In simple terms, an Irrevocable Life Insurance Trust (ILIT) is a irrevocable trust that holds a life insurance policy, generally on the grantor's life. The policy can be either term or permanent. Generally, the grantor will make cash gifts to the ILIT, and the trustee of the ILIT will use that money to purchase life insurance. Although the concept of the ILIT is fairly simple, the trust document must be drafted by an experienced attorney and the trustee must be chosen carefully in order to cause adverse tax consequences.
There are several benefits of using an ILIT over having the grantor own the life insurance policy himself (or having grantor's children purchase a policy on grantor's life with cash gifts from the grantor).
1) The life insurance death benefit is excluded from the grantor's taxable estate (it would be included if he personally owned the policy). For example, in Oregon, the Oregon Estate Tax is assessed on taxable estates over $1 million. If Grantor dies and his estate consists of $1 million worth of real estate and personal property, and a $1 million life insurance policy owned personally, he has a taxable estate of $2 million. His estate will be subject to over $100,000 in Oregon Estate Tax. However, if Grantor properly settles an ILIT and the ILIT holds the $1 million policy, Grantor only has a taxable estate of $1 million, and thus subject to no Oregon Estate Tax. Grantor has effectively saved over $100,000 by settling an ILIT.
2) The trustee of the ILIT can withhold distributions for various purposes as outlined by the grantor. For example, Grantor requires the trustee to withhold the bulk of the trust fund until the grantor's children (or grandchildren, should a child predecease the grantor) reach 30 years of age, paying only education and support expenses in the meantime.
3) If Grantor is a small business owner, an ILIT can be used to fund a buyout of his partner's interest (or vice versa). Example: Grantor is a co-owner of a business worth $2 million, with both him and his partner 50% owners. Grantor and his business partner want the other to own the business outright upon the death of the other. Grantor settles an ILIT with a $1 million policy on his partner, and his partner settles an ILIT with a $1 million policy on Grantor's life. Grantor dies, his partner now has $1 million cash, and he uses that $1 million to purchase Grantor's business interest from his estate. Grantor's family now has $1 million, and his old business partner owns 100% of the business. There are many variations of this arrangement.
1) The grantor loses complete control of the policy and beneficiary designation after the ILIT is settled. Grantor cannot change beneficiaries, or their respective interest in the ILIT as he could if he owned the policy personally.