Setting Up an ILIT Checklist

Understanding Irrevocable Life Insurance Trusts (ILITs)

An Irrevocable Life Insurance Trust (ILIT) is a type of trust specifically designed to own life insurance policies. By transferring ownership of your life insurance to an ILIT, the death benefit proceeds are removed from your taxable estate. This helps minimize or avoid federal estate taxes.

In an ILIT, you create an irrevocable trust document naming a trustee to manage and distribute the assets per your instructions. You then transfer ownership of your existing life insurance policies to the trust. Going forward, the trust owns the policies and will receive the death benefit proceeds when you pass away.

The key benefits of an ILIT are:

• Death benefit is kept out of your taxable estate
• Proceeds can pass to beneficiaries estate tax-free
• Allows you to maximize inheritance for heirs

For larger estates, using an ILIT can result in significant estate tax savings. However, it does involve some up-front costs and ongoing maintenance requirements.

Why Set Up an ILIT?

The primary purpose of establishing an ILIT is to shelter a life insurance policy's death benefit from federal estate taxes. This can result in major tax savings for those with larger, taxable estates.

When you own a life insurance policy, the death benefit gets included in your taxable estate. For 2023, the federal estate tax exemption is $12.92 million for an individual ($25.84 million for a married couple). Any estate value above these amounts is subject to a hefty 40% federal estate tax rate.

By transferring an existing policy (or establishing a new one) under the ownership of an ILIT, the death benefit is no longer part of your taxable estate. The full proceeds can then pass tax-free to your beneficiaries named in the trust.

For example, let's say you have a $5 million life insurance policy. If owned by you, the $5 million would be counted as part of your taxable estate. However, if that $5 million policy is owned by an ILIT, the full amount could pass to heirs without any estate taxes due.

Finding the Right Attorney for Your ILIT

While you can find ILIT forms and templates online, it's highly recommended to have an experienced estate planning attorney draft your Irrevocable Life Insurance Trust. There are many complex legal and tax issues to consider.

When interviewing potential attorneys, look for those who specialize in estate planning, trusts, and life insurance. They'll understand all the technical requirements for establishing a properly structured ILIT.

Some key questions to ask:

• How many ILITs have you drafted? Ask about their specific experience.
• What are the most important structuring issues to be aware of?
• How will you ensure the trust is set up in compliance with IRS regulations?
• What's your approach to ongoing administration and maintenance?
• What are your fees for setting up and maintaining the ILIT?

You'll want an attorney who can explain the concepts in easy-to-understand language. They should make you feel confident they'll set everything up properly while minimizing potential pitfalls.

Drafting the ILIT Agreement

With your chosen attorney, the next step is to have the Irrevocable Life Insurance Trust agreement drafted. This legally establishes the trust and defines its terms.

The ILIT agreement should cover:

• Identifying the settlor (person creating the trust) and naming a trustee
• Outlining the purpose and dispositive provisions for trust assets
• Determining beneficiaries of the trust and their interests
• Defining trustee duties, powers, and limitations
• Specifying how life insurance policies will be treated and managed
• Provisions for removing or replacing a trustee
• Mechanisms for trust amendments or terminations

Your attorney will guide you through making key decisions on things like choosing a trustee, naming contingent beneficiaries, and distribution provisions.

It's crucial the ILIT agreement is drafted properly. Any errors could result in the intended tax benefits being disqualified or other legal issues arising.

Transferring Existing Policies Into the Trust

If you already have existing life insurance policies you want included in the ILIT, you'll need to transfer ownership to the trust. This process must be handled very carefully.

First, your attorney will have you follow the insurance company's required procedures and documentation for transferring policy ownership. This typically includes:

• Completing a change of ownership form
• Having the form signed by you as current owner
• Having form signed by trustee as new owner
• Providing trust certification showing trust existence

After the transfer is complete, the ILIT will be the official owner of the policy going forward. Annual premium payments will be made from the trust by your designated trustee.

It's crucial that you survive at least 3 years after transferring an existing policy to the ILIT. Otherwise, the IRS can still include the policy proceeds in your taxable estate!

So if you are not expected to live 3+ more years when setting up the trust, it may be better to start a new policy owned directly by the ILIT instead.

Setting Up and Funding New Policies in the ILIT

Alternatively, your ILIT can purchase and own new life insurance policies from the outset. This avoids the 3-year estate inclusion period if transferring existing policies.

To set up new policies owned by the ILIT:

1. Your attorney will help establish the trust and have it apply for life insurance. The trustee will be the owner.
2. You'll need to gift cash to the ILIT to cover policy premiums. These gifts need to be within annual gifting limits.
3. The trustee uses the cash to pay premiums and set up the policy within the trust.

Having the trust purchase the policies directly avoids issues with the 3-year look-back required for transferred policies. However, it does require upfront funding via allowable tax-free gifts.

Another option is to use an ILIT "criss-cross" strategy where you loan money to the trust to fund premiums. There are special provisions that enable this.

Work closely with your attorney and financial advisors to pick the most suitable and tax-efficient approach for establishing new policies in the ILIT.

Ongoing Administration and Maintenance

An Irrevocable Life Insurance Trust is not a set-it-and-forget-it arrangement. There are ongoing administrative requirements:

• Paying annual insurance premiums from ILIT assets
• Filing annual tax returns (Form 1041) for the trust
• Sending Crummey Power notices if premiums are paid via gifts
• Maintaining ownership records and other documentation
• Ensuring trustee succession plans are in place
• Monitoring trust terms conformity and updating as needed

Some of these tasks can be handled by your attorney or tax preparer. However, the trustee has a fiduciary duty to properly administer the trust according to its terms.

Diligent administration is critical to preserve the tax benefits and legal standing of the ILIT. Lapsed policies, unfiled returns, or other deficiencies could potentially undermine the whole strategy.

Be sure to budget for the ongoing costs of administration when setting up an ILIT. Meet with your trustees annually to review procedures and responsibilities.

Potential Pitfalls to Avoid

While ILITs can be incredibly useful estate planning tools, there are some potential pitfalls and risks to be aware of:

• Improperly drafted agreement invalidating trust
• Tax risks if funding or transfers aren't handled correctly
• Trustee mismanagement or improper administration
• Missing key filing or maintenance requirements
• Procrastinating on establishing the trust until it's too late
• Loss of control over policies once transferred to ILIT

Most of these pitfalls can be avoided by using an experienced estate attorney and being diligent about proper establishment and maintenance.

Many attorneys recommend setting up your ILIT well in advance, ideally by age 60 or even earlier. This accounts for the 3-year look-back rule and provides a buffer if your health situation changes unexpectedly.

Additionally, your ILIT should be reviewed every few years and updated as needed if situations or objectives change. With proper oversight, an ILIT can ensure your intended legacy for years to come.

Wrapping Up - Your Next Steps

Setting up an Irrevocable Life Insurance Trust may seem complicated, but taking it step-by-step makes it manageable. Here are your next action items:

1. Assess if an ILIT could be beneficial for reducing estate taxes on life insurance proceeds. Consider your estate size and assets.
2. Interview and hire an experienced estate attorney who specializes in ILITs and life insurance trusts. They'll guide you through the entire process.
3. Work with your attorney to have the ILIT drafted and established according to your objectives.
4. Decide if you'll transfer existing policies or establish new ones owned by the trust. Follow proper procedures.
5. Name a trustee and ensure they understand ongoing administration requirements.
6. Revisit and update your ILIT periodically as your situation evolves over time.

With some upfront effort and legal guidance, an Irrevocable Life Insurance Trust can become a powerful estate planning tool. By removing life insurance proceeds from your taxable estate, you can maximize how much gets passed along to your heirs and beneficiaries.

Take the next step today by consulting with an estate planning expert about whether an ILIT is right for you.