Q: Which should own my life insurance policy – a FLP or an ILIT?

A: As with most estate planning questions, the answer depends on your objectives. At the heart of this issue lies a balance between security and flexibility. 

The irrevocable life insurance trust (ILIT) is a time-proven estate planning tool for allowing the death benefits of its policy to pass directly to the trusts beneficiaries without being subjected to federal estate taxes. Also, the use of an ILIT allows the insured to reduce the size of his or her taxable estate by making annual-exclusion gifts to the trust to pay the insurance premiums.

However, the ILIT must be irrevocable, which means that changes in trust terms usually require judicial intervention. Lack of flexibility can make some clients nervous. But a variety of techniques can allow the insured to maintain some control over the policy while still protecting the death benefits from taxation.

• Funding the ILIT with term insurance. This allows the client to stop paying the premiums, thereby allowing the trust to fail. Assuming the client is still insurable, he or she may then fund a new ILIT with a new policy.
• Using survivorship life insurance. With this technique, the spouse with the shortest life expectancy establishes the trust and owns the policy, with the trust acting as contingent owner and beneficiary. If the couple decides to make changes to the policy, the policy owner need only establish a new trust and name it as contingent owner and beneficiary.

The FLP can be the owner and beneficiary of a life insurance policy on the general partner. Upon the general partner’s death, only his or her percentage of the death benefits are includible in his or her estate. In other words, if the general partner owns a 1% general partnership interest, and the heirs own the remaining 99% limited partnership interest, only 1% of the death benefits will be included in the decedent’s taxable estate.

Since the partnership agreement can be modified to adjust to new circumstances with the consent of the partners, an FLP can offer greater flexibility than an ILIT, but the FLP must be a valid business enterprise. An ILIT, on the other hand, may offer a simpler, more secure method of ensuring that death benefits remain exempt from federal transfer taxes.

Please consult a qualified estate planning attorney before deciding how to use life insurance in your estate plan.