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Life insurance often is a critical part of a properly structured estate plan. There are three primary purposes for purchasing life insurance. First, it may be acquired to replace lost income, if there is a premature death of the wage earner. Second, it many be acquired to provide liquidity to pay estate taxes (or replace funds used to pay estate taxes), often upon the death of the last to die of a married couple. Lastly, it may be acquired as an investment asset, in that the earnings can accumulate to increase the policy's cash value on an income tax-free basis.

Life insurance, however, is an asset like any other asset---if the insured owns or "controls" the policy as of date of death---the full amount of the policy proceeds will be includible in the insured's estate for estate tax purposes. This result can be avoided, however, by having someone other than the insured own the insurance and receive the insurance proceeds. This is often accomplished through the use of an irrevocable life insurance trust ("ILIT").

What is an ILIT?

To avoid inclusion of the proceeds of an insurance policy in the estate of the insured, all "incidents of ownership" in the policy must be possessed by someone other than the insured (and, if an existing policy is transferred by the insured to an ILIT or other owner, it must have been transferred at least three years prior to the insured's death.) An incident of ownership includes not only the right to receive the insurance proceeds, but also the right to designate the beneficiary, borrow from the cash value and almost any other right to affect the benefits flowing from the policy. Insurance can be transferred to one's spouse; however, this does little to save estate taxes, because unless the spouse spends the insurance proceeds, the unspent portion will be included in the spouse's estate. And in those situations where the insurance involved is survivorship insurance (also known as last to die insurance), having the insurance owned by either of the spouses will result in estate tax inclusion upon the death of the surviving spouse.

The ownership of insurance policies also can be given to the insured's children to avoid estate tax inclusion in the insured's estate. The problems with this solution, however, are two-fold. First where the insurance is on the life of the wage earner, it is often the family's desire that the surviving spouse have access to the insurance proceeds or the income generated by the proceeds. Second, even where survivorship insurance is involved, the insureds often do not want the children to be in the position to spend the proceeds immediately upon the death of the insureds. The solution to both these common scenarios is the ILIT.

An ILIT is created by the insured(s). This trust is irrevocable and becomes both the owner and beneficiary of the insurance. As such, the trust cannot be changed by the insured and, if properly structured, the proceeds of insurance will not be included in the estate of the insured(s).

Where the insurance is on the life of the wage earner, the surviving spouse can be the trustee of the ILIT and, generally, can be entitled to all the income of the trust and principal, if needed for reasonable living needs, as determined by the surviving spouse. Notwithstanding all these rights, upon the death of the surviving spouse the assets of the trust are not subject to estate tax in that spouse's estate. And upon the spouse's death, the assets of the trust can then be held for the benefit of the children (or other heirs) or distributed outright to them without imposition of estate tax.

How Does An ILIT Mechanically Operate Year After Year?

After the ILIT is formed, it is responsible for the annual premium payments on the insurance it owns. Generally, the funds are provided by the insured. While the provision of these premium dollars is a gift, the trust often can be structured so that the gift qualifies for the insured's $10,000 per donee annual exclusion. In other words, the trust can generally be structured so that annual premium payments can be equal to $10,000 multiplied by the number of beneficiaries of the trust (even contingent beneficiaries) before there would be liability for gift tax.

Estate Tax Savings of Transferring Insurance Ownership

The estate tax savings resulting from parting with the ownership of an insurance policy can be significant. For instance, if the insured owns an insurance policy with a face amount of $1,000,000 upon his death (or, in most instances, upon the later death of his spouse), the estate may be depleted by federal estate taxes ranging from 37% to 60% of the amount of the insurance proceeds. The beneficiaries named in the policy would then only receive the balance. However, if a properly structured ILIT were to own the same policy, no estate tax would be due, saving the beneficiaries from $37,000 to $600,000 of estate tax on the $1,00,000 policy proceeds.