In this article, we will explain Irrevocable Life Insurance Trusts (“ILITs”) for Illinois Estate Tax Planning. We will answer the questions: “what is an ILIT?,” “are life insurance proceeds subject to estate tax?,” “what are ‘incidents of ownership’ of a life insurance policy?,” and “should I transfer an existing life insurance policy to an ILIT?” We will also explain how to reduce estate tax with an ILIT, ILITs and gift tax, ILITs as leveraged gifts, Irrevocable Life Insurance Trusts and the three year rule, and Second to Die Insurance in the context of irrevocable trusts.
What is an ILIT?
An ILIT is an irrevocable trust used to remove the death benefit of a life insurance policy from the insured’s taxable estate. The insurance policy is owned by the ILIT, rather than by the person whose life is insured.
Are Life Insurance Proceeds Subject to Estate Tax?
Estate tax is a federal and state tax placed on the assets of a deceased individual over and above that individual’s lifetime gift and estate tax exclusion limit. The lifetime exclusion limit for Illinois estate tax is $4 million. The exclusion limit for federal estate tax is approximately $11.5 million. For more on estate tax, check out our article: How to Avoid Estate Tax.
When an individual dies, the administrator of his or her estate must add up all of the assets of any type owned by the deceased individual, including the death benefit of life insurance policies owned by the deceased individual. To the extent that the assets are above the Illinois and federal estate tax exclusion, the assets are subject to Illinois and federal estate taxes, respectively.
The fact that life insurance proceeds are included in your taxable estate is important, because such proceeds are often the largest single asset in an estate. A $2 million life insurance policy can easily push an estate that would otherwise not be taxable past Illinois’ $4 million threshold.
We use ILITs to remove the death benefit of life insurance policies from the taxable estate. For this reason, ILITs are one of the first lines of defense against estate tax.
How to Reduce Estate Tax With ILITs
If an individual would like to reduce the amount of assets in his or her taxable estate, he or she may transfer ownership of an existing life insurance policy on his or her life to an irrevocable trust. Alternatively, he or she may first create the trust and transfer money to the trust to purchase the policy. The differences between these two strategies will be discussed below. To learn more about the various ways irrevocable trusts can be used to minimize estate tax, check out our article: Irrevocable Trusts for Estate Tax Planning.
If an ILIT is set up properly, the death benefit of any life insurance policies it owns will not be included in the taxable estate of the individual whose life is insured. In order to accomplish this, the individual whose life is insured must not retain any “incidents of ownership” over the policy.
What are “Incidents of Ownership” of a Life Insurance Policy?
“Incidents of Ownership” of a life insurance policy include:
- The ability to change a beneficiary;
- The ability to cancel the policy; and
- The ability to assign the policy.
So, when you transfer a life insurance policy to an ILIT, you give up the ability to make changes to the policy. For most people this is not a problem. If you are using the policy to take care of your spouse and children, it is not likely that you will ever want to change the policy beneficiaries. If you decide you no longer want to keep the policy, you retain the option to stop making payments to the ILIT to cover the premiums and the policy will lapse.
Part of giving up incidents of ownership over the life insurance policy generally involves naming someone other than the insured to act as trustee of the ILIT. However, it may be possible for the insured to also act as the trustee if the terms of the trust remove any discretion from the trustee’s actions.
What are the Responsibilities of an ILIT Trustee?
The trustee of an ILIT will be responsible for:
- Receiving payments from the policy creator to cover the policy premiums;
- Paying policy premiums on time;
- Keeping the beneficiaries informed of any developments related to the policy or the ILIT;
- Receiving the proceeds of the policy when the insured passes; and
- Distributing the proceeds of the policy to the beneficiaries.
ILITs and Gift Tax
In addition to estate tax, another consideration when establishing an ILIT is gift tax. For an explanation of how gift tax works, check out our article: Illinois Gift Tax Explained. The short version is as follows:
- You can transfer up to $15,000.00 per year to as many individuals or entities as you’d like without the transfer being subject to gift tax. This is called the “annual gift tax exclusion.”
- Transfers over and above this amount reduce your lifetime gift and estate tax exclusion (the same exclusion discussed above).
- Once your lifetime gift and estate tax exclusion is used up, gifts over and above the annual exclusion will be subject to gift tax.
If you transfer an existing life insurance policy to an irrevocable trust, the value of the gift is the terminal reserve value of the policy, which is typically much less than the death benefit.
This is still not ideal, as we would like to avoid gift tax entirely with our ILIT strategy. We can do so by opening a new life insurance policy owned by the ILIT rather than transferring an existing policy to the ILIT. There will be no gift tax implications for transferring the policy if the policy is owned by the ILIT in the first place. Payments made to the trust to cover the policy premiums will not be subject to gift tax either, so long as they are below the annual gift tax exclusion limit.
So long as a new policy is purchased by the ILIT itself, neither gift tax or estate tax will apply to the policy.
ILITs as Leveraged Gifts
One of the key challenges in estate tax planning is to maximize the amount that an estate’s beneficiaries will receive free and clear of estate tax without triggering gift tax through lifetime transfers. One of the key strategies we use to accomplish this is making leveraged gifts to irrevocable trusts. We cover the concept of leveraged gifts in detail in our article, Irrevocable Trusts for Estate Tax Planning.
The concept of a leveraged gift is for an individual to transfer assets to an irrevocable trust during his or her lifetime in small enough annual amounts that the transfers will not be subject to gift tax, but to have the irrevocable trust ultimately provide a tax-free benefit to the trust beneficiaries that will be much larger than the sum of the tax-free transfers.
Let’s explain how this works through a real life example. Let’s say Dad transfers $15,000.00 per year for 10 years to an ILIT in order to pay the premiums of a life insurance policy with Daughter as the beneficiary. This total of $150,000.00 will not be subject to gift tax, because each transfer was below the annual exclusion. Now let’s say the life insurance policy has a death benefit of $5 million. When Dad passes away, the $5 million death benefit of the policy will pass to Daughter free and clear of both estate tax and gift tax. Dad has leveraged his $150,000.00 to transfer $5 million to daughter tax free.
Irrevocable Life Insurance Trusts and the 3 Year Rule
If you pass away within three years of transferring an existing life insurance policy to an ILIT, the death benefit of the policy will be treated as part of your taxable estate. The policy behind this “three year rule” is to prevent deathbed transfers for the sole purpose of avoiding estate tax from being effective.
However, the three year rule does not apply to policies that were purchased by the ILIT in the first place. This means that if an individual dies within 3 years of an ILIT purchasing a new life insurance policy on his or her life, the death benefit of the policy will pass to beneficiaries free and clear of estate tax, and will not be treated as part of the insured’s taxable estate.
Should I Transfer an Existing Life Insurance Policy to an ILIT?
In a vacuum it is better to create an ILIT, transfer funds to the ILIT for policy premiums, and then have the ILIT purchase a new life insurance policy as opposed to transferring an existing policy to an ILIT. This is the case for two reasons, both discussed in detail above:
- The transfer of an existing policy may have gift tax implications, the purchase of a new policy will not; and
- Policies transferred to an ILIT are subject to the “three year rule;” new policies purchased by an ILIT are not.
However, when dealing with the realities before you, transferring your existing policy to an ILIT may be your best option, depending on the deal you have locked in with the policy compared to the cost of a new policy and also depending on the existing policy’s favorable terms. If estate tax is a concern, transferring an existing policy to an ILIT will almost always be a better option than allowing the policy to become part of your taxable estate.
Second to Die Insurance and Irrevocable Trusts
Finally, let’s discuss a type of life insurance that is particularly suited to ownership by an ILIT. “Second to Die Insurance” is often purchased by married couples engaging in a leveraged gift strategy. Second to Die Insurance does not pay out a death benefit until the death of the second spouse. This causes the premiums to be more cost-effective.
This makes sense when the purpose of the policy is to provide a leveraged gift to the children, as opposed to providing for the surviving spouse’s needs. The smaller premiums relative to death benefit allow the couple to maximize the amount that will be paid out free of both gift and estate tax.
If the couple pays $30,000.00 toward premiums every year in order to maximize the amount they are transferring from their estate without incurring gift tax (remember: each has a $15,000.00 annual exclusion), the same amount will purchase a larger tax-free death benefit if the ILIT purchases a Second to Die Policy as opposed to a traditional life insurance policy.
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