ILITs are complex to create and administer and raise liability concerns.
There are at least two sides to every Irrevocable Life Insurance Trust (ILIT). One side is liability of the trustee; the other side is planning for the insured and his or her family. Let's discuss planning first.
What motivates the creation of an ILIT is Internal Revenue Code Section 2042, which mandates insurance on the life of the insured will be included in that person's estate at death, even if the proceeds are not payable to the estate, but to others, if the insured had "incidents of ownership." Note that this means that someone else can own the policy, like the trustee of an ILIT, but it will still be included in the insured's estate.
What are "incidents of ownership?" They are economic or controlled ties to the policy. The most typical "incidents" are: the retained right to change the policy's beneficiary, the right to borrow against the policy, the right to pledge the policy for a loan, the right to cancel the policy, and many others, some very fragile.
If the insured transfers a policy on his or her life to the trustee of an ILIT, surrenders all these rights by making the trustee total and complete owner of the insurance contract and lives three years after assignment of ownership, the policy proceeds, when payable to the trustee, are not includible in the insured's estate and thus not taxed either as income or as an estate asset. The trustee follows the instructions of the insured set out in the trust agreement. Usually, the terms of the trust provide that the spouse and children are beneficiaries, and when the spouse dies, the children receive what is left. Because of the careful crafting of the trust when the second spouse dies, there is no estate tax on that spouse's estate, just as when the insured died, so the children receive the proceeds totally tax-free. The spouse can even be trustee or a co-trustee of the ILIT with the same results.
Another approach to the formation of the ILIT is to put cash into the trust and let the trustee apply for and purchase the policy on the insured's life, and use the cash to pay for the first premium. Why? Because the insured no longer will have the policy in his or her estate if death occurs within three years of the trustee becoming owner of the contract.
The money to pay the annual premium comes from the insured, and that is a gift to the beneficiaries of the trust, usually covered by the $22,000 per person which the insured, so long as there is consent by the spouse, can gift to any individual annually. If the insured is single, the amount is $11,000. There is a complicated mechanism to accomplish this through the use of so-called "Crummey Powers." The annual exclusion is only available if the beneficiaries have a present right to what is contributed to the trust.
After the money goes in for a recommended 30-day period, the beneficiary, or his or her representative if the beneficiary is a minor, must have a right to take the money out. In the classic case, if the money is not withdrawn it is then used to pay the premium. The rules differ slightly for group term insurance because the insured usually is paying the premium through payroll deduction so the children are given the right to withdraw the contract itself. No kidding here! The beneficiaries must have a genuine right to withdraw for the period indicated or "sayonara" to the annual exclusion, and that may mean a tax on the gift of the money that was put into the trust.
Most people feel the game is worth the candle because all types of insurance can be so transferred by the insured, or so purchased by the trustee, and the proceeds are not part of the insured's estate irrespective of the amount of the proceeds, literally from $100,000 to $100 million or more. It is a device that has been tested and proven to work. Why own a policy on your life for $1 million and name your children as beneficiaries? The $1 million is part of your estate, and depending upon the overall size of your estate when you die and the year of death, the kids will receive $500,000, not $1 million, because of the 50% estate tax. If an ILIT were used, they receive $1 million, and there is no estate tax. There is even some authority that your trustee, in the trustee's absolute discretion, can pay your estate taxes and debts and that the existence of this power, per se, will not make the insurance proceeds includible in your estate.
The trust also means the insured's spouse and children are protected from creditors' claims, and an investment advisor is managing twice the amount of money for the family because a confiscatory estate tax of 50% has been made inapplicable. The investment advisor is also receiving cash, which, when coupled with the absence of capital gains, makes allocation and diversification easier. All in all, notwithstanding some administrative headaches in running the trust and complying with tax rules, the game is worth the candle, indeed, perhaps several candles.
Now the liability side to the trustee should be discussed. Let me share an example that says it all about liability, but the case involved was fortunately settled before creating very bad law.