How Are ILITs Used To Generate Estate Liquidity?

Considerations for the mismatch of liable parties

This is a continuation of the series on everything you ever wanted to know about estate planning trusts.  For an intro and index to this series, please click here. The linked article will have a series index that gets updated periodically as well, so please bookmark it.

For the prior article on ILITs, please click here.

Table of Contents

1. Intro

2. Option One: Loan to the Estate

3. Option Two: Purchase (Swap) of Assets Between Estate and ILIT

4. Other Risks

5. Conclusion

Intro

In the introduction to ILITs, we explored how an ILIT (irrevocable life insurance trust) that is optimally funded can accomplish two goals. One, it can protect proceeds of life insurance from estate taxes and creditors. Two, as somewhat of a diametrically-opposing goal, it can create liquidity to pay estate taxes and creditors’ claims against the probate estate itself.

The difference between the two goals is the level of control. Without an ILIT, life insurance paid to the estate would automatically be subject to estate tax and claims against the estate. While the executor could have some power to control how these funds are applied, federal tax law would take out a bite of up to 40% of the death benefit while state laws would create (potentially superseding) priorities for satisfaction of claims.

If the life insurance goes to an individual beneficiary, it may be protected from claims against the estate because of state-law exemptions for certain non-probate assets. But, the death benefit would still be subject to estate tax if the insured held incidents of ownership at death (or transferred incidents of ownership by gift within 3 years of death). Further, since the estate is the party responsible for claims and estate taxes, it would create a mismatch between possession of the funds and the liable party.

Of course, on the surface, this mismatch is still apparent when we use an ILIT. So, if an ILIT is itself protected from estate taxes and claims against the estate, how can the life insurance proceeds within the ILIT be used to satisfy such taxes and claims?