Irrevocable life insurance trusts.

AuthorDonato, Linda Fiorentini

Life insurance is a significant component of almost every estate, and especially those encompassing closely held businesses. It has become a very important estate planning tool for solving a variety of estate planning problems, including liquidity, providing income for surviving spouses or heirs, and funding buy-sell agreements among the owners of closely held businesses. Proper planning is critical, and often includes the use of an irrevocable life insurance trust. This article will address the gift and estate tax considerations of unfunded irrevocable life insurance trusts; illustrate by a comprehensive example with applications throughout the article the practical issues associated with the use of such trusts, as well as the significant estate tax savings realized by having a trust own the life insurance policy; and explain the use of a split-dollar arrangement between a shareholder and a closely held corporation, including an S corporation.

Overview

Individuals with estates in excess of $600,000 ($1.2 million for married couples) may find significant estate tax savings available through the use of an irrevocable life insurance trust. A properly designed irrevocable life insurance trust will shield life insurance proceeds from estate taxation. In order to achieve this savings, the trust must be the owner of the life insurance policy. The grantor of the trust must forgo control over the policy, at the same time (since the trust is irrevocable) relinquishing the power to change the terms of the trust agreement.

Generally, life insurance proceeds are includible in the insured's estate.(1) The test is whether the deceased retained "incidents of ownership" over the policy. If "incidents of ownership" are retained, the face value of the policy is included in the decedent's estate on his death. If he can avoid the "incidents of ownership" test, the proceeds from the insurance policy can escape estate taxation. Thus, from an estate tax perspective, the goal of a life insurance trust is to remove "incidents of ownership" from the decedent, while accomplishing the decedent's other objectives (providing liquidity, funding a buy-sell or providing a source of income to another person) of owning the life insurance policy. The trust agreement must be designed properly and must contain language sufficient to shift the ownership of the policy from the grantor to the trust.

There are numerous advantages to having a trust own life insurance, including:

* The grantor can dictate restrictions and limitations on the use of policy proceeds. Spendthrift provisions or similar clauses can be included in the trust.

* The trust can essentially provide unlimited settlement options. Multiple beneficiaries can be provided for through the use of sprinkling powers. Contingencies (such as divorce, remarriage, after-born issue and similar events) can be easily provided for.

* Collection and management of multiple policies (along with testamentary or inter vivos transfers of other property) can be consolidated and coordinated.

* The expense and inconvenience of guardianship proceedings for minor beneficiaries can be avoided.

* Policy proceeds can avoid one, and possibly two, generations of estate taxes.

* Some income tax savings may be possible through accumulation and sprinkling provisions (use of the 15% versus 36% or 39.6% tax brackets).

* The trustee can be granted great investment flexibility and discretion.

* The estate of the grantor/insured can be provided with the liquidity to pay estate taxes, debts and expenses or to fund the purchase of business assets from the estate.

For a variety of reasons, life insurance trusts are unfunded. An unfunded life insurance trust requires an annual gift to the trust to pay the insurance premium. The gift must be one of a present interest in order to qualify for the $10,000 annual gift tax exclusion.(2) A gift to a life insurance trust will normally be a future interest unless certain "demand provisions," often referred to as Crummey withdrawal provisions,(3) are written into the trust agreement. Thus, it is important that the trust be structured to make maximum use of the $10,000 annual donee exclusion. (The use of the Crummey power is explained in detail later.)

Comprehensive Example:

Using a Life Insurance Trust

The examples that appear throughout the article, which apply the facts below, illustrate the use of a life insurance trust in the estate tax planning for a married couple with three children.

* Facts

Husband H is 40 years old. He is- the president and sole shareholder of X, an S corporation. H and his wife, W, have three children. Their oldest son, S1, is employed by X and has the requisite skills to run the business in the future; their daughter, D, and younger son, S2, are currently attending college. D wants to be a doctor and it is doubtful that she will work in the family business. S2 is a skilled musician and wants to pursue a music career. X is very profitable, and H can foresee that the value of his estate on his death could be significant. Currently, H estimates that the value of the business is approximately $4 million. He wants to expand the distribution business and keep it in the family, with S1 at the helm. The chart below represents H and W's "estate tax" balance sheet.

Assets Liabilities Cash and liquid assets 9 500,000 Credit line $ 100,000 Closely held Advances business 4,000,000 from X 150,000 Residence Mortgages and land 700,000 and bonds 950,000 Life insurance policy ($70,000 cash value) 2,000,000 Total Total assets $7,200,000 liabilities $1,200,000 Net worth $6,000,000 As shown, H currently has a life insurance policy with a face value of $2 million that he owns to provide for his wife and children in the event of his death. He has also decided to acquire an additional policy for $2 million to provide estate tax liquidity. The use of an unfunded irrevocable life insurance trust can save a substantial amount of estate taxes.

Example 1 illustrates the tax savings generated by establishing an irrevocable life insurance trust for the existing and new policies. Example 1: H's life insurance is transferred to an irrevocable trust (assumes no growth rate on his assets and that H dies after five years).

Transfer prior to death: Value at death (for estate tax purposes) Cash and assets $ 500,000 Business 4,000,000 Residence 700,000 Life insurance (two $2,000,000 policies) 0 Gross estate 5,200,000 Less: Liabilities (net of unified credit) 1,200,000 Taxable estate $ 4,000,000 By removing the life insurance from the estate, the value of the taxable estate is decreased by $4,000,000. Assuming the $4,000,000 is not taxed in either H's or W's estate and they are in the 55% estate tax bracket, the use of a life insurance trust results in an estate tax savings of $2,200,000 (S4,000,000 X 55%).

In its simplest form, an irrevocable unfunded life insurance trust is created by the grantor, H. H transfers all incidents of ownership of both policies with a total face value of $4 million (insuring his life) to the trustee. The primary beneficiaries of the trust are H and W's three children. The trustee designates the trust as beneficiary of the policies. Each year, H deposits to the trust sufficient funds to pay the premium on the policies. on his death (hopefully more than three years after creation of the trust), the trustee collects the policy proceeds, and invests and distributes them according to the provisions of the trust agreement. The results can be impressive. Assume that the annual premium on the policies is $30,000 and the death benefit is $4 million. If the policies are properly drafted and administered, each year H has made a gift of $30,000 (which qualifies for the annual gift tax exclusion), and $4 million passes free of estate and gift tax to the trust for the children. Assuming a marginal estate tax bracket of 55%, H has avoided $2.2 million of taxes had he owned the policy. A diagram of this simple irrevocable trust arrangement is on page 399.

Creating an Irrevocable Life Insurance Trust

An irrevocable life insurance trust is a trust established by the grantor (i.e., insured) to own and hold life insurance on his life for the benefit of the insured's spouse, children, grandchildren or other heirs. Ownership of a life insurance policy (usually on the grantor's life) is vested in the trust. A trust of this type is created inter vivos, or during the insured's lifetime. A testamentary trust, i.e., one created as part of the decedent's will, is not effective in removing the life insurance proceeds from the decedent's estate.

An irrevocable trust is used to separate ownership of the life insurance policy from the grantor. A revocable trust offers no estate and gift tax benefits because the grantor retains control over the corpus (an incident of ownership). One of the disadvantages of the irrevocable trust is that the grantor loses control of the trust assets. However, with the use of special powers of appointment, or simply not giving the funds to make premium payments, the grantor is able to exercise some influence over the trust.

* Funded vs. unfunded trusts

There are two basic types of irrevocable life insurance trusts - funded and unfunded. A funded trust, as the name implies, is funded with one or more life insurance policies and other income-producing assets. In a funded trust the income generated by the assets is used to pay all or part of the insurance premiums. One income tax aspect of using a funded trust to purchase life insurance is that, to the extent trust income is used to pay premiums on life insurance policies on the life of the grantor or grantor's spouse, the grantor will be taxed on that amount.(4)

The unfunded trust is much more popular, and is most preferred by estate tax practitioners An unfunded trust has as its sole asset ownership of the life insurance policy(ies), usually on the creator's life. Each year gifts are made to the trust to...

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