This handout is designed to illustrate the use of an Irrevocable Life Insurance Trust
(“ILIT”) in an estate planning context and answer some questions you may have with
regard to its use.

1.0 What is an ILIT?

An ILIT is a form of irrevocable trust. The trust is structured to hold life
insurance on your life while allowing the proceeds to pass to your heirs free of estate tax
upon your death.

2.0 Why do I need an ILIT?

When one buys an insurance policy, that person is typically the “owner”
and designates the beneficiaries to whom the proceeds are payable on death. The owner
pays all the premiums on the policy, retains the right to change the beneficiaries, and can
borrow from the policy. In this situation, the cash value inside the policy builds-up income
tax free and the proceeds will be paid to the designated beneficiaries free of income tax.
However, because the insured retains ownership of the policy at death, the proceeds will be
subject to estate tax. If the property were held in an ILIT, the Trust would “own” the policy
and the proceeds would be paid to the designated beneficiaries free of income and estate
tax.

3.0 How does an ILIT work?

An ILIT works best with a new policy, but can also work with an existing policy.
With a new policy, the insured first creates the ILIT and the ILIT purchases the insurance
policy. In order to make the required premium payments, the insured typically gifts cash to
the ILIT before each premium is due. Depending upon the number of potential
beneficiaries, the gifts can be structured to qualify for the insured’s $18,000 annual
exclusion so no gift tax will imposed on the transfers. The Trustee of the ILIT can then pay
the premiums as they come due. When the insured dies, the proceeds are paid to the ILIT
and distributed to the ILIT beneficiaries free of tax. To illustrate, if the insured purchased a
$2,000,000 life insurance policy and held the policy in the insured’s name, the full
$2,000,000 when payable would be subject to estate tax, and the insured’s heirs would
receive only $1,200,000 (assuming 40% estate tax bracket and the insured’s other assets
exceed his/her unified credit). Use of a properly structured ILIT will avoid the $800,000
estate tax liability, leaving the full $2,000,000 available to the beneficiaries.

4.0 Can I avoid estate taxes without an ILIT?

Yes, if you instead transfer “ownership” of the policy outright to your heirs and
make annual gifts directly to them to allow them to pay the premiums on the policy.
However, an ILIT provides the following advantages over direct ownership by your heirs:

(a) Continued Control over Property. Rather than passing the life
insurance proceeds to your heirs outright on your death, an ILIT allows you to control the
timing and amount of distributions by designating the ages at which distributions should be
made from the ILIT to your heirs. This not only prevents the proceeds from passing to your
children at too young an age, but can be used to prevent distributions from being made if a
child is then in bankruptcy, in the middle of a divorce, or is physically or mentally incapable
of handling the proceeds. In addition, because you select the Trustee who will manage the
policy during life (and the proceeds after death) and you can retain the right to remove and
replace the Trustee, you can effectively retain continued control over the policy during your
life.

(b) Facilitates Administration. Rather than having multiple owners,
the policy is owned singularly by the ILIT. This allows the Trustee you have selected to
make ownership decisions on behalf of the policy. This also prevents your heirs (and their
creditors) from having access to the cash value in the policy during your lifetime.
Additionally, this facilitates the use of the insurance proceeds to provide liquidity to pay
estate taxes due upon your death because the Trustee is typically given the power to
purchase assets from your estate for cash. Your estate can thus exchange its non-liquid
assets for the insurance proceeds and use the proceeds to pay its estate tax liability.
(c) Facilitates Gifting of Premiums. Without the use of an ILIT,
you must pay the insurance premiums by gifting cash outright to each of your children
and/or grandchildren. Problems can arise with this technique if your heirs are too immature
to handle the gift or even too young to legally “own” the policy. By using an ILIT, you can
make gifts to the trust for the benefit of your heirs and the Trustee will use the funds to
purchase the policy. For example, if you have five children and three grandchildren, you
could gift up to $144,000 to the ILIT for premiums under your annual exclusion (and up to
$288,000 if you are married). While you must issue withdrawal notices to qualify the gifts
to the ILIT for your annual exclusion, this is a relatively simple procedure (see below).
(d) Creditor Protection. By holding the policy and the proceeds in an
ILIT, the cash value of the policy during your life as well as the proceeds of the policy after
your death will not be subject to your creditors or to your heirs’ creditors. Keeping the
proceeds in trust can also prevent your heirs from commingling the separate property
proceeds with their community property — thereby preventing the spouses of your heirs
from acquiring an interest in the proceeds.

(e) Allows Generation-Skipping. With some advanced planning
inside the ILIT, you can prevent estate tax from being imposed on the proceeds at your
children’s death as well as at your own death. This allows you to benefit both your children
and successive generations and can result in millions of dollars of tax savings.
5.0 Do gifts to the ILIT qualify under my annual exclusion?
A gift to an irrevocable trust alone will not qualify under one’s annual exclusion
because the gift tax rules require the beneficiary to have a present right to the gift — rather
than simply a future interest in the trust. However, a technique was developed in the
1960’s to qualify gifts to a trust under the annual exclusion. This technique involves
granting each beneficiary of the ILIT the limited right to withdraw their portion of the gift for
thirty days after each contribution. If the beneficiary fails to affirmatively exercise his or
her right of withdrawal after being notified, the right lapses. While this technique is more
complicated that gifting outright, no cash needs to pass directly to your children and you

can claim annual exclusion gifts for all beneficiaries, without dividing ownership in the
policy.

6.0 Can I transfer an existing policy to an ILIT?

While an existing insurance policy can be transferred to an ILIT, a new policy

works better for the following reasons:

(a) Prevents Taxable Gift. When an existing policy is transferred to
an ILIT, the owner makes a gift to the ILIT equal to the cash value of the policy. To the
extent the cash value exceeds the owner’s available annual exclusions, a taxable gift
results. As a result, the amount the owner can pass free of estate tax at death (“unified
credit”) will be decreased and/or a gift tax will be imposed.

(b) Death Within 3 Years. While proceeds payable to an ILIT will
typically be received free of estate tax, if the owner/insured transfers the policy to the ILIT
within three years of death, the proceeds will be includible in the insured’s estate and
subject to estate tax at death.

Even after taking these issues into account, however, transferring an existing
policy to an ILIT may still be advantageous if you expect to live for at least three years after
the transfer because the policy proceeds (which will then be exempt from estate tax) are
usually much greater than the cash value of the policy and the taxable gift, if any.

7.0 What are the possible disadvantages to an ILIT?

7.1 Issuance of Withdrawal Notices. As discussed above, in order to
qualify gifts to the ILIT under your annual exclusion, the Trustee is required to issue notices
to each beneficiary of his or her right of withdrawal on an annual basis. However, you are
not required to give each beneficiary the same right of withdrawal and can choose to deny a
specific beneficiary a right of withdrawal in any year (thereby reducing the amount that can
be gifted to the ILIT without tax that year).

7.2 Name Independent Trustee. To avoid having the insurance proceeds
included in your estate, you must appoint someone other than yourself (and your wife if the
policy is on both of your lives) to serve as Trustee. But, you may retain the right to remove
and replace the Trustee with a different independent Trustee at anytime during your
lifetime.

7.3 Terms of ILIT Irrevocable. Because the ILIT must be irrevocable to
avoid inclusion in your estate, you may not change the beneficiaries or alter their
distribution rights. However, if you later decide not to pass your wealth to the designated
beneficiaries, you may always discontinue gifting to the ILIT and force the beneficiaries to
fund further premiums themselves.

Clay R. Stevens © 2011