How to Terminate an Irrevocable Life Insurance Trust

Situation: An irrevocable life insurance trust (ILIT) may be established for many reasons, including liquidity for federal estate tax and/ or state death tax liability, creditor protection, and survivor income. In almost all cases, an ILIT is drafted in such a manner that the insurance death proceeds will not be included in the estate of the insured(s). In general, this means the trust is drafted so the proceeds are not payable to the estate of the insured(s) or the insured(s) do not have “incidents of ownership” in the life insurance policy under IRC § 2042. Also, the insured(s) cannot have the ability to alter, amend, revoke, or terminate the trust under IRC § 2038.

Over the past few years, many individuals established ILITs in anticipation of the estate exemption being reduced. However, the One Big Beautiful Bill Act made the high exemption permanent and increased it to $15 million starting in 2026. This may result in a reduced need for an ILIT to provide liquidity for federal estate tax liability. As a result, financial representatives may begin to be asked by insured(s) and/or trust beneficiaries whether it’s possible to have the trust terminated. Although this question is best directed to the client’s legal advisor, this Counselor’s Corner attempts to provide financial representatives with a general overview concerning the complexities and avenues involved in terminating an ILIT.

Solution: To make an appropriate recommendation on how to terminate an existing ILIT client’s advisor must take into consideration existing legal documents, state-specific trust laws, and federal and state tax laws. It’s important to note that a trustee(s) of an ILIT has fiduciary duties to trust beneficiaries, not to the insured(s)/trust grantor(s). Such duties typically include a duty of impartiality to trust beneficiaries, a duty of loyalty to trust beneficiaries, and a duty to protect trust assets for the benefit of trust beneficiaries. Violation of any of these fiduciary duties can result in the trustee becoming personally liable for damages that may occur. Consequently, a trustee will normally seek protection by either following the terms of the trust or following the options provided by the state law governing the trust. The following are some of the frequently explored avenues for terminating an ILIT.

Possible Options Available Under the Trust Document

The first place a client’s legal advisor will start is with a review of the client’s specific trust document to determine whether it contains provisions for terminating the trust. Examples of trust provisions include:

• Some trust documents allow the trustee to terminate the trust under certain circumstances. For example, a trust might be drafted to allow a trustee discretion to terminate a trust of relatively small value or that has become overly burdensome/expensive to administer. In this regard, a grantor is normally not obligated to make ongoing gifts, and without further gifts a trust-owned policy may not be sustainable. This may help the trustee to decide that trust termination is a good option for the trust beneficiaries.
• Some trust documents give the trustee broad discretion to distribute trust assets. Under this provision, it may be possible to distribute life insurance policies to trust beneficiaries, perhaps through joint ownership, or cash surrender the policy with cash distributed to the trust beneficiaries.
• Many trust documents give the trustee the power to sell trust assets for their full fair market value. Under this provision, it may be possible to sell the policy and have the cash received distributed to the trust beneficiaries. With this option, there is at least three additional considerations that must be addressed as part of the sale. First, if the policy is in a gain position, the sale may trigger taxable income. Second, the transfer-for-value rules under IRC § 101(b) must be taken into consideration in determining who the policy will be sold to in order to avoid having the death benefit subject to income tax. Finally, there is the partical issue with the trustee arriving at a fair market value. While the IRS has issued regulations and rulings on the valuation of life insurance, there still remains a great deal of uncertainty as to what measure of value to use in many situations. The variety of elements that make up an insurance product, the differences in the health of the insured and other circumstances mean the same type of life insurance policy may have different values.
• Some trust documents name a trust protector. One of the powers sometimes given to a trust protector is the power to terminate the trust with the distribution of the trust assets to the trust beneficiaries.

Possible Options Available Under State Law

In the absence of trust provisions, state law may permit a trust to be terminated under certain circumstances, with trust assets distributed to trust beneficiaries.

• The laws of many states permit modification/termination of trust provisions. Depending on the state law, all trust beneficiaries and the grantor(s) may be required to agree to the termination with or without court approval.
• Several states have decanting statutes that permit a trustee authority to pour over the assets of one trust to a new trust with modified terms. However, the taxation of trust decanting is not clear in all instances.

In Summary: The rules regarding the termination of an ILIT are complex. This Counselor’s Corner describes what clients’ advisors must take into consideration to terminate an existing ILIT.