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Your Guide to Irrevocable Life Insurance Trusts (ILITs)

If your estate’s value is worth more than the federal estate tax exemption, you may be a good candidate for an Irrevocable Life Insurance Trust, known as an “ILIT” for short (pronounced EYE-LIT). However, because of the increased estate tax exemption, the use of ILITs in estate planning has decreased. In 2019, the federal estate tax exemption is $11.4 million per person, meaning that if your gross estate (i.e., basically everything you own) is less than this amount and your net worth is not expected to exceed this amount during your lifetime, then having an ILIT as part of your estate plan is probably not necessary. However, for high net worth individuals and couples, ILITs remain an integral planning tool. The remainder of this article will discuss the recent history of the federal estate tax, the purpose of ILITs, ILIT mechanics, and, what is quickly becoming more relevant, what to do if you have an ILIT you no longer need.

Irrevocable Life Insurance Trusts (ILITs) Provide Liquidity to Pay Estate Tax

To understand the purpose of an ILIT, you need to have a basic understanding of how the federal estate tax work. Florida does not have a state-level estate or death tax, so most Florida residents who don’t own real estate in other states or countries only need to be concerned about the application of the federal estate tax. Throughout most of the 1990s, the federal estate tax exemption was only $600,000.00 per person, so having a taxable estate was a lot more common than it is today. During the 1990s and continuing into the early 2000s, estate planning attorneys often recommended and implemented ILITs for the primary purpose of providing liquidity to pay the federal estate tax upon the death of the client. As the estate tax exemption has increased from $600,000.00 to $1 million, $1.5 million, $2 million, $3.5 million, $5 million, and now $11.4 million (per person), the need to provide liquidity to pay the federal estate tax conversely has decreased. There just aren’t as many clients with a net worth exceeding $11.4 million (double that for a married couple) than there were clients worth $600,000.00 ($1.2 million for a married couple) back in the 1990s.

Historical Federal Estate Tax Exemptions & Rates

Year Estate Tax Exemption Top Estate Tax Rate
1997 $600,000.00 55%
1998 $625,000.00 55%
1999 $650,000.00 55%
2000 $675,000.00 55%
2001 $675,000.00 55%
2002 $1,000,000.00 50%
2003 $1,000,000.00 49%
2004 $1,500,000.00 48%
2005 $1,500,000.00 47%
2006 $2,000,000.00 46%
2007 $2,000,000.00 45%
2008 $2,000,000.00 45%
2009 $3,500,000.00 45%
2010 $5,000,000.00 or $0 35% or 0%
2011 $5,000,000.00 35%
2012 $5,120,000.00 35%
2013 $5,250,000.00 40%
2014 $5,340,000.00 40%
2015 $5,430,000.00 40%
2016 $5,450,000.00 40%
2017 $5,490,000.00 40%
2018 $11,180,000.00 40%
2019 $11,400,000.00 40%

Irrevocable Life Insurance Trust (ILIT) Mechanics

An ILIT is an irrevocable trust principally designed to own a life insurance policy on the client whose estate is anticipated to owe estate tax. Because the insurance policy is owned by the ILIT and not by the client individually, the value of the policy, as well as the entire value of the death proceeds, is not included in calculating the value of the client’s estate by the IRS. Upon the death of the client, the policy pays the death proceeds to the Trustee of the ILIT, who is empowered to purchase assets from the client’s estate, thereby providing liquidity to pay the estate tax due, if needed. To the extent any death proceeds are not needed to pay estate tax liability, the Trustee will manage and distribute the remaining proceeds according to the terms of the ILIT as dictated by the client.

ILIT Example – Donna’s Estate

For example, Donna has an estate worth approximately $15 million, consisting primarily of a $3 million Florida primary residence, a $5 million portfolio of investment real estate, a $2 million public relations company, $3 million in non-qualified investments, and $2 million in an IRA (qualified monies). Donna is concerned that upon her death, her children will be forced to liquidate a portion of her investments or, worse, sell the PR company in a fire-sale to satisfy the estimated $1.5 million estate tax liability to the IRS. Currently, the cornerstone of Donna’s estate plan is a revocable trust that devises her entire estate to her three daughters in equal shares. To solve Donna’s liquidity problem, Donna’s estate planning attorney recommends that Donna acquire a $2 million life insurance policy to be owned by an ILIT. The terms of the ILIT devise the entire trust estate to Donna’s daughters in equal shares (same as her revocable trust). When Donna dies, her estate tax liability is $1.7 million. Upon receipt of the death proceeds, the Trustee of the ILIT purchases $1.7 million of investment real estate from Donna’s estate from the Trustee of her revocable trust. The Trustee of the revocable trust then uses the $1.7 million net sales proceeds received from the ILIT to pay the estate tax liability to the IRS, and Donna’s daughters do not have to sell any estate assets. Additionally, none of the $2 million death proceeds will be subject to the estate tax, because the policy was owned by a properly drafted ILIT and not by Donna individually. Importantly, if the policy had been owned by Donna individually, the IRS could have claimed up to 40% of the $2 million death proceeds (40% x $2 million = $800,000.00), meaning the net proceeds would not have been adequate to pay the entire $1.7 million estate tax liability; hence, the power of the ILIT to shelter the death proceeds from taxation. Furthermore, the excess $300,000.00 in death proceeds not needed to satisfy Donna’s estate tax liability can be distributed outright to Donna’s daughters pursuant to the terms of the ILIT. In Donna’s case, supplementing her revocable trust-based estate plan with an ILIT was the perfect solution to ensure a seamless estate and trust administration with sufficient liquidity to keep her assets intact for the benefit of her daughters and for generations to come.

Fixing Old or Broken Irrevocable Life Insurance Trusts (ILITs)

Because of the increased estate tax exemption, I frequently have clients ask what they can do with ILITs they no longer need – ILITs which still require hefty insurance premiums every year to keep the policies from lapsing. In some cases, modifying the life insurance policy, e.g. by reducing the death benefit and thereby the annual premiums, is the appropriate solution. In other cases, modifying the terms of the ILIT document itself can solve the issue. For some clients, however, terminating the ILIT altogether is the only viable economic maneuver. Many clients and their financial advisors believe, incorrectly, that ILITs cannot be modified because they are, by definition, irrevocable (meaning not revocable or modifiable); however, this is not the case! Florida law permits modification of irrevocable trusts in many scenarios. There are many factors to consider in determining the path of least resistance to modify or terminate an ILIT, including, for example:
  • whether the client who established the ILIT is still living;
  • whether the ILIT beneficiaries are in agreement with the proposed changes; and
  • whether the Trustee of the ILIT is willing to cooperate.
In some cases, ILIT modification can be accomplished by private agreement without the need to obtain court approval, while in other cases, court approval is required. In any event, ILIT modification often involves federal tax issues, so the oversight of a seasoned estate planning attorney is imperative. If you believe you have an ILIT that no longer benefits your estate and the premiums are a drain on your resources, it is crucial to consult with an experienced estate planning attorney as soon as possible. This is because most life insurance policies purchased by ILITs in the 1990s and 2000s have escalating costs of insurance as the insured person ages. As the cost of insurance rises, the premium payments are no longer sufficient to cover the annual cost of insurance, and so the accumulated cash value within the policy is eaten away year after year. When this cycle happens, the policy may lapse before the insured person dies, and all of the cash value from prior premium payments dwindles to zero. The sooner you can identify this issue, the sooner you can act to either salvage the policy by reducing the death benefit or salvage the remaining cash value by directing the Trustee to surrender the policy through a modification or termination of the ILIT. To execute either of these options, your estate planning attorney must ensure compliance with state trust law, as well as navigate potential IRS tax traps.

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