When It’s Best to Use an Irrevocable Life Insurance Trust - The Unger Company | Estate Tax Planning | New York, Manhattan, Long Island, NY

When it comes to estate planning, life insurance is one of the mainstays in the industry, but if care is not exercised, it can create as many estate-planning problems as it solves. That’s just one of the reasons we like to review Irrevocable Life Insurance Trusts (ILIT) with our clients.

Like most trusts, it is a holding device. In this case, the trust owns and is the beneficiary of the life insurance policy on the insured’s life thereby keeping it from being included in the taxable estate. And as is part of the name, it is irrevocable. Once it has been created and funded, the assets cannot be repatriated. For the most part, it cannot be amended, modified or rescinded in any way after its creation except for “decanting.” This is a relatively new legal process wherein the trust may be amended. And, in some states, this may be accomplished without court approval.

At death, the insurer pays the policy proceeds to the ILIT. The trustee(s) then looks to its terms to determine how to distribute them. Generally, the proceeds are free of income taxation except for the interest earned by the policy post death and prior to payment to the trust. Sounds pretty restrictive, but in truth, not so much. For example, in the trust documentation, the grantor (generally the insured) names the beneficiaries and defines the terms under which they will receive benefits. The grantor can also choose the initial trustee(s), successor trustee(s), state jurisdiction under which the trust is governed, and permits the trustee(s) to change jurisdictions. The grantor may also divide responsibilities for adhering to the terms of the trust and investment of trust funds. But, to be clear, all of these terms must be laid out in the trust instrument and, generally, not modified after its execution.

Best Uses for an ILIT

There are several good reasons to create an irrevocable trust. Estate tax considerations used to be the leading reason for the creation of an ILIT. Now, let’s now dig deeper.

One of the primary reasons why a lot of people create an ILIT, is that they are concerned about the beneficiaries of their estate. The ILIT allows the grantor to control when and how his/her beneficiaries receive the proceeds of the policy (and, there may be more than one). If the grantor’s beneficiaries are minors, or adults who may have mental incapacities, addictions, or other problems handling their finances, it is a good idea to set up an ILIT. This allows the grantor to appoint a trustee to act as a supervisor to distribute the assets per the terms of the trust documents according to his/her wishes. Most life insurance provides a considerable cash payout all at once, and that can create problems. Even adults with experience managing their finances can become overwhelmed with a sudden sizeable monetary windfall. For young adults, the Porsche store may become irresistible.

In addition, if properly drafted, the ILIT might help protect the proceeds from seizure by a governmental agency when a trust beneficiary is receiving certain types of governmental assistance. For example, if the beneficiary is disabled in some way, or even just elderly, and is receiving certain types of governmental benefits, such as Medicaid, then the proceeds from the life insurance contained within the ILIT might make them ineligible for further government benefits. Worse, the governmental agency may attempt to recapture the funds it has expended on behalf of the beneficiary. By not having that beneficiary own or have the absolute right to receive funds, he/she might be able to receive payments for treatments and expenses that Medicaid won’t pay for, such as a home health aide.

Another reason to set up an ILIT is asset protection. The ILIT will help protect the trust assets, including the insurance cash value and death benefit, from the grantor’s creditors. An ILIT can also provide a level of asset protection for beneficiaries while the funds remain within the ILIT. This means that there may be some protection for the beneficiary who is subject to litigation. Once the funds have been paid to the beneficiary, then they are available to creditors. That means that creditors can remain at bay until the funds are distributed.

The bottom line here is that forethought and proper document drafting are key prerequisites for the creation of an effective and useful trust. Of course, not everyone is clairvoyant and able to see exactly what the future will bring. Hence, decanting…

BTW, the term ”decanting” is derived from wine decanting wherein the contents of the wine bottle are run through a filter before ending up in a flask-like container. More about decanting in a future blog…

We welcome the opportunity to further explain to you the benefits of this estate-planning tool. You may reach us at The Unger Company Ltd., 212-755-4777 x100.