Life insurance proceeds are excludible from beneficiaries’ income under §101, provided the policy had not been transferred for valuable consideration. Proceeds from policies transferred in trust will also be excluded from the insured’s gross estate provided the insured (i) retained no incidents of ownership in the policy and (ii) survived three years after making the transfer. To ensure favorable estate tax consequences, the trust must also be both irrevocable and not amendable. It is therefore crucial that the insured understand the finality of decisions made when executing the trust.
Even though the policy in trust may be excluded from the gross estate, proceeds can nevertheless be used to satisfy estate tax liabilities. However, the trust agreement must not obligate the trustee to assist in the payment of estate taxes. Thus, even though a major objective of an irrevocable life insurance trust may be to satisfy estate tax liabilities, the trust language must not mandatorily direct such payments. Language appearing to require the trust to pay estate taxes could result in estate tax inclusion under §2042 — regardless of whether the proceeds are so used.
In order to accomplish the desired objective, the trust could authorize the trustee to purchase assets from, or make commercially reasonable loans to, the estate. Alternatively, the insurance proceeds might simply be distributable to beneficiaries who would ultimately bear the burden of estate taxes, as determined by the insured’s Will. The Will must be carefully coordinated with the Trust to accomplish that objective. Inconsistent language in the two instruments could result in harsh estate tax consequences.
Life insurance trusts are flexible post-mortem vehicles for distributing income and principal to beneficiaries: If broad discretionary powers are granted to the trustee, principal may be distributed estate tax-free to children either when they reach a particular age, or earlier, if the trustee is given such discretion. The trust may also permit “sprinkling” income distributions to the surviving spouse, who may or may not require trust income or principal.
To ameliorate the harsh estate tax consequences occasioned by the application the three-year inclusion rule, the trust might might direct that in such event insurance proceeds instead be payable to the insured’s estate. While this would negate provisions benefiting children, it would allow the Will (if so drafted) to claim a marital deduction which would at least keep the wolf at bay and result in exclusion from the gross estate.
Premiums paid by the insured may qualify as annual exclusion gifts under the Crummey doctrine. The IRS has attempted to defeat Crummey powers where a contingent beneficiary had “no interest other than the withdrawal power”. However, the Tax Court in Kohlsatt (T.C. Memo 1997-212) rejected that position where “credible” reasons were offered by trust beneficiaries not to exercise withdrawal rights. Where the Crummey withdrawal right exceeds $5,000, the use of a “hanging” power may avoid the lapse which would cause a gift back into the trust by the Crummey beneficiary.
For those estates potentially subject to GST tax, if trust beneficiaries include grandchildren, the transfer must be a direct skip, and the trust must provide that if the beneficiary dies before the trust terminates, trust property must be included in his estate. Alternatively, the insured could fail to include GST provisions and simply allocate part of the GST exemption to the transfer.