Life Insurance Trusts
By Stuart G. Schmidt, Esq.

While it may be desirable to obtain life insurance to provide financial protection for your dependents or beneficiaries, the proceeds of any life insurance policy which you own are subject to estate tax. An irrevocable life insurance trust offers a solution by allowing your beneficiaries to receive the proceeds in a manner you direct without any payment of estate tax. If you already own life insurance, the life insurance trust can save your beneficiaries from paying substantial estate tax, provided you survive three years after transferring the policy.

Instead of purchasing or owning the life insurance yourself, a separate life insurance trust can be created to own the life insurance policy. The primary objective of a life insurance trust is to provide your loved ones with the full financial protection of the life insurance proceeds by avoiding the payment of estate tax. If you are married, a second objective is to avoid estate tax on the death of your spouse while still providing the surviving spouse with the financial security of all the life insurance proceeds. If these objectives are met, a life insurance trust can provide the financial protection originally desired without reduction through the payment of estate taxes which start at rates of 37%.

The Attributes of a Life Insurance Trust

Irrevocable: A life insurance trust is irrevocable. After it has been established none of its terms can be changed.

Trustee: As with all trusts, a trustee is required for a life insurance trust. The trustee can be an individual or a bank. However, the trustee cannot be you, and in many cases it is inadvisable to have your spouse serve as trustee.

Obtaining or Transferring Life Insurance: If you are obtaining a new life insurance policy, the application should be made by the trustee of the trust, rather than by you as an individual. In order to avoid the payment of estate tax on existing life insurance you can transfer the policy into a trust but you must live for at least three years after the transfer.

Ownership/Beneficiary: The trustee of the trust will be both the owner and the beneficiary of the life insurance. This means that at your death the life insurance proceeds will be paid into the trust.

Paying the Premiums: The trustee will need to make the insurance premium payments to the life insurance company. Because the trust will not likely have any funds to make the premium payments, you will need to transfer funds to the trustee who will then make the premium payments. Because your payments to the trust are actually gift (and thus subject to gift tax), the payments of premiums need to be handled in a special manner to avoid a gift tax. This is explained further below.

Trust Beneficiaries

You will need to choose the beneficiaries of the trust who will ultimately receive enjoyment of the life insurance proceeds. The beneficiaries must be chosen when you set up the trust and they cannot be changed later. Often the beneficiaries of a life insurance trust are the same beneficiaries as under your will or living trust. If you decide to include your grandchildren as beneficiaries, you will need to take into consideration the effect of the Generation Skipping Transfer tax (a separate transfer tax which is assessed on transfers that skips a generation).

Distribution of the Life Insurance Proceeds

Generally, no distributions are made from the trust until after your death and the collection of the life insurance proceeds. The trust can provide for immediate distribution of the proceeds or direct that the proceeds be held in trust for a period of time. Holding the assets in trust is particularly useful with young beneficiaries. The proceeds can be held in trust for one or more beneficiaries and the trustee can be given the power to use the proceeds to provide for the beneficiaries' needs such as health, education, support and maintenance. The trust can also allow for partial or lump sum distributions at a different times depending on the age of a beneficiary (such as 50% at age 25 and 50% at 30).

Life Insurance Proceeds Provides Liquidity to Pay Estate Tax The proceeds of the insurance policy will also provide liquidity for your estate. If because of other assets your estate is subject to estate taxes, the proceeds can be used to purchase assets of the estate. The estate will then have cash available to pay any estate tax without having to sell assets of the estate, such a residence or business.

Contributions to the Trust to Pay the Premiums

Any contribution to the trust to pay life insurance premiums is a gift to the beneficiaries of the trust and thus may be subject to gift tax. Generally, you will want to keep annual transfers less than $10,000 per beneficiary so that your contributions will qualify for the $10,000 annual exclusion. However, the $10,000 annual exclusion is only applicable if the gift is a present interest (i.e. the beneficiary has an immediate right to enjoy the property). In order for a gift to meet this "present interest" requirement, the beneficiary must have a right to withdraw any contribution made to the trust for at least a thirty (30) day period before the contribution is used to pay the life insurance premium. In order to provide this withdrawal right, a special power (called a "Crummey" power) is given to a beneficiary to allow the beneficiary to make a withdrawal of the contributed amount. Clients are sometimes concerned that beneficiaries will actually exercise their withdrawal rights and take the contributed amount. While the beneficiary must be given a legal right to withdraw the money, as a practical matter a withdrawal usually does not occur. Most beneficiaries realize that if they exercise the right, it will be contrary to your wishes and jeopardize further contributions to the trust. It is imperative, however, that there not be a prearranged plan that the powers will not be exercised, as this would enable the IRS to contend that the withdrawal power did not really exist. If a beneficiary is not given a legally enforceable right of withdrawal, gifts to the trust will not qualify for the $10,000 annual exclusion. This will mean that your transfers into the trust will have the undesirable effect of using up part of your $650,000 lifetime applicable exclusion amount (an amount that is scheduled to increase to $1,000,000 by 2006).

Despite these complicated rules, Life Insurance Trusts are relatively easy to administer with proper guidance. Upon proper implementation, a Life Insurance Trust ensures tremendous estate tax savings. It enables all the life insurance proceeds to pass to your dependents or other beneficiaries completely estate tax free and provides them with the maximum financial security.

If you have any questions and/or would like to set up a free consultation, please do not hesitate to call me at (408) 356-3000 or contact me via e-mail at sschmidt@smwb.com.