There are a number of estate tax implications that must be considered with respect to revocable life insurance trusts. One concerns the inclusion of trust assets. A second relates to the taxation of proceeds from policies owned by a third party but payable to the revocable trust. A third concerns the mechanism through which policy proceeds payable to a revocable trust can be used to provide estate liquidity.
- General estate tax inclusion issues – Picture the box that represents a trust. Now imagine that the client retains a string on that box, enabling him to pull back the assets in the box at any time or use the income from the assets in the box for any purpose. Precisely because the client retains until death that right to alter, amend, revoke, and terminate the revocable trust, all the assets in such a trust will be included in the client’s estate. The provision encompassing such transfers is IRC Section 2038 which deals with lifetime gratuitous transfers in which the transferor retains the right to alter, amend, revoke, or terminate the gift. So revocable trusts—contrary to what is sometimes conveyed to the public—provide absolutely no shelter from the federal estate tax. Policy proceeds and any other assets in the trust at the client-grantor’s death are estate tax includable. However, this may not be an issue for most people, as the federal estate tax exemption became $11 million effective as of January 1, 2018 and is indexed annually for inflation.
- Third party owner issues – Can the IRS include a life insurance policy in an insured-decedent’s estate merely because the policy names a revocable trust established by the decedent as beneficiary? The IRS has (unsuccessfully) argued that by virtue of his power to appoint (i.e., direct the disposition of) trust property, the grantor of a revocable trust had to include in his estate a policy on his life purchased and owned by his spouse. In other words, through the ability to change the trust and its beneficiaries, the husband had the indirect ability to change the beneficiary of the life insurance. But the court held that unless the property over which one holds a power was in existence prior to the decedent’s death, there is nothing to tax. In this case, the insured-decedent had a mere expectancy.
But there are other traps for the unwary. For instance, the IRS will argue that even though the proceeds may not be estate tax includable under these facts, when the insured’s death occurs, the surviving spouse (who was the policy owner) is deemed to have made a gift to the other beneficiaries. For instance, if the trust set up by the deceased insured provided income to the surviving spouse for life with the remainder passing at her death to her children, the IRS would claim that, at the moment the insured died, a gift equal to the present value of the children’s remainder interest was made by the wife. Worse yet, since the surviving spouse is deemed to have made a gift (the remainder interest) but retained a lifetime income from the gift, the IRS would claim that the entire amount in the trust at the time of her death should be included in her estate.
- Providing estate liquidity – The trust document should provide that assets in the trust at the decedent-insured’s death can (or even must) be used to: (a) pay the expenses, administrative costs, and taxes of the estate; and (b) of the surviving spouse’s estate if other funds are not available. But planners should note that if the surviving spouse is the trustee or has the power to appoint the trustee, the IRS could argue that the proceeds should be included in the surviving spouse’s estate to the extent those proceeds could be used if the trustee is required (or even authorized) to pay the surviving spouse’s debts, administrative expenses, or taxes.
Of course, the revocable life insurance trust—although not technically an estate tax planning vehicle—can save estate taxes and thereby enhance relative liquidity by including provisions that create a combination of a Credit Shelter Trust (a.k.a., Bypass Trust) and a marital trust upon the death of the grantor. The revocable trust would allocate a portion of the grantor’s estate into the Credit Shelter Trust so that an amount equal to the federal estate tax exemption (equal to $11,400,000 in 2019, as indexed for inflation) would pass to it without federal estate tax, and the balance of the assets passing into the trust would pass to the surviving spouse in a manner qualifying for the marital deduction. It should be noted that the need for the use of a Credit Shelter Trust for individuals dying after 2012 is substantially diminished due to the combination of a high federal estate tax exemption and enactment of portability rules which enable a married couple to use any remaining federal estate exemption at the second death that was unused at the first death.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM