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 also endows the policy with the many attractive legal features of the trust vehicle. For example, since the trust instrument will itself provide for the disposition of the insurance proceeds following death, it will be part of the decedent’s nonprobate estate. Moreover, the flexibility of the trust vehicle can grant the purchaser broader discretionary latitude than the insurance policy standing by itself could provide in the distribution of benefits.
Income and transfer tax consequences of life insurance trusts are also generally quite favorable, although the tax treatment depends in substantial part upon the nature and extent of rights retained by the grantor. The more “incidents of ownership” the insured retains during his lifetime, the more likely it is that the trust will be subject to estate taxes in his estate. Thus, for example, although a revocable life insurance trust, like its irrevocable counterpart, will not be part of the insured’s probate estate, the proceeds of the policy will nevertheless constitute part of the insured’s taxable estate.
Income tax consequences of an irrevocable life insurance trust are extremely attractive. The distribution of insurance proceeds to beneficiaries is nontaxable under the Code. Moreover, unlike investments that are subject to capital gains tax based on appreciation in asset value, the internal build up of corpus in an insurance policy is not taxed. Not being part of the decedent’s taxable estate, an irrevocable transfer in trust will receive no basis step-up at the decedent’s death. However, since benefits are distributed in cash, this basis step-up is unnecessary and its loss will occasion no unfavorable tax consequences.
Transfer tax consequences of life insurance trusts are more complicated and require careful planning to meet gift and estate tax objectives. When a life insurance policy is transferred to an irrevocable trust, the purchaser is giving up “dominion and control” of the policy, and a taxable gift occurs at that instant. However, that transfer may qualify for the $10,000 annual gift tax exclusion. If so, the insured’s $600,000 lifetime exemption for transfer tax purposes will not be diminished by reason of the transfer in trust. Future premiums may also qualify for the annual exclusion, depending upon how the trust is drafted.
Provided the transfer has occurred more than three years before insured’s death, the irrevocable transfer in trust of the policy will take it out of the taxable estate of the insured. Where the insured is not expected to survive for 3 years, adverse estate tax consequences may be avoided by having the beneficiary or trustee take out the insurance policy, perhaps using funds originating from the insured and transferred by gifts qualifying for the $10,000 annual exclusion.
As previously indicated, if the insured does not retain incidents of ownership of the policy during his life, the transfer will be deemed complete for transfer tax purposes and no estate tax will be occasioned upon the death of the insured. Another advantage of an irrevocable insurance trust is that its appreciation, which may be quite substantial, is also removed from the insured’s estate. Care must be exercised to ensure that the purchaser has not retained any prohibited “incidents of ownership” after nominally transferring the policy into an irrevocable trust. Retention of these prohibited attributes, even if inadvertent, would bring the entire policy proceeds back into the insured’s taxable estate, with potentially drastic estate tax consequences. Prohibited powers 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 insured must avoid “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 might provide that insurance proceeds be distributed only upon the death of the insured’s spouse. By granting the surviving spouse a lifetime income interest together with a special power of appointment at her death, inclusion of the policy in the insured or his spouse’s estate will be avoided.
The 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, without the necessity of perhaps selling a family business or other asset that might be difficult of valuation, unlikely to bring full value in a forced sale, or illiquid.
None of these techniques made possible by use of a trust would, if properly administered, cause prohibited “incidents of ownership” to remain with the insured. Yet the trust vehicle will have enabled the insured to possess greater control over the timing and distribution of life insurance proceeds, while at the same time providing needed liquidity for the estate’s obligations.