LIFE INSURANCE TRUSTS
Life insurance is usually purchased to accomplish several major objectives. The main reason people purchase insurance is to create an estate that will provide enough cash for their families to sustain an accustomed standard of living should the insured die unexpectedly. Secondly, wealthy people buy insurance to provide a fund to satisfy their estates' need for liquidity and to fund the payment of estate taxes. Less commonly, people may buy life insurance to establish a wealth replacement fund to replace property transferred to a charitable remainder trust.
Insurance trusts can be used to help accomplish all these objectives at minimal tax cost.
WHY USE A LIFE INSURANCE TRUST
Giving a life insurance policy to a trust has several advantages over direct ownership: the trustee will collect the proceeds and disburse them under the terms specified in the trust document, and the trust may provide income tax benefits, in that if the trust's income is spread among several beneficiaries in lower tax brackets than those of the grantor or the trust itself, there is a reduction in total tax liability for the group. In addition, the existence of a trust assures that the insurance proceeds will be available to pay the insured's estate settlement expenses. However, the major purpose of the transfer to the trust is ensure that the insurance proceeds are not included in the insured's estate.
Life insurance held by a trust is generally included in the decedent's estate only if the grantor/decedent had incidents of ownership over the policy, or the proceeds of the policy are required to be used to pay taxes and expenses of the estate of the insured. <1> Thus, the trust must be irrevocable, and the grantor must not be the trustee or beneficiary of the
trust. In addition, the transfer to the trust should be carried out while the insured is still in good health, as life insurance transfers made within three years of death cause inclusion of the death proceeds in the grantor's gross estate.<2>
MINIMIZING GIFT TAXES
The transfer of a life insurance policy to an irrevocable trust is a taxable gift. <3> In general, the gift will not be eligible for the annual exclusion, since it is not a gift of a present interest. <4> In addition, any subsequent payment of premiums by the grantor can result in gift tax liability.<5> However, the transaction, as well as subsequent payments of premiums by the grantor, can be structured so that the annual gift tax exclusion for gifts of present interests will apply. <6>
In the case of the initial transfer, the use of a Crummey power, in which the beneficiary is given the right to withdraw all or a portion of the annual additions to the trust is the best alternative. This allows the transfer to qualify for the gift tax annual exclusion for gifts of present interests, and may allow the avoidance of gift tax on the payment of the premiums, without resulting in any possible estate tax inclusion. <7> Other alternatives, such as allowing the trust beneficiary to demand the trust's principal, or setting up the trust to qualify as a transfer of a present interest under the rules on gifts to minors, are not recommended, since they will cause the inclusion of the life insurance proceeds in the estate of the beneficiary. <8>
To minimize gift taxes, the Crummey power should limit the right to withdrawal to an amount not more than the greater of $5,000 or 5 percent of the total value of the assets out of which the power can be exercised. Otherwise, if the beneficiary does not in fact exercise the right of withdrawal, the lapse of the right can be treated as a gift by the beneficiary to the trust. <9> For this reason, many life insurance trusts limit the annual withdrawal power to the lesser of (1) the beneficiary's prorated share of the transferred amount; (2) the annual exclusion of the transferor or transferors ($ 10,000 or $20,000); or (3) the $5,000/5 per cent amount.
The use of a Crummey power also allows the grantor to pay the premiums without gift tax consequences, assuming that the premiums amount to less than $ 10,000 per donee per year (or $20,000 in the case of a split gift). Alternatively, it may be possible to avoid a gift tax result by having the donor make cash gifts to the beneficiary and having the beneficiary pay the premiums.
1/ Reg. Section 20.2042-1. If the decedent had incidents of
ownership or the proceeds are required to be used to pay estate expenses,
the entire proceeds are included in the estate. If a portion is not
required to be but is in fact used to pay expenses, only that portion is
included in the estate.
2/ Code Section 2035.
3/ Code Sections 2501, 2511.
4/ Reg. Section 25.2503-3(c).
5/ Rev. Rul. 76-490 , 1976-2 C.B. 300; Rev. Rul. 79- 47, 1979-1 C.B.
6/ Code Section 2503.
7/ Crummey v Commissioner, 397 F2d 82 (9th Cir 1968).
8/ See Code Sections 2033, 2503(c).
9/ Code Section 2514.