Now that the federal gift and estate tax exemption is scheduled to go down in 2026 to $5,490,000 with an index for inflation, many clients are looking for ways that they can better protect their estates from needing to fire sale assets, provide creditor protection for beneficiaries, provide liquidity, and/or to allow for easier payment of estate taxes later on down the road.
One of the ways that we can use to accomplish one or all of these objectives is to create an irrevocable trust called an Irrevocable Life Insurance Trust (ILIT) that owns a life insurance policy on the Grantor of the trust. Since the death benefit becomes part of the trust and not the Grantor’s taxable estate in a properly drafted ILIT, a large death benefit can be distributed to the beneficiaries of the trust without triggering a federal estate tax on the death benefit.
An ILIT can be set up to be the owner of a new life insurance policy or you can gift or sell an existing policy to an ILIT. However, if you gift a policy to an ILIT and you pass away within three years of the transfer, the death benefit will be included in your taxable estate. This is known as the IRS's three-year look-back rule. Most often, if the life insurance is going to be needed to pay potential future estate taxes, a permanent life insurance policy purchased by the Trustee of the ILIT is probably the best way to go.
Because the ILIT is the owner of the life insurance policy, the Trustee of the ILIT is the responsible party for paying the policy premium if there’s an annual premium due. Some clients may wish to purchase what is termed as a “paid up” policy (a large amount is contributed to the trust as a gift and then the Trustee of the trust purchases a permanent life insurance policy on the Grantor of the trust). When using this option, a 709 gift tax return will need to be filed to document the gift which will reduce your federal estate and gift tax exemption.
Other clients may wish to make annual exclusion gifts to the trust so that they don’t need to utilize any of their estate and gift tax exemption for the gift each year to the trust. The Grantor of the trust may also make a loan to the trust and then the trustee would use the loan money to pay policy premiums. The trust would need to be properly collateralized in advance of such a loan, however. Split-dollar arrangements are also another option. In this type of arrangement, the Grantor of the ILIT pays the policy premiums and the ILIT Trustee makes payments to the Grantor of the ILIT equal to the life insurance policy's economic benefit cost as determined by the IRS.
ILITs can offer a great solution for individuals or married couples looking to transfer a significant amount of wealth without triggering estate taxes, provide liquidity for an estate, pay estate taxes, provide creditor protection for children, grandchildren or other beneficiaries, and for many other purposes.If you, a friend or family member need help with planning for any of these issues and are interested in discussing setting up an ILIT or any other estate planning device, please reach out to our team at (760) 448-2220 or connect with us at https://www.geigerlawoffice.com/contact.cfm. We serve clients in Carlsbad and Laguna Niguel and the greater San Diego and Orange Counties, but are also able to assist others throughout the state of California.