Life insurance exists for a reason: It's because people die.

But people don’t just die—they die at different ages, under different circumstances, with different amounts of accumulated wealth, and with different personal and family obligations, and so using life insurance successfully can be a complicated—and sometimes very complicated—wealth planning exercise.

The purpose of this article is to revisit that most common and popular of estate planning tools, the irrevocable life insurance trust (ILIT), and examine some of the ways that an ILIT can be used by individuals at various stages of life.

This article will address 1) life insurance, 2) the legal and mechanical aspects of implementing an ILIT, and 3) some specific “real life” case studies showing how life insurance purchased through an ILIT can achieve superior results.

Life Insurance Versus Death Insurance
Life insurance is a sophisticated financial product, with as many variations and permutations as there are creative insurance companies (there are many) and creative insurance planners (there are even more). But the universe of life insurance products can be distilled into two basic categories: life insurance and death insurance.

Death insurance is the traditional and widely understood purpose of life insurance: It provides a specified payout on the death of the insured. That can be a simple but very effective financial tool because, without belaboring the point, we will all eventually depart this vale of tears.

Life insurance, by contrast, is a description of the policies that meet actuarial standards as “life insurance” but are really designed to take advantage of the internal tax-free return that qualifying insurance products enjoy under the federal income tax laws. This type of insurance must necessarily have a “death” component, but its predominant emphasis and true purpose is to act as a tax-deferred and even tax-free investment vehicle that, oh, by the way, also includes a death benefit.

The full and flowery details that arise along the continuum of life insurance to death insurance are beyond the scope of this article, but the path is complicated and fascinating and will be the subject of a future article. What we have established, however, is that life insurance products can serve multiple simultaneous purposes, both to provide wealth and comfort for the still living and a legacy to heirs from the dearly departed.

Why I (Or We) Like ILITs
The Irrevocable Life Insurance Trust (ILIT) is a sophisticated and highly technical trust that combines in roughly equal measure complicated structuring under state trust law and sophisticated strategies under federal income tax law.

Sounds complicated already, doesn’t it?

The good news is that ILITs have been battle-tested in court cases, audits and private letter rulings, and therefore a capable estate planning attorney can draft this detailed and highly technical document with relative certainty and, dare we say, ease.

The benefit of an ILIT is that life insurance is owned outside the estate of the insured and therefore greatly enhances the after-estate tax wealth enjoyed by the insured’s spouse and/or heirs. The first “I” in ILIT is “irrevocable,” meaning that the transfer is intended to be permanent and non-recoverable—although innovations in the irrevocable trust in recent years have added some measure of flexibility to a formerly rigid and inflexible arrangement.

The annual insurance premium amount is typically contributed by the insured to the ILIT, subject to Crummey withdrawal powers (so named after a famous case) that give named persons (usually but not always beneficiaries of the ILIT) the power to withdraw all or a portion of the contributed premium amounts within specified periods (often 30 days or 60 days, but sometimes, under a so-called “hanging power,” on an annual schedule). There are lots of complications, nuances and details, but basically the ILIT allows an insured to purchase life insurance on his life that is held outside of his estate (but also outside of his access), permits the insured to treat the insurance premium payments as non-taxable gifts under the annual exclusion provisions of Code Section 2503(b), and provides safety and security to the trust beneficiaries while avoiding the diminution in wealth that occurs if the insurance proceeds are includible (and taxable) in the insured’s estate.

What’s not to love about the ILIT? Now for case studies.

Mid-40s And Creating Increasing Wealth
Let’s start with a young(ish) couple, Richard, age 42, and Sarah, age 37, who are married and have two children, ages 3 and 1. (Having children is a life-changing event that often transforms life insurance from an interesting abstraction to a top priority.)

In many cases, a young couple with children does not yet have a strong accumulation of wealth, and so “death insurance” is an attractive option, hedging the small but devastating consequences of an early parental death with a policy purchased at a comparatively low annual premium. In this case, however, Richard is an equity owner in a successful, privately owned technology company, and the couple’s combined net worth is now already over $15 million. Unfortunately, most of this wealth is tied up in stock in the technology company, which like all such companies is both illiquid and subject to ongoing risk. Working with their advisors, they decide to purchase life insurance policies held in two ILITs:

• The first on the life of Richard for the benefit of Sarah (and the children), anticipating Richard predeceases her.
• The second, a second-to-die survivorship policy, to provide liquidity to pay estate taxes on the death of the latter-to-die spouse.

On recommendations from their insurance advisor, they purchase two whole life policies:

• An individual policy on Richard’s life with these characteristics:
– Initial death benefit of $5 million, based on an annual premium of $74,000 for 23 years.
– Total premiums paid of $1,702,000.
– Total liquid income tax-free assets at age 80 of $7.3 million, IRR of 5.4%.

• A survivorship whole life policy on both lives, with these characteristics:
– Initial death benefit of $5 million, based on an annual premium of $41,000 for 23 years.
– Total premiums paid of $943,000.
– Total liquid, income tax-free assets at age 80 of $6.1 million, IRR of 5.75%.

These ILITs are especially efficient if Crummey withdrawal powers can cover the full annual premium amounts—which is not always easy to do in a small-sized family unless extended family members, or non-family members, are also given withdrawal powers. This is often a structuring possibility, (see e.g., Cristofani v. Commissioner), but beyond the scope of this article. Contact your “capable estate planning attorney” for further information.

Buy-Sell Agreements—Creative Estate Planning For Partners In A Small, Successful Cpa Firm
The traditional structure of a “buy-sell agreement” for a small private business is for either the entity or the business partners to agree to buy out the equity of a deceased partner, with the payment obligation often funded with life insurance. While these insurance arrangements offer timely funding for the surviving business partner(s), there are several problems with these classic arrangements, notably that the insurance proceeds go into the taxable estate of the decedent rather than being paid tax-free to an ILIT for the spouse and descendants.

The better idea may be for each business partner, instead of purchasing life insurance on the other partners, to purchase an insurance policy on his/her own life owned in an ILIT. By utilizing this simple but effective variation in the traditional buy-sell structure, the insurance proceeds can now pass tax-free outside of the insured’s taxable estate, leaving greater after-tax assets to the heirs.

HELP! Illiquid Assets In My Mom’s Estate
How often do wealthy families holding illiquid assets—an art collection, a horse farm, a real estate portfolio—worry about paying estate taxes when the parent generation passes? They discuss it all the time. How soon do they act on this obvious and dire need? The honest answer is sometimes never, but more often belatedly and in a sudden rush after years of inaction.

Assume the Jackson family owns a successful vineyard that is now worth $100 million. The father recently passed at age 76, leaving the family vineyard to Mom, who is 71. The father refused to acknowledge his mortality and wanted nothing to do with estate planning, and now a huge financial burden is dropped in Mom’s lap. How worried is she? It is fair to say that she is scared to death.

Mom can work with her financial advisors to implement various tax strategies, including transfers and gifting of equity interests in the vineyard to children and grandchildren, but a key element of this plan will be to provide liquidity to the estate in order to pay estate taxes and keep the vineyard in the family.

The advisors recommend an ILIT holding a life insurance policy with a death benefit of $10 million and an annual premium of $330,000, and a term through age 105. The annual premiums are funded from the vineyard’s revenue, and Crummey withdrawal powers will let Mom take advantage of annual gift exclusions to preserve her lifetime unified credit as much as possible. Mom has four adult children as well as 10 grandchildren, and so the first $210,000 of premiums per year ($15,000 x 14 beneficiaries) can be contributed without impacting her lifetime unified credit amount. Under the Cristofani case, Mom may be able to add nieces and nephews to the power of withdrawal, even though they are not beneficiaries of the trust, to enhance the annual exclusion utilization.

Premium contributions in excess of the amount subject to Crummey withdrawal powers will be a taxable gift by Mom, but such gifts can be offset by her unified credit amount (which works well if the unified credit is not needed for other wealth transfers).

Assume the family picks a guaranteed universal life policy, guaranteed through age 105, with a $10 million death benefit. The arrangement achieves these objectives:

• If Mom passes the next day, there is $10 million immediately available to deal with estate tax liabilities—this amount does not solve the estate tax problem fully but does provide the first $10 million toward solving the problem.
• If she dies after 10 years, she will have invested $3,300,000 with a return of $10 million, a return of greater than 200%.
• If she dies at 15 years, she will have invested $4,950,000 with a return of $10 million, a return of greater than 100%.
• If she dies at 20 years, she will have invested $6,600,000 and with a return of $10 million, a return of greater than 50%—which is no longer impressive, but after 20 years the estate has in effect bought time to address its liquidity issues in other ways.
• If she lives 35 more years, to age 106, the policy will lapse and will no longer have value. Mom by that time will have paid $9,570,000 (premium payments often end at age 100) and all she will have is the satisfaction of living to age 106. Who wouldn’t be happy to take that deal?

The bottom line for ILITs and for this article is that the ILIT is a very flexible and sophisticated estate-planning vehicle that can be used to solve problems in a variety of challenging life (and death) situations.      

Joseph B. Darby III, Esq., is an adjunct professor at the Boston University School of Law and the founding shareholder of Joseph Darby Law PC, a law firm that concentrates on sophisticated tax and estate planning for individuals and businesses.

Kimberly A. Furnald is an estate planning and private business solutions specialist focused on creative insurance-based solutions for individuals and private business owners at Penn Mutual in the Boston area.