Client's Guide to
Irrevocable Life Insurance Trusts
This page contains answers to commonly
asked questions regarding the estate taxation of life insurance
and how using Irrevocable Life Insurance Trusts can help avoid
having to pay these taxes.
1. What do you
mean the proceeds on my life insurance would be subject to
estate taxes? I was always told that life insurance
proceeds were tax-free!
The "tax-free" nature of life
insurance proceeds is a common and very dangerous misconception.
While it is true that under Section 101(a) of the Internal
Revenue Code, a beneficiary on a life insurance policy will
generally receive the proceeds free of income taxes, the
proceeds may nevertheless be subject to estate taxes.
Section 2042 of the Code provides that the
proceeds on any life insurance policy under which you are
insured will be "included" in your gross estate (and
thus potentially subject to estate taxes) if either (1)
the proceeds are paid to your estate, or (2) you own the policy or,
if you do not own the policy outright, have retained certain
"incidents of ownership" at the time of your death.
These incidents of ownership include the right to change or add
beneficiaries, the right to borrow against the policy's cash
value, or to cancel or surrender the policy.
The first prong of Section 2042 is easily
avoided. Don't name your estate as beneficiary, and do
make sure that you have a current beneficiary designation on
file with the insurance company, because your estate may be the
default beneficiary under the policy if you fail to name a
beneficiary or if your beneficiary predeceases you and there is
no contingent beneficiary.
The second prong is tougher. In most
cases, the insured person under a life insurance policy is also
the owner, and no one questions whether this ownership is
appropriate until the insured is terminally ill or already
deceased. Because of the "three year rule"
(discussed below), it becomes exceedingly difficult to avoid
estate taxation of life insurance if the owner/insured is
already at death's door.
The failure to plan life insurance
ownership properly is one of the most common and costly estate
planning mistakes. The IRS collects an incredible
amount of estate taxes on life insurance proceeds every year!
2. But except for my
life insurance, I'm not all that wealthy. Is this
something I really need to worry about?
Yes! Section 2042 puts the lie to
the belief that only the wealthy pay estate taxes. In the
eyes of Congress under Section 2042, being "wealthy"
means having the few hundred or thousand extra dollars per year
needed to pay the premiums on even a term life insurance policy
if the face value of the policy (not the cash value) is enough,
combined with your other assets, to put you above the estate tax
threshold ($1,500,000 in 2004, with additional increases slated
for future years).
For example, if someone dies in 2004 with
$500,000 of assets, plus a $1,500,000 term policy payable to his
children, then his gross estate for federal estate tax purposes
will be $2,000,000, which means that the estate tax bill could
be as much as $225,000! This is true even though the
policy had little or no cash value before his death, and the
value of his assets before death from a strict balance sheet
point of view was much less than the estate tax threshold.
This can place a tremendous burden on the
surviving family members, not only in terms of the taxes to be
paid, but also the financial and emotional costs of
administering a "taxable" estate requiring the
preparation and submission of federal and state estate tax
returns with required professional appraisals, waiting many
months for IRS and Florida Department of Revenue clearance
before distributing the estate assets, and, at worst, a
protracted and draining estate tax audit (although an audit is
probably unlikely in this situation).
3. I'm married and my
spouse is named as beneficiary of my life insurance. I
thought that estate taxes didn't apply to property left to my
spouse. Wouldn't that apply to avoid any estate taxes
here?
Hopefully! If you name your spouse
as beneficiary of your life insurance, and if your
spouse doesn't die before you and if you're still
married to each other when you die, then the federal estate tax
marital deduction will apply, and no estate taxes will be paid
on the life insurance proceeds at that time.
However, this will not avoid the
federal estate tax return filing requirement if the proceeds
plus your other assets exceed the estate tax threshold
($1,500,000 in 2004), even if the marital deduction applies and
no estate tax is due.
More importantly, any proceeds that your
spouse doesn't spend or give away during his or her remaining
lifetime may be subject to estate taxes on his or her death,
depending on the total amount of the surviving spouse's assets
and the federal tax laws at that time.
4.
All of the above sounds like a disaster waiting to happen.
How can I avoid this?
A simple way to avoid problems is not to
own any life insurance policies on your life. Instead, the
rule of thumb for proper ownership is that the beneficiary,
not the insured, should own the policy.
You can do this directly. For
example, your children can be the owners and beneficiaries of a
policy on your life, pay the premiums themselves, and upon your
death, can receive the proceeds free of estate taxes, subject to
the "three year rule" discussed below if you
originally owned the policy yourself.
However, if you're married and want to
ensure that the proceeds benefit your spouse, this technique
doesn't help much. If your spouse owns the policy and is
named as beneficiary, then any unused proceeds will be subject
to estate taxes upon his or her subsequent death. If the
children are the owners and beneficiaries, then the surviving
spouse has to rely on the generosity of the kids, which most
clients find unpalatable.
For this reason, many clients with
substantial life insurance choose to establish an Irrevocable
Life Insurance Trust to be the owner and beneficiary of the
policy. If the trust is properly drafted and
administered, and assuming that the three year rule doesn't
apply, the insurance proceeds will not be subject to estate
taxes on your death, nor will they be subject to estate taxes on
your spouse's death, and can be held so as to avoid estate taxes
in your children's estates as well.
5. What's this
"three year rule" you keep talking about?
Under Internal Revenue Code Section 2035,
if you own or have "incidents of ownership" on an
existing life insurance policy on your life, and give away the
policy or release the incidents of ownership within three years
before your death, then the proceeds will still be included in
your estate. This rule was established to avoid last
minute "deathbed" transfers to avoid estate taxes.
This rule applies regardless of whether
the ownership is transferred to an individual or to a trust.
It can be easily avoided with respect to any new policies by
ensuring that the policy application is made in the name of and
the policy initially issued to the trust or other intended
beneficiary.
There are sophisticated techniques that
can be used to transfer an existing policy to an Irrevocable
Life Insurance Trust while avoiding potential application of the
three-year rule, if the trust is properly drafted and the
transaction properly structured. These
techniques are not without risk, however.
The best and easiest way to avoid the
three-year rule is to take immediate steps to ensure the proper
ownership of any significant insurance policy that you currently
own and of any policy you purchase in the future.
6. How does an
Irrevocable Life Insurance Trust work?
An Irrevocable Life Insurance Trust is a
legal agreement between you as Grantor of the Trust and a
Trustee or Co-Trustees named in the trust instrument, under
which the Trustee agrees to hold the insurance policies that you
contribute to the Trust, pay the premiums, collect the policy
proceeds on your death, and administer them for the benefit of
your spouse and/or family members under the terms of the trust
instrument. If the Trust is structured as a spendthrift
trust, not only the estate tax benefits discussed here will be
achieved, but so will the other creditor protection and tax
planning benefits applicable to assets
held in trust.
As discussed above, to save estate taxes,
the Trust must be named as both the owner and the beneficiary
of the policies during your lifetime.
7. Who can serve as
Trustee of the Trust? Can I serve as Trustee? How
about my spouse?
You may not serve as Trustee of an
Irrevocable Life Insurance Trust holding policies on your life,
because the trustee powers given under the trust instrument and
under state law are considered "incidents of
ownership" that will result in estate tax inclusion under
Internal Revenue Code Section 2042.
While it is technically permissible for a
spouse to serve as Trustee, assuming that the Trust does not own
any policies of which the spouse is an insured, this is
generally not advisable. Your spouse may serve as Trustee
after your death assuming that the Trust is properly drafted to
avoid the spouse's service as trustee from causing estate tax
inclusion in his or her estate.
Typically, the initial Trustee of an
Irrevocable Life Insurance Trust is a relative, close
family friend, or a trusted advisor, such as your CPA, with the
surviving spouse becoming Trustee or Co-Trustee after your
death.
8. What does the
Trustee have to do during my lifetime?
Not much. Generally, all the trust
will own will be one or more insurance policies and a small cash
bank account to use for premium payments.
The Trustee will need to ensure that the
Trust is properly documented as the owner and beneficiary of
each policy with the applicable life insurance company.
The Trustee will also coordinate with you
regarding the payment of premiums. A couple of months
before a premium is due, you should write a check to the Trustee
for the amount of the premium. The Trustee will then
deposit the check in a Trust bank account, send the appropriate
contribution notices to the trust beneficiaries, and then pay
the premium when due from the Trust bank account.
Because an Irrevocable Life Insurance
Trust is considered a "grantor trust" for income tax
purposes, a separate taxpayer identification number for the
Trust is not required during your lifetime, so the Trust bank
account can be opened under your personal social security
number, and any interest income from the account simply be
reported on your own 1040. A discussion of the IRS
regulations on this can be found here.
Upon your death, the Trustee then files
the claim with the insurance company, receives the proceeds and
administers the proceeds under the terms of the Trust.
9. Can I retain
the ability to modify the terms of the Trust after it is set up?
Can I fire and replace the Trustee?
To avoid estate taxes, the Trust must be
irrevocable and you cannot retain any ability to change the
terms of the Trust after it is established. However, you can
give a third party, such as an independent Trustee or
Trust Protector, or a Trust Protector committee, the
ability to change the terms of the Trust within guidelines that
you can set forth in the Trust instrument. Because the
personal circumstances of the beneficiaries (not to mention the
tax laws!) can change unforeseeably after the Trust is set up,
building flexibility in the Trust instrument is a very important
and unfortunately often overlooked feature.
You may be able to retain the right to
replace the Trustee under certain circumstances, so long as the
Trust instrument prohibits you from naming yourself or a
"related" or "subordinate" party as
Successor Trustee. IRS Revenue Ruling 95-58. While
this ruling does not directly address Section 2042, most
commentators believe and later IRS private letter rulings in
this area suggest that this retained power is permissible.
10. What are
the tax consequences of transferring an existing policy to an
Irrevocable Life Insurance Trust? What are the tax
consequences of my contributions to the Trust for premium
payments?
Generally, the transfer is structured so
that there will be a gift in an amount of the cash value of the
policy as of the date of transfer. If the policy is a term
policy, this amount should be nominal.
Typically, the Trust is drafted so that
the beneficiaries of the Trust (i.e., your spouse and children)
have temporary withdrawal rights (sometimes referred to as Crummey
powers, which is a reference to the name of the court case which
approved their use) with respect to any contribution to the
trust, whether it is a contribution of a policy or of cash for
premium payments, so that the transfers qualify in whole or part
for the annual gift tax exclusion ($11,000 per trust beneficiary
in 2003). This withdrawal right is typically drafted to
lapse if not exercised within 30 or 60 days after notice of the
contribution.
Technical note: For tax reasons, many
practitioners draft these powers as "hanging powers"
that only lapse to the extent of the greater of $5,000 or 5% of
the trust assets, and remain exercisable indefinitely (i.e.
"hang" around) to the extent that they exceed this
amount. These "hanging powers" accumulate with
respect to each contribution, which means that the total
withdrawal right after several years can be very large, which
can be problematic if a beneficiary dies while the withdrawal
right remains outstanding, decides to exercise the power, or has
creditor problems. There are provisions that can be used in the
Trust to avoid having to use a "hanging power" and its
potential adverse consequences, while accomplishing the same tax
purposes.
To the extent that any transfer exceeds
your annual exclusion, then there will be a taxable gift that
will need to be reported on a gift tax return (IRS Form 709),
and will use up a portion of your applicable exclusion amount (in
2004, $1,500,000 for estate tax purposes and $1,000,000 for gift
tax purposes), although no actual gift tax will be payable
assuming that you have not used up your applicable gift tax
exclusion amount.
In situations where the annual exclusions
are not sufficient to cover anticipated trust contributions,
there are techniques that can be used to avoid taxable gifts,
including taking a loan against a portion of the cash value of a
policy prior to contribution to reduce its value for gift tax
purposes, and entering into a "split dollar"
arrangement, wherein a third party (which can be a family owned
business entity or even your spouse under a 1996 IRS private
letter ruling) agrees to pay part of the premiums in exchange
for an interest in the proceeds when paid.
Special care must be taken to ensure that
any transfer of an existing policy does not trigger the
"transfer-for-value" rules, which can have potentially
disastrous income tax consequences, and professional tax
assistance is strongly recommended regarding any such
transfer.
11. What is a
Second-to-Die Life Insurance Trust?
A second-to-die Life Insurance Trust is an
Irrevocable Life Insurance Trust designed to own a second-to-die
life insurance policy (also known as a "joint and
survivor" policy) that only pays upon the death of the
surviving insured. Such a policy is typically purchased to
provide cash to pay the anticipated estate taxes on the
surviving spouse's death without having to liquidate estate
assets, such as a family business.
If the policy is owned by the insureds,
then the proceeds will be subject to estate taxes on the
surviving spouse's death. These taxes can be avoided by
having a second-to-die Irrevocable Life Insurance Trust own and
be the beneficiary of the policy.
Upon the death of the surviving insured,
the Trustee can then typically uses the cash proceeds received
to purchase assets from the surviving spouse's estate and/or
Living Trust in order to provide the estate with the cash to pay
the estate taxes. The Trustee then administers the assets
so purchased for the Trust beneficiaries according to the terms
of the Trust.
As an alternative, the Trustee can loan
cash to the estate if a sale of estate assets is not
practicable. However, the Irrevocable Life Insurance
Trust cannot permit direct payment of estate taxes from
the Trust assets, which can result in subjecting the Trust
assets to estate taxes in the surviving spouse's estate.
12. What is the cost of an
Irrevocable Life Insurance Trust?
The cost of setting up and funding the
Trust will vary based upon the complexity of the Trust
provisions, the number of policies being transferred, and the
estate, gift and income tax issues presented.
Usually the cost of the Trust will be less
than a single year's premium, yet the Trust can possibly double
the after-tax proceeds that your beneficiaries will receive,
depending upon your estate tax situation, making it a much
better value than simply increasing the face value of the
policy.
13. Who should
prepare my Irrevocable Life Insurance Trust?
We recommend that the Trust be prepared by
an experienced attorney specializing in estate tax planning.
The issues involving these trusts can be extremely complicated,
with numerous traps for the unwary.
James F. Gulecas, Esq., is board certified
in Tax Law and Wills, Trusts & Estates by the Florida Bar.
