Irrevocable Life Insurance Trust (ILIT)

How to make life insurance an estate planning benefit instead of an estate planning burden.

I was contacted some time ago by a farm family in one of the three states where I am licensed that does not have an estate tax like Minnesota.  The husband and wife have adult children that were likely to return home to the family farm after college.  The estimated assets for the farm were approximately $4,000,000.00.

When the husband contacted my office he was very excited.  His local insurance agent had drafted life insurance policies for both him and his wife.  The couple was past middle age, and was happy that they passed their physicals and could be approved for the policies that were being offered.  Each life insurance policy was worth $5,000,000.00 each, for a total of $10,000,000.00.

The husband asked me if there was something he should know about life insurance in regards to his estate plan.  He remembered a discussion we had had many months before that, and my discussion of Irrevocable Life Insurance Trust (also called an ILIT).

I asked the husband if this insurance agent had recommended an ILIT. He said that the agent had not mentioned it.  As an estate planning attorney with a Master of Laws in Taxation I was horrified to hear this.  I briefly mapped out the potential liabilities in estate tax for this farm family as follows.

First, one of the biggest misconceptions in estate planning is that life insurance, or anything with a beneficiary designation, will avoid estate taxes.  This is not true.

Life insurance is tax-free for income tax purposes only.  The final payout on life insurance, not the cash value, will be included in your gross estate.

Thus, for this farm family, assuming that husband and wife owned their $4,000,000.00 farm estate equally, for $2,000,000.00 each, their ownership of the life insurance policies would increase their gross estates by $7,000,000.00 each, or $14,000,000.00 total.

If one of the two spouses died in 2016 with a $7,000,000.00 gross estate, this would put them over the federal exemption of $5,450,000.00.  Estate taxes would be assessed on $1,550,000.00 at a rate of 40%, which would make the tax bill $620,000.00 if one of the spouses died in 2016.

If unfortunate events happen to both spouses in 2016 (farming is one of the most dangerous professions) this would mean a $1,240,000.00 federal estate tax bill.

I reminded this farmer that an Irrevocable Life Insurance Trust (ILIT) could be established.  The ILIT would purchase the policy by gifts made to the ILIT by the farmer for his policy, and the spouse for her policy with a separate ILIT.  The two trusts would then own the policies.  Annually the trust would have to maintain certain formalities to comply with the Internal Revenue Code and applicable rulings, for which our office provides ongoing assistance and maintenance.

I reminded the farmer that with a properly established ILIT for himself, and another established for his spouse, the entire $10,000,000.00 for the two life insurance policies could be passed to their family free of federal estate taxes.  Because the ILIT owns the policies, and the ILIT is irrevocable, it will not be included in the gross estate.  This would bring the total estate for the spouses back down to $4,000,000.00, or $2,000,000.00 each, which will easily avoid federal estate taxes.