The Truth About Life Insurance Trusts

One estate tax shelter untouched by the government over the years is the irrevocable life insurance trust. At various times the IRS has tried to shut down this valuable tool, but the courts and Congress kept the structure intact.

The purpose of an irrevocable life insurance trust is to exclude insurance benefits from the taxable estate of an insured individual. That makes the trust a safe and effective way to transfer substantial wealth tax free. The trust also can protect the insurance benefits from creditors of the insured or the beneficiaries.

Life insurance can provide several benefits. It can pay estate taxes or debts, provide income to survivors, or purchase assets from the estate. You might want to use life insurance for example, when one child wants to own a valuable asset (such as a business or real estate) but other children don’t have an interest in the asset and simply want its value. The insurance enables the one child to buy out the others, so everyone gets an equal inheritance.

Insurance also can be used to provide substantial tax-free wealth to heirs. If you have enough cash to pay insurance premiums, purchasing insurance allows you to supplement the estate. Depending on your age, the insurance can pay heirs anywhere from three times the premiums you paid to 10 times the premiums. Often, that is a better after-tax return than your investments, and the return is the same regardless of when the policy pays benefits.

To get the maximum benefits of life insurance, its ownership must be structured to exclude the proceeds from the estate of the insured and to avoid the generation-skipping tax. Life insurance is included in the estate of the insured if the insured exercised any ?incidents of ownership? over the policy within the last three years. Incidents of ownership include the power to change the beneficiary and borrow against the policy. The benefits also are included in the estate if they are required to be paid to the estate or can be used for the benefit of the estate. But it is permissible for a trust to be allowed to lend money to the estate or buy assets from it.

Obviously, to keep life insurance out of the estate, it shouldn’t be owned by you. One option is to have it owned by an Irrevocable Trust. The trust has to be irrevocable to ensure you won’t exercise any incidents of ownership over the policy. You also shouldn’t be trustee. You can name a friend, family member, or advisor as trustee, but it shouldn’t be you or your spouse. You can have the power to change one independent trustee for another. Any other rights over the trust or the policy are likely to trigger problems with the IRS.

The trust can be created to purchase new life insurance or you can transfer existing life insurance to it. If you transfer an existing policy, it will be included in your estate if you die within three years after the transfer.

Premiums on the policy generally are paid with the proceeds from annual gifts from you to the trust. The trick is to ensure the gifts qualify for the annual gift tax exclusion. To do so, the gift must be of a “present interest.”

A gift to a trust ordinarily doesn’t qualify as a present interest if the beneficiary won’t get a payment until sometime in the future. But you can give the trust a Crummey clause and qualify gifts for the annual exclusion. The Crummey clause says that a beneficiary may withdraw his or her share of the annual gift within a stated period (usually 30 days or longer) after receiving notification of the gift. If the money is not withdrawn within that time, then it stays in the trust until it is distributed under the trust terms.

The Crummey power is a sore issue with the IRS. You must be sure that each beneficiary is notified in writing of the gifts each year to meet Crummey qualifications. The IRS frequently requires proof that beneficiaries were notified of their right to withdraw gifts. It isn’t enough to tell them once when the trust was created. Most estate planners recommend sending a certified letter after each gift is made.

Suppose your situation or the law changes after setting up the irrevocable trust. You cannot revoke the trust. But you can put some flexibility in the trust when it is created. You can give the trustee the right to distribute the policy to either you or to a new trust after determining that the existing trust no longer is useful or appropriate.

An irrevocable trust takes some time and money. You can simplify matters by having the children own the policy outright. Then make annual gifts directly to them, that they use to pay the premiums. This will keep the proceeds out of the estate without the workload of maintaining a trust. Disadvantages of this are that you don’t know if the money is used to pay premiums. Also, you might want to limit access to or the use of the insurance proceeds after your death. Then, a trust is necessary. Also, a trust can protect the insurance benefits from creditors of you or the children.