Did you know that your estate could incur significant taxes on life insurance policies you own? Yes, it is true that your beneficiaries receive life insurance proceeds free of income tax. However, if you own the policy or your estate is the beneficiary, and your estate's value exceeds the federal exemption level, your estate would likely be depleted by significant estate taxes on the proceeds, even if it is a term policy. An irrevocable life insurance trust (ILIT) can be of benefit in avoiding such unnecessary estate taxes, as well as providing other benefits.

An ILIT is a legal agreement between you, as grantor, and a trustee you choose to hold a policy insuring your life. The trustee pays the premiums on the policy, collects the proceeds at your death, and administers those proceeds for your chosen beneficiaries under the terms you set in the trust document.

You can transfer an existing policy to the trust. However, you should consider using a new policy purchased by your trustee because, under IRS rules, gratuitous transfers within three years of your death are brought back into your estate and taxed. Your trustee should provide at least 30-day withdrawal powers to beneficiaries with respect to contributions to the trust, including amounts to be used to pay premiums, so that such contributions qualify in whole or in part for the annual gift tax exclusion. Of course, the intent is that the beneficiaries will not exercise these powers, and the funds will be used to pay the premiums.

An ILIT can provide several benefits in addition to removing the proceeds of life insurance policies from your estate. First, the trust can be set up to provide income for a surviving spouse and other descendants while keeping the trust assets out of the spouse's estate. Second, you can decrease your taxable estate by making gifts of premium to the ILIT of up to $12,000 per beneficiary (contributions can be doubled by splitting gifts with your spouse). Third, because a trust does not go through probate, unlike wills, the provisions are confidential. Fourth, it is difficult for discontented heirs to challenge a trust, as they might a will. Fifth, generally, trusts can be set up so that trust assets are not subject to claims of the creditors of beneficiaries.

There are some caveats associated with ILITs. First, once the ILIT is established, it is difficult to change its provisions, including the beneficiaries. Second, you cannot retain any incidents of ownership in the policy, such as the right to take policy loans. Third, any transfer to the ILIT exceeding the annual gift exclusion must be reported on a gift tax return (amounts exceeding the annual gift exclusion will use up a portion of your applicable exclusion amount). Fourth, beneficiaries can withdraw funds that are supposed to be used to pay premiums, defeating the purpose of trust. Fifth, you must continue making policy premium payments in order to keep the policy in force.

This is a general overview of the benefits and drawbacks associated with ILITs. There are additional tax and legal issues that should be considered. If interested in this concept, you should consult an attorney specializing in estate planning to ensure that your ILIT is structured to meet your particular situation and objectives.

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