Irrevocable Life Insurance Trust

Life insurance has become a frequently used tool in estate planning. Most individuals are familiar with it and utilize it due to its common nature. But the effects of using life insurance as an estate planning tool really are not that simplistic. Gone are the days when the insured being the owner is the norm - there are now dozens of advantages and disadvantages to using life insurance, depending on who (or what) owns the policy. Most of you are aware of the fact that if you own a life insurance policy of which you are the insured, the death benefits payable upon your death are includible in your estate for estate tax purposes. Whether or not the death value will be taxed depends on whom you have named as the beneficiary of that policy. If you have named your spouse as the beneficiary, the unlimited marital deduction will prevent the proceeds from being taxed at your death. Nevertheless, if those proceeds remain in the estate of the spouse, they will be included in the spouse’s estate upon death. The key to taxation of life insurance proceeds revolves around the ownership of the policy. The irrevocable trust is one technique utilized to address the issue of ownership.

An irrevocable trust is just that, irrevocable. Once an individual creates such a trust, the terms of the trust contract can not be changed. As such, the individual gives up all control and capability of management over any assets owned by such a trust. Therefore, the Internal Revenue Service recognizes the fact that under such a scenario, the assets included in this type of trust cannot be included in the estate of the individual for estate tax purposes.

When an individual creates an irrevocable trust to hold the ownership of a life insurance policy, the policy proceeds are removed from the gross estates of both the insured and his or her spouse for estate tax purposes, assuming there is no direct policy transfer by the insured or the insured outlives any such transfer by three years. The insured’s spouse can and normally does have an interest in the trust after the insured’s death, as long as the policy is not a survivorship policy and he or she is not given an estate tax sensitive power or interest in the trust. For decedents dying after 1981, this is the only way to do more than defer the tax and give the spouse any benefit from the proceeds.

The general advantages of naming a trust as the beneficiary are as follows:

  • flexibility
  • protection of the beneficiaries against creditors’ and spouses’ claims
  • investment management of the process
  • avoidance of the generation-skipping transfer tax altogether, if the trust can be arranged to be effectively exempt from the tax by application of the insured’s GST exemption (and that of the spouse) or by relying on the non-taxable gift exception to the GST.

The proceeds can be made available to the executor to pay costs and taxes of the insured’s estate by a loan, purchase of assets or direct payment. Each of these techniques has its possible disadvantages; perhaps, the purchase of assets concept makes the most sense - assuming a stepped-up basis for the assets at death.

Another advantage is that is solves the problem of the primary beneficiary’s death before the insured’s. It also avoids the problem of the possible incompetence of the policy owner, the potential frustration of the insured’s plan by the owner during the insured’s life; and the problems of multiple and/or potentially legally incompetent owners.

Under state law, naming a trust as the policy owner provides creditor protection for the policy during the insured’s life. It also can provide creditor and spousal protection for the beneficiaries.

The policy, although beyond the insured’s direct control, is in the hands of the trustee chosen by the insured to carry out the terms of a trust created by the insured. Therefore, this is a fairly - but by no means totally - comfortable arrangement for most insured’s once the decision has been made to give up policy ownership.

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