If you are able to withdraw or borrow the cash value, pledge the policy for a loan, surrender, cancel or assign the policy, or change the policy beneficiary, you are deemed to have “incidents of ownership” which will subject the policy and its proceeds at your death to the estate tax system. Fortunately, proper planning can help shield these assets from estate taxation and preserve the benefits of your planning.
One way to eliminate any “incidents of ownership” and keep life insurance policies and proceeds outside of your taxable estate is to establish an Irrevocable Life Insurance Trust (ILIT) for your policies. An ILIT is a unique trust established to be both the owner and beneficiary of one or more life insurance policies. When properly established and administered, the policies held by the ILIT and their proceeds pass outside of your estate and are not subjected to the estate tax system.
Additionally, using an ILIT can enable you to provide management help for your heirs, protect them from creditors, and facilitate the coordination of life insurance with your overall estate plan. Depending on how it is structured, it can also provide your family with a quick source of cash to fund the payment of estate taxes and other expenses after your death.
Once an ILIT has been created, it must be properly administered. Failure to properly administer an ILIT can result in unintended taxable gifts to the ILIT, loss of the gift tax annual exclusion, and possible income and estate taxation of the insurance death benefits.
The below is a general overview regarding the administration and funding of an ILIT: