LIFE INSURANCE AND THE IRREVOCABLE TRUST
In advance of an initial conference, I request that clients complete a financial statement, to determine their net worth. This statement includes a life insurance category, and most clients leave it blank. When I then ask, "Do you own any life insurance?" they answer, "Well yes, but life insurance death benefits are not subject to taxation." I respond "That is the truth, but not the whole truth."
The whole truth is as follows:
Life insurance death benefits are not subject to income taxation when paid to a beneficiary. However, as long as you retain an "incident of ownership" in the policy, the entire death benefit (i.e. the amount paid to a beneficiary), is includable in your estate and is subject to federal estate taxation. An "incident of ownership" does not include premium payments, but does include the right to borrow against a policy's cash value or the right to change a beneficiary designation. Therefore, if you decide to buy life insurance for the primary purpose of paying federal estate taxation, and acquire the policy in your own name, you have only compounded the problem, by increasing your taxable estate.
You may now ask: "Who should be the owner of a life insurance policy, if its purpose is to provide liquidity to pay federal estate taxation?" There are several choices:
1. Your spouse?
2. A Revocable Trust?
3. Your adult children?
4. An Irrevocable Trust?
If your spouse is the policy owner, its death benefit value will now be totally includable in the spouse's estate. By comparison, if a Revocable Trust of which you are the Settlor (i.e. creator), is the policy owner and beneficiary, its death benefit value will result in total inclusion in your estate. Likewise, if an adult child is the policy owner, there is no assurance that the death benefit will be utilized for its intended purpose. Suppose that your child goes through a divorce, the policy's ownership may become an asset in the divorce settlement. In addition, suppose that your child predeceases you. The policy will likely then become a probate asset in your child's estate. It could be willed to your child's spouse.
By comparison, an Irrevocable Trust funded with a life insurance policy is an ideal estate tax savings vehicle for both married and single clients. The Trustee of the Irrevocable Trust should be the original policy owner and beneficiary. If the Irrevocable Trust is properly drafted, policy proceeds are entirely excluded from your estate, your spouse's estate, are not subject to a child's control or divorce decree, and yet available to pay estate taxation.
For example, assume you are married and have a $5,000,000 taxable estate consisting of a residence, marketable securities and a $1,000,000 life insurance contract. By establishing the traditional Revocable Living Trust, including a Survivor's Trust, a QTIP Marital Trust, and a Family Exemption Trust you may reduce your federal estate tax at the death of the surviving spouse in 2007 from $1,300,000+ to approximately $400,000, a savings of nearly $900,000. Now establish an additional Irrevocable Trust to be the owner and beneficiary of the $1,000,000 life insurance policy, and also assume you survive three (3) years from the date of transfer (See IRC Section 2035 discussed below). The remaining $400,000 of estate taxation can be reduced to zero (0). Please understand this is an ideal situation. However, many estate plans can be designed to achieve similar favorable tax results.
An Irrevocable Trust may be designed to be funded with a "Survivorship" or "Second To Die" life insurance policy. This type of policy is one that insures both husband and wife, but pays off only at the surviving spouse's date of death. It is an ideal policy for married couples with an estate liquidity problem, because as a general rule the remaining federal estate tax burden can be deferred until the second death. Please also understand the Irrevocable Trust concept can also be easily tailored for a surviving spouse's income needs, as well as single client estate liquidity needs.
While all of the above Irrevocable Trust benefits sound very appealing, look before you leap, and consider the following technical issues:
1. Irrevocability: The most important consideration is to realize once this Trust is established, it is irrevocable and cannot be amended. As the insured, you will no longer retain any "incident of ownership." Therefore, you cannot borrow against the policy. However, the Trustee may always purchase additional life insurance.
2. Trust Creation: Because this Trust is irrevocable, you do not approach its creation lightly. It must be drafted so that its terms are properly coordinated with your other estate planning documents. Do not rely on boilerplate forms. Remember you get what you pay for! In an ideal estate planning case, the Irrevocable Trust should be established before any life insurance is even applied for. By comparison, if you transfer an existing life insurance contract into an Irrevocable Trust on which you are the insured, and then die within three (3) years after the transfer its total death benefit value will be includable in your estate, and subject to federal estate taxation. Therefore, the Trustee should be the original owner, applicant and beneficiary of any new life insurance policy. If this latter procedure is carefully followed, the "three (3) year rule" under IRC Section 2035 is entirely avoided.
3. Transfer To The Trust: Because an Irrevocable Trust funded by a life insurance policy generally consists of no other assets, the Trustee must rely on transfers (i.e. gifts) from you, as the Settlor, to provide the funds needed to pay the premium. Transfers to an Irrevocable Trust are considered as" taxable gifts", unless they qualify under IRC Section 2503 (b) as a "present interest" gift for the $12,000 "Annual Exclusion." Various IRS and Court rulings have held that for such transfers to qualify as a "present interest" gift the Trustee must always notify all beneficiaries in writing of their rights to withdraw a "pro-rata" share of the gift. This right is frequently referred to as a"Crummey Power."
4. Trustee Selection The selection of the Trustee and Successor Trustee is a critical issue. As a beginning point, the Settlor should never be the Trustee. Likewise, I have serious reservations about naming a Settlor's child, spouse, or former spouse, as Trustee during the Settlor's lifetime. Because of the strategic importance of the Irrevocable Trust in your estate plan, the Trustee's selection should be closely coordinated with fiduciaries appointed in other documents. Ideally, the Trustee should be an independent third party (i.e., no family relationship).
5. Community Property Considerations: If the Trust is established in a community property state, and the insured's spouse is a trust beneficiary, the life insurance policy and all future transfers to the Trust must be the Settlor's " separate property". The eight (8) community property states are as follows: Louisiana, Texas, New Mexico, Arizona, California, Nevada, Washington and Idaho. Failure to carefully follow exact procedures for the creation of separate property will result in at least one-half (½) of the death proceeds being includable in the surviving spouse's estate.
6. Separate Tax Entity: All Irrevocable Trust's are required to apply for and have a separate Employer Identification Number (IRS Form SS-4). However, this does not mean that all such Trusts must annually file a Fiduciary Income Tax Return.
In conclusion, an Irrevocable Trust funded with a life insurance policy is well suited for the needs of various married and single clients wishing to avoid unnecessary federal estate taxation. However, as with all estate planning endeavors, the use of an Irrevocable Trust funded with life insurance should be approached with careful thought and the retention of expert legal counsel.
