Irrevocable life insurance trusts (ILITs) are designed to keep life insurance from being subject to estate tax in the insured’s estate. However, the trust must be precisely drafted and administered to be successful.
Clients, scriveners, and trustees who are not familiar with life insurance trust drafting can unwittingly trigger taxation of the trust assets at the client’s death or other problems with the trust. What follows are seemingly innocent maneuvers that can result in negative outcomes. A solution to each situation is also offered.
Naming a Spouse as Trustee. Clients are often tempted to name spouses as trustees of their ILITs. As tempting as it may be, naming a spouse as a trustee of an ILIT owning a second-to-die policy will cause taxation of the trust assets for federal estate tax.
Solution: Avoid naming the spouse as trustee of an ILIT. As a best practice, even a trust owning a single-life policy should not name the spouse as a trustee. This is true regardless of whether the spouse is serving alone or as a co-trustee.
The ILIT Pays Estate Tax Directly. Having an ILIT directly pay a creditor of the grantor’s estate, including the government as an estate tax creditor, will result in taxation of the ILIT assets at death. This presents a problem as many policies are purchased with the intent of providing liquidity to satisfy death taxes without having to sell a family business or real estate.
Solution. Make sure that the ILIT does not pay to the grantor’s creditors, including tax liabilities.