Irrevocable Life Insurance Trusts

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.


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.


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.


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 $12,000 annual exclusion so no gift tax will be 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 $5,000,000 life insurance policy and held the policy in the insured’s name, the full $5,000,000 when payable would be subject to estate tax and the insured’s heirs would receive only $2,250,000 (assuming a 40% estate tax bracket and the insured’s other assets exceed his/her unified credit).  Use of a properly structured ILIT will avoid the $2,000,000 estate tax liability, leaving the full $5,000,000 available to the beneficiaries.


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 $120,000 to the ILIT for premiums under your annual exclusion (and up to $240,000 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.


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.


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, the tax rules require that 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.


7.1 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.

© 2011