Anthony S. Danna, Esq. 

A life insurance trust can save on estate taxes

When you created your estate plan, did you consider how your life insurance policy might affect it? The Internal Revenue Service thinks about such issues all the time, and that means it could cost your heirs dearly.

The IRS may tell your heirs that the policy's death benefits have pushed the estate's value over the $1.5 million limit that can be passed on to them tax-free. So instead of getting all of your inheritance, some of it will go to Uncle Sam. At the very least, it could increase the amount owed to the government.
The implications of owning a life insurance policy can be very costly. It even beats cross-ownership policies, in which each spouse owns the other's life insurance policy. There are drawbacks to cross-ownership policies that you should consider by looking at our sidebar on cross-ownership.

An irrevocable life insurance trust may be the solution for you.

What is it?
An irrevocable life insurance trust is a trust that owns your life insurance policy (or policies). It pays the premiums to keep the insurance in force, collects the death benefits when you die, and distributes the money according to the terms of the trust. Since you don't own the insurance (the trust does), the proceeds aren't included in your estate.

You can determine the trust terms when you set it up, but you can't change your mind later on. So if two of your three children turn out to be model citizens and the third one blows through money like water, you can't change the trust to cut out the wayward one.

The idea is to keep the money your heirs will receive from your insurance policy from getting hit with estate taxes. If you have an estate with assets that might exceed the 2005 maximum of $1.5 million, the proceeds from your policy could get taxed. By putting it in a trust, you keep Uncle Sam from getting a slice.

Setting it up
The process of setting up an insurance trust and keeping it running until your death involves four steps:

1. Have the trust drafted by an attorney. Find an attorney who specializes in estate planning for this step. These trusts are complicated and will likely be in effect for many years. You may want to use this attorney as your trustee as well.
2. Put the policy in the trust. You can transfer an existing life insurance policy to the trust, or the trustee can apply for a new one on your life.
3. Fund the trust. Make a gift to the trust of the first year's premium so the trustee can make the annual premium payments.
4. Make annual gifts. Each year, make a gift to the trust at least 30 days before the premiums are due. You want to make your payments "present interest gifts," so that you can use up your annual exclusion of $11,000 per beneficiary without having to pay gift taxes.

To make the gifts, have your trust drafted with Crummey powers (named after a famous court case). Every year, the trust beneficiaries must be notified of the amount that has been given to the trust. They then have 30 days to withdraw any amount in excess of their share of the gift.

Obviously, you want to tell your children of the irrevocable trust in advance so they don't withdraw the funds. After 30 days, when their power of withdrawal lapses, the trustee then writes a check to the insurance company.

There are a few caveats:

• If you die within three years after the policy has been transferred to the trust, the insurance proceeds are considered part of your estate.
• The transfer of an existing policy to an irrevocable life insurance trust is considered a taxable gift. You can apply it to your unified credit amount if you have not already used it up, so that no taxes would be due. If it's a term insurance policy, the value of the gift is the current year's premium. If it's a permanent policy, the value of the gift is the cash value amount at the time of transfer.

If you use a new policy, you should set up the trust, fund it with the first year's premium, and have the trustee apply for the insurance. That way you avoid the two potential problems just mentioned of using an existing policy.

Pros
The benefits of an irrevocable life insurance trust are many:

• The proceeds of the policy are out of your estate and free of estate taxes.
• Since the trust does not pass through probate, the provisions are confidential.
• The trust can't be challenged by disgruntled beneficiaries.
• If you're married, the proceeds aren't in your spouse's estate either. But you can have provisions in the trust that pay income to your spouse during his or her life or to allow the trustee to supplement your spouse's income to maintain his or her lifestyle or to handle unexpected expenses. It solves the problem of children owning your insurance. Minor children can't own insurance policies, and adult children may disagree about paying the premiums as required by the trust. Recall that you're making gifts to the trust in your children's names and each one has the prerogative to request the cash.

Cons
Irrevocable life insurance trusts are not without their drawbacks, however:

• Once you set up the trust, the terms are etched in stone. You can't change anything. All you can do is stop making premium gifts so that the insurance will lapse.
• Once you transfer your life insurance policy into the trust, or if your trustee applies for a new policy, you must give up all control over the policy to keep the proceeds out of your estate. This means you can't have any "incidents of ownership." Incidents of ownership are defined as any conceivable way the government can think of that would allow you to change the beneficiaries, get out some cash or change the trust's terms.
• If you want to keep the policy in force, you (or someone) must continue to make the premium payments. This is one reason why, if you're using permanent insurance, it's wise to purchase the policy on a "vanishing premium" basis -- at some point, the cash value and interest or dividends will be enough to keep the policy in force without additional premium payments.

If it looks as if your heirs are going to get hit with estate taxes, an irrevocable life insurance trust may be just what your estate attorney ordered.

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