ILITs, A/B trusts and other legal artifacts
October 1, 2023 | View PDF
I recently spoke to a family who had an unpleasant surprise after the father died. Everything was going smoothly as far as transfers, until they contacted the life insurance company. That was when they were told that there was something called an ILIT which was the beneficiary of the life insurance policy.
What, they asked me, is an ILIT?
I was a bit taken by surprise, because I hadn’t seen an ILIT in quite a few years. It stands for Irrevocable Life Insurance Trust, and it is usually pronounced like “eye-lit”. It is something I used to see fairly regularly back in the old days.
An ILIT is primarily an estate tax device. Today, very few people have to worry about estate taxes, because the first $12.9 million of your estate is free from that tax, and that is obviously all the vast majority of people need. But back in the day, it used to be different. When I graduated from law school, back in the Pleistocene, only the first $600,000 was excluded from estate tax.
An ILIT was a way to pass money along to your heirs, outside of the taxable estate. It was, as the name suggests, an irrevocable trust. You would set up this trust, and the trust would actually own a life insurance policy, with you as the insured. You would pay the insurance premium each year, but the premium amount would be less than the amount which was excluded, each year, from gift tax. Back in those days you could give $10,000 per year to any one person. So if you and your spouse had three kids, you could each give $10,000 to each of the kids, for a total of $60,000. You could actually give that money to an ILIT, as a gift to the kids, and the ILIT would use that money to pay the premium on the life insurance policy. And then, when you died, this huge life insurance payout would not count as part of your taxable estate.
But aside from the very wealthy few who still have to worry about that $12.9 million exclusion amount, people don’t need to do that anymore. But there it was, in this particular case, an ILIT that was still being funded.
And that sent me on a trip down memory lane.
The most common device we used to use to avoid estate tax was the “A/B Trust”. This was a trust that split in two when the first one of a married couple died, and it was a way to make full use of both a husband’s, and a wife’s, estate tax exclusions.
Let us say that, back in the day (when the exclusion amount was $600,000) a husband and wife had a total estate of $1 million. The husband died, leaving everything to his wife. Later on when the wife died, the estate was still worth $1 million. But she would only get a single exclusion amount, so everything above $600,000 would be subject to a whopping estate tax (the top rate in those days was 55%). What happened to the estate tax exclusion for her husband? It died when he did.
But with an A/B Trust, you could effectively double up that exclusion amount. The trust would split into two parts (the A trust and the B trust) automatically when the first spouse died, with part of the assets going into a restricted, irrevocable trust. The restrictions didn’t have to be unduly harsh, and typically the surviving spouse would have the right to some financial support from the restricted part. The other part would be unrestricted and the surviving spouse could do whatever she wanted with that.
Nonetheless, in order for this to work, there had to be some restrictions after the first spouse died.
For the most part, A/B Trusts became obsolete in 2013, when the Congress passed a law allowing “spousal portability”. Now all you have to do, to preserve the first spouse’s exclusion amount, is file some forms with the IRS after the first spouse dies. But of course, for almost everybody, that is unnecessary because the exclusion amount is so much higher than it was back in the day.
But here’s the rub: a lot of those A/B Trusts are still out there. Most people don’t even know that they have one. And when the first spouse dies, they may find that a significant portion of their assets are restricted. Even though it did them no good, if those are the terms of the trust, then those are the terms of the trust.
And that isn’t the kind of trip down memory lane that you want to take.
Kenneth Kirk is an Anchorage estate planning lawyer. Nothing in this article should be taken as legal advice for a specific situation; for specific advice you should consult a professional who can take all the facts into account. Now if you don’t mind, I’m going to go home and put on some Beatles records. That’s my kind of trip down memory lane.