Insurance Trusts Provide Tax Benefits
Life insurance often forms a large part of a family’s estate. Your family may not need the insurance proceeds to live on. However, the insurance may be necessary to provide estate liquidity, so that debts and estate taxes can be paid without having to sell off assets. Unfortunately, life insurance forms the IRS’s major source of estate tax revenue. The IRS will take up to half of the life insurance benefit. But, with proper planning your family doesn’t have to give the IRS a dime of the insurance proceeds.
Most people mistakenly believe that their life insurance proceeds will pass tax free to their family. Life insurance benefits are not taxed as income to the recipients, but they are taxed as part of the decedent’s estate, and the IRS isn’t shy about taking half of the insurance proceeds, even if your family needs the money to live on. That’s probably not what you had in mind when you paid your premiums.
Making life insurance benefits pass to your family without any income or estate tax is relatively easy, even though few people do it. All you need is an irrevocable life insurance trust (ILIT). The trust is used to hold the insurance outside of your estate, so that it can be used for your beneficiaries without any estate taxes or income taxes being imposed on it. However, when you use an insurance trust you have to make sure that it is properly written and operated, so that the IRS won’t disallow the favorable tax treatment. This article will give you a checklist to help determine whether or not you need an insurance trust, and if you already have an ILIT, it will show you whether or not your insurance trust is going to give your family the tax benefits that were promised.
Insurance Trusts Must Be Irrevocable
An insurance trust should not be confused with a revocable living trust which is established to help avoid probate and divide the estate between a husband and wife so that they can each take advantage of the maximum unified credit and reduce estate taxes. If your “insurance trust” is established as a revocable trust, you will not get the desired tax benefits. An insurance trust must be irrevocable. Once it is put in place, the terms of the irrevocable trust cannot be changed.
The Right Trustee Is Required
If you establish the trust and you are the insured, you cannot serve as the trustee. In theory, anyone else could act as the trustee. Your spouse is probably your second choice as trustee, but it is very dangerous, because the trust has to be written exactly right. It’s like walking a legal tightrope. Even if the trust is exquisitely drafted, if the spouse wants to act as the trustee they have to be exact in performing their fiduciary duties. Even if your attorney is meticulous and specialized in drafting insurance trusts, it is often best to have an independent trustee. An independent trustee is an individual who is not a blood relation to you or your spouse. Also, it can’t be anyone you have control over, such as a full time employee. Banks, CPAs, and close friends with business sense make good choices for trustees. If you are given power to do things like borrow from the cash value, change beneficiaries, or any one of a dozen other powers, even if you never exercise any of the powers, the IRS will determine that you have an “incidence of ownership” over the policy and the insurance proceeds may be taxed in your estate.
Trust Must Own the Policy
Ideally, the trust will purchase, as owner, the life insurance with you as the insured. Existing policies owned by you or your spouse can be transferred to the trust’s ownership by filling out a change of ownership form supplied by the insurance company. You are making a gift of the insurance policy to the trust when you transfer ownership from you to the trust. If there is cash value in the policy, there may be a gift tax due. Additionally, you must live at least three years from the date of transfer. Otherwise, the insurance proceeds will be included back in your estate and be subjected to estate taxes. When estate taxes are calculated, your attempt to transfer the policy will be “undone” by the IRS. If the insurance trust is the original owner of the policy, no three year rules apply.
Ownership Rights Transferred
If you retain any “incidents of ownership” in your life insurance policy, the policy will be included in your estate and taxed at your death. Incidents of ownership include any economic interest, the power to change a beneficiary, to surrender or cancel the policy, to assign the policy, to pledge the policy, or borrow the cash value. Basically, all of your rights have to be given up or you will have the policy taxed as part of your estate. The reason you can’t act as trustee is because as trustee of your own policy you are considered to have rights that are “incidents of ownership.” If an independent trustee holds the rights as trustee, you are safe. You won’t be considered as having any incidents of ownership over the policy.
Paying Insurance Premiums
Life insurance trusts are usually not funded with enough property to generate sufficient income to pay the policy premiums. So, money has to be “gifted” to the trust each year. If the trust is established with a “Crummey Provision,” your gifts to the trust will usually qualify for the “annual exclusion,” and there won’t be any gift taxes owing on the gift to the trust. A man named Crummey took on the IRS in court and established the rules that must be followed in order to get the gift tax exclusion, thus the “Crummey Provisions.”
The rules require gifts to the trust to be made in time so the beneficiaries have at least 30 days prior to the end of the year in which they can remove the gift from the trust and spend the money gifted to pay the premiums. The beneficiaries usually know that it is to their advantage to leave the money in the trust. They have to be given written notice of the gift and their right to remove the gift from the trust. Keep good records on all of these fine points, because the IRS will be watching. Even though the gifts may not generate a gift tax, the gifts are not deductible from income as expenses, i.e., an after tax dollar has to be use to make the gift.
With proper planning it is possible to make life insurance premiums a tax deductible expense. Some cafeteria plans or welfare benefit plans permit the participants to purchase some life insurance in group term insurance, and the premiums are tax deductible to the company and employees. However, the larger premiums associated with key man insurance, buy-sell agreements, and larger estate needs are only tax deductible if they are structured though some sort of a benefit plan, such as a Voluntary Employee’s Beneficiary Association (VEBA).
If you already have a life insurance trust, review it to make sure that it meets the requirements to avoid estate taxes. If you don’t have an insurance trust yet and you have a good sized estate of several million dollars (including the life insurance), an irrevocable life insurance trust can be a great benefit to your family and estate. It can be worth millions of dollars extra to some families and hundreds of thousands of dollars extra to a lot of families.