ESTATES & TRUSTS
Creation Of Life Insurance Trusts
By Robert Harrison, CPA,
Richard A. Eisner & Company, LLP
An irrevocable life insurance trust can achieve substantial savings and is appropriate in many situations. Existing life insurance policies are often attractive estate planning assets in that they may have little or no current value (for gift tax purposes) and do not generally provide value during the owner's life. Alternatively, many individuals have a need for new life insurance policies that can be insulated from the impact of estate taxes.
Naming a surviving spouse as the beneficiary of a life insurance policy will avoid estate tax on the death of the insured because of an unlimited marital deduction. However, the estate tax burden will be imposed on the assets remaining in the surviving spouse's estate at the time of death. An irrevocable life insurance trust can avoid even this delayed tax burden, yet make the proceeds of the policy available should the surviving spouse need them. In many situations, a survivorship or second-to-die type of life insurance policy will be desirable, and this type of policy can also be placed in an irrevocable life insurance trust.
A typical irrevocable life insurance trust is established during a person's lifetime to be the legal owner of insurance policies on her life, to collect the proceeds upon death, to pay income earned on the proceeds and possibly a portion of the principal to a surviving spouse during her life, and to distribute the remaining proceeds to designated individuals (e.g., children or grandchildren) upon the death of the surviving spouse.
Creation of an Insurance Trust
Irrevocable Transfer. An individual must relinquish all present and future ownership interests in the insurance policy in order for the proceeds to be excluded from the estate. Thus, the transfer to the trust must be irrevocable and the insured must not retain any incidents of ownership in the policy. The following are examples of "incidents of ownership":
* The right to change the beneficiary,
* The right to revoke an assignment,
* The right to pledge the policy for a loan or obtain a loan from the insurance company based on the policy's cash surrender value, and
* The retention of a reversionary interest in excess of five percent of the value of the policy immediately prior to death.
If the decedent possesses any of these "incidents of ownership" at the time of death, the proceeds of the insurance policy will be included in the estate, even if it is payable to an irrevocable trust.
A Funded or Unfunded Trust. If a taxpayer transfers a policy that is not fully paid for to a life insurance trust, a decision has to be made as to whether the insured will continue to pay the premiums or whether to fund the trust so that it can make such payments directly. If the insured continues to pay the premiums, each payment will constitute a taxable gift. If the trust is to pay the premiums, the insured will have to transfer enough property, in addition to the insurance policy, to the trust so as to generate the funds needed to meet premium costs. This additional property transfer is also subject to gift tax. Many individuals are reluctant to give up enough principal to generate the required income and therefore prefer an unfunded trust.
Distributions to Surviving Spouse. The surviving spouse's entitlement to income from the insurance trust during her life will not cause the principal of the trust to be included in her estate. In addition, if the surviving spouse will have sufficient funds available from other sources, the trustee can be given the right to accumulate income and make discretionary distributions to the spouse or other designated beneficiaries based on need. This "sprinkling" of income can result in income tax savings by shifting income to beneficiaries in lower income tax brackets. It can also achieve additional estate tax savings by avoiding unnecessary increases in the surviving spouse's estate. In order to secure these additional tax advantages, it will be necessary to appoint an independent trustee (i.e., someone other than the surviving spouse).
Generally, if the surviving spouse is given an unrestricted right to invade the principal of the trust, the full value of the principal will be included in the estate for tax purposes. This would defeat the primary purpose for establishing the trust. However, it is possible to structure the trust so as to give the surviving spouse the right to some principal distributions without materially diminishing the potential tax savings.
If an individual has a power to withdraw principal and such power is limited by an ascertainable standard based on health, education, support, or maintenance, then the value of the property will not be included in the estate. For example, if a trust provides that in addition to receiving the income, the surviving spouse has the power to invade principal in the case of serious illness, or for the purpose of supporting herself in her accustomed manner of living, such power (whether exercised or not) will not cause the value of the trust to be included in her estate. Even if the power to invade principal is not limited by an ascertainable standard, the trust's corpus will not be includable in the estate of the surviving spouse if such power is only exercisable in conjunction with an adverse party (e.g., the remaindermen, who may be the children).
In addition, the surviving spouse can have a noncumulative right to principal distributions limited to the greater of $5,000 or five percent of the trust principal each year, without having the trust principal included in the spouse's taxable estate.
Survivorship Requirement. The Internal Revenue Code includes in a decedent's taxable estate transfers of life insurance policies made by the decedent during the three-year period ending on the date of death. Thus, the transfer of a life insurance policy within this period would not avoid estate taxation even though the decedent had transferred all incidents of ownership before death. Where a new policy is to be acquired, the three-year survivorship rule can be avoided by having the life insurance trust acquire the policy directly from the insurance company.
Gift Tax Considerations
Transfer of the Policy. The irrevocable transfer of a life insurance policy to a trust constitutes a taxable gift. The value of the gift will depend upon the type of policy. Generally, term insurance and recently acquired ordinary life policies have little or no value, so that gift tax liability is not material. Even if the transferred property has substantial value, an individual is allowed a unified credit that may be subtracted from either a gift tax or estate tax liability. The amount of the unified credit available to eventually offset estate tax will be reduced by the amount used to offset gift tax.
In addition to a unified credit, each donor is allowed a $10,000 annual exclusion for each donee. If the gift is deemed to be to third parties, a husband and wife may make tax-free gifts annually to individuals of up to $20,000 per donee. In order to qualify for the annual exclusion, a gift must be one of a present interest. That is, the donee must have a current unrestricted right to enjoyment of the property. Properly structured, a transfer to a life insurance trust may qualify for the annual exclusion.
Payment of Premiums. If the insurance trust is unfunded, the grantor will continue to contribute money annually in order to pay premiums. Such payments will constitute gifts subject to taxation. As with the initial policy transfer, if the trust is structured so as to qualify the gift as one of a present interest, the donor may utilize her and her spouse's annual gift tax exclusion to avoid or reduce the gift tax resulting from premium payments. *
Reprinted with permission from Trends and Developments, the newsletter of Richard A. Eisner & Company, LLP, July 1997.
Milton Miller, CPA, consultant, was the contributing editor for this article.
Eric M. Kramer, JD, CPA
Alan D. Kahn, CPA
The AJK Financial Group
Richard H. Sonet, JD, CPA
Marks Shron & Company LLP
Frank G. Colella, LLM, CPA
Lawrence M. Lipoff, CPA
Rogoff & Company, P.C.
Jerome Landau, JD, CPA
James B. McEvoy, CPA
The Chase Manhattan Bank
Nathan H. Szerlip, CPA
Edward Isaacs & Company LLP
Lenore J. Jones, CPA
Jacobs Evall & Blumenfeld LLP
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