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Irrevocable life insurance trust

The irrevocable life insurance trust (ILIT) provides an accessible means of avoiding estate taxes on life insurance proceeds. The potential savings may outweigh the disadvantages of what you have to give up. You decide.

Basics of Life Insurance and Estate Tax
Estate tax is a tax on the transfer of property at your death. Life insurance proceeds are among the types of property that are subject to estate tax. However, depending on the size of your estate, you may not even have to pay estate tax.

Estate taxation of life insurance proceeds centers around ownership of the policy and payment of the proceeds. If the proceeds of a policy are paid to the insured person’s estate, then they will be fully subject to tax on the insured person’s death.

If you own a life insurance policy, upon death, your estate will be fully subject to tax if (1) the proceeds of the policy are payable directly or indirectly to your estate, or (2) if you, while alive, held any ownership in the property, such as the right to charge a beneficiary, surrender or cancel the policy or borrow against the policy.

If you have an life insurance policy covering you and you do not own it, then the proceeds of the policy will not be subject to estate tax. It is not unusual for an insurance policy to be taken out on someone else. However, beware that if you don’t own the policy, you can’t make any changes to it or cancel it.

If you leave life insurance proceeds to someone other than a spouse, such as a child, relative, or friend, the proceeds will be taxed as being part of your estate.

On the other hand, if you leave life insurance proceeds to a spouse, the proceeds will not be subject to your estate at your death, but the surviving spouse’s estate may be taxed.

An Irrevocable Life Insurance Trust (“ILIT”) offers the opportunity of escaping taxes not just in one estate, but in several estates. The ILIT is typically a trust for the benefit of the spouse and/or children.

An life insurance policy that is placed in an ILIT is considered to have no owner. Thus, once placed in an ILIT, you do not have the power to change or cancel the life insurance policy.

If you already has a life insurance policy, ownership of the policy can be assigned (transferred) to the ILIT. This is done by signing an irrevocable assignment form available from the insurance company or from the agent. Proper completion of the form will indicate that the ILIT will be the new owner and the beneficiary.

Take note, however, that if the insured/transferor dies within three years of the date from which the policy was transferred, the life insurance proceeds will be included in his estate for tax purposes. This does not mean that the beneficiary will not receive the money, it merely means that your estate will have to report the proceeds as being part of your estate when computing the estate tax.

For this reason, where the insured has a spouse, the ILIT should usually contain a fail-safe clause, providing that if the insured/transferor dies within three years of the transfer of any policy to the ILIT, then the proceeds of such policies will be held separately under the ILIT and administered for the surviving spouse in a way that will qualify for the estate tax marital deduction.

This arrangement will render those proceeds tax free if the insured dies within three years and is survived by is spouse. The trade-off is that whatever is left of these proceeds will then be included in the estate of the surviving spouse.

If the insured dies after a crucial three-year period, the fail-safe clause would not apply and the entire trust could provide for the family.

The three-year concern can be completely avoided if the policy is purchased at the outset by the trustee of the ILIT. This way there is no policy transfer, so no three-year period to worry about.

Question For Your Attorney
•How do I create an ILIT?
•Do I have to go through my insurance company to create an ILIT?
•Will my estate be subject to estate tax when I die? Will my life insurance proceeds?

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