1. A Problem of Inclusiveness. The death benefits payable on life insurance that you own is included in calculating the value of your estate subject to Federal estate taxes.  Even though you cannot spend the death benefits yourself, you control who will receive them, and that’s good enough for the IRS to tax them.

2. ILITs: Better than iPods. Life insurance that is owned by an irrevocable life insurance trust (ILIT) is not included in the taxable estate of the insured person.  Why?  As long as certain formalities are observed, the ILIT is treated as a distinctive taxpayer, separate from the insured person.  ILITs are a great way to keep the taxable estate below the available credit threshold or to provide tax-free cash to pay estate taxes on illiquid property.

3. Independently Minded. The insured person should not be the sole trustee of an ILIT.  As trustee, the insured person could still control who will receive the death benefits, which would make them taxable.  The best practice is to have an independent trustee or co-trustee of the ILIT.  An independent trustee is a person who is not related or employed by the insured person.

4. Minimum Standards. Although the spouse of the insured person is not independent, it may be possible for the spouse to be the sole trustee.  As trustee, the spouse’s authority regarding distributions must be limited to his or her health, education, maintenance or support.  Trust property that is limited to these “ascertainable standards” are not ordinarily included in the person’s taxable estate.  However, there’s no guarantee.  Having an independent trustee is a much safer approach.

5. Premium Dollars. In most cases, annual premiums must be paid in order to continue a life insurance policy.  When life insurance is owned by an ILIT, the trust must come up with cash to pay the annual premiums.  Unless the trust has other investments, the grantor/insured person will often make gifts to the ILIT in amounts to cover the annual premiums.  The trustee of the ILIT will use those funds to pay the premiums.

6. Feeling Crummey. To avoid Federal gift taxes on the premium funds the grantor gives to the ILIT every year, the trust beneficiaries must have the right to immediately withdraw the funds.  This is called a Crummey power, named after a tax case.  The beneficiaries have to be notified when gifts are made to the ILIT (called Crummey notices), but they should understand that the funds are needed to pay life insurance premiums.

7. Measure Twice. ILITs must be irrevocable, meaning that they cannot be amended or terminated after they are created.  So what happens if you (or your attorney) make a mistake?  You might have to start all over and let the life insurance policy owned by the bad ILIT lapse.

8. A View to the Past. An ILIT can either buy a new policy of life insurance one the insured person or an existing policy can be transferred to the ILIT.  However, if an existing policy is transferred to the ILIT and the insured person dies within 3 years, the death benefits will still be included in his or her taxable estate.

9. A Whole Solution. ILITs can also own whole life insurance or any other kind of investment quality insurance.  Unless the investment returns on whole life insurance are intended solely to pay the annual premiums, the ILIT should be structured as an intentionally defective grantor trust (IDGT).  An IDGT has special language to allow the grantor to borrow funds from the trust and cause trust income to be taxed to the grantor.

10. Till Death Do Us Part. ILITs can hold life insurance on the life of one person, or they can hold second-to-die life insurance.  Second-to-die policies pay a death benefit when both spouses have died (which is typically when cash is needed for estate taxes).  ILITs holding second-to-die policies must be structured as joint trusts.