Estate Taxes & Irrevocable Life Insurance Trusts (ILITs)

November 2021 Newsletter | By: Ian Sachs, CFP®, CLU®
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As many of you are aware, I am a Certified Financial Planner® and Chartered Life Underwriter. I specialize in providing my clients – through advanced life insurance planning – solutions to specific tax, estate, and financial planning challenges.¹ When it comes to Irrevocable Life Insurance Trusts (ILITs) my role as an advisor is to properly design and implement life insurance policies. While this month’s newsletter deviates in a more technical direction from what I typically cover, I believe the topic is increasingly relevant and timely.

Estate Taxes

Background: Federal estate taxes are a financial levy on one’s estate. When someone dies (or if married, the surviving spouse dies), estate taxes will be owed on assets that exceed an exemption amount. The current estate tax rate on assets in excess of the estate exemption is 40%.

A dozen states also levy their own state estate tax on top of the federal estate tax. Half a dozen states impose their own inheritance tax, which is owed by the living heir, not the deceased.

History: Estate tax was first introduced in 1790 to raise funds for the naval war against the French Republic. It was reintroduced again for the Civil War, Spanish-American War, and finally WWI where it was officially signed into law. The basic exemption amount is adjusted for inflation and was recently doubled to $10 million per person (inflation adjusted at $11.7 million for 2021) and sunsets in 2026 back to $5 million.

Similar but Different Taxes: Also at the federal level, gift tax returns are required for individuals who give anything of value to another person when the value exceeds the annual gift exclusion ($15,000 for 2021). Gift tax is only due when the cumulative amount of lifetime gifts exceeds the lifetime exemption.

What is an ILIT?

An Irrevocable Life Insurance Trust (ILIT), as the name implies, is a type of irrevocable trust. Once a grantor places an asset in an irrevocable trust, it is considered a gift and cannot be revoked by the grantor. Generally, property transferred to an irrevocable trust is not includible in the gross value of a person’s estate when they die, making irrevocable trusts particularly useful in reducing the tax liability of large estates.

ILITs are created to serve the specific purpose of owning one or more life insurance policies to provide asset protection. To minimize federal gift taxes, the grantor can make annual gifts to the trust to cover insurance premiums. If an individual is married, the policy is typically second-to-die insurance (also known as a survivorship policy). The benefit is paid after the death of the surviving spouse.

If the trustee applied for and purchased the policy or if the grantor gifted the policy to the ILIT and outlived the three-year look-back period and did not retain any beneficial interest in the trust, the policy’s death benefit proceeds that are paid to the trust are excluded from the grantor’s gross estate.

What are some of the benefits of an ILIT?

• Avoids federal income and estate taxes on life insurance policies held by the trust

• Maximizes the advantage of the lifetime gift tax exemption and/or annual gift tax exclusion

• Serves as a source of liquidity to pay estate settlement costs

• Provides a stream of income or cash resources for the trust’s beneficiaries

• Protects trust assets from the beneficiary’s creditors and from legal claims arising from lawsuits, divorce, or bankruptcy

• Avoids probate and its attendant costs with regard to assets held by the trust

• Maintains confidentiality, since trusts are private documents

Why is it important to address now?

Potential Tax Law Changes: Wealth transfer plans will be affected if proposed tax code changes are signed into law. Some of the changes contained in “The 99.5 Percent Act” would have a dramatic effect on a foundational component of wealth transfer planning – the ILIT – and would reduce the basic exemption amount to $3.5 million.

Potential Lifetime Gifting Changes: The current gift exclusion would be reduced from $15,000 to $10,000 and the number of annual exclusion gifts to trusts would be limited to two per donor.

Implications for New and Existing ILITs: Gifts made to ILITs could expose some portion of the trust to estate tax inclusion, reducing the net assets intended to meet tax obligations or other personal goals. Continuing to make gifts to existing ILITs would no longer have the same benefits.

What actions are we taking?

We are discussing with our clients that have ILITs the feasibility of making a single lifetime gift that would be adequate to fund their ILIT’s policy through life expectancy and/or the advantages of funding new trusts prior to enactment.

If you’d like to learn more or discuss your own situation, please feel free to contact us.

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¹ I am not an attorney or a CPA but am well-versed in Irrevocable Life Insurance Trusts (ILITs) and their implications across all planning mentioned. When it comes to ILITs, my role is to properly design and implement life insurance policies. We work with estate planning attorneys and tax professionals who plan and create the trust documentation.