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C. Life Insurance Trust

C. The Life Insurance Trust

This is a widely used, but unfortunate name for a Trust that is not really a special breed. A “life insurance” Trust is just any Trust, usually irrevocable, that is permitted by its terms to buy insurance. The Trust should be authorized to hold a wide range of investment vehicles, with no requirement that life insurance be purchased.

BEWARE ! The folks at IRS do not like the fact that life insurance enjoys some unique tax advantages. They search for ways to justify taxing it. Although many “Insurance Trusts” are named as such, placing the “I” word on the cover of the document only raises a red flag unnecessarily. It suggests that the Trust was created with tax planning in mind, and might be a good place for the IRS to look more closely. Instead, why not just call it “The Jones Family Irrevocable Trust”?

Why use a Trust to own insurance policies, anyway? First, remember that proceeds from policies you own will be included in your estate, even though paid to a third party. If an irrevocable Trust owns the policy, however, death proceeds can be received by the family income tax-free (as usual), yet not be included in your taxable estate. But a Trust is not necessary to get this result. For example, if a child owns, pays for and is beneficiary of a policy on the life of a parent, he/she can receive the policy proceeds with no tax consequences to anyone.

The real value of using a Trust to hold insurance is to provide for the use and management of the policy proceeds according to your wishes. The beneficiaries might not be old enough to manage a sizeable lump sum of money. Even if age is not a problem, lack of financial and investment savvy might be. Finally, having just lost a loved one, survivors tend to just not care about money matters. This is a terrible time to have to make important decisions. Not coincidentally, it is also a time when grieving spouses are most vulnerable to bad advice and scams.

To avoid estate taxation, the estate owner/insured must avoid all “incidents of ownership” in the policy. Obviously, this is why the insured should not own the policy outright. The IRS, however, looks (way) beyond the obvious for any controlling “strings” or links between the insured estate owner and the policy on his/her life. If any such connection is found, IRS often argues it is an “incident of ownership,” requiring that the policy proceeds be included in the decedent’s taxable estate. Unfortunately, “incidents of ownership” is not a clearly-defined concept, and the court decisions have not been uniform. So be careful, and seek good advice on this point.

Too often, an irrevocable life insurance Trust is prepared by an attorney as part of a family estate plan, but little guidance is offered on avoiding tax pitfalls. The family breadwinner, for example, often has a life insurance policy already, and is simply told by his/her lawyer to make it a gift to the Trust. That is easily done. It might not be so simple, however, to do it in a way that severs all the insured spouse’s “incidents of ownership” in the policy, to achieve the desired tax result. This is a matter on which professional tax advice should be sought.

Ideally, somebody other than the insured (or spouse) should be used as the Grantor of the Trust (e.g., an adult child) to apply for and buy the policy to begin with. If the child lacks funds to pay the premiums, this can be handled by unrestricted parental gifts of less than $12,000 per child from each parent, each year (as of 2006). Parents can always voice their desire as to how their gifts should be spent.

But if a formal agreement were made that the gifts would be used for insurance, IRS might consider that an “incident of ownership” in the policy by the parent. On the other hand, one has to assume the kids are not stupid. If they are not, it should be clear that future gifts would be in serious doubt if this year’s money is used to make a down payment on a luxury car.

Often, it is just not practical to obtain new life insurance. If the ideal situation is not attainable, you should recognize several potential problems to work around. Again, these arrangements should not be made without the advice of an attorney and/or accountant experienced in these matters.

An existing policy can avoid inclusion in your estate if transferred to an irrevocable Trust (and if you, as the insured/former owner retain no “incidents of ownership”). Try to wait three years before dying, however. Policies transferred to a life insurance Trust within three years of death will be included in the estate anyway. (Other property is not treated this way.)

When we speak of “transferring” life insurance policies here, it is always meant that the transfer will be a gift, and this is important. As a piece of property, an existing life insurance policy may also be sold by its owner. But in this situation, the special tax treatment given to the insurance is lost. The buyer is treated as having made an ordinary personal financial investment, and the proceeds will be taxed as income when received.

In the intra-family context, accordingly, there should seldom – if ever – be anything of value exchanged when a life policy changes hands. There is still the federal gift tax to consider, however. The taxable value of the policy must be established, and this is not always easy. Remember that a policy placed in Trust, is not a gift the beneficiaries can presently use, so the annual $12,000 gift tax exclusion (in 2006) is not available. The policy cash value is often worth more than $12,000, anyway.

A favorite area of IRS scrutiny is the source of premium-payment funds into the Trust. If it is determined that the funds are, in practical terms, under the insured’s control, the proceeds may be included in his estate, even though the policy is owned by the Trust. (That is why, although the insured estate owner might hope his gifts will be used for premiums, the gifts must truly be free and clear, with no requirement as to how the money is spent.) Certainly, too, the insured should not be a Trustee of the life insurance Trust or the policy proceeds may be included in his/her taxable estate.

The Trustee of an irrevocable life insurance Trust must be viewed by IRS as truly independent. Of course, the Trustee is made well aware of the family’s situation and desires, and might be expected to honor them. But he/she/it cannot just be a stand-in for the insured estate owner. (That is one advantage of using an institutional Trustee.) If the Trustee is believed to be a mere puppet of the Grantor, the policy proceeds will not be removed from the taxable estate. The primary (but not the only) purpose of the Trust would then be defeated.

TIP: Remember, too, that when IRS challenges something – like the independence of a Trustee – the examination is done after the fact, with 20/20 hindsight. The examiners do not care how good an arrangement looks “on paper.” The focus is on what actually happened, and what the final result was. (This advice applies to all tax questions and strategies, not just Trusts. That is why it is pointless to get too “cute” with one’s tax planning.)

BEWARE ! Sometimes, people run into trouble just because of what could have happened under the terms of the Trust in question. Example: Assume the Trustee of your life insurance Trust is not specifically prohibited from expenditures in fulfillment of your legal obligations, i.e., the Trustee could buy groceries for the kids, without violating the terms of the Trust document. (Remember, the Trust might well have liquid assets during your lifetime, besides the policy.) Assume further that the Trustee never did so, or had any thought of it. Still, IRS might argue that IF you had been in a bind, the Trustee could have helped you out. Therefore, your so-called “irrevocable insurance Trust” was just a nice, big safety net, that you were fortunate enough not to need. So, IRS might say, never mind the Trust; the policy proceeds should be included in the taxable estate anyway.

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