An Irrevocable Life Insurance Trust (ILIT) is designed to be permanent. However, even a well-drafted ILIT can stop working as intended over time.
Life insurance agents, trustees, and advisors frequently encounter ILITs that no longer align with a client’s current goals. This usually happens because circumstances have changed since the trust was created.
Common reasons an ILIT may go “bad” include:
- Changes in family dynamics
- Beneficiaries facing unexpected financial situations
- Shifts in tax law or trust law
- Outdated distribution terms that no longer fit the client’s intentions
Although an ILIT is labeled “irrevocable,” there are several legitimate ways to repair or restructure a problematic ILIT.
Start With a Full ILIT Review
Before taking action, an attorney licensed in the trust’s governing state should review:
- The trust document
- State trust law
- Tax implications
- The current facts and family circumstances
This review often reveals built-in flexibility or legal remedies that may not be obvious at first glance.
Common Built-In Fixes Inside an Irrevocable Life Insurance Trust
Many ILITs include provisions that give the trustee limited but meaningful discretion. For example, the trust may allow discretionary distributions that permit the trustee to distribute the life insurance policy to one or more beneficiaries. Some ILITs include powers of appointment, trust protector provisions, or amendment powers held by a special trustee.
In other cases, a savings clause may provide relief if certain tax objectives are threatened. When these features exist, they often provide the cleanest and least disruptive way to address an ILIT that no longer aligns with the client’s intentions.
Trust Law Solutions When the ILIT Lacks Flexibility
When the trust document itself does not provide a solution, state trust law may step in. Traditionally, irrevocable trusts could only be modified through court proceedings with unanimous beneficiary consent. Over time, courts and legislatures have recognized that this standard is often impractical.
Today, many states allow trusts to be modified or even terminated when circumstances have changed in ways the settlor could not have anticipated. These legal tools can be especially helpful when an ILIT’s original purpose has been frustrated or when continuing the trust no longer makes sense for the family.
Trust Decanting: A Powerful ILIT Repair Tool
Trust decanting has become one of the most effective ways to repair a bad ILIT. In simple terms, decanting allows a trustee to move assets—such as a life insurance policy—from one trust into a new trust with improved terms.
When authorized by statute or common law, decanting gives trustees flexibility without requiring court approval or beneficiary consent in many cases. That said, decanting is not unlimited. Most states require the trustee to have the power to distribute principal, and some states restrict decanting if that power is limited to an ascertainable standard.
One advantage of decanting is privacy. Unlike court-supervised trust modifications, decanting can often be completed without making the trust’s terms part of the public record. Still, the tax consequences of decanting must be carefully analyzed before proceeding.
Using the Uniform Trust Code (UTC) to Fix an Irrevocable Life Insurance Trust
The Uniform Trust Code (UTC) has significantly expanded the options available to trustees dealing with a bad ILIT. In states that have adopted the UTC, an irrevocable trust may be modified or terminated in several circumstances.
In some cases, modification is possible with the consent of both the settlor and the beneficiaries. In others, a court may approve changes when the trust no longer serves a material purpose or when unanticipated circumstances have undermined the trust’s goals. The UTC also allows courts to reform trusts to correct mistakes, adjust administrative provisions, or better achieve tax objectives.
Unlike decanting, most UTC-based solutions require either beneficiary consent, court involvement, or both. Even so, the UTC provides trustees with valuable tools that simply did not exist in many states a generation ago.
Transferring a Life Insurance Policy to a New ILIT
Another option is to move the life insurance policy itself into a new ILIT with more favorable terms. While this can be an effective solution, it raises one of the most serious tax concerns in life insurance planning: the transfer-for-value rule.
If a life insurance policy is transferred for valuable consideration, part of the death benefit may become subject to income tax. Certain exceptions apply, including transfers to the insured, to partnerships or entities in which the insured is an owner, and between certain grantor trusts. Because the consequences of getting this wrong can be severe, no policy transfer should occur without careful tax analysis.
Policy Valuation and Fiduciary Challenges
Even when a transfer is permitted, determining the fair market value of a life insurance policy is notoriously difficult. IRS guidance is limited and often outdated, and the trustee must navigate conflicting fiduciary duties. The selling trustee is obligated to obtain the highest possible price, while the purchasing trustee must protect the interests of the buyer.
These competing duties become even more complicated when the same individual serves as trustee for both trusts but the beneficiaries differ. For this reason, many trustees seek court approval for the transaction and the valuation used, even when court approval is not technically required.
Fiduciary Responsibilities of ILIT Trustees
Serving as trustee of an ILIT is demanding even under ideal conditions. Trustees must balance competing beneficiary interests, interpret trust language, manage assets prudently, and exercise discretion in good faith. They are also typically required to keep beneficiaries informed and provide regular accountings.
When family relationships are strained or when the settlor requests changes that beneficiaries may oppose, the trustee may face increased liability risk. In these situations, seeking beneficiary consent or court guidance can provide important protection and clarity.
Practical Options for Fixing a Bad Irrevocable Life Insurance Trust
When an ILIT no longer works, there is no one-size-fits-all solution. Depending on the circumstances, the trustee may consider allowing a policy with minimal value to lapse and starting over with a new ILIT. In other cases, the policy may be distributed to beneficiaries, sold to the insured or an entity they own, or transferred to a new ILIT for full and adequate consideration.
Other approaches include modifying or terminating the trust under state law, decanting the policy into a new trust, or using a life settlement combined with a split-dollar arrangement. Each option carries its own legal, tax, and fiduciary implications, which must be evaluated carefully.
The Bottom Line
Although an Irrevocable Life Insurance Trust (ILIT) is designed to be permanent, it is not necessarily inflexible. When an ILIT no longer reflects a client’s intentions, modern trust law provides multiple paths to a better outcome.
The best solution depends on the governing state law, the trust’s terms, the trustee’s powers, and the family’s current needs. With thoughtful analysis and careful execution, a bad ILIT can often be repaired—or at least significantly improved—without undermining the original planning objectives.
