Irrevocable Life Insurance Trust
How Does a Irrevocable Life Insurance Trust (ILIT) work?
A trust is essentially a set of instructions explaining how trustmaker wants a trustee to distribute trust income and principal to beneficiaries. A Trust can be revocable or irrevocable.
An Irrevocable Life Insurance Trust (ILIT) is a special type of irrevocable trust. It is specifically designed to be the owner and the beneficiary of life insurance policies. When the life insurance proceeds are paid into the trust upon the death of the trustrnaker, they are not included in taxable estate of the trustmaker for federal estate tax purposes. As a result, 100 percent of the proceeds can be used for the benefit of the beneficiaries pursuant to the trustmaker's instructions. ILITs are used to assure an insured that life insurance proceeds do not have to he reduced by 37 to 55 percent before they can be used for beneficiaries. For this estate tax-free status to be attained, however, all of the technical and procedural rules governing ILITs must be followed to the letter.
An ILIT's chronology can be described as a progression of steps. These steps, summarized in the following list, are critical in maintaining the effectiveness of an ILIT.
The trustmaker signs an ILIT prepared by an attorney. As soon as possible after the ILIT is signed, the ILIT's trustee notifies the beneficiaries that the trust exists and that they have the right to withdraw funds as they are contributed.
The trustmaker makes a gift to the ILIT. (Usually just over the amount required to pay the life insurance premium bill.)
The ILIT's trustee - which cannot be the trustmaker and, to be absolutely safe, should probably not be the trustmaker's spouse - opens a checking account in the name of trust, with the trustee as the only signatory, using the gift as the initial deposit.
After the gift is made to the ILIT, the trustee immediately sends a written notice to all of the trust's beneficiaries telling them of the date and amount of the gift. The trustee also informs the beneficiaries that they have the right to immediately demand their pro rata share of the gift and that their right to do so will stay open for a period of time. Thirty to forty-five days is standard, but that period can be extended to the year-end as well. (See Notification of Demand Right).
The trustee notifies the beneficiaries that their demand rights are annual and that these rights do not carry over to subsequent years.
If the beneficiaries do not demand their share of the contribution, the trustee is free to invest the gift or purchase life insurance on the trustmaker's life.
The ILIT's trustee - not the trustmaker insured - applies for the life insurance.
The insurance can be applied for either before or after the gift is made to the trust, as long as it is applied for by the trustee.
The application should not be submitted before the trust is in existence. However, a medical examination may be arranged prior to its inception.
If the life insurance must be applied for before the ILIT is executed, it should be applied for by the insured's spouse. This technique is not, however, recommended as the preferred procedure in the normal course of business.
The first premium is paid by the ILIT's trustee on the ILIT's checking account after the expiration of the demand period or immediately after the beneficiaries have waived their demand rights.
On the death of the trustmaker, the ILIT generally has terms that are identical with, or similar to, the terms of the client's master estate plan. Although an ILIT routinely mirrors the terms of the master estate plan, it is not legally compelled to do so. It is possible for an ILIT to be created in the absence of any other estate planning documentation.
A well-drafted ILIT has language that states that all monies contributed by the trustmaker, and not demanded by a beneficiary, will immediately go to a separate subtrust within the ILIT for each such beneficiary.
It also provides that its trustee can loan money to, or purchase assets from, the trustmaker's estate or living trust. This is how the ILIT's trustee gets the ILIT's life insurance proceeds - that all important liquidity - into the client's estate or living trust to pay federal estate tax.
