What is an irrevocable life insurance trust (ILIT) in Texas?

Why does it matter who owns a life insurance policy?

Many people assume that because they name a beneficiary on their life insurance policy, the death benefit avoids estate tax. That assumption is half right: life insurance proceeds paid to a named beneficiary generally avoid probate and pass outside the will. But federal estate tax is a different question.

If the insured person owns the policy at the time of death, the full death benefit is included in their taxable estate for federal estate tax purposes. On a large policy, that inclusion can create a substantial tax liability payable within nine months of death, often forcing the estate to liquidate other assets to pay the bill.

An ILIT solves this problem by transferring ownership of the policy to the trust. Because the trust owns the policy, and the trust is a separate legal entity, the death benefit is not part of the insured's estate for federal tax purposes when the trust is properly structured.

How is an ILIT set up and funded in Texas?

Setting up an ILIT involves creating an irrevocable trust document that names a trustee and beneficiaries, then either transferring an existing policy into the trust or having the trust apply for a new policy directly.

Transferring an existing policy carries a complication: if the insured dies within three years of transferring the policy to the trust, the IRS pulls the death benefit back into the taxable estate under the three-year rule. For this reason, it is generally preferable to have the trust apply for the policy from the outset rather than transferring one that already exists.

The trust is funded by making annual gifts to it. The trustee uses those gifts to pay the insurance premiums. These gifts must be structured correctly to qualify for the annual gift tax exclusion, which requires following a specific notice procedure.

What are Crummey notices and why do they matter?

For a gift to an ILIT to qualify for the annual gift tax exclusion, each beneficiary must have a brief window to withdraw the gift from the trust before it is used to pay premiums. This withdrawal right converts the gift from a future interest (which does not qualify for the exclusion) into a present interest (which does).

Providing written notice of this withdrawal right to each beneficiary is called a Crummey notice, named for a tax court case that established the practice. The beneficiaries virtually never exercise the withdrawal right, but the notices must be sent, documented, and retained. An ILIT whose trustee fails to send proper Crummey notices risks losing the gift tax exclusion on those contributions.

This is one reason the administrative details of an ILIT matter as much as the structural design. A trust that is drafted correctly but administered sloppily can fail to deliver its intended tax benefit.

How does an ILIT benefit the family after the insured dies?

When the insured dies, the death benefit is paid to the trust rather than to the beneficiaries directly. The trustee then administers those funds according to the trust document.

This creates flexibility that a direct beneficiary designation does not. The trust can hold the funds and distribute them to a surviving spouse over time, pay for children's education, provide for a beneficiary with special needs without disqualifying them from government benefits, or hold the funds for grandchildren who are not yet old enough to manage a large sum responsibly.

The ILIT can also be designed to provide liquidity to the estate itself. If the estate owns illiquid assets (a family business, real estate) and needs cash to pay estate taxes or administration costs, the trustee can loan funds to the estate or purchase assets from it, providing liquidity without triggering additional transfer taxes.

When should you speak with a Houston estate planning attorney about an ILIT?

This article provides general legal information, not legal advice. Whether an ILIT is appropriate, and how it should be structured, depends on the size of the estate, the existing life insurance holdings, the family's circumstances, and the federal tax position at the time of planning.

The estate planning attorneys at Edison Legal work with Houston-area clients on life insurance trust structures as part of broader generational wealth planning. Request a planning consultation to discuss whether an ILIT fits your overall plan.