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 Irrevocable Life Insurance TrustsWhat is an Irrevocable Life Insurance Trust? An Irrevocable Life Insurance Trust is a separate tax-paying entity which is both owner and beneficiary of life insurance policies. Its primary purpose is to keep life insurance proceeds out of the estate of the insured and therefore save federal estate tax. An Irrevocable Life Insurance Trust also is used for the management and orderly disposition of the trust's assets to beneficiaries. What are the pros and cons of establishing an Irrevocable Life Insurance Trust? Some individuals feel Irrevocable Life Insurance Trusts are too complicated and expensive to establish and maintain. They do not wish to control their life insurance proceeds, and are not particularly concerned that up to 55 percent of their property will go to the IRS rather than to family or charity. Other individuals are concerned about the loss of control over the terms of the Irrevocable Life Insurance Trust's provisions and the inability to use the cash value of the life insurance. These people want to ensure that if tax laws change or their circumstances change, they can exercise some kind of control over the trust and its terms. Although the cost to create and maintain these trusts is but a small fraction of the eventual tax savings that will pass to their children and grandchildren, some people do not feel comfortable using this technique. They feel that their children or grandchildren should buy and maintain their own insurance policies on their parents' or grandparents' lives. Having children or grandchildren own the policies has potential disadvantages. They may not have the funds, so the parent or grandparent may have to make gifts. The children or grandchildren may use the money for other purposes or may lose it to creditors. There is no control over how the premiums, the policies, or the death tax proceeds are used. Others prefer to pay for the insurance and simply make the eventual beneficiaries the owners of the policies. However, if this technique is used, the proceeds will be subject to federal estate tax. The reasons that most people use an Irrevocable Life Insurance Trust are not only to keep the proceeds of their life insurance federal estate tax-free but also to concurrently provide control over those proceeds through their personalized instructions to their trustees. By having an Irrevocable Life Insurance Trust drafted by an excellent estate planning attorney, flexibility can be built in so that if circumstances change, so, too, can some aspects of the trust. What purpose does an Irrevocable Life Insurance Trust serve? A properly established Irrevocable Life Insurance Trust owns life insurance on the life of the trust maker, thereby keeping the life insurance proceeds outside of his or her estate and avoiding federal estate tax (federal income tax is also avoided for different reasons). An Irrevocable Life Insurance Trust keeps policy proceeds free of federal estate tax upon the death of the trust maker and also on the subsequent death of his or her spouse. The proper use of this type of trust allows the trustees to satisfy the trust maker's estate settlement costs and death tax obligations without subjecting the insurance proceeds to those costs and taxes. By utilizing this planning vehicle, a 50 percent federal estate tax bracket taxpayer can purchase half as much life insurance as he or she would own personally and still get the same after-tax insurance benefit for his or her beneficiaries. Or he or she could double the amount of the coverage passing to his or her beneficiaries without paying a dime more of premium. What makes my trust irrevocable? You retain absolutely no ownership or control rights over the assets that are held by the trustee of an irrevocable trust and forgo any right to change trust provisions in the future. When an irrevocable trust is properly drafted and established, the assets you put into it will be treated as gifts and will no longer be part of your estate except for gifts of existing life insurance policies on your life which will be included in your estate if you die within 3 years of the transfer. When should life insurance be purchased on my spouse's life? Dual-career households are common today, and planning is often required due to the financial loss to the family if either spouse dies prematurely. The single Irrevocable Life Insurance Trust provides a tool to insure a spouse without correspondingly increasing the federal estate taxes to the children and grandchildren. This approach also allows the surviving spouse and family members to offset the financial consequences due to the loss of a spouse's income or contributions to the family as a homemaker. This arrangement is both income tax-free and estate tax-free, and the trust makers get full value for the premium dollars they spend on their coverage. Life insurance should be purchased on your life or your spouse's life individually whenever there is a need to provide an income stream or principal amount to the survivor. However, the second-to-die policy is a less expensive, and therefore a much more effective, vehicle to cover the estate tax liability on the death of the surviving spouse. Individual insurance often creates an estate; second-to-die insurance protects an estate that is already built. Who should own second-to-die insurance? Second-to-die insurance should be owned in a separate Irrevocable Life Insurance Trust created by both spouses as trust makers. This technique ensures that the life insurance proceeds paid to the trust will be totally estate tax-free. The policy could also be owned by adult children or grandchildren, but this may not be wise. Children or grandchildren may die or become disabled while owning the policy, creating problems as to ownership. In addition, as discussed earlier, there is loss of control over the premiums paid and the policy. Why use second-to-die life insurance? The price of second-to-die life insurance is based upon the joint life expectancy of two individuals insured. It significantly reduces the premium cost of the life insurance. For example, if the odds are 1 in 10 of one spouse dying within a year and 1 in 15 for the other spouse also dying within that year, it could roughly be predicted that the odds of both the spouses dying within that same year would be closer to 1 in 150 rather than 1 in 12.5. Are there other benefits to second-to-die policies owned by Irrevocable Life Insurance Trusts? Federal estate taxes must generally be paid in cash within 9 months of death, unless certain statutory qualifications are met as exceptions to the general 9-month rule. The second-to-die Irrevocable Life Insurance Trust can easily provide that cash, thus preserving family assets and preventing them from being sold at deep discounts or at forced sales in order to generate the needed cash to pay the IRS. How can a second-to-die policy owned by an Irrevocable Life Insurance Trust benefit my family in addition to saving estate taxes on insurance? This technique is especially useful in planning for the business owner whose goal is to pass the business to one or more children but who also wants to equalize assets going to children who are not active in the business. The second-to-die insurance proceeds can also provide tax-free cash to pay estate settlement costs. If a business owner has one child who works in the business and another who works elsewhere, the owner can purchase additional life insurance to fund the second child's inheritance, thereby equalizing it in value with the first child's interest in the business. Is there more to second-to-die insurance than favorable pricing? Because the current estate tax laws provide an unlimited marital deduction, federal estate taxes can be easily deferred until the death of the surviving spouse. It is on the death of that spouse that significant estate taxes are usually generated. A second-to-die policy both creates the cash on that death to cover those taxes and augments the size of the estate passing to children and grandchildren. The joint Irrevocable Life Insurance Trust that is created by a married couple applies for, owns, and is the beneficiary of the second-to-die insurance on their lives. The Irrevocable Life Insurance Trust provides tax-free insurance dollars at the exact time that the estate taxes are typically due: upon the death of the surviving spouse. Can a trust maker name as many beneficiaries as he or she wants as lifetime or demand beneficiaries without making them ultimate beneficiaries in order to give more tax-free funds to the trust? The IRS has made it clear that any plan that includes demand beneficiaries who are not ultimate beneficiaries or grandchildren will be contested by it. Can contributions be made to the trust several times during the course of a year? Contributions can be made at any time during the year. Does each transfer to a trust then require a separate notice to the beneficiaries? The IRS position is that a single notice at the beginning of the year notifying each beneficiary of the anticipated contribution dates and the respective withdrawal periods following each contribution will suffice to meet the notice requirements and preserve the gift tax annual exclusion. How are the death proceeds paid to an Irrevocable Life Insurance Trust used by an estate to pay death taxes? Either the trustees of the Irrevocable Life Insurance Trust can lend the proceeds to the estate and take back a promissory note, or they can buy assets from the estate and own those nonliquid assets in the Irrevocable Life Insurance Trust. How do I transfer my group life insurance policy which is paid for by my employer to an Irrevocable Life Insurance Trust? The transfer is made by preparing an assignment which irrevocably assigns all your rights under the group policy to your irrevocable trust. This would include your rights to ownership, your rights to change the beneficiaries, and your rights to convert the policy to a permanent form of insurance. This change of ownership should be documented and forwarded to the insurance company for its acknowledgment. The insurance company may have a form that is appropriate for your use. However, it may be necessary to use your attorney. If any identification documentation is required (i.e., ownership certificates, etc.), this documentation should be reissued by the insurance company in the name of the irrevocable trust. Some group policies include provisions prohibiting assignment of employees' rights. If you find yourself in this situation, you should contact the insurance company and ask that it "waive" this prohibition; this usually requires the written consents of the insurance company and your employer. Is there a way to give to an Irrevocable Life Insurance Trust an existing life insurance policy and avoid the 3-year inclusion in the trust maker's estate? There is no good way to accomplish this transaction. Individuals have tried to accomplish this result by giving money to the irrevocable trust and then having the trust buy the policy from the insured. This technique can subject the life insurance policy to the "transfer for value" problem and subject all policy proceeds exceeding premiums to ordinary income taxation: a most unwelcome result. If the insured is still healthy, it may be more appropriate to purchase a new policy with the irrevocable trust as the applicant, premium payer, owner, and beneficiary of the policy. If this is done correctly, the life insurance proceeds will immediately avoid taxation without having to wait the 3 years. What is a "Crummey Trust"? A Crummey Trust is an Irrevocable Life Insurance Trust that allows the beneficiaries to demand that the trustee pay them their share of the monies contributed to the trust within a specified period of time. Most professionals use the terms Crummey Trust and Irrevocable Life Insurance Trust to mean an irrevocable trust with Crummey demand powers that owns and is the beneficiary of life insurance. The name Crummey Trust comes from Clifford Crummey, whose court case resulted in the approval of the demand right technique. What is the benefit of a Crummey Trust? A Crummey Trust that gives its beneficiaries a right of withdrawal from the monies contributed to it allows transfers to the trust to qualify for the annual gift tax exclusion of $10,000. In order for the transfer to qualify, however, the beneficiary must be given notice of the transfer and his or her right of withdrawal. What is the "Crummey" demand power? The Crummey demand power is an extremely important gift tax planning device. This power permits all transfers to a trust to qualify for the $10,000 gift tax exclusion even if the trust benefits are otherwise delayed into the future. The annual exclusion is available only for gifts of a present interest; the recipient of the gift has the present right to use or access the gift because of this demand power. The demand power normally gives the beneficiary the power to withdraw his or her share of a gift made to the trust. However, because of special rules in the Internal Revenue Code, each beneficiary may be prohibited from withdrawing an amount that does not exceed the greater of $5000 or 5 percent of the value of the trust. A demand power will generally lapse after a short period (for example, 30 to 45 days). Trust makers anticipate that the beneficiaries of the trust will let the demand power lapse, thereby permitting the trust funds to accumulate for specified future trust purposes, including the purchase of life insurance policies on the life of the trust maker. In funding a Crummey Trust, how many annual gift tax exclusions are available to the donor? The long-standing position of the IRS has been to allow annual gift tax exclusions only to the direct beneficiaries of the trust and not to contingent beneficiaries. Several private letter rulings in the past have clearly stated the IRS's continued adherence to this policy. However, in one particular case the Tax Court ruled against the IRS on this issue. In this case, the decedent established an irrevocable trust with her two children as primary beneficiaries and her five grandchildren as contingent beneficiaries. All seven persons were given Crummey demand rights. The decedent made annual gifts to the trust of $70,000 and took seven annual exclusions. The IRS disallowed the five exclusions attributable to the grandchildren and said that despite the withdrawal right, the grandchildren did not have a current right to income from the trust and were only contingent remaindermen of the trust. The Tax Court disagreed, ruling that the Crummey "test" did not hinge upon a likelihood that a beneficiary might never receive property from the trust. Rather, the court reasoned that it was the existence of their legal right to receive funds that controlled and, therefore, allowed the five additional exclusions. IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements imposed by the IRS, we inform you that, unless expressly stated otherwise, if any U.S. federal tax advice contained in this communication, (including any attachments) is not intended or written to be relied upon or used, and cannot be relied upon or used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction of matter addressed herein. |
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| ©2010, Dallas W. Jolley, Attorney & Counselor at Law. Send questions or comments to info@jolleylaw.com. | |||||
