There are two basic ways an irrevocable trust becomes a life insurance trust. The first way is when a client makes an absolute assignment of one or more life insurance policies to the trust. The obvious disadvantage to this method is the potential for estate tax inclusion under the transfers within three years of death rule of Code section 2035 (purchase of the policy by the trust for fair and adequate consideration can avoid the three-year rule, but creates potential transfer for value issues). Alternatively, under the preferred approach, the trust is established, cash contributions are made by the grantor to the trust, and then the trustee uses cash or income from funds provided by the grantor or others to purchase new insurance on the life of the grantor. Preferably, the trustee should initiate the purchase of life insurance, own from inception all the incidents of ownership in the policy, be the premium payor, and be named as beneficiary.
An irrevocable life insurance trust may either be funded or unfunded. In the most general sense, the term funding means that assets other than life insurance policies have been placed into the trust. In the narrower and commonly used sense, when applied to irrevocable life insurance trusts, funding means the placement of income producing assets into the trust. These assets typically are placed inside the trust in order to produce sufficient income to pay the insurance premiums. If the trust is funded, the trust agreement should specify:
- what should happen if the income of the trust is insufficient to pay the entire premium; and
- what should happen if trust income is more than sufficient and there is an excess of income.
Usually, the trust will provide that if trust income will not be sufficient to pay the entire premium, the trustee is responsible for notifying the grantor (or beneficiary or other interested party) of the shortfall. The trust should specifically authorize the trustee to borrow on the policy to keep it in force or to place the policy on extended term or purchase paid up whole life coverage if the grantor fails to pay the balance of the premium.
Most irrevocable trusts are unfunded and contain only life insurance policies. The insured typically pays premiums on policies held by an unfunded life insurance trust, by either making direct payments to the insurer or by the preferred method, annual gifts to the trustee in amounts large enough for the trustee to pay the premiums and have enough cash left over to cover any incidental trust expenses. Here, the trustee typically assumes no obligation to keep the life insurance in force or even the responsibility to notify the client that premiums are due or overdue.
The major tax objectives of many irrevocable life insurance trusts are to: (1) make the maximum amount of income and capital available to the surviving spouse and increase both her personal financial security and that of those she loves and feels responsibility toward; and (2) avoid inclusion of the proceeds in both spouses’ estates.
To accomplish these goals, the draftsperson of the trust inserts certain provisions that:
- allow the trustee (and only the trustee) discretion to sprinkle income or spray capital to the spouse and the grantor-insured’s children; and/or
- give the surviving spouse “all of the income for life and as much principal as necessary for her Health, Education, Maintenance, and Support” (HEMS); and
- state “when she dies, my surviving spouse can appoint the remainder of the trust assets among our then living children.”
Most irrevocable life insurance trusts are designed to do more than provide food, clothing, and shelter for the grantor’s survivors. A major goal of such trusts is to keep assets, such as a family business or real estate, in the family by avoiding the forced (and often fire) sale that results from a lack of liquidity. Properly arranged, an irrevocable trust does just that; provides liquidity for the insured grantor’s estate without increasing the estate tax burden.
These twin goals, estate liquidity and exclusion of the life insurance that provides that liquidity, must be carefully planned. If the provisions of a life insurance trust required the trustee to pay to the insured’s estate any cash needed to pay debts, expenses, and taxes, such an instruction would result in federal estate tax inclusion of all amounts that could be so expended (as amounts receivable by the executor). This would cause a loss of the estate tax savings objective. However, the IRS has provided guidance that giving the trustee the “discretion” to use proceeds of life insurance to pay federal estate taxes will not cause inclusion of the life insurance proceeds pursuant to Code section 2042.2 Presumably, if the trustee were actually to use some of the death proceeds to pay estate taxes, this portion would likely be includible in the estate as an “ amount receivable by the executor,”3 which makes this a less than attractive option except in extenuating circumstances.
The solution is simple. A provision is placed into the trust document authorizing, but not directing, the trustee to:
- lend money to the estate at an interest rate equal to or in reasonable excess of the current bank lending rate in the area; or
- purchase assets at their fair market value from the estate of the insured and the estate of his spouse.
Such loans and/or purchases will (to the extent of the life insurance relative to the taxes and other expenses) solve or reduce the decedent’s estate’s liquidity problem while keeping purchased estate assets within the family unit. If the draftsperson has been careful to frame the wording of the trust in the form of a permission rather than as a command, neither loans by the trust nor purchases from the estate should cause the insurance proceeds to be included in the insured’s gross estate. Neither should be interpreted as falling within the scope of the statute dealing with the inclusion of life insurance proceeds.
Furthermore, the estate should realize little or no gain on the sale, because appreciated assets in the estate receive a stepped up basis equal to the estate tax value of each piece of property. Best of all, when the trustee pays the executor cash for an appreciated asset, the trustee then takes that asset with a basis that is stepped up to its purchase value. The trustee (or the trust’s beneficiaries if the assets are distributed) can then invest the assets, or sell them with relative income tax impunity and diversify their portfolio to achieve higher safety, liquidity, growth, or income.
These clauses must be carefully inserted into an irrevocable life insurance trust so as to accomplish a delicate balancing act. On the one hand, they are designed to enhance the trust’s flexibility and usefulness as a means of providing managed financial security for the surviving spouse. Yet, on the other hand, they must not give the surviving spouse powers broad enough to be considered a general power of appointment (i.e., a virtually unlimited right to say who receives the proceeds), since such a power would cause the policy proceeds to be included in the surviving spouse’s gross estate. The three standard clauses above are designed to accomplish these two important objectives.
A policy should be placed into the trust as follows:
- An attorney drafts and the client signs the irrevocable trust document.
- The trustee then applies for the policy on the insured’s life, under a provision in the document allowing the trustee to purchase a policy and/or pay premiums on a policy insuring the life of the grantor.
Of course, that is the ideal arrangement and, with a lawyer who is expert in estate planning and who has a modern well-automated office, the appropriate speed, accuracy, and efficiency, is possible. But it will not always work so smoothly. More often, the insured wants to put a policy in force immediately, but the trust will not be established until a future date. Here, several alternatives are available.
Under Plan A
Putting a plan into place under Plan A works like this:
The client could apply for the policy as policyowner.
After the trust is created, the client could transfer ownership of the policy to the trust by an absolute assignment or ownership form “for love and affection.” (Note that if a beneficiary transfers a policy to the trust, he will be considered a grantor of the trust. So, for example, in a community property state, rather than having the insured grantor’s spouse transfer an existing policy on his life directly to the trust, the insured should purchase the policy on his life from his wife and then transfer it—in a time-separated and independent step—to the trust by gift.) A copy of the executed trust is sent to the insurance company together with the absolute assignment form.
In a nonprepaid case, an informal application could be submitted to the insurer for an informal opinion as to whether the policy will be issued on a select, standard, or rated basis. Once the policy’s issue status is known, plans can be made to establish the trust, and then the trust formally applies for the policy.
Under Plan B
A second alternative, Plan B, works like this:
The client applies for term life insurance.
When the trust is established, the trustee applies for new permanent life insurance coverage. (Some form of permanent protection is almost always indicated as the sole, or the bulk of the, insurance coverage when a major objective of the irrevocable trust is to provide estate liquidity, since a term contract may expire before the client dies and the need for liquidity begins). Once the permanent coverage is issued, the term policy can be lapsed. Some companies treat the two transactions as a policy conversion.
Under Plan C
Often called the substitute application, Plan C works like this:
The applicant, owner, and policy date of a recently issued policy (less than a year old) are changed to coincide with the effective date of the trust. At this point, the policy may appear to have been originally purchased by the trustee. Under this substitute application procedure, a short term premium is charged to pay for coverage from the date of the original application to the new policy date. A variant of this is to use an informal life insurance application. This allows the underwriting of the policy to take place while the trust is being created. Once the trust is created, then the informal application is cancelled and a new application is completed by the trustee of the trust.
Planners should note that the IRS could claim in Plan A, B, and C that a constructive transfer of a policy occurred and so, if death results within three years of that transfer, inclusion may result. Whenever possible, therefore, the trust should be in existence prior to the purchase of the life insurance and the trustee should apply for and own the policy from inception. A copy of the signed trust document accompanies the policy application and the trustee signs as owner-applicant and the insured signs only as proposed insured.
What about the case where a client wants to transfer existing policies to an irrevocable trust? Existing policies may be transferred to the trust through an absolute (and gratuitous) assignment of ownership from the insured to the trust or through a change of ownership form obtained from each insurer. Again, the client must survive the three year period commencing on the date of the transfer or ownership change in order for the proceeds to be excludable from his gross estate.
It is important that the client transfers all ownership rights to the trustee, not only to divest himself of incidents of ownership and avoid the transfers within three years of death rule, but also to avoid a conflict between the terms of the trust instrument and the terms of the policies. A list and description of all the policies transferred to the irrevocable trust should be attached to the trust document. Included in the description should be the following information:
- policy number;
- name of insurer; and
- face amount of coverage.
There are alternatives to these fairly standard ways to set up an irrevocable trust. For instance, someone other than the insured can establish the trust and one or more persons other than the insured could fund the trust. If some third party sets up the trust and funds it, some or all of the income and estate tax traps common under the classic arrangement can be avoided. For instance, once grandparents set up and fund a trust, the trustee could split the premium dollars with the son or daughter of the clients and insure the son or daughter for the benefit of grandchildren. Arranged this way, it can be shown that the insured never held any incidents of ownership and the proceeds should be excludable from the insured’s estate as well as the estate of the insured’s spouse.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM