Irrevocable Life Insurance Trusts (ILITs) and non-grantor trusts are two popular types of irrevocable trusts. How do you know which one is right for you? This article explains what these trusts are and when they make sense.

Key Highlights and Takeaways

• Two Powerful Estate Tax Strategies: ILITs and non-grantor trusts both save estate tax, but they’re used in different circumstances.
• ILITs are Extremely Tax Efficient: ILITs are highly estate-tax efficient because they can shelter life insurance proceeds from estate tax, while the life insurance wrapper shelters the life insurance investment returns from income tax.
• Non-Grantor Trusts Avoid Both State Income Tax and Estate Tax: A non-grantor trust can be a valuable tool for taxpayers in high-tax states who are looking to transfer wealth to future generations, as non-grantor trusts can avoid not only future estate tax but also state income tax.

What is an ILIT?

An ILIT is a type of irrevocable trust that is designed to hold insurance. A person (the “grantor”) creates an ILIT for the benefit of one or more loved ones — such as children, grandchildren, a spouse, or siblings. Typically, the grantor funds the trust with cash, which the trust uses to acquire one or more life insurance policies, often on the grantor’s life. Once the life insurance policy is in the trust, it is outside of the grantor’s estate, and the proceeds will not be subject to gift tax, estate tax, or generation-skipping transfer tax. Because life insurance policies generally are not subject to income tax, ILITs are able to generate both income-tax savings (via the insurance policy) and estate-tax savings (via the trust). It’s possible for ILITs to own assets aside from life insurance, though generally they stick to holding life insurance policies plus a small amount of liquidity.

ILITs can hold any type of life insurance policy, from indexed universal life insurance (IUL) to term life insurance. But a specific type of variable universal life insurance policy, known as Private Placement Life Insurance (PPLI), works particularly well with ILITs and has become quite popular with high-net-worth individuals who are looking to transfer as much post-tax wealth to their family members as possible. Even after accounting for the fees that life insurance companies charge, an ILIT funded with PPLI will generally outperform other estate-tax strategies. (You can learn more about ILITs here.)

ILIT Example

Imagine that Ronald is a 40-year-old New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Ronald sets up an ILIT and then contributes $6 million to fund premiums on a PPLI policy, he will use up $6 million of his lifetime gift tax exemption, but the investments in the life insurance policy will be able to grow outside of his taxable estate. Even after fees, the policy will generate more than 8% annual post-tax returns. Meanwhile, the insurance charges will pay for a generous death benefit. If Ronald dies in Year 25, his beneficiaries will receive roughly $59.9 million of cash proceeds from the ILIT, and the total tax savings for his heirs will be about $39.9 million relative to if Ronald had done nothing.

Benefits of ILITs

1. Estate Tax Savings: The primary advantage of an ILIT is that it can shelter the proceeds of life insurance policies from estate tax upon the grantor’s death. Since the federal estate rate is 40% and in some states the effective state and federal estate tax rates are as high as 52%, this is an important benefit. When PPLI and ILITs are used in conjunction, the combined tax savings can be quite significant.
2. Asset Protection: An ILIT, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, ILITs can help shield inherited assets from a divorcing spouse.
3. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to an ILIT when the trust is first funded. As a result, the ILIT is a popular form of dynasty trust.

Drawbacks of ILITs

1. Cash Funding: ILITs are typically funded with cash or cash equivalents so that the ILIT can pay large upfront insurance premiums. If an ILIT is funded with an appreciated asset, that asset will likely need to be sold in order to pay the insurance premiums.
2. Irrevocability: When a grantor makes a gift to an ILIT, the gift is irrevocable.
3. No Direct Control: Typically the grantor does not act as trustee of the ILIT, though he or she can remove and replace the trustee at any time.

What is a Non-Grantor Trust?

A non-grantor trust is a type of irrevocable trust that is treated as a separate taxpayer for income-tax purposes. By setting one up in a no-tax state, taxpayers can avoid state income tax. Properly structured non-grantor trusts also help families avoid estate tax, since assets gifted to them (and any appreciation after the date of the gift) will be outside the grantor’s estate for estate-tax purposes.

Typically, a person (the “grantor”) creates a non-grantor for the benefit of one or more loved ones — such as children, grandchildren, or siblings. The grantor funds the trust using a portion of his or her lifetime gift and estate tax exemption. Once an asset is in the trust, that asset is outside the grantor’s estate and will never be subject to gift tax, estate tax, or generation-skipping transfer tax as long as it remains in the trust. Any resulting appreciation will also be outside the grantor’s estate. (You can learn more about non-grantor trusts here.)

Non-Grantor Trust Example

Imagine that Jim is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Jim sets up a non-grantor trust and then contributes a $6 million asset to it, he will use up $6 million of his lifetime gift tax exemption, but the asset will be able to grow outside of his taxable estate. After 25 years, the non-grantor trust’s assets will be worth about $33.5 million! And if Jim dies in Year 25, he will have saved his heirs about $15.2 million of tax between state capital gains taxes and estate taxes relative to the counterfactual where he hadn’t funded the non-grantor trust.

Benefits of Non-Grantor Trusts

1. Estate Tax Savings: Non-grantor trusts use a grantor’s lifetime gift tax exemption to efficiently shift assets out of the grantor’s estate for estate-tax purposes.
2. State Income Tax Savings. In California, the top marginal state income-tax rate is 13.3%. In New York City, the top rate is 14.776%. In South Dakota, the top marginal state income-tax rate is 0%. Setting up a non-grantor trust in a state like South Dakota, and then putting investments that generate lots of investment income inside of that trust, can save a grantor’s family a lot of income tax over time.
3. Asset Protection: A non-grantor trust, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, non-grantor trusts can help shield inherited assets from a divorcing spouse.
4. QSBS Stacking. For founders or early startup employees who have QSBS-eligible stock, perhaps the biggest benefit of non-grantor trusts is the additional QSBS exclusion they receive. Non-grantor trusts are eligible for their own $10 million QSBS exclusions — a single QSBS-stacking non-grantor trust can save a family millions of dollars of capital gains tax.
5. Various Federal Deductions. Non-grantor trusts get their own federal deductions and exemptions such as the $10,000 state and local income tax deduction, excess business loss deductions, mortgage interest tax deductions, Section 199A small business tax deductions, and more. Collectively, these tax benefits can be quite significant.
6. Ideal for Illiquid Assets: Non-grantor trusts work well whether funded with liquid or illiquid assets.
7. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to a non-grantor trust when the trust is first funded. As a result, the non-grantor trust is a popular form of dynasty trust.

Drawbacks of Non-Grantor Trusts

1. Illiquidity: When the grantor makes a gift to a non-grantor trust, he or she loses access to the assets in the trust. Unlike IDGTs some other trust types, with a non-grantor trust, the grantor cannot “swap” or borrow assets without income-tax consequences.
2. Irrevocability: When a grantor makes a gift to a non-grantor trust, the gift is irrevocable.
3. Spouse Cannot Be Beneficiary: Generally the grantor’s spouse cannot be the beneficiary of a non-grantor trust.
4. Potentially Higher Federal Tax Brackets: Non-grantor trusts are taxed at the highest federal tax bracket on annual income above a few thousand dollars. If the grantor is not a high-bracket taxpayer, gifting assets to a non-grantor trust may actually increase the effective federal tax rate paid on any income generated by assets inside the trust.
5. No Direct Control: The grantor cannot act as trustee of the non-grantor trust, though he or she can remove and replace the trustee at any time.

Should You Set Up an ILIT or a Non-Grantor Trust?

ILITs and non-grantor trusts both save estate tax. They can both be set up as dynasty trusts that can benefit not only a taxpayer’s children but also their grandchildren, great-grandchildren, and beyond. And they can both avoid state income tax. But there are crucial differences. ILITs are more tax efficient overall, because ILITs (or the assets they hold) can avoid federal income tax as well as state income tax.

However, taking advantage of the full potential of an ILIT requires acquiring income-producing assets — like private credit — inside of a permanent insurance policy. Some people don’t want to invest in income-producing assets. Others simply don’t trust permanent insurance and would rather pursue non-insurance options. For such people, a non-grantor trust funded with some other asset type might be a better fit.

Non-grantor trusts are also desirable for people with QSBS stock, since they can claim their own $10 million QSBS exclusions.

It is important to note that there are lots of other gift and estate tax strategies that may make more sense than an ILIT or a non-grantor trust, depending on circumstances. Those strategies are also worth exploring. Moreover, ILITs and non-grantor trusts are not mutually exclusive; some people set up both.

Conclusion

ILITs and non-grantor trusts are both powerful estate-tax strategies. Hopefully this article has given you a better idea of what each structure entails, and whether one or the other might be a better fit.

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