Life insurance can be an invaluable estate planning tool. It can provide a broad measure of financial security for loved ones as well as provide the liquidity necessary to meet tax and other estate settlement obligations.
Ownership of a life insurance policy by either a new or preexisting trust endows the policy with the many attractive legal features of the trust vehicle. Since the trust instrument will itself provide for the disposition of the insurance proceeds following death, it will be excluded from probate. Since the policy may have been irrevocably gifted to the trust when its value was low, transfer taxes associated with the gift could well be minimal. The gift might qualify for the annual exclusion. Finally, the flexibility of the trust vehicle enables the grantor to determine who will receive the proceeds, and when. Trust provisions can take into account contingencies which could not be addressed by an outright distribution of insurance proceeds.
As discussed below, the insured must avoid retaining “incidents of ownership” that might cause inclusion of the policy in his taxable estate upon death. Yet the raison d’etre for the transfer in trust is to permit the insured greater control over the benefits of the policy. These competing objectives may be reconciled. For example, the trust could limit the yearly withdrawal right of the surviving spouse to the lesser of $5,000 or 5% of trust assets. This would effectively remove the insurance proceeds from the estate of both the insured and the insured’s spouse. Thus, the $600,000 lifetime exemption of both spouses would remain available. Other dispositive provisions could provide for a “sprinkling” of assets by the trustee to the surviving spouse or children in accordance with their relative needs. This flexibility could not be be achieved without a trust.
Most trusts are drafted with a spendthrift, or anti-alienation, provision. This provision endows the trust with asset and creditor protection features since the creditor of a beneficiary cannot reach undistributed trust assets protected by a spendthrift provision. A spendthrift trust might also contain a discretionary trust provision, such as the sprinkling trust, described above. If the trustee of a discretionary trust foresees creditor problems, the decision could be made to make no distributions to that particular beneficiary until the threat disappears.
The gift tax consequences of creating a life insurance trust are few and favorable if certain guidelines are adhered to. Assuming no powers have been retained that would render the gift incomplete for gift tax purposes, a taxable gift occurs when a life insurance policy is transferred to an irrevocable trust, since the purchaser is giving up “dominion and control” of the policy. Although one could purposely prevent a taxable gift from occurring (e.g., by retaining the power to change beneficiaries), one would normally avoid doing this since it could have deleterious estate tax consequences.
Provided the transfer has occurred more than three years before insured’s death and no prohibited powers have been retained, the irrevocable transfer in trust of the policy will remove it from the taxable estate of the insured. Where the insured is not expected to survive for three years, adverse estate tax consequences may be avoided by having the trustee take out the insurance policy. The insured may transfer money to the trustee, who can then purchase the policy in the name of the trust. Moreover, this transfer may qualify for the $10,000 annual exclusion.
Future premiums paid by the grantor for the insurance policy in trust may also qualify for the $10,000 annual exclusion. If they do, the insured’s $600,000 lifetime exemption for transfer tax purposes will not be diminished by his premium payments. To qualify, the trust must contain a “Crummey” demand power. Only gifts of a present interest qualify for the annual gift tax exclusion. Gifts to an irrevocable life insurance trust are not present interest gifts. However, if the trust allows each beneficiary a yearly withdrawal right (which lapses if unexercised after 60 days), the Crummey court held that the premium payment would qualify as an annual exclusion gift.
The estate tax treatment of life insurance trusts at payout (the insured’s death) depends on the nature and extent of rights retained by the grantor. The more “incidents of ownership” the insured retained during his lifetime, the more likely it is that the decedent will be considered as having an “interest” in the trust such that the proceeds are drawn into his gross estate for estate tax purposes. One need not actually own the policy for it to be included in the one’s estate. Prohibited powers which could cause adverse estate tax consequences include, but are not limited to, the power to change beneficiaries, to cancel the policy, to revoke an assignment, or to obtain a loan against the policy.
The danger of inclusion also rises if the grantor names himself as sole trustee. This risk can be lessened somewhat by naming an independent co-trustee. Note that even if the grantor has retained sufficient powers to pull the policy back into his gross estate, the policy will nevertheless remain excluded from his probate estate. Thus, it would not be necessary to consult the Will since the terms of the insurance policy itself would be dispositive in this regard. The significance of this displays yet another attractive feature of the irrevocable life insurance trust: it is not likely that the disposition of proceeds, as provided for by a trust instrument executed years before the grantor’s death, could be successfully challenged in court.
Where the insurance trust is not made irrevocable (e.g., it is expected that the proceeds will be consumed during the life of the surviving spouse and children, and the unlimited marital deduction will shield the deceased’s estate from estate tax), the life insurance trust must be coordinated with the decedent’s Will.
If the Will provides that estate taxes are to be paid out of the residuary estate, the result could obtain that beneficiaries under the Will who are not beneficiaries under the insurance policy might end up paying the estate taxes attributable to the policy. To avoid this result, the Will could provide that estate taxes are to be apportioned to the recipient of the legacy or devise. Of course, a cleaner way to achieve the result would be simply to ensure that the life insurance is excluded from the deceased’s taxable estate altogether. This could be accomplished by making the trust irrevocable and by ensuring that the grantor retained no prohibited powers that would cause inclusion in the gross estate.
Income tax consequences associated with irrevocable life insurance trusts are attractive. The distribution of insurance proceeds to beneficiaries is not taxable income under the Code. Moreover, the internal build-up of corpus eludes the capital gains tax during the insured’s life (there being no realization event). Not being part of the decedent’s taxable gross estate, an insurance policy irrevocably transferred in trust will receive no basis step-up at the death. Nevertheless, since benefits are paid in cash, this basis step-up is unnecessary and its loss will occasion no unfavorable income tax consequences.
The fact that life insurance proceeds may be distributed to a trust (rather than outright to beneficiaries) will not result in the future forfeiture of the favorable income tax rules governing bequests: while future income from the insurance proceeds held in trust will be taxable (either to the trust or to the trust beneficiaries, if distributed), the original insurance proceeds, or principal, will not be taxed to beneficiaries, even if received many years after the death of the insured.
To ease liquidity concerns during estate administration, the life insurance trust may also permit the trustee to purchase assets from the insured’s estate or to make loans to the estate. Estate obligations may thereby be paid with a portion of the insurance proceeds. This could obviate the necessity of selling a family business or other assets which might be difficult of valuation, unlikely to bring full value in a forced sale, or illiquid. Thus, prudent use of a life insurance trust further insulates Will beneficiaries from the delays, and its attendant problems, which can sometimes occur during probate.