Irrevocable Life Insurance Trusts: Using ILIT Proceeds to Pay the Death Tax*

One of the more confusing aspects of an Irrevocable Life Insurance Trust (ILIT) is how the life insurance proceeds paid out to the ILIT can be used to pay the death taxes of the insured person.  The temptation is for the ILIT trustee (especially if the trustee is an inexperienced family member) to find out what the tax bill is, and then write a check to the IRS.  However, just as there are certain steps that must be followed in establishing an ILIT, there are also special considerations in receiving and paying out the life insurance proceeds after the insured has passed.

In a nutshell, the trustee of the Irrevocable Life Insurance Trust cannot pay the death taxes created by the insured person's estate  directly.  If the ILIT trustee does so, the payment is considered a taxable gift.  Instead, the death taxes should be paid by the living trust or probate estate of the deceased insured person.  Assuming the ILIT was set up and the insurance was purchased specifically to take care of this expense, how do we get the death proceeds from the ILIT to the living trust?

One method we employ is to include special language in the ILIT that allows the trustee to make loans to the maker's living trust or probate estate.  Let's say the life insurance proceeds are for $1,000,000 and the estate tax bill is $894,000.  The trustee of the ILIT can loan money to the trustee of the living trust.

If the loan method is used, the transaction must be at arm's length to avoid any gifting problem.  In addition, the indebtedness should be evidenced by a formal promissory note, and interest must be paid on the loan.  The loan must eventually be repaid or extinguished in some manner.  (We'll say more about that momentarily.)  So at the end of the transaction, the ILIT has a note receivable and the living trust has a note payable.

An alternative to making a loan is to have the Irrevocable Life Insurance Trust buy property from the maker's revocable living trust or probate estate.  Under current law, all of the property included in the maker's estate receives a step-up in basis at death.  Therefore, if the ILIT purchases property that has a step-up in basis for the purchase price equal to that stepped-up value, there will be no taxable gain.  If the price paid exceeds the value, then the difference will be subject to capital gains tax.

The net effect is that the living trust or estate has cash with which to pay the death taxes, and the ILIT now owns property.  Since the beneficiaries of the revocable living trust and the ILIT are almost always identical, there has been no real change in their economic positions.

Additionally, we typically included a merger clause in both the revocable living trust an the ILIT. This language allows the two trusts to collapse into one another and be administered as one trust -- as long as the terms of the two trusts are substantially identical.  In such a merger, the notes payable and receivable from the loan strategy would also cancel each other out.

*Adapted from the Planning Partners Press.