Contrary to popular belief, life insurance proceeds are included in a decedent's gross estate for federal estate tax purposes. This could potentially be problematic for individuals with large life insurance policies. A great solution to this problem is placing life insurance policies into an Irrevocable Life Insurance Trust ("ILIT").
An ILIT is a trust created to own an insurance policy on the life of the settlor. The trust may also be named as beneficiary of the life insurance policy. The main goal is to remove the value of the life insurance proceeds from the settlor's gross estate for estate tax purposes. So long as the life insurance policy is transferred into an ILIT more than 3 years prior to the death of the settlor, the life insurance policy will be removed from the settlor's gross estate, thus reducing the overall taxable value of the settlor's gross estate at death.
When the settlor dies, the life insurance proceeds are typically held in further trust for the benefit of the settlor's beneficiaries, free of any transfer tax. The proceeds may also be used to purchase assets from the estate to enable the estate to pay estate taxes without having to liquidate certain assets.
In ILIT planning, the settlor cannot be trustee of the ILIT. Instead, he or she must relinquish all power and control over the life insurance policy to a third party in order for the proceeds to be excluded from their estate. Thus, choosing a proper trustee is important in the ILIT context.