The principal advantage of using an inter vivos (living) irrevocable life insurance trust (“ILIT”) is that it may keep the life insurance policy proceeds from being taxed as part of the estates of both the insured and the insured’s spouse, while allowing the insured’s surviving spouse to enjoy the benefits of the proceeds as a trust beneficiary. The surviving spouse may be entitled to all or a portion of the income and/or the insurance policy proceeds, in the discretion of a trustee other than the spouse, without causing the proceeds to form part of the surviving spouse’s gross estate. The surviving spouse also may have the right to demand some of the proceeds for his or her support, maintenance, education, and health, limited by an ascertainable standard.
Alternatively, the surviving spouse may be given the power to demand the greater of $5,000 or 5% of the value of the trust each calendar year, without subjecting any portion of the insurance proceeds to tax in the survivor’s estate, except for the portion subject to the withdrawal power in the year of the survivor’s death.
Potential advantages include:
- Estate tax savings.
- The life insurance proceeds may not be subject to the claims of creditors under applicable law.
- The trust arrangement may provide significant protection from the claims of the insured’s spouse. For example, having the insurance proceeds payable to a trust may protect the proceeds from any state law elective share right of a surviving spouse; such an elective share right, if exercised, could potentially inflict substantial damage to the carefully crafted estate plan.
- A trust provides a flexible tool for the management and distribution of assets. It provides a “ready-made” asset management vehicle which may be crafted as flexibly as the settlor designs the arrangement.
- The goals for which the insurance was acquired may be advanced by the ownership and receipt of the insurance proceeds by a trust. For example, if the insurance proceeds are to provide liquidity for the insured’s estate for the payment of debts, expenses of administration, and taxes, then this goal generally can be achieved by authorizing the trustee to purchase assets from or make loans to the insured’s estate or the beneficiaries. Moreover, this goal may be more easily accomplished by trust ownership of the policy because the proceeds may not be subject to estate tax.
Thus, there are circumstances under which the ownership of a life insurance policy by an irrevocable trust, instead of individually, is more beneficial. The tax savings of excluding, for example, $500,000 of life insurance proceeds from the estate of the second to die could be as much as $245,000. Although the ILIT provides this significant estate tax savings opportunity, it presents some distinct drawbacks.
- The insured’s loss of control over the policy, including the right to borrow against or otherwise use the cash value of the policy, to designate settlement options, and to change beneficiaries of the policy. This loss of control can be significant, both psychologically and economically.
- The settlor cannot alter or amend the trust beneficiary designations. However, appropriate drafting of the trust instrument can reduce the impact of these drawbacks.
- Costs associated with drafting and funding the ILIT. Besides the legal costs, if a professional trustee is selected, there will be trustee’s fees.
This article is intended to give you enough information to decide which of these estate planning tools might be appropriate, and which are definitely not. We can then discuss further how the ones in which you remain interested may be tailored to meet your goals.