Okay so the entire purpose of life insurance to provide sufficient funds to the widow or children of the insured.   Certainly, the life insurance policy proceeds can make the difference between losing your home when the bread-winner dies or keeping the house—and the cars, and the private school or college attendance and a number of other dramatic financial impacts.

What is lesser known?  How to make the payment of the life insurance policy proceeds tax-free.   Really, the adjustment to tax-free life insurance is the incorporation of a life insurance trust.

If your life insurance policy is not owned by the irrevocable life insurance trust it could be includable in your estate when you die.   If the life insurance trust is the owner, your estate does not have to recognize the proceeds as part of the taxable estate.

A life insurance trust is an irrevocable, non-amendable trust which is both the owner and beneficiary of one or more life insurance policies.[1] Upon the death of the insured, the trustee invests the insurance proceeds and administers the trust for one or more beneficiaries. If the trust owns insurance on the life of a married person, the non-insured spouse and children are often beneficiaries of the insurance trust. If the trust owns “second to die” or survivorship insurance which only pays when both spouses are deceased, only the children would be beneficiaries of the insurance trust.

In the United States, proper ownership of life insurance is important if the insurance proceeds are to escape federal estate taxation.[2] If the policy is owned by the insured, the proceeds will be subject to estate tax. (This assumes that the aggregate value of the estate plus the life insurance is large enough to be subject to estate taxes.)[3] To avoid estate taxation, some insureds name a child, spouse or other beneficiary as the owner of the policy.

There are drawbacks to having insurance proceeds paid outright to a child, spouse, or other beneficiary.

  • Doing so may be inconsistent with the insured’s wishes or the best interests of the beneficiary, who might be a minor or lacking in financial sophistication and unable to invest the proceeds wisely.
  • The insurance proceeds will be included in the beneficiary’s taxable estate at his or her subsequent death. If the proceeds are used to pay the insured’s estate taxes, it would at first appear that the proceeds could not be on hand to be taxed at the beneficiary’s subsequent death. However, using insurance proceeds to pay the insured’s estate taxes effectively increases the beneficiary’s estate since the beneficiary will not have to sell inherited assets to pay such taxes.

The solution to both drawbacks is usually an irrevocable life insurance trust.

If possible, the trustee of the insurance trust should be the original applicant and owner of the insurance. If the insured transfers an existing policy to the insurance trust, the transfer will be recognized by the Internal Revenue Service only if the insured survives the date of the transfer by not less than three years.[4] If the insured dies within this three-year period, the transfer will be ignored and the proceeds will be included in the insured’s taxable estate.

Insurance trusts may be funded or nonfunded. A funded life insurance trust owns both one or more insurance contracts and income producing assets. The income from the assets is used to pay some or all of the premiums. Funded insurance trusts are not commonly used for two reasons:

  • the additional gift tax cost of transferring income producing assets to the trust and
  • the grantor trust rules of IRC §677(a)(3) cause the grantor to be taxed on the trust’s income.

Unfunded insurance trusts own one or more insurance policies and are funded by annual gifts from the grantor.

Customarily, the trustee of the insurance trust is authorized, but not required, to either purchase assets from the insured’s estate or lend insurance proceeds to his or her estate. Since the trustee of the insurance trust possesses all incidents of ownership in the insurance policy, the insurance trust provides the insured’s estate with liquidity while shielding the insurance proceeds or assets purchased with the proceeds from estate tax when the insured dies, provided the trust has the appropriate settlor and trustee.

In an excellent article on this topic, Asher Rubinstein, Esq. wrote as follows:

If you own or control a life insurance policy, then the proceeds of the policy may be included in your estate at death and subject to estate tax.  This comes as a surprise to many people who are under the impression that life insurance is tax-free.  To avoid estate tax, we use an Irrevocable Life Insurance Trust (ILIT).  We create an independent trust, with an independent trustee, who will own and control the insurance policy.  Ideally, the trustee solicits and pays for the insurance policy with trust funds, and the trustee administers the trust and its insurance policy, including paying the premiums as they become due.  Pre-existing Insurance policies may be conveyed to the insurance trust, but subject to a three-year look-back period (i.e., if the transferor of the policies to the trust lives for three more years, the trust is then said to own the policy fully and the policy will be removed from the taxable estate of the transferor).

When the insured person dies, the insurance company pays the proceeds of the policy into the trust.  The trustee will then distribute the funds to the beneficiaries of the trust, who are usually the family of the insured.  We can draft the trust with specific terms (e.g., mandatory distributions to pay for college; asset protection provisions to protect the trust from creditors and ex-spouses).

The tax savings are significant.  The insurance policy is not considered to be within the estate of the insured (because an independent trustee owned, paid for and controlled the policy), and therefore not subject to estate tax.  The receipt of the insurance proceeds by the trust beneficiaries is not taxable to them.  In this manner, life insurance is tax-free.

There are many rules to understand and traps to avoid.  For example, if a relative of first degree (spouse, sibling, parent or child) is named the trustee of the insurance trust, the IRS might argue that the trustee is too close to the insured and the insured is deemed to control the policy.  The IRS may argue that the policy is still within the estate of the insured and the death benefit subject to estate tax.  In addition, the trustee has to give annual notice to the beneficiaries of the trust, by what is known as a “Crummey” letter, named after an important court case.  Experienced tax and estate planning attorneys can guide you through these requirements and tax traps.

References

  1. ^The Use of Life Insurance In Estate Planning: A Guide To Planning And Drafting, Jon J. Gallo, Fall 1999 Real Property, Probate and Trust Journal, American Bar Association
  2. ^“Internal Revenue Code Section 2042(1)&(2)”.
  3. ^In 2011, the threshold for estate taxation is $5,000,000.“Internal Revenue Code Section 2010(c)(3)(a)”.
  4. ^“Internal Revenue Code Section 2035”.

 

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