With an ILIT, you set up a trust to own an existing or new life insurance policy. Annually, you can make gifts to the trust to pay the policy premium, with a properly structured gift subject to the annual gift tax exclusion ($12,000 per beneficiary in 2006, $24,000 per beneficiary if the gift is split with your spouse). After your death, the trust receives the insurance proceeds, which are distributed according to the trust’s terms. For the proceeds to be excluded from your taxable estate, several conditions must be met:

• The trust must be irrevocable. Once the trust is set up, you can’t change its provisions or control the assets. In legal terminology, you can’t retain any incidents of ownership, which include the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to remove an assignment, to pledge the policy for a loan, and to obtain a policy loan. You can stop funding premiums, but you cannot recover any sums already paid to the trust.

• Gifts to the trust must represent a present interest to qualify for the annual gift tax exclusion. Typically, beneficiaries won’t receive benefits from the insurance policy until sometime in the future. To change this future interest to a present one, the beneficiaries must have the ability to withdraw the money now. The trustee will normally send a written notice to all beneficiaries when the cash is received, giving them a short period, perhaps 30 days, to demand the assets. Once that period passes, the trustee can use the funds to pay the insurance premium.

• The trustee can’t be specifically instructed to pay the insured’s estate tax liabilities. If that is done, the proceeds are considered received for the estate’s benefit and will be subject to estate taxes. However, the trustee can have the power to loan money to the estate or to purchase assets from the estate to provide liquidity for paying estate taxes.

• A transferred life insurance policy must be in the trust for three years before your death or the proceeds will be included in your taxable estate.

If you are concerned about the irrevocable nature of the ILIT, you can give broad powers to the trustee, so he/she can do things like change the policy type, withdraw or borrow from the policy, surrender the policy, or distribute assets while you are alive.

In light of the uncertain future of the estate tax, you should carefully assess the advantages and disadvantages before setting up an ILIT.