Life Insurance Trusts, Estate Plans, and Asset Protection for Doctors

We've previously devoted a number of discussions to the use of life insurance by physicians including a look at how to buy insurance and discussions of its specific uses and how much life insurance a doctor and his or her spouse should have. This week we take an introductory look at a legal structure that often accompanies life insurance in your estate plan, the Irrevocable Life Insurance Trust or ILIT.

What is an ILIT?

It is an irrevocable trust that, for the purposes of our introductory discussion, cannot be changed or amended outside few very specific exceptions. It is a formal legal structure that should be drafted by a qualified attorney familiar with both estate and gift tax laws. It is specially created to hold life insurance policies as well as cash and various other valuable assets that may be used to fund policy premiums or managed for other benefit of the named "beneficiaries" - the parties for whom the trust was set up.

The policy may be either purchased by the ILIT outright or later sold or gifted to the trust by the person creating the trust, known as the "grantor." Finally, the grantor appoints a trust manager who can make discretionary distributions and who helps manage the trust known as a "trustee." The trustee cannot also be a grantor and despite the common practice by many estate planners, in my opinion, should not be a beneficiary. In other words, it should be a third party.

What does an ILIT do?

In the majority of cases it's used for a basic estate-planning reason - to put the proceeds of a large life insurance policy outside the taxable estate of the doctor. This means that the death benefit can be used to either supplement the value of the estate or to help pay any estate taxes that might be due by purchasing illiquid assets that might otherwise have to be sold to pay the taxes, as just one of several examples.

Why Can't a Grantor also be a Trustee?

We avoid this practice for the reason that is at the core of this column, asset protection, as we do not want a beneficiary who has the power to make discretionary distributions of trust assets to be forced to make a distribution to his or her own creditors.

The ILIT provides creditor and principal protection of the assets in the trust (including any death benefit received upon the death of the insured) in several ways:

1. It protects the assets in the trust from estate tax by excluding them from the grantor's taxable estate.

2. It can protect the cash value and death benefit of a life insurance policy from creditors. Some states protect cash values to a very high, even unlimited, dollar amount, while others do not; a properly drafted trust easily achieves this result.

3. It protects the death benefit and other trust assets from the creditors of the beneficiaries themselves, including future spouses. So, if the beneficiaries of your estate face a future lawsuit, bankruptcy, or divorce this asset will be protected from those exposures or even from the beneficiary themselves if they are minors or have other significant exposures like mental or physical disabilities, addiction problems, or other behavioral issues.

4. It protects present assets intended to go to the beneficiaries, including plain old cash you may intend to fund the policy with now or in the future, from the grantor's creditors. Said simply, it allows the irrevocable present transfer of assets into a "safe" that the trustee can use to pay for the insurance premiums in the future.

This is a very general introduction to a tool that can be exceptionally complex and is not a recommendation that every doctor out there needs or is even qualified for an ILIT. As always, a good tool is only "good" if it is a fit for your very subjective goals and needs. We will continue our discussion of this topic in the near future, including a look at how assets in an ILIT can be protected from your creditors and still accessible to you during your lifetime through the use of loans.