An Irrevocable Life Insurance Trust (ILIT) is a trust used to own life insurance to avoid estate taxes on the life insurance proceeds.
Most people believe that life insurance and its proceeds are tax free; this is not generally the case.
Estate taxes can be owed on proceeds from life insurance you own on your own life. For example, if you own a life insurance policy on your own life and your children are the beneficiaries when you die, the proceeds will be included in your estate when you die for determining whether estate taxes are to be paid.
If the life insurance policy is owned by an ILIT, there should be no estate taxes on the insurance proceeds when you die and the proceeds can be distributed to your beneficiaries estate tax-free.
In addition, you can use the ILIT to hold the insurance proceeds for your beneficiaries until they reach certain ages, and to protect them from their creditors, spouses and future estate taxes.
An important matter you need to know about an ILIT is that you cannot be the trustee of the ILIT. You would name someone else to be the trustee, usually the person you name to be the trustee for your assets after you die. The trustee must follow the rules for administering the ILIT, or the life insurance proceeds may be subject to estate taxes when you die.
An estate tax is imposed when you die if you leave more than the amount that is exempt from estate taxes to your surviving spouse and he or she is not a United States citizen at the time of your death. This issue can be eliminated by creating a Qualified Domestic Trust (QDT) for your spouse.
Generally, if your spouse is a US citizen, you can leave your spouse as much as you want when you die without having an estate tax imposed at that time. The estate tax will be imposed when your spouse dies. If your spouse is not a US citizen, there will be an immediate estate tax at your death, leaving less for your surviving spouse to inherit from you.
A QDT is a trust you set up for your non-US citizen spouse, which will hold the assets you leave to your spouse in excess of the amount that can be left estate tax-free when you die. Establishing a QDT, in general, will defer the estate tax until your spouse’s death and put your spouse in the same estate tax position he or she would have been in if he or she were a US citizen when you died.
A Special Needs Trust (SNT) is a trust established to hold assets for a beneficiary without having the beneficiary lose his or her benefits from Supplemental Security Income (SSI) and Medi-Cal (California’s version of Medicaid).
SSI provides monthly cash benefits to persons who are disabled, blind or aged (65 years or older). Medi-Cal provides for various types of medical treatment and is the only government program that pays for long-term nursing home care. Both of these programs are need based and available only to those with minimal financial resources. While persons eligible for SSI are eligible for Medi-Cal, persons who are not eligible for SSI may be eligible for Medi-Cal if they are deemed “medically needy”.
Since both SSI and Medi-Cal require the person receiving benefits have to minimal financial resources, it is important that you do not leave an inheritance directly to a person who is eligible for either of these programs. If you do, you may disqualify that person from the benefits.
To ensure your beneficiary continues to qualify for SSI and Medi-Cal, place his or her inheritance into a SNT. This is a trust that will have a third person (e.g., a relative or a friend) be the trustee and control distributions to your beneficiary. In general, the SNT will provide that no distributions are to be made to the beneficiary if those distributions will disqualify the beneficiary from SSI or Medi-Cal.
You may think that the inheritance you leave your beneficiary will generate enough income that your beneficiary will no longer need the benefits of SSI and Medi-Cal, and that losing those benefits may not be an issue. This, however, should be given a lot of consideration.
The monies you place in trust for your beneficiary today may not be enough to cover all of the beneficiary’s needs in the future, at which time the governmental assistance may be necessary. Also, because Medi-Cal provides for medical treatment, if your beneficiary does not qualify for his or her own medical insurance, you may want to preserve his or her ability to be covered under Medi-Cal.
As with all estate planning, it is important to not only look at your beneficiary’s present situation, but to look at how the inheritance you leave will affect the beneficiary in the future.