Last-to-die (or second-to-die) policies pay at the second death, regardless of which insured dies first. These survivorship contracts are often used in estate planning with irrevocable trusts for the following reasons:
- The payment pattern of last-to-die policies often tracks with the estate’s need for cash; by paying proceeds only after the survivor of the insureds (typically, a husband and wife) has died, the event which creates the need for the greatest amount of federal estate tax creates the cash to solve that liquidity problem. But planners should note that, even with married couples who will eliminate all or much of the federal estate tax at the first death through the marital deduction, not all of the demand for cash is delayed until the second death. In fact, a distressing amount of money is needed to pay off debts, expenses, and state death taxes at the first death. Also, a surviving spouse can, and often will, survive for decades and need hundreds of thousands of dollars to provide food, clothing, and shelter, as well as education for herself and the couple’s children.
- Last-to-die policies require a lower outlay than if the same amount of coverage were obtained on the older of the two insureds, since: (a) the premium will in many cases be paid for a longer period of time; and/or (b) the insurer will have the use of policy dollars for longer periods of time. (The probability of two people dying in the early years of a contract is much less than the probability of one of those persons dying during such period.)
From a planner’s perspective, last-to-die policies placed in an irrevocable trust present potential problems not raised with regular policies because, for tax purposes, both spouses are insureds under a last-to-die policy. Here are some guidelines:
- If either insured spouse is a grantor of the trust, do not name a grantor spouse a life beneficiary of the trust. If a grantor is given the right to the income of the trust for life, the proceeds will be includable in that spouse’s estate as a retained life interest.32 However, it is possible to name a nongrantor insured spouse as a beneficiary of the trust. Merely being both an insured and a beneficiary of the trust should not cause estate inclusion in that spouse’s estate, as the insured spousal beneficiary would not have the requisite incidents of ownership to cause estate inclusion pursuant to Code section 2042.
- As a general rule, do not name either insured spouse as the trustee of a trust holding a last-to-die policy. Since both spouses are insured, if the spouse who serves as trustee dies second, it is likely the IRS will include the proceeds in the spouse’s estate under an argument that “As trustee, the insured held incidents of ownership.” Should the insured trustee discover the problem and resign as trustee during the three years prior to death, the proceeds will nevertheless be included in his estate as a transfer within three years of death.
- Even if the trustee’s spouse dies first, the consequences could be severe. The fair market value of the policy at that time (usually, interpolated terminal reserve plus unearned premium on the date of death) is included in his gross estate, since that best reflects the estate tax value of the policy. This may be quite a large amount and can aggravate the first decedent’s liquidity problem, since it creates a cash need but the policy’s reserve cannot be used to provide cash to satisfy that need.
- It may be possible to have a nongrantor spouse who is both an insured and a trust beneficiary serve as trustee as long as a special trustee is used to hold the incidents of ownership on the policies insuring the spousal beneficiary’s life. This may be desired in situations where more flexibility is desired, as discussed in the previous “What Ifs” section.
- How does the three-year rule of Code section 2035 operate where a survivorship policy is owned by an irrevocable trust (or other third party)? Only if: (a) both spouses die within the three-year period following the transfer of a second-to-die policy to an irrevocable trust; and (b) the transferor spouse is the second to die, will the life insurance proceeds be includable under the three-year rule. If both spouses died within three years of the transfer but the transferor spouse died first, the policy would have been included, if at all, under section 2033, as an interest one person held in a policy on another person’s life. That section does not apply, however, unless an interest was held at death—which it was not. Furthermore, section 2035 applies only if, within three years of the transfer, section 2042 (incidents of ownership) would have applied had there been no transfer.
Planners should note that there are many situations in which survivorship policies are not indicated (or should be used in conjunction with first to die contracts). These include:
- estates where the client wants to pass significant wealth to someone other than a surviving spouse;
- estates where there is no surviving spouse;
- estates where the surviving spouse is not a U.S. citizen and the qualified domestic trust (QDOT) is contra indicated; and
- estates where the need to provide funds to maintain the survivors’ standard of living will require significant capital.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM