I’ve recently been involved in some discussions with physicians and business owners about life insurance. Their questions and criticisms almost universally reflect an ignorance about the topic and frustration that my answers are always preceded by more questions. And then given with caveats and qualifications.
That may be because I’m somewhat cautious in this age of litigation. Or it may be because I’ve seen so many situations go awry that making a truly informed decision, even though it takes longer, simply avoids a lot a pain and heartache most of the time. But Ike’s comments are good ones, so please, pay attention.
Ike Devji on July 1, 2014
We’ve previously devoted a number of discussions to the use of life insurance by physicians and business owners, including a look at how to buy insurance, discussions of its specific uses and how much life insurance a doctor and his or her spouse should have. In this article we take an introductory look at a legal structure that often accompanies life insurance in an estate plan, the irrevocable life insurance trust (ILIT).
What is an ILIT?
It is an irrevocable trust that, for the purposes of our introductory discussion, cannot be changed or amended outside a few very specific exceptions. It is a formal legal structure that should be drafted by a qualified attorney familiar with both estate and gift tax laws. It is specially created to hold life insurance policies, as well as cash and various other valuable assets that may be used to fund policy premiums or managed for other benefit of the named “beneficiaries” — the parties for whom the trust was set up.
The policy may be either purchased by the ILIT outright or later sold or gifted to the trust by the person creating the trust, known as the “grantor.” Finally, the grantor appoints a trust manager who can make discretionary distributions and who helps manage the trust known as a “trustee.” The trustee cannot also be a grantor and, despite the common practice by many estate planners, in my opinion, should not be a beneficiary. In other words, it should be a third party.
What does an ILIT do?
In the majority of cases it’s used for a basic estate-planning reason — to put the proceeds of a large life insurance policy outside the taxable estate of the grantor. This means that the death benefit can be used to either supplement the value of the estate or to help pay any estate taxes that might be due by purchasing illiquid assets that might otherwise have to be sold to pay the taxes, as just one of several examples.
Why can’t a grantor also be a trustee?
We avoid this practice for the reason that is at the core of this column, asset protection, as we do not want a beneficiary who has the power to make discretionary distributions of trust assets to be forced to make a distribution to his or her own creditors. The ILIT provides creditor and principal protection of the assets in the trust (including any death benefit received upon the death of the insured) in several ways:
1. It protects the assets in the trust from estate tax by excluding them from the grantor’s taxable estate.
2. It can protect the cash value and death benefit of a life insurance policy from creditors. Some states protect cash values to a very high, even unlimited, dollar amount, while others do not; a properly drafted trust easily achieves this result.
3. It protects the death benefit and other trust assets from the creditors of the beneficiaries themselves, including future spouses. So, if the beneficiaries of your estate face a future lawsuit, bankruptcy or divorce, this asset will be protected from those exposures or even from the beneficiary themselves if they are minors or have other significant exposures like mental or physical disabilities, addiction problems, or other behavioral issues.
4. It protects present assets intended to go to the beneficiaries, including plain old cash you may intend to fund the policy with now or in the future, from the grantor’s creditors. Said simply, it allows the irrevocable present transfer of assets into a “safe” that the trustee can use to pay for the insurance premiums in the future.
This is a very general introduction to a tool that can be exceptionally complex and is not a recommendation that every doctor or business owner out there needs or is even qualified for an ILIT. As always, a good tool is only “good” if it is a fit for your very subjective goals and needs. We will continue our discussion of this topic in the near future, including a look at how assets in an ILIT can be protected from your creditors and still accessible to you during your lifetime through the use of loans.
(Note: Mr. Devji lives, I think, in the state of Washington. If you want someone local to help you with this, call or email me and I will have local names for you that are excellent attorneys – TK)