Filing income tax returns for life insurance trusts.

• Author: Koppel, Michael D.

As a general rule, life insurance trusts are grantor trusts. Because all the income, credits and deductions of a grantor trust are attributed to a grantor, a trustee does not have to file a Federal income tax return for the trust. The trustee, however, must notify the grantor of the items the grantor must report on his income tax return. On the grantor's death, or if the trust otherwise ceases to be a grantor trust, the trust may have to file Federal and state fiduciary income tax returns and provide its beneficiaries with a Form K-1.

Estate planners often draft intentionally "defective" insurance trusts, under which the grantor is taxed for income tax purposes without causing the inclusion of the proceeds in his gross estate. The intentional deficiencies are generally what make a life insurance trust (which ordinarily would be a complex trust) a grantor trust for tax purposes.

If a life insurance trust qualifies as a grantor trust, it does not have to file tax returns, particularly when the only asset owned by the trust is a life insurance policy on the life of the grantor, the grantor's spouse or both. Generally, the grantor must make annual gifts to the trust, from which it can pay the life insurance premiums. Because the inside, "build-up" on a life insurance policy is not taxable, the trustee will have no income to report to the grantor.

If a life insurance trust does not qualify as a grantor trust, it will most likely be a complex trust. If an insurance trust is a complex trust, it must file tax returns based on the regular rules for filing returns. Thus, for example, if the trust's only asset is a life insurance policy, the trust would not have to file income tax returns, because it does not have gross income of $600 or more or any taxable income.

Exhibit 1 presents a checklist for deciding if an insurance trust is a grantor trust or a complex trust.

Exhibit 1: Checklist for Determining If an Insurance Trust Is a Grantor Trust for Income Tax Purposes

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Sec. 677(a)(3) states that a grantor is treated as the owner under Sec. 677(a) of any mast or portion of a trust the income from which can be used, without the consent of an adverse person, to pay the premiums on policies of life insurance on the life of the grantor or the grantor's spouse (except for policies of insurance irrevocably payable for a charitable purpose).

Factors that give a trust grantor trust status for income tax purposes:

* Does the trust provide...