This article explores the upsides and downsides of the “ILIT.” The author concludes that an ILIT is both a cost-effective and powerful tool for providing liquidity, paying estate tax, avoiding Generation Skipping Transfer Tax (GSTT), protecting beneficiaries from creditors, and for business owners, Elder Lawyer Queens keeping a business in the family. An ILIT is an irrevocable trust that holds life insurance. Its primary purpose is to keep life insurance proceeds out of the estate of the settlor. But it can also have a number of other purposes. Below are five reasons why one might consider an ILIT:
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.
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 “Crummey” 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.
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 $3.5 million exemption exists (in 2009) 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 using the GSTT exemption (resulting in 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.
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.