The goal of the irrevocable life insurance trust is to obtain the benefit of the life insurance proceeds for the beneficiaries of the irrevocable life insurance trust without subjecting the proceeds to federal estate taxes in the estate of the decedent-insured or the estate of the surviving spouse.
Proceeds held in an irrevocable life insurance trust, and the associated investment assets, escape federal estate tax on the eventual transfer to the children.
Table of contents
- Structure of Trust
- Operation During Lifetime
- Income and Principal Distributions During Surviving Spouse’s Lifetime
- Payment of Premiums
- Present Interest Requirement
- Crummey Withdrawal Rights
- Sample Language
- Payment of Premiums—Use of Applicable Credit Amount
- Trust as Owner and First Beneficiary
- Three-Year Rule
- Purchase of Assets From Estate
Structure of Trust
An irrevocable life insurance trust is an irrevocable trust established during the lifetime of the insured. Typically the insured person is the settlor of the trust.
The trustee must be someone other than the insured because the insured may not have incidents of ownership in the policy. Typically, the spouse or an adult child is the trustee.
Operation During Lifetime
During the lifetime of the insured-settlor, an irrevocable life insurance trust is typically relatively passive. The trust owns the policy. The premiums may be paid on an annual basis. Generally there are no distributions of income or principal to the family.
Income and Principal Distributions During Surviving Spouse’s Lifetime
The irrevocable life insurance trust generally provides that upon the insured’s death, the proceeds (and associated investment assets) will be held in trust for the surviving spouse and often for the children. After the death of the insured, the irrevocable trust is much like a Credit Shelter Trust. There may be distribution of income and principal for the health, support, maintenance, and education of the surviving spouse and children.
The surviving spouse may have a special power of appointment—to provide the flexibility to adjust to later developments in the personal and family circumstances of the children. Upon the surviving spouse’s death, the trust estate is distributed to the remainder beneficiaries, typically the children and grandchildren, and usually in trust. Distributions to the grandchildren can present significant generation-skipping transfer taxes which will be discussed in the next chapter.
From a federal estate tax perspective, the key is that the investment proceeds held in the irrevocable insurance trust are not included in the surviving spouse’s taxable estate. Like a Credit Shelter Trust, the irrevocable insurance trust makes it possible to pass assets to the second and third generation free of federal estate tax.
This can be effective planning.
Payment of Premiums
Present Interest Requirement
To make possible the annual premium payments, the settlor-insured generally makes gifts each year to the trust. Depending on the structure of the trust, these gifts may qualify for the annual exclusion.
As noted above in the chapter on gifts, the gifts must be a gift of present interest [§2503(b)]. To pay the premiums on the policy during the insured’s lifetime, gifts must be made to the trust of assets from which the trustee can pay the premiums on the policy.
Because there are no current income or principal distributions during the insured’s lifetime, the enjoyment of rights under the trust is postponed. Therefore, “Crummey powers” are needed so that the gifts of the amounts to pay the premiums each year are qualified as annual exclusions.
Crummey Withdrawal Rights
In the Crummey case [397 F.2d 82 (9th Cor. 1968)], beneficiaries were given an immediate right to withdraw assets added to a trust. The right of withdrawal extended for 30 days and then lapsed. The beneficiaries did not demand or withdraw any of the contributions to the trust, but the court held that the gifts to the trust were gifts of present interests. This resulted because the beneficiaries had a legally enforceable right to demand and withdraw the contributions to the trust under the terms of the trust document.
Eventually the Internal Revenue Service acquiesced to the holding in Crummey provided that in the cases involving minor beneficiaries there is “no impediment under the trust or local law to the appointment of a guardian and the minor donee has a right to demand distribution” (Rev. Rul. 73-405, 1973-2 C.B. 321; see Rev. Rul. 80-261, 1980-2 C.B. 279).
Crummey withdrawal rights are structured so that the power to withdraw will be limited and that there is adequate notice given to the beneficiaries who have the withdrawal rights. The beneficiaries are notified immediately in writing at any time assets are added to the trust. Then at least thirty days is given for the beneficiaries to demand their withdrawal rights over the assets contributed and described in that notice.
The Crummey withdrawal right and the lapse or failure to exercise the withdrawal right is a general power of appointment [§2514(b), (c)]. To avoid a taxable gift under the power of appointment rules, the withdrawal right is often limited to the greater of $5,000 or 5% of the trust principal [§2514(e)].
The withdrawal rights in trust would be established by language similar to the following:
ARTICLE 8: WITHDRAWAL RIGHTS
8.1 Withdrawal Right. In each calendar year in which a transfer or transfers are made by me to the trust, each descendant of mine who is living on the date of such transfer shall have the right to withdraw from the principal of such trust the lesser of (a) the full amount of such transfer or transfers divided by the number of my descendants living on the date of such transfer; (b) Twenty Thousand Dollars ($20,000), if my wife and I notify the trustee at the time of such transfer or transfers that my wife and I intend to consent under Section 2513 of the Code to treat such transfer as having been made one-half by each of us; or (c) $10,000, if my wife and I do not so notify the trustee.
8.2 Notice. The trustee shall promptly give notice to the person(s) with the right to withdraw under 8.1 with respect to any transfer of property specifying the date of transfer, the amount he or she may withdraw, and the date the withdrawal right terminates. The trustee may give such timely notice annually by furnishing to such person(s) a schedule of the anticipated gift transfers to such trust and the periods in which he or she may exercise such withdrawal rights ifsuch gift transfers are made as scheduled. If such person(s) is a minor or legally incapacitated person, such timely notice shall be given to his or her parents, legal guardian, or conservator.
8.3 Provisions Relating to Withdrawal Rights. The transfers referred to under the preceding provisions of this Article shall not include any transfers made at my death. Any right of withdrawal under 8.1 shall apply only against the principal of this trust and shall take precedence over any other distribution or application of principal directed or permitted under this trust agreement. Each such right of withdrawal shall be noncumulative and must be exercised within thirty days following the transfer which gave rise to such right by a written notice delivered to the trustee, provided in all events such right must be exercised by the last day of the calendar year in which a transfer is made. Exercise of any right to withdraw principal, in whole or in part, shall be by written notice to the trustee. To the extent a right to withdraw principal is not timely exercised, no further right of withdrawal shall exist with respect to such transfer. Any beneficiary entitled to demand a withdrawal from this trust may make such demand even though such beneficiary is a legally incapacitated person, in which event such demand may be made by such beneficiary’s conservator, if any. The specific dollar amounts permitted to be withdrawn from this trust during any calendar year under 8.1 are limited to some extent in accordance with certain sections of the Internal Revenue Code to cause the lowest federal gift and estate tax liabilities. If any one or more of Sections 2041, 2503, 2513, and 2514 of the Code is amended after execution of this agreement by me to increase the amount or amounts permitted to be transferred during a calendar year without incurring any federal estate orfederal gift tax liabilities, then the dollar limitations set forth under 8.1 shall be correspondingly adjusted to accomplish the tax planning objectives embodied in this agreement.
8.4 Mandatory Distributions to Maintain Insurance. The trustee shall apply the principal of this trust not required to make distributions under 8.1 first to maintaining the insurance policies which are trust assets.
Payment of Premiums—Use of Applicable Credit Amount
The premiums may exceed the annual exclusion for significant policies and/or older insured clients, even after gift-splitting is applied. The applicable credit amount is then available for use for gifts of the premiums. This is often a good use of the applicable credit amount because its use for premium gifts makes possible the eventual transfer of a much larger amount in insurance proceeds for the beneficiaries.
Trust as Owner and First Beneficiary
After the transfer of policy to the irrevocable insurance trust, the trust must be the policy owner. The trust is also the beneficiary of the policy and as noted above, receives all of the proceeds of the policy upon death of the insured.
The transfer of life insurance policies is included in the three-year rule. Suppose the insured dies within three years of transferring the policy to the irrevocable life insurance trust. In that case, the entire value of the life insurance proceeds is included in the decedent’s estate even though the policy is owned by the irrevocable life insurance trust (§2035).
Accordingly, when a client is considering purchasing a new insurance policy, it is preferable that the irrevocable insurance trust be established first and that the trust be the initial owner of the policy.
Suppose the irrevocable life insurance trust is the initial owner of the policy and the insured dies within three years of the purchase. In that case, the insurance proceeds will not be included in the taxable estate of the decedent-insured.
If, by contrast, the insured person acquires a policy and then transfers the policy to an irrevocable insurance trust, the insured-settlor must survive the transfer by three years to remove the proceeds from the estate.
Purchase of Assets From Estate
One of the primary uses of life insurance for estate planning purposes is to provide liquidity for an estate to pay taxes and other expenses of the estate. The terms of the irrevocable life insurance trust will provide that the trustee may purchase assets from the insured’s estate at fair market value. The life insurance provides the estate with the cash it needs for liquidity purposes.
The irrevocable insurance trust continues after such transaction, now holding assets purchased from the estate. The purchase of the assets from the estate generally does not trigger taxable gain to the estate (on the sale of assets to the insurance trust) because the assets have received a step-up in basis at the decedent insured’s death.