Trusts are an important estate planning tool that can address a wide range of goals as part of a carefully structured, thorough estate plan. An irrevocable life insurance trust is a specific type of trust that may avoid estate taxes and provide asset protection. However, complex tax laws govern an ILIT. You should never set up an irrevocable life insurance trust without advice from an experienced estate planning attorney.
What Is an ILIT?
Many individuals purchase a life insurance policy, often to provide for their loved ones. When the policy owner/insured passes away, the cash value of the policy is includible in calculating the gross estate forestate tax purposes. If the taxable value of the estate exceeds thefederal lifetime transfer tax exemption, the estate (including the value of the policy) is subject to federal estate tax. For 2022, the exemption is $12.06 million for an individual and $24.12 million for a married couple.
An irrevocable life insurance trust is a specific type oftrust established by a grantor for the purpose of owning a life insurance policy, with the proceeds payable to the designated beneficiaries after the grantor passes away. If properly structured andfunded in accordance with the applicable complex federal tax laws, an ILIT may avoid federal estate tax on the value of the policy. Due to the complicated rules that apply, an ILIT should only be set up by a knowledgeable estate planning lawyer as part of a complete estate plan.
An ILIT also may serve as an asset protection trust to prevent creditor access to a life insurance policy during the grantor’s lifetime. However, an ILIT is not the only estate planning tool that may protect assets from creditors. For example, adomestic asset protection trust (DAPT) is another type of trust available in Michigan that may protect assets from creditors.
If you are concerned about protecting assets from estate tax or creditors, it is essential to talk with a knowledgeable estate planning lawyer before taking any action, including establishing an irrevocable life insurance trust or any other type of trust. Attempting to make any type of trust or estate plan documentwithout assistance from a lawyer is a serious mistake that creates substantial risks.
Restrictions on an Irrevocable Life Insurance Trust
An irrevocable life insurance trust established under the applicable tax laws is subject to mandatory restrictions. As the name implies, the trust must beirrevocable. The grantor cannot retain any control over possession or ownership of the life insurance policy, or reserve any powers over the trust or trustee.
The restriction means the grantor cannot have the power to revise the trust terms, change the trustee or beneficiaries, surrender or cancel the policy, borrow against the policy or use it as collateral for a loan, or take other actions relating to the trust or insurance policy. Protecting the policy from estate taxes or creditors in an ILIT results in the policy owner losing the flexibility to use the policy for any purpose during their lifetime.
In addition, tax law restrictions prohibit spouses from creating reciprocal, identical ILITs with each other as beneficiary to avoid estate taxes. Spousal ILITs must have meaningful differences to avoid this issue.
Funding an ILIT
To fund an ILIT, the grantor may transfer an existing policy into the trust after it is created. However, under tax law provisions, an existing policy transferred into an ILIT is included in the grantor’s gross estate for federal estate tax purposes for the first three years after the transfer. So, if the grantor passes away within three years, the goal of avoiding estate taxes is not accomplished. The alternative to transferring an existing policy is for the grantor to transfer other assets into the ILIT for the trustee to use in purchasing a life insurance policy. When the trustee purchases the policy, the three-year period does not apply.
When premiums become due, the trust must generate the cash to pay the premium. The grantor cannot pay the premiums directly to the insurance company without compromising the estate tax exemption. The grantor may initially transfer income-producing assets that will pay the premiums, or make periodic cash gifts to the ILIT that enable the trustee to pay the premiums.
Federal gift tax rules apply to transfers and contributions to the trust, which is an important consideration in creating and funding an ILIT. Special provisions in an ILIT may overcome some gift tax issues that arise. However, the estate and gift tax issues and solutions are complicated, which is another important reason why an ILIT should never be established without assistance from an estate planning lawyer.
Should You Consider an ILIT?
If your estate planning goals include avoiding federal estate taxation or protecting assets from creditors during your lifetime, an irrevocable life insurance trust may be worth considering for inclusion in your estate plan. However, other estate planning strategies may also accomplish those goals and be better suited to your personal and financial circumstances.
The only right way to decide whether you should consider an ILIT is to consult with an experienced estate planning attorney. Your lawyer works with you to determine the best structure for your estate plan to accomplish all your goals and address all your concerns.
Talk With Our Experienced Michigan Estate Planning Attorneys
Our attorneys at the law firm ofBarron, Rosenberg, Mayoras & Mayoras, P.C., provide a full range of services relating toestate planning, including all types of trusts, as well as wills and other essential estate planning documents. We’ve been serving clients in Oakland County and beyond for more than 40 years. Our clients count on our commitment, experience, and credentials when they turn to us for their legal needs. Call us at 248-641-7070 or use ouronline form to contact our trusted estate planning attorneys.