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The Pros and Cons of ILITs

Learn when to use these flexible instruments and when to seek alternatives.

By John Scroggin, J.D., LL.M.

As a result of the significant new estate-tax unified credit exemption amount, financial advisors are increasingly asking if irrevocable life insurance trusts are still a viable option for most clients. While not every client needs an ILIT, there remain valid reasons for using ILITs, including the following:

Exemptions could change. While most Americans are no longer subject to a federal estate tax, there is no assurance that that exclusion will continue over the coming decades. Changes in Congress and the White House and the need for new federal revenue could result in future changes in the unified credit exemption amounts. Given the three-year contemplation of death rule on transfers of life insurance policies, it may be worthwhile for some clients to hedge their bets by placing the policies in ILITs to avoid the negative impact of potential future changes in the transfer tax exemptions.


Long-term estate growth. Just because the client’s estate is currently nontaxable does not mean the estate will remain nontaxable. The estate may grow in value over time (e.g., by an inheritance or growth of a business) and the assumptions that the estate will remain at its current value could be misplaced. By placing life insurance in an ILIT, the life insurance proceeds will not further enlarge the estate and create readily avoidable estate taxes.

Income-tax basis planning. If the other assets that were a part of the taxable estate are not readily tradable and therefore do not have a readily determinable market value, then part of a client’s tax-planning strategy may shift from avoiding estate taxes to minimizing income taxes. As part of this strategy, it may make sense for the client to increase the fair market value of his assets to obtain a higher basis. This higher basis will both reduce the heirs’ future income tax and/or capital gains and (if the asset is a depreciable asset) allow for a new depreciation basis. By removing the insurance proceeds from the taxable estate, a significant cushion can be created to allow the personal representative to argue for a higher fair market value for the assets, while reducing the risk of creating a state or federal estate tax.

State death taxes. The “decoupling” of the state estate taxes from the federal estate tax means that in many cases, clients who are not subject to a federal estate tax will be subject to a state estate tax. ILITs can minimize this state estate tax liability. For example, assume the state estate tax exemption is $750,000 in 2005, when the federal estate tax exemption is $1.5 million. The state estate tax rate is 12 percent. A single taxpayer currently has a $500,000 taxable estate and is considering acquiring a $1 million life insurance policy. By placing the million-dollar life insurance policy inside an ILIT, the client could avoid the imposition of a state inheritance tax of $90,000 in state estate taxes.

Creditor protection. When a life insurance policy is owned by the decedent and/or is payable to his estate, the insurance policy may be subject to the claims of creditors. By placing the assets into an ILIT, this possibility is effectively eliminated. Because the ILIT owns the policy, as opposed to the debtor/insured, the possibility of creditor claims being made against the policy’s death proceeds is significantly reduced. The trust should contain spendthrift language that limits the ability of beneficiaries to assign their interest (e.g., to avoid creditor demands on a spouse who also personally guaranteed the debt) and of creditors to make demands on the trustees to pay the debts of beneficiaries.

Avoidance of probate delay. The probate process can be time-consuming. However, many clients want to make sure that funds are quickly available to family members in the event of their death. By placing the assets in an ILIT, the funds can become immediately available to fund the needs of the heirs.

Secrecy. In many cases, a client wants to make sure that dispositional decisions are not reflected in public records. The dispositions in the client’s will are part of the public probate records. By placing the policy in an ILIT, the client can effectively remove the proceeds from the scrutiny of the public. This can also be done using a revocable living trust.

Executors’ fees. Most executors’ fees are determined as a percentage of a decedent’s probate estate. By placing the policy in an irrevocable trust, clients may reduce an executor’s fees. For example, assume a client has a $2 million life insurance policy and state law permits a personal representative to be paid 2.5 percent of the assets flowing into the estate and 2.5 percent of the assets flowing out of the estate. Effectively, by placing the policy into an ILIT, the executor’s fees would be reduced by $100,000 (i.e., $2 million x 2.5 percent x 2).

Elective shares. Most states provide that a surviving spouse and/or minor children can make an elective-shares claim against the probate estate of a deceased spouse. The Uniform Probate Code provides that a surviving spouse has a right to make an elective claim against one-third of the decedent spouse’s augmented estate. However, life insurance that is payable to an ILIT is not part of the estate and therefore the election does not apply. If a client wanted to restrict the potential elective claim of a surviving spouse or minor children (e.g., children in the custody of an ex-spouse), the ILIT could provide a mechanism to reduce the value of the assets against which the claim could be made.

Divorce obligations. Many divorce decrees require the wealthier spouse to maintain a life insurance policy to fund any alimony or child support that remains at the insured’s death. If the ex-spouse is owner of the policy, the ex-spouse will direct the ultimate disposition of the death proceeds. Instead, the insured could place the policy in an ILIT and give the ex-spouse a beneficial interest until the ex-spouse has died, married or co-habitated, at which time the benefits of the trust could pass free of transfer taxes to other heirs (e.g., the children from the first marriage). If the policy is owned by an ILIT, the insured will lose the alimony deduction for the payment of insurance premiums, but as the grantor of the trust, the insured can still determine the ultimate disposition of the death proceeds.

When not to use an ILIT
There are also many reasons not to create an ILIT:

Cost. There is a cost for both establishing and maintaining an ILIT. This cost must be factored in when deciding if an ILIT should be created. However, clients should be advised not to be penny-wise and pound-foolish. For example, saving $2,000 in legal fees by not placing a $1 million policy in an ILIT may not make sense if the inclusion of the policy in the taxable estate is going to create additional executor fees of $50,000 or open the funds up to claims by creditors.

Complexity. Many clients perceive the creation of an ILIT as too complex. However, the complexities of an ILIT may be grossly overstated. In most cases, the disposition of the insurance trust mirrors the client’s desired disposition under his will. It may be that advisors just have not explained things appropriately.

Inflexibility. The word “irrevocable” gives many clients the perception they can no longer change the trustees, dispositional terms or other provisions of their “irrevocable trust.” However, with proper flexible planning, trustees can be removed and dispositional terms can be changed (e.g., through a limited power of attorney in a trusted nongrantor.)

John J. Scroggin, J.D., LL.M. is a speaker and author with over 300 published articles, outlines and books. To get his free blast email on estate and income tax planning, contact


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