Irrevocable Life Insurance Trust

Life Insurance may offer a way to provide for the next generation, and, if properly structured, keep the proceeds from the policy out of the taxable estate. An Irrevocable Life Insurance Trust is a device to "move" a life insurance policy out of the insured's federally taxable estate. Although the estate planning goal is straightforward, some aspects of the trust are complicated.

Ownership of Insurance

A life insurance policy is a peculiar type of asset. Its real value may only arise upon your death. Nevertheless, the Federal Tax Code views life insurance as something "owned" by someone. If you own the insurance policy, or retain any incidents of ownership, it will be included in your gross estate for federal estate tax purposes. One incident of ownership is the right to name, or change the name of, the beneficiary. Other incidents of ownership include the right to borrow against the policy, to cancel or surrender the policy, or to assign the policy.

Why A Trust?

One advantage of making a gift to an irrevocable life insurance trust over giving it outright to a beneficiary is that you can insure that the policy will be retained in trust and not be cancelled by the beneficiary. Another advantage is that the proceeds can be held in further trust to provide for your beneficiaries, protecting the assets during their minority and for a period of time until they become established.

Trustee Selection

The Tax Code imposes certain restrictions on your ability to name a Trustee.

A cardinal rule is that you cannot act as Trustee yourself. This flows from the fact you must give up ownership rights to the policy. If you were to be Trustee, you would have control over the policy and therefore make it taxable to your estate.

A corollary to this cardinal rule is that you are not permitted to unilaterally control Trustee selection once the trust is established. This means that you cannot retain an unfettered ability to fire an existing Trustee and to name a successor. It may be possible to draft a provision permitting you to remove and rename a corporate Trustee under certain limited circumstances, but this is an area involving fine distinctions and evolving law. The safest course is to forego the right to rename and replace Trustees.

The Three Year Rule

Life insurance is subject to a special tax rule governing gifts of the policy. The general rule is that a gift of a life insurance policy within three years of death will not be effective to remove the proceeds of the policy from your gross estate.

If the trust is created and it then purchases a new policy, the three-year rule should not apply.

Beneficiary Withdrawal Rights

The trust utilizes the annual gift tax exclusion provisions of the Federal Tax Code. Under those provisions, each person can make an annual gift of up to $13,000 per donee per year without the gift being taxable or reducing the donor's unified gift and estate tax credit. To qualify under the annual exclusion, however, the gift must be of a present interest. A gift to someone in trust is not, of course, a gift of a present interest in property.

The planning device used to avoid this problem is the use of the so-called "Crummey power". (This technique was used in a famous tax case, Crummey v. Commissioner, thus its name). The Crummey power simply lets the trust beneficiaries take out of trust the amount of the annual contribution made to the trust. If the beneficiary does not exercise the power to withdraw this gift, then the power to withdraw lapses and the amount continues in trust. Obviously, it is the donor's hope that the trust beneficiaries would not exercise their withdrawal rights so that the funds remain in the trust to accomplish its purposes. In order to protect annual exclusion treatment, however, it is important that there be no agreement or understanding to the effect that the beneficiaries will not withdraw the annual contributions.

There is an additional complication to the "present interest" issue. If someone permits a withdrawal power to lapse, he or she is deemed to have made a taxable gift to a person who benefits thereby. This second gift (created by the lapse of the withdrawal power) also will not be considered a present interest, as it lapses into the trust. There is an exception in tax law for lapsed powers that are worth no more than $5,000 or 5% of the trust corpus. Depending on the specific situation, the trust agreement can be drafted to cover these contingencies.

Generation Skipping Tax Planning

The Generation Skipping Transfer Tax is imposed on transfers that skip generations. The tax rate is high – currently 50% – but every person has a $1.1 million exemption (the tax rate will decrease and the exemption amount will increase annually). Using part of the exemption for gifts to a life insurance trust can be very advantageous, as the cost of the exemption is limited to the amount of the gift, but the proceeds of the insurance are fully covered. The exemption must be elected, and tax-filing formalities are required.