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Life insurance trusts have long assumed a position of importance in estate planning, especially for larger estates, since insurance proceeds may be excluded from the settlor’s gross estate, thereby reducing or eliminating estate taxes. These tax savings may be achieved if the trust is drafted to authorize (but not require) the trustee to purchase assets from, or loan money to, the estate.
The life insurance trust is especially attractive for a married couple whose estate will exceed the couple’s combined exemption equivalent. Substantial tax savings can be achieved since the trust may reduce the portion of the combined estate that exceeds the combined exemption equivalent. Trustee and legal fees associated with creating and maintaining a life insurance trust, though not insignificant, may be modest in comparison to the tax benefits reaped by the estate.
Life insurance trusts also provide creditor protection, as they enable the grantor to decide at what age beneficiaries will be suitably mature to receive trust distributions. To maximize creditor protection, the trustee should be accorded substantial discretion with respect to trust distributions of income and principal. This can be accomplished by using a “sprinkling” trust. Substantially more creditor protection will also be achieved if a trust contains more than one beneficiary, since a court is far less likely to utilize trust funds to satisfy a judgment if the rights of a nondebtor beneficiary would be affected.
Funding the trust is facilitated by use of “Crummey” powers, through which gifts to the trust qualify for the annual exclusion, at least to the extent that the beneficiary has a right to withdraw annually the greater of $5,000 or 5% of trust assets. Maximizing the amount which can be contributed while utilizing the full annual exclusion may require the use of “hanging” powers or alternatively, may require that the trust be “funded,” i.e., contain substantial assets, so that the 5% limitation, rather than the $5,000 limitation, comes into play.
The insured settlor should not be chosen as trustee, since trust assets would be drawn into the settlor’s estate under IRC § 2042 — precisely the result intended to be avoided. Choosing the settlor’s spouse as trustee is acceptable, provided the spouse is not granted any powers which would result in the spouse holding a general power of appointment. The choice of an independent corporate trustee (to exercise powers which the spouse could not for tax reasons) in addition to the spouse may be advisable.
If an existing policy is transferred to a new trust, the insured must survive for three years to reap estate tax benefits. If a new policy is purchased, the three-year rule of IRC § 2035 can be avoided if the trustee purchases the policy. To ameliorate the result dictated by the three-year rule, the trust could direct that if the insured dies within three years, the proceeds would be paid 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 result in preventing estate tax at the insured’s death.
If insurance proceeds are to bear the burden of estate taxes, the trust should authorize the trustee to purchase assets from, or make commercially reasonable loans to, the estate. Alternatively, the proceeds might simply be distributable to beneficiaries who would ultimately bear the burden of estate taxes, as determined by the tax apportionment clause in the insured’s Will. The Will and trust must be carefully coordinated to accomplish this objective. It cannot be overemphasized that inconsistent language in the two instruments could result in harsh or unintended estate tax consequences.