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When should you set up an Irrevocable Life Insurance Trust (ILIT)?

Law Offices of Yu & Associates

Life insurance is an important means of asset appreciation and wealth inheritance. This financial product that uses leverage to steadily increase family wealth has unique features that other financial products cannot match. For high-net-worth families, can life insurance alone maximize the protection of asset accumulation and growth? The answer is obviously no. In some cases, it is still necessary to make an Irrevocable Life Insurance Trust (ILIT) in order to achieve full estate tax exemption for large insurance policies and maximize the wealth to be passed to future generations.

An Irrevocable Life Insurance Trust (ILIT) has a life insurance policy as the trust asset. The grantor, the policyholder, hires an attorney to draft the life insurance trust document, put the life insurance policy into the trust, and appoint a trustee to manage the assets in the trust according to the instructions of the grantor. When the trust is terminated, that is, when the policy is paid, the assets in the trust will be passed to the beneficiary of the trust. When drafting the trust documents, attorneys will discuss with the client and confirm who will be the owner of the ILIT; who will be the beneficiary of the life insurance; who will be the trustee of the ILIT; whether to set up an irrevocable trust before buying life insurance or transfer an existing life insurance policy into an irrevocable trust; and so on.

The main reason for buying life insurance to multiply family wealth is that the policyholder pays a small premium to lock in a large amount of policy compensation for the beneficiary, which allows the policyholder to preserve their assets for the beneficiary and the family when they die, and guarantees the family's quality of life to the greatest extent. However, in the U.S., the government levies estate tax on the estate of the deceased. Compensation from life insurance can be directly distributed to the beneficiary without going through the court probate process because the beneficiary has been previously appointed. The life insurance payout does not count as the beneficiary's income and is not subject to income tax. However, if the amount of insurance claims plus other assets of the insured exceeds the statutory estate tax exemption limit, then estate tax must be paid for the part exceeding the exemption limit. However, an ILIT can be used to gain exemption from estate tax. Here are some of the advantages of an ILIT:

1. The biggest advantage of an ILIT is that it provides the maximum legal exemption from estate tax. If you count life insurance claims in the hundreds of thousands or even tens of millions, plus real estate assets, retirement accounts, and deposits and balances at banks and financial institutions, the size of a life insurance policyholder's estate may be very large. The federal tax deduction is $12,060,000 for the year 2022, and Maryland's state estate tax deduction is $5,000,000 for the year 2021. The total estate tax deduction for a couple in 2022 is $24.12 million. Anything that exceeds this deduction amount will be subject to an estate tax of up to 40% by the IRS. The relevant tax laws will be adjusted again starting from year 2026. By then, the amount of tax relief is likely to be halved, and there will be more assets involved in the collection of estate taxes. Therefore, whether now or in the future, people with high assets should seriously consider the use of irrevocable trusts as an effective tool for estate planning to maximize the wealth of the family.

The benefit of an ILIT is to exclude life insurance payouts from the estate's taxable assets, while still meeting the need of passing these funds on to spouses and descendants. However, it needs to be pointed out that ILITs must ensure that the principal, the policyholder, does not have incidents of ownership regarding the insurance policy. Otherwise the life insurance payment will be added to the total estate of the policyholder, and it will not be possible to reduce the estate and achieve the goal of maximizing relief from estate tax.

2. ILITs are also effective in asset protection. ILITs can be used as an effective tool to manage and control life insurance payout income against threats from the beneficiary's creditors. Life insurance assets held by ILITs are generally protected from encroachment by creditors of the beneficiaries. ILITs are especially effective and useful when the policyholder's children are minors or have debts.

3. The ILIT can also be used as an effective tool for policyholders to obtain a generation skipping transfer (GST) tax exemption. The Generation Skip Transfer Tax is separate from the estate tax and applies when assets are transferred to descendants across more than two generations. The government collects the generation-skipping transfer tax (GST) to prevent insurance policyholders from skipping a generation and transferring assets directly to the next-generation descendants without paying estate tax. The GST tax exemption in 2022 is $12.06 million. GST tax should be paid on the portion exceeding the exemption amount. The function of the ILIT is to help reduce the size of the estate and minimize the effect of the estate tax and/or GST tax, so that generations of offspring can benefit from the trust assets to the greatest extent.

4. A well-planned and drafted ILIT can also prevent adverse gift tax consequences. Premiums paid by policyholders to a life trust can be considered a gift to beneficiaries. In 2021, for example, the gift tax exempt amount per person is $15,000. The portion of each person's annual gift in excess of the limit needs to be consolidated and taken up into the lifetime exemption of the giver's estate tax. But adverse gift tax consequences can still be avoided if the ILIT is run properly and follows the famous "Crummey" letter. The trustee of an ILIT must use a Crummey letter to notify the beneficiaries of the trust of their right to withdraw the premium contributed by the policyholder within a thirty-day period. This process allows annual premium payments to be considered as a gift to qualify for the annual gift tax exemption, thereby avoiding the need for these premiums to be included in the policyholder's total estate at the time of death.

The above are the advantages of irrevocable trusts. Of course, the disadvantage of ILITs is also obvious, that is, the nature of irrevocability. Once an irrevocable trust is created, it is irreversible and cannot be changed by the policyholder, nor can the policyholder act as the trustee of the irrevocable trust. Once this irrevocable trust is established and the assets are transferred into the trust, the policyholder no longer has control over it, and thus loses flexibility. In addition, it is worth noting that if life insurance has already been purchased and then an ILIT is set up to put the insurance policy in trust, and the policyholder dies three years after the assets are transferred into the trust, the death benefit from the insurance policy will not fall into the estate of the policyholder for estate tax purposes. However, if the policyholder, the person who created the ILIT, dies within three years of the assets being transferred into the trust, the IRS will still include the insurance payment in the estate for estate tax purposes. So if you own a large estate and also have a life insurance policy, or you are considering buying a life insurance policy, it is better to carefully consider the pros and cons of creating an ILIT before making the decision strategically to benefit you and your family.

The above is a general introduction, and should not be construed as individual legal advice. For specific legal questions, please contact the Law Offices of Yu & Associates. Tel: 301-838-8986, Fax: 202-595-1918; E-mail:, Address: 110 N. Washington St., Suite 328E, Rockville, MD 20850. (All rights reserved.)

Ó Yu & Associates LLC, 110 North Washington Street, Suite 328E, Rockville, MD 20850, USA. Tel: 301-838-8986