You may be surprised to learn that upon your death, the proceeds of your life insurance policies are includable in your taxable estate – and potentially subject to state and federal estate tax. This is true even if the policy has no accessible cash value during your lifetime, and even though the proceeds of the policies are paid out directly to the named beneficiaries upon your death. An excellent tool for removing the value of these insurance proceeds from your taxable estate is an irrevocable life insurance trust, or “ILIT.”

An ILIT is an irrevocable trust created by the individual whose life is the subject of the life insurance policy (the “grantor”). As with any other trust, the insurance trust is a contract between a grantor and a trustee to administer certain property – in this case an insurance contract – for the benefit of named beneficiaries. The insurance trust, like other irrevocable trusts, typically cannot be rescinded, amended, or modified in any way after it is created. In addition, once the grantor contributes property to the trust, he cannot later reclaim ownership of the property or change the terms of the trust. This seeming inflexibility, however, is outweighed by the many benefits of an ILIT.

One of the primary benefits of executing an ILIT is to minimize the impact of estate tax. If an ILIT is properly structured and funded, the death benefits paid to the trust from any insurance policies in the ILIT will be free from inclusion in the gross estate of the grantor for estate tax purposes. In addition, the ILIT can also be structured so that the trust will provide benefits to the insured's surviving spouse without inclusion in the surviving spouse's gross estate either. Keeping life insurance proceeds out of the insured’s estate is particularly important today, in light of the uncertainty of state and federal estate taxes in the future. For example, Illinois’ recent reinstatement of the estate tax means that Illinois estates valued at more than $2,000,000 will be subject to estate tax.

In addition to providing a vehicle for excluding insurance proceeds from the grantor’s taxable estate, an ILIT can also provide liquidity for those who wish to allow their survivors to preserve a closely held business or other unique asset that might otherwise have to be liquidated to pay estate taxes and expenses.