insurance-trust-structures-ilits — insurance and protection planning

An irrevocable life insurance trust (ILIT) is a legal structure designed to remove life insurance death benefits from the insured's taxable estate. For individuals with substantial estates, life insurance proceeds owned personally can push the estate over tax thresholds, triggering federal estate taxes of up to 40%. By having an ILIT own the policy, the death benefit passes to beneficiaries free of estate tax. This planning technique has been used for decades and, when properly implemented, provides significant tax savings for high-net-worth families.

The Estate Tax Problem with Life Insurance

Life insurance death benefits are income tax-free to beneficiaries. However, if the insured owns the policy at death, the full death benefit is included in their taxable estate for federal estate tax purposes.

2024 federal estate tax exemption: $13.61 million per individual ($27.22 million for married couples using portability)

2026 scheduled exemption: Approximately $7 million per individual (the current high exemption is scheduled to sunset)

Consider an individual with $15 million in assets who owns a $5 million life insurance policy. At death, their taxable estate totals $20 million. With a $13.61 million exemption, $6.39 million is subject to estate tax at 40%, resulting in approximately $2.56 million in estate taxes.

If that same $5 million policy were owned by an ILIT, the taxable estate would be $15 million. Only $1.39 million would be subject to estate tax, resulting in approximately $556,000 in taxes—a savings of roughly $2 million.

The savings become more pronounced if the exemption decreases in 2026. With a $7 million exemption, a $20 million estate would face tax on $13 million, while a $15 million estate would face tax on only $8 million.

How an ILIT Works

An ILIT is an irrevocable trust that owns life insurance on the grantor's life. The key elements:

Irrevocability: Once established, the grantor cannot modify or revoke the trust. This permanence is what removes the policy from the estate. If the grantor retains any "incidents of ownership" (the right to change beneficiaries, borrow against the policy, surrender the policy, etc.), the death benefit remains in the estate.

Trust ownership: The trustee, not the insured, owns the policy. The trust applies for new insurance or receives transferred existing policies. The trust is named as owner and beneficiary on the policy.

Grantor contributions: The grantor makes cash gifts to the trust. The trustee uses these funds to pay insurance premiums. The grantor never pays premiums directly—doing so could constitute an incident of ownership.

Death benefit distribution: When the insured dies, the death benefit is paid to the trust. The trustee then distributes funds to beneficiaries according to trust terms, which might be outright, in stages, or held in further trust.

Crummey Powers and the Annual Exclusion

Gifts to an irrevocable trust are not automatically eligible for the annual gift tax exclusion ($18,000 per recipient in 2024). The exclusion applies only to gifts of a "present interest"—meaning the recipient has immediate access to the gift. Contributions to a trust for future distribution are "future interests" and don't qualify.

Crummey powers solve this problem. Named after a landmark Tax Court case, Crummey powers give beneficiaries a temporary right to withdraw their share of contributions to the trust.

How it works:

Grantor contributes $54,000 to the ILIT (intended for premium payment)
Trustee sends written notice to three beneficiaries that each has a right to withdraw $18,000 within 30-60 days
Beneficiaries allow the withdrawal period to lapse (they don't actually withdraw)
Trustee pays the insurance premium
Because beneficiaries had a present right to withdraw, each $18,000 contribution qualifies for the annual exclusion
No gift tax is due on the $54,000 contribution

Critical requirements:

Written notices must be sent for each contribution
Beneficiaries must have actual legal right to withdraw
Withdrawal period must be reasonable (typically 30-60 days)
Notices and lapses should be documented and retained
Beneficiaries should generally be adults or have guardians who can act on their behalf

Gift tax calculation with Crummey powers:

Annual Premium	Number of Beneficiaries	Annual Exclusion Used	Taxable Gift
$36,000	2	$36,000	$0
$54,000	3	$54,000	$0
$100,000	4	$72,000	$28,000
$150,000	5	$90,000	$60,000

If the premium exceeds available annual exclusions, the excess is a taxable gift that uses the grantor's lifetime gift tax exemption.

The Three-Year Rule

Internal Revenue Code Section 2035 provides that if the insured transfers an existing life insurance policy to an ILIT and dies within three years of the transfer, the death benefit is included in the taxable estate as if the transfer never occurred.

This rule exists to prevent deathbed transfers. It applies to:

Direct transfers of existing policies to an ILIT
Any incident of ownership relinquished within three years of death

Planning implications:

For new policies: Have the ILIT apply for and own the policy from inception. The insured never owns the policy, so the three-year rule does not apply. The trustee completes the application, and the trust is listed as owner and beneficiary from day one.

For existing policies: If you transfer an existing policy to an ILIT, you must survive three years for the transfer to be effective for estate tax purposes. Some planners purchase a separate three-year term policy outside the ILIT to cover this risk period.

For older grantors: The three-year rule creates meaningful risk for those in poor health or advanced age. New policy acquisition, rather than transfer, is strongly preferred.

Trustee Selection

The choice of trustee is critical. The wrong trustee can inadvertently cause the policy to be included in the grantor's estate.

Who cannot serve as trustee:

The insured: If the insured is trustee, they hold incidents of ownership over the policy (the power to change beneficiaries, surrender the policy, etc.). This defeats the entire purpose of the ILIT.

The insured's spouse: Community property rules and attribution doctrines can cause the insured's spouse's powers to be attributed to the insured. Most estate planning attorneys advise against spousal trustees for ILITs.

Appropriate trustee options:

Adult children: If mature and financially responsible, adult children can serve as trustees. However, this creates conflict if they are also beneficiaries (they control when and how they receive distributions).

Trusted family members: A sibling, in-law, or other relative not named as beneficiary can serve effectively.

Professional trustees: Corporate trustees (bank trust departments) or individual professionals (attorneys, CPAs) provide expertise and continuity. Fees typically range from 0.5% to 1.5% of trust assets annually, though ILIT administration is often charged as a flat annual fee ($1,500-$5,000) given the limited asset base during the insured's lifetime.

Trust companies: Specialized trust companies offer ILIT administration services, often at lower cost than bank trust departments.

Successor trustees: The trust document should name successor trustees in case the primary trustee dies, resigns, or becomes incapacitated.

ILIT Administration Requirements

An ILIT requires ongoing attention to remain effective:

Annual premium funding: The grantor must contribute funds; the trustee must send Crummey notices; beneficiaries must allow withdrawal rights to lapse; the trustee must pay premiums on time.

Crummey notice documentation: Maintain copies of all notices sent and records of when withdrawal periods expired.

Trust accounting: The trustee should maintain records of contributions, premium payments, and any other trust transactions.

Policy monitoring: Verify the policy remains in force, review performance (for permanent policies), and ensure coverage remains adequate.

Trust document review: Periodically review trust terms with counsel, especially after tax law changes or family circumstance changes.

Worked Example: $5M Policy in ILIT for $20M Estate

The Situation: Robert and Margaret Chen, both age 60, have a combined estate of $20 million, including a primary residence, investment portfolio, business interests, and retirement accounts. They have three adult children. They want to ensure their children receive a substantial inheritance while minimizing estate taxes.

The Problem Without Planning:

Combined estate: $20,000,000 Current exemption (married, 2024): $27,220,000 Estate tax at current exemption: $0

If exemption drops to $14 million (married) in 2026: Taxable estate: $6,000,000 Estate tax at 40%: $2,400,000

If they purchase a $5 million life insurance policy and own it personally: Estate at death (2026 rules): $25,000,000 Exemption: $14,000,000 Taxable: $11,000,000 Estate tax: $4,400,000

The ILIT Solution:

The Chens establish an ILIT and fund a $5 million second-to-die life insurance policy (pays on the second spouse's death).

Policy details:

Coverage: $5,000,000 second-to-die whole life
Insured: Robert and Margaret Chen
Owner: Chen Family Insurance Trust (ILIT)
Beneficiary: Chen Family Insurance Trust
Annual premium: $48,000

Trust structure:

Trustee: Margaret's brother, William (not a beneficiary)
Successor trustee: First National Bank Trust Department
Beneficiaries: Three adult children, equal shares
Distribution: Held in separate subtrusts until age 35, then outright

Annual funding process:

Robert and Margaret contribute $48,000 to the ILIT in January
William (trustee) sends Crummey notices to each child, informing them of their right to withdraw $16,000 within 45 days
Children do not exercise withdrawal rights
William pays the $48,000 premium to the insurance company
No gift tax is due ($48,000 is within the combined annual exclusions of $54,000 for three beneficiaries)

Estate tax calculation with ILIT (2026 rules):

Robert dies first; no estate tax due (unlimited marital deduction) Margaret dies second:

Estate: $20,000,000 (insurance not included)
Exemption: $14,000,000 (combined via portability)
Taxable estate: $6,000,000
Estate tax: $2,400,000

Trust receives $5,000,000 death benefit (estate tax-free and income tax-free) Children ultimately receive: $20,000,000 - $2,400,000 + $5,000,000 = $22,600,000

Without ILIT (policy owned personally):

Estate: $25,000,000
Exemption: $14,000,000
Taxable: $11,000,000
Estate tax: $4,400,000
Children receive: $25,000,000 - $4,400,000 = $20,600,000

ILIT savings: $2,000,000

Premium costs over time:

If the Chens live another 25 years and pay $48,000 annually: $1,200,000 in total premiums The $2 million estate tax savings more than justifies this cost.

ILIT Limitations and Considerations

Irrevocability: Once established, the ILIT cannot be easily modified. If circumstances change (divorce, estrangement from beneficiaries, no longer need coverage), unwinding is difficult and may have tax consequences.

Premium commitment: You must continue funding premiums for the policy to remain in force. If financial circumstances change, maintaining premium payments may become burdensome.

Opportunity cost: Funds contributed to the ILIT for premiums cannot be used for other purposes. Permanent insurance premiums, in particular, represent significant ongoing commitment.

Complexity and cost: Establishing an ILIT requires legal fees ($3,000-$10,000), ongoing administration, and potentially trustee fees.

Not for everyone: ILITs primarily benefit those whose estates will exceed estate tax exemptions. For estates comfortably below exemption levels, the complexity may not be warranted.

ILIT Planning Checklist

Initial Planning

Confirm estate will likely exceed estate tax exemption (currently or after 2026)
Calculate insurance need based on estate tax projection and liquidity needs
Determine policy type (term, whole life, second-to-die)
Obtain quotes from multiple carriers
Engage estate planning attorney to draft ILIT document
Select appropriate trustee (not insured or spouse)
Name successor trustees
Determine beneficiaries and distribution terms

ILIT Establishment

Execute trust document before insurance application
Obtain trust tax identification number (EIN)
Open trust bank account
Have trustee apply for insurance (trust as owner and beneficiary)
Verify policy documents name trust correctly
If transferring existing policy, document transfer and note three-year rule risk

Ongoing Administration

Insurance Trust Structures: ILITs