Irrevocable life insurance trusts (ILITs) remain the Rodney Dangerfield of planning tools-they just don't get enough respect. Life insurance trusts are one of the most powerful estate and financial planning tools a planner has. Although there are many variations as to how ILITs can be structured, clients (and even some advisors) think of ILITs as unsophisticated boilerplate documents.

In fact, insurance trusts are a tremendously powerful tool. A proper insurance plan can safeguard your family and loved ones. When that insurance is held inside an ILIT, it can be managed professionally, and the client can create a framework for distributions, investments and other planning. This can be ideal to assure the succession of a closely held business, family farm or other asset. The proceeds can be protected from ex-spouses, claimants, taxes and more.

A CLEAVER PLAN

In the classic sitcom Leave It to Beaver, the Cleaver boys' shenanigans always ended with a stern lecture from their dad, followed by family mealtime. An ILIT is kind of like the lecture and meal part. Heirs can and do get entangled in misadventures, from poor business investments to divorce, but an ILIT will protect their inheritance from most of them.

Parents or other benefactors can use the ILIT to communicate values and objectives through their directions to the trustees as to how and when distributions are permitted. Trustees can be directed to favor distributions for college and postgraduate studies, to encourage and help a beneficiary start a business or buy a house and follow other parameters that establish a moral framework. The ILIT can also protect a nest egg to assure coverage of life necessities, like the Cleavers' hot meal, if the beneficiary stumbles financially.

A CLEVER PLAN

In addition to Cleaver ways to plan ILITs, there are clever ways to do so:

* Grantor trust. A grantor trust is a trust whose income is taxed to the grantor. In the case of an ILIT, that is usually the insured person. Grantor trust status might be achieved if the trustee can use trust income to pay insurance premiums for policies insuring the grantor.

However, it isn't absolutely certain that this will create grantor trust status for the entire trust, so other provisions could be necessary. For example, if someone holds the right to add a charitable beneficiary, that might suffice.

There is also a land mine to avoid. If the grantor holds the right to substitute trust assets for other assets of equivalent value, that creates grantor trust status, but if the right could extend to include life insurance that could be an "incidence of ownership," that might cause inclusion of the entire policy in the grantor's estate. This would defeat the entire tax objective of the ILIT.

So careful planning can assure grantor trust status for the entire ILIT. This is particularly valuable because of the flexibility it can provide. If at a later date the trustees opt to sell existing insurance policies to a new trust that better serves family needs, the sale may occur without triggering income tax.

* Marital savings clause. If life insurance is transferred to an insurance trust and the insured dies within three years of the transfer, the insurance will be included in the insured's estate (let's ignore the 2010 estate-tax repeal anomaly to keep life simple). So obviously the best approach is to have the ILIT buy new insurance coverage so that the three-year period is not triggered. If the ILIT buys a new policy from inception (and the trust and implementation are properly handled), the policy proceeds will not be included in the insured's estate.

But life is not always so simple. The client might have health issues and not be able to obtain new insurance, or perhaps the existing insurance is too sweet a deal to lose. So if insurance is transferred to the ILIT and the insured dies in less than three years, the proceeds will be included in the insured/decedent's estate and subject to estate tax.

* State law to protect trustee: Some states, such as Delaware, have laws that provide considerable protection to trustees of an insurance trust. These laws can protect the trustee from liability for insurance policy decisions the insured or other family members may have suggested, or the responsibility to review and monitor a policy in later years. If these types of protections are availed of, advisors should caution clients to have some mechanisms to address a periodic review of the insurance coverage and planning.