Trusts are often found in the average estate plan. In fact, trusts have evolved to the point where there are a variety of highly specialized trusts that serve specific purposes. One such trust is an irrevocable life insurance trust, or ILIT. Let’s look into whether a beneficiary can also serve as the Trustee of your Irrevocable Life Insurance Trust.
How Does a Trust Work?
A trust is a fiduciary legal arrangement that allows a third party, referred to as a Trustee, to hold assets on behalf of a beneficiary or beneficiaries. The person who creates a trust is referred to as the “Settlor”, “Trustor” or “Grantor.” The Settlor transfers property to a Trustee, appointed by the Settlor. The Trustee holds that property for the trust’s beneficiaries as well as invests trust assets and administers the trust terms according to the terms created by the Settlor. Trusts all fall into one of two categories – testamentary or living trusts. A testamentary trust is activated by a provision in the Settlor’s Will at the time of death whereas a living trust activates once all formalities of creation are in place and the trust is funded. Living trusts can be further divided into revocable and irrevocable living trusts. Because a testamentary trust is activated by a provision in the Settlor’s Will, and a Will can always be revoked up to the time of the Testator’s death, a testamentary trust is also revocable up to that point.
What Is an Irrevocable Life Insurance Trust?
An Irrevocable Life Insurance Trust is a highly specialized trust that provides tax advantages along with the general benefits you get from a trust. Life insurance proceeds usually pass to the named beneficiary free of any income tax; however, the payout from a life insurance policy is generally included in the “gross estate” of the policy owner for estate tax purposes at the policy owner’s death and is potentially subject to federal and state estate taxes. At a tax rate of 40 percent, gift and estate taxes should be avoided whenever possible. An ILIT takes advantage of a loophole created by Congress. If an ILIT is created to own the life insurance policy and the proceeds of the life insurance policy are payable to the trustee of the ILIT upon the insured’s death, then the proceeds are not included in the insured’s estate and, therefore, are not taxable for federal estate tax purposes. This applies even though the insured gives the money to the Trustee of the ILIT to pay the annual premiums of the life insurance policy.
Can a Beneficiary Be the Trustee of an ILIT?
From a legal perspective, there is no impediment to a beneficiary of an ILIT also being the Trustee of the trust. The better question, however, is whether you should appoint a beneficiary as your Trustee. The Trustee of a trust has many duties and responsibilities; however, in general, a Trustee is responsible for managing trust assets and administering the trust using the terms created by the Settlor. Most professionals advise against appointing a beneficiary as the Trustee, particularly if there are additional beneficiaries as well. The likelihood of a conflict arising increases exponentially under such circumstances. By the same token, the Settlor cannot be the Trustee because that results in the Settlor having an incident of ownership in the life insurance policy which, in turn, means that the policy proceeds would be taxed in the estate of the Settlor upon his or her death. Given both the complex nature of an ILIT, and the important part one often plays in an estate plan, it is wise to consider appointing a professional Trustee if you choose to include an ILIT in your overall plan.
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