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An Irrevocable Life Insurance Trust, (often referred to by estate planning attorneys as an “ILIT”), is an Irrevocable Trust funded by a life insurance policy on the life of the settlor.

Generally, the proceeds of a life insurance policy are includible in the insured’s gross estate for purposes of calculating the estate tax. This is the case even though life insurance proceeds are not considered a “probate” asset. The result is a higher risk of estate tax liability upon the death of the insured. One way to avoid this consequence is to transfer the life insurance to an ILIT. The ILIT will hold all incidents of ownership in the policy, and a trustee (who is not the settlor) will have the right to change the beneficiary, surrender or cancel the policy, and borrow against the policy.

By giving up all incidents of ownership in the policy, its proceeds will effectively be removed from the estate of the insured. In addition, the insured can apply the annual gift tax exclusion, (projected to remain at $14,000 in 2016), to make tax-free gifts to the trust which can be used for payment of the life insurance premiums. This practice further reduces the taxable estate of the insured.

The ILIT must be irrevocable, and accordingly, it cannot be revoked or amended by the settlor during the settlor’s lifetime. The provisions of the trust agreement will govern the distribution of the life insurance proceeds upon the death of the settlor.

A caveat to consider with regard to the ILIT is the rule that requires the value of any property gratuitously transferred within 3 years prior to a person’s death to be included in their taxable estate. (Internal Revenue Code 2035). To be safe, we recommend the ILIT be created prior to the purchase of the policy in order to avoid the 3-year rule.