Advantages to Ownership of Life Insurance by an Irrevocable Trust

Incredible federal estate and state death tax savings are possible though an irrevocable trust which has as one of its assets a life insurance policy on the life of the grantor. For the highly successful individual, no means exists under current law to transfer large amounts of wealth and provide financial security that are as certain or as dramatic as the irrevocable life insurance trust.

Reasons for the popularity of this estate planning tool include almost all of the advantages listed for implementing revocable trusts and these important additional reasons:

  1. Federal estate taxes on millions of otherwise taxable dollars can be avoided, not only when the client dies, but also when the client’s spouse dies. Leveraging life insurance through tax savings in this manner means death taxes bypass both spouses’ estates and the amount effectively passing to heirs is substantially increased.
  2. State death taxes can be saved in the same manner as federal estate taxes. This advantage becomes particularly important in states that provide limited exemptions for life insurance proceeds and those that have high rates on transfers at death to persons other than spouses.
  3. In most cases, relatively little (and in many cases, no) gift tax is required to create and simultaneously shelter high amounts of life insurance from transfer taxes. At a relatively low gift tax cost (because the gift tax value of life insurance transferred to the trust is valued at its much lower lifetime value, in most cases the interpolated terminal reserve plus any unearned premiums on the date of the gift) the many times larger amount of the policy proceeds is removed from the client’s estate. This leverage is impossible to find with any other estate transfer tool or technique under current law.
  4. There will be no probate expenses, delays, or uncertainties with respect to the transfer of assets in an irrevocable life insurance trust. Had the surviving spouse owned the coverage on her husband’s life, proceeds she didn’t exhaust during her life would be subject to both federal and state death taxes and probate costs.
  5. By making loans to the client’s estate or purchasing assets from the estate, the trustee can use trust assets at the client’s death to help provide estate liquidity, prevent a forced sale of a family business, valuable real estate, or a securities portfolio, and keep treasured property in the family. Furthermore, because the life insurance used to make that loan or purchase is not included in either spouse’s taxable estate, the irrevocable life insurance trust provides estate liquidity without increasing the liquidity problem. Had some other third party policy ownership arrangement been used, it is possible that such a person, depending on the terms of the insured’s will or that person’s relationship with the other beneficiaries, may be unwilling to make loans to the estate or purchase assets from the estate with the proceeds.
  6. Significant income and capital can be provided for, or on behalf of, the surviving spouse without causing inclusion of the life insurance proceeds or other trust assets in the surviving spouse’s estate.
  7. The irrevocability of the trust generally translates into protection from the claims of creditors.
  8. Trusts that are irrevocable generally provide protection from a surviving spouse’s rights of dower, courtesy, or right of election under state law.
  9. A gift of an insurance policy to a life insurance trust gives the insured more control over the ultimate disposition of both the policy and its proceeds than would an outright policy gift. In other words, when an irrevocable trust is the owner of life insurance on the client’s life, the client controls the ultimate disposition of the policy after the surviving spouse’s death through provisions in the trust. It also resolves the problem of what happens to the policy if the third party owner predeceases the insured. An individual donee policyowner can give or bequeath the policy to third persons, frustrating the insured’s planned use of the proceeds. The use of a trust provides greater assurance that the proceeds will be used for the grantor’s intended purpose. For instance, if a client transfers a policy to a potential beneficiary, such as a child, and that party predeceases the client, it is possible that the policy would revert back to the client and end up being taxed in the client’s estate. The use of an irrevocable trust can prevent this result. The irrevocable trust also reduces the potential that a policy owned by a spouse on the other spouse’s life will inadvertently lapse upon the death of the owner prior to the insured.
  10. Sprinkle and spray powers (i.e., giving the independent trustee discretion to sprinkle income and spray capital among the trust’s beneficiaries in the manner that best meets the client’s dispositive objectives and the beneficiaries’ needs and minimizes the income taxes of the family unit) are highly advantageous. Most importantly, the trustee can deny payments, when appropriate, on a more objective basis and with less potential for family conflict than if a family member received the insurance proceeds and then attempted to provide family security.
  11. When compared to the use of settlement options (an often overlooked alternative to trusts in small estates), the trust offers greater flexibility and, in some cases, an opportunity for increased capital and income. A trust can provide for payments according to the beneficiaries’ needs and circumstances by giving the trustee sprinkle and spray powers and by giving beneficiaries limited powers of appointment. This is particularly important where a primary function of the trust is to fund a large security reserve for beneficiaries who are inexperienced, minor, or disabled. The trustee can be authorized to invest aggressively to maximize income and growth (but in comparing trusts to settlement options, planners should also consider the increased risk).
  12. Generation-Skipping Transfer (GST) tax problems can be reduced or eliminated by judicious use of GST tax annual exclusions and the GST tax exemption. Significant leverage can be obtained through the use of life insurance inside the trust.
  13. Wealth replacement is another advantage to the use of irrevocable life insurance trusts. A client may want to make a tax deductible gift to a charity during lifetime or at death, yet replace the net after estate tax wealth his heirs would have received had no charitable gift been made. This goal can be accomplished through gifts to an irrevocable trust followed by a purchase by the trustee of life insurance on the client’s life in an amount sufficient to replace the (after estate tax) value of the donated land, stock, or other gift made to charity.
  14. Clients who establish GRITs, GRATs, or GRUTs3 or charitable lead trusts and who die during the initial term of the trust will have all or a large portion of the trust’s assets included in their estates. If the client survives that term, nothing will be included in the client’s gross estate and great wealth can be shifted at a gift tax discount. Clients can insure the estate tax savings by making annual gifts to a trustee who uses the money to purchase insurance on the client’s life equal to the potential estate tax savings.
  15. An often overlooked advantage of an irrevocable life insurance trust is that through the leverage of life insurance and the flexibility of the trust vehicle, even a person of modest means can be assured that adequate financial security and the achievement of important and costly economic goals such as the education of children or grandchildren can be met.
  16. An irrevocable trust provides all the above advantages, in addition to the classic uses for trusts in general: professional management, protection from creditors, postponement of receipt of inheritance, and avoidance of guardianship for minors or other incompetents.
Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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