Irrevocable Life Insurance Trusts

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information provided below.

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A Trust is an arrangement in which an individual or an entity, such as a corporation or bank, is given property to hold and manage for the benefit of one or more third parties. The benefits of this kind of arrangement are many. Trusts and Trust-like arrangements created upon the death of a property owner have been utilized for centuries. Such arrangements that take effect during the lifetime of a property owner are a more recent Trust development but essentially serve the same purposes.

The law that governs Trust arrangements today can be traced back through English Law to Roman Law. Current Trust law is complex. It defines the roles and responsibilities of all parties involved in a Trust arrangement, specifies the manner in which Trusts must be written, and sets forth what can and cannot be accomplished with a Trust arrangement. There are many different types of Trusts, each of which serves a specific purpose. One of the most common types of Trusts is the Irrevocable Life Insurance Trust.

Every Trust involves a number of parties:

The person transferring property into the Trust is almost always the one who creates it. This person is called a Grantor, a settlor, or, more simply, the creator of the Trust. The party who holds and manages the property in a Trust is the Trustee. The individual for whom the property is held and managed is the Beneficiary.

While this description of the participants in a Trust arrangement suggests only a single Grantor, Trustee, or Beneficiary, this is not always the case. It is possible for more than one individual to be the Grantor and transfer property into a single Trust. Depending on the circumstances surrounding the establishment of the Trust and who is chosen to hold and manage the Trust property, it is often more beneficial to have multiple Trustees rather than a single Trustee.

And certainly, since the vast majority of Trusts are created to benefit a Grantor’s spouse and heirs—children, grandchildren, and perhaps even great-grandchildren—there can be multiple Trust Beneficiaries. It is possible as well, however, for a Grantor to establish a Trust solely for personal benefit, in which case there might be as few as two individuals involved in the Trust: a single Grantor, who is also the Beneficiary, and a single Trustee.

The role of the Grantor, which will be discussed later in this course, and the role of the Beneficiary in a Trust arrangement are quite simple. The Grantor transfers property into the Trust, and the Beneficiary receives benefits associated with that property, either from Trust income or from Trust principal. The Beneficiary may receive a benefit immediately or at some specified or unspecified time in the future. The role of the Trustee, however, is more complex. The Trustee serves as intermediary between the other two parties to the Trust and acts in the capacity of a Fiduciary.

When property is transferred into a Trust, the ownership of the property is split into two interests. The first is a nominal or legal ownership interest. This interest is held by the Trustee in a fiduciary capacity. It allows the Trustee to manage the property in the Trust as if the Trustee owned the property personally. The second Ownership Interest is an Equitable or Beneficial Ownership Interest.

This interest vests in the Trust Beneficiaries, except in those Trusts specifically created to benefit the Grantor, only third-party Beneficiaries of the Trust can enjoy benefits from Trust Income or Principal. Aside from receiving a fee for providing services, the Trustee is NOT allowed to benefit personally from any transactions involving Trust assets.

The prohibition against personally benefiting from transactions involving Trust assets is central to the Trustee’s fiduciary role. A fiduciary, as one who manages property for another’s benefit, is obligated to always act in the best interests of Trust Beneficiaries.

A Trustee should be competent; that is, able to fulfill the duties required under the Trust’s provisions, including the ability to manage the assets held in the Trust. This includes both the ability to understand the nature of the assets held in the Trust and to manage those assets personally.

A Trustee must act in the best interests of the Trust Beneficiaries. This may seem simple and straightforward on the surface, but it can become a complex issue for a Trustee to negotiate. For example, it is possible that a transaction that clearly should be undertaken for the benefit of Trust Beneficiaries might have a negative impact on one of the Trustee’s close associates, a member of the Trustee’s family, or perhaps the Trustee personally.

Or, a Trust created to provide income currently to one Beneficiary and principal to another at some future date may raise issues. With each investment decision, the Trustee will have to weigh both the rights of the Trust’s income Beneficiaries and the principal Beneficiaries.

A Trustee also needs to understand the Grantor’s objectives as expressed in the Trust document because the Trustee is under a legal obligation to implement these directions.  A Trustee must also be capable of serving, physically, mentally, and emotionally. It is also important to choose a Trustee who can operate as an impartial third party with respect to Beneficiaries and others involved with the Trust assets.

There should be no conflict between the Trustee and others who provide services to the Trust, such as Investment Advisers, whether family members or not. Finally, there should be no conflict between the Trustee and the Beneficiaries, whether over their lifestyle choices, career decisions, personal relationships, or use of Trust assets.

Trust documents are written, or drafted, by qualified attorneys. When a Trust document has been drafted, reviewed, and accepted by a Grantor, the Grantor then executes the document, which means that he or she must sign and date the Trust agreement and have it witnessed by disinterested third parties.

At this point, property can be placed in the Trust. This property is called the Trust Corpus, Principal, or Res, or more simply the Trust assets. When the Trust is established during a Grantor’s lifetime, it is called an Inter Vivos, or Living Trust. When established at death through the Grantor’s will, the Trust is called a Testamentary Trust.

Beneficiaries named in the Trust generally fall into two categories:

Primary and Contingent Beneficiaries. Primary Beneficiaries receive benefits under the Trust before any benefits are made available to contingent Beneficiaries. A contingent Beneficiary, in contrast, receives benefits only if the primary Beneficiary dies or disclaims his or her interest in the Trust.

Trusts may also contain provisions specifying what property or how much asset value goes to each Beneficiary. Very commonly, however, distributions to family members are done on either a per stripes or a per capita basis. Per stripes means “by the branches or stocks.” Per capita means by the number of “heads” that can be counted.

The general purpose of any Trust arrangement is to hold and manage property. An equally important purpose is to facilitate the transfer of that property to designated Beneficiaries in the most tax-efficient manner.

While there are many reasons why a Trust would be attractive to a property owner, three of them stand out:

When an Irrevocable Life Insurance Trust is created, the Grantor completely relinquishes title to the Trust property and does not retain any right to revoke, amend, control, or terminate the Trust. Once an Irrevocable living Trust is established, the Grantor cannot:

There are a number of disadvantages associated with utilizing an Irrevocable Trust in an estate plan:

A Trust can be an effective way to achieve various estate-planning objectives. For example, many individuals who own Life Insurance policies want to ensure that the proceeds are not included in their estates for estate tax purposes. To accomplish this goal, the owner can transfer an existing policy to an Irrevocable Life Insurance Trust, thereby removing the asset from his or her estate.

Or, a person can purchase a new policy to be owned by the Irrevocable Life Insurance Trust so that the proceeds can be used to pay any estate taxes due at death. However, those who establish Irrevocable Life Insurance Trusts must also be aware of several potential tax issues that can impact their Trusts including the “Kiddie Tax”.

The Non-U.S. Citizen Irrevocable Life Insurance Trust

The estate tax rules that apply to transfers to non-U.S. citizen spouses are different from the rules that affect transfers to spouses who are U.S. citizens. For example, as we learned earlier, the marital deduction allows one spouse to transfer an unlimited amount of property to the other spouse upon death without incurring any estate tax. This means that one spouse can leave his or her entire estate—regardless of size—to the other spouse and not pay federal estate taxes. However, spouses cannot take advantage of the unlimited marital deduction if the surviving spouse is not a U.S. citizen. Instead, once a U.S. citizen spouse has used his or her estate tax exemption, the remainder of his or her estate would be subject to immediate taxation unless it is transferred into a Qualified Domestic Trust (QDOT). A surviving non-U.S. citizen spouse can receive income from a QDOT during his or her lifetime and principal as needed for his or her health, education, maintenance, and support. At the surviving spouse’s death, the QDOT assets pass to the trust remaindermen (i.e., typically children and/or grandchildren), and estate taxes are assessed.

One problem with a QDOT is that it leaves a surviving non-U.S. citizen spouse without any personal resources to manage as he or she sees fit. This problem is sometimes addressed by having the U.S. citizen spouse give the non-U.S. citizen spouse annual gifts that, like annual exclusion amount gifts, can be made free of any immediate tax consequences. These gifts to non-U.S. citizen spouses, however, can be much larger ($152,000 in 2018) and are subject to inflation adjustment.

ILITs in which the non-U.S. citizen spouse is the sole beneficiary are often used to provide the spouse with financial independence.
This approach is simple and straightforward. Funding for the Irrevocable Life Insurance Trust is provided, not by a second-to-die policy, but by a single individual life insurance for expats policy on the life of the U.S. citizen spouse. At the insured’s death, the tax-free proceeds flow into the trust and through the trust into the hands of the non-U.S. citizen spouse. Receipt of these proceeds does not affect the non-U.S. citizen spouse’s right to receive income from the QDOT, although having additional assets will affect his or her ability to obtain principal from the trust under its ascertainable standards provision.

Prohibited Powers Under the Grantor Trust Rules

To avoid having Trust income taxed to the Grantor or Trust property included in the Grantor’s estate, an Irrevocable Life Insurance Trust must conform to the Grantor Trust rules. These rules address a wide range of controls, or powers, that a Grantor might attempt to retain or that might inadvertently or negligently be afforded a Grantor when a Trust is carelessly drafted.

These powers are collectively called Prohibited Powers. A Grantor must, therefore, avoid retaining any of the following rights:

With respect to these last two prohibited rights, having either of these rights included in the Trust document will cause income from the Trust to be taxed to the Grantor. Actual distribution of the income is not necessary. Income is also taxable to the Grantor if it can be used to pay Life Insurance premiums on the life of the Grantor or the Grantor’s spouse unless the proceeds of such policy had been irrevocably made payable to a qualified charity.

Permitted Powers Under the Grantor Trust Rules

While a Grantor can avoid adverse tax consequences by strictly following the Grantor Trust rules and relinquishing all dominion and control over property transferred to an Irrevocable Trust, there are some controls that a Grantor can maintain, including:

Another important issue that Grantors must consider when creating an Irrevocable Life Insurance Trusts is the implication of having Trust Beneficiaries from two or more generations and the impact the generation-skipping transfer tax (GSTT) will have on such arrangements. Trusts that provide benefits to multiple generations are commonly called dynasty Trusts.

For GSTT purposes, there are two kinds of Generation-Skipping Beneficiaries, or Skip Beneficiaries. A Direct Skip Beneficiary has an immediate unfettered right to use and enjoy the property being transferred. An Indirect Skip Beneficiary receives a transfer indirectly, as in a Trust arrangement. In other words, there is some intermediate step between the transfer of property and the unfettered use and enjoyment of it by the Indirect Skip Beneficiary.


There are two types of distributions from Dynasty Trusts: Taxable Terminations and Taxable Distributions. Taxable Terminations occur either when a Trust terminates or when all of the interests in the Trust are held by Skip Beneficiaries.

For example, let’s assume Gerry Grandfather created a Trust for the benefit of his three children and his six grandchildren. While any of his children are alive, they will receive an equal pro rata share of any income generated by the Trust assets. When the last child dies, the Trust will terminate, and the principal will be distributed in equal shares per stirpes to the three branches of Gerry’s family and within each branch in equal shares to each living grandchild. A taxable termination will therefore occur upon the death of the last of Gerry’s children and when all the interests in the Trust would be held solely by skip Beneficiaries.

Alternatively, Gerry could have established his Trust to provide income to his children in equal shares while they were alive, but with the stipulation that the Trust would remain in effect after the death of the last child until the youngest grandchild attained the age of 45, at which time the Trust would terminate and distribute Trust principal as in the foregoing example.

Until the youngest grandchild attained the age of 45, the Trustee would make the same per stirpes income distributions to the branches of Gerry’s family that were previously being made to the heads of those branches, his children. These would be taxable distributions. When the last grandchild turned 45—a time specified by the Grantor—the taxable termination of the Trust would occur. In other words, a Taxable Distribution occurs when Trust assets are transferred to skip Beneficiaries while the Trust remains in effect, while a Taxable Termination occurs when the Trust ceases to exist.

The common law rule against perpetuities, which applies in some states, is designed to ensure that property placed in Trust will eventually make its way back into the economy so that it can be taxed. The basic rules state that a Trust can remain in effect for the lifetime of someone named in the Trust plus 21 years. At the end of this period, Trusts in those states that follow the rule must be terminated, and Trust property must be distributed.

Annual Exclusion Gifts

Any time one person gives something to another without receiving anything in return, a gift has been made. Gift-giving can have a substantial impact on the intergenerational transfer of wealth. However, the IRS has absolutely no interest in gifts of relatively low value. Keeping track of these kinds of gifts would be nearly impossible, both because they occur so frequently in our everyday interaction with others and because keeping track of such gifts would be difficult for taxpayers and the IRS.

To eliminate dealing with small gifts, the IRS established a threshold under which a gift does not have to be reported for tax purposes. Under current law, individuals can give up to $15,000 each year (known as the annual exclusion amount) to as many individuals as they wish without incurring any gift tax liability. These gifts are made entirely free of gift or estate tax and generate no immediate income tax consequences for either the person making the gift or the person receiving the gift.

Taxable Gifts

Along with the right to make annual exclusion amount gifts, either individually or jointly with a spouse, everyone can also transfer a certain amount of property free of gift or estate transfer tax, either during his or her lifetime or at death, respectively. This is because the federal government provides every taxpayer with three potential tax exemptions. First, spouses who are U.S. citizens can transfer an unlimited amount of property to each other during life and at the first spouse’s death without tax consequences. These transfers are sheltered under what is called the unlimited gift and estate tax marital exemption.

Transfers to someone other than a spouse are treated differently and are subject to a maximum lifetime limit. Prior to the enactment of the Tax Cuts and Jobs Act of 2017, a person could make up to $5 million (indexed) in lifetime gifts to non-spousal Beneficiaries without gift tax liability. This is known as the lifetime gift tax exemption. Any gifts in excess of this amount would be subject to gift tax. Under the Tax Cuts and Jobs Act of 2017, the Lifetime Gift Tax Exemption has been increased to $10 million ($11.18 million in 2018, as indexed for inflation), beginning in 2018 and scheduled to continue through December 31, 2025.

Bequests at a taxpayer’s death are exempt from Federal Estate Tax under the Federal Estate Tax Exemption as long as they do not cumulatively exceed the Exemption Limit ($11.18 million in 2018).