Irrevocable Life Insurance Trusts

Our prior posts have focused solely on Living, or Revocable, Trusts. However, as a client’s assets increase so does the potential complexity of their estate plan. A frequent concern of higher net worth clients is the prospect of paying estate taxes on the assets they choose to leave to their beneficiaries. Due to the present large estate tax lifetime exclusion of $5,120,000.00 (due to expire on December 31, 2012), planning strategies that address this concern have become less common in the past decade. However, for those clients with a net worth large enough to create an estate tax liability (a group that could increase in size dramatically should the Lifetime Exclusion decline to $1,000,000 or some other amount in 2013) the Irrevocable Life Insurance Trust may be a valuable tool. The greatest benefit of the Irrevocable Life Insurance Trust its ability to provide liquidity and finance a fund to offset expected estate taxes. 

The Irrevocable Trust

An "Irrevocable Life Insurance Trust" is a Trust designed to have as its only asset a life insurance policy on the life of a Grantor or a Grantor and his or her Spouse. It is drafted to provide that the proceeds from the insurance policy will not be a part of the Grantor's estate upon death and will pass to beneficiaries income tax-free. If the Grantor owns an insurance policy and retains control over the policy, then the proceeds from that policy are included in the Grantor's estate even if the proceeds from that policy are payable to someone other than the Grantor. For example, if the Grantor owns a $1,000,000.00 policy, and dies, that policy will be includable in the Grantor's estate and be subject to federal estate tax (taxed at a 35% rate this year and potentially a 50% rate next year), if the Grantor's estate exceeds the Lifetime Exclusion. If the Irrevocable Trust owns the $1,000,000.00 life insurance policy, and the Grantor dies, the policy proceeds are not includable in the Grantor's estate and will not be subject to the estate tax.

The Irrevocable Life Insurance Trust is commonly part of an estate plan when the Grantor's estate exceeds the value of the Lifetime Exclusion and there will be taxes owed at the time of the Grantor's death. Rather than having the taxes paid on a dollar for dollar basis from the Grantor's estate, an Irrevocable Life Insurance Trust holds an insurance policy and receives the proceeds from that policy. Those proceeds offset the taxes paid to the federal government and are distributed to the beneficiaries pursuant to the terms of the Irrevocable Trust, which may be the same or different from the terms of the Grantor’s Living Trust. The benefit to the estate comes from the fact that the cost of the annual insurance premiums are a fraction of the cost of the taxes paid on a dollar for dollar basis from the estate. 

In situations where the estate exceeds the value of the Lifetime Exclusion, an Irrevocable Life Insurance Trust is a good strategy. However, many of my clients are reluctant initially because of their lack of knowledge of life insurance policies and premiums costs. I suggest they consider this strictly from an economic standpoint. If the payment of the premiums will reduce their lifestyle, do they really want to give their children a greater lifestyle at the expense of their own inconvenience? However, the reality for most clients considering this technique is that the payment of premiums will come from excess assets, not assets otherwise used to support a client's lifestyle, and therefore the decision to use an Irrevocable Life Insurance Trust becomes an easier one.

A second use of an Irrevocable Life Insurance Trust is to provide for the needs of a special needs child while preserving any existing government benefits. The proceeds of the life insurance policy held by the Irrevocable Trust are used as appropriate for the child while the remainder of the Grantor's assets can benefit the Grantor's other beneficiaries. When used for this purpose the Trust will include language to ensure that distribution of the proceeds occurs at the Trustee's complete discretion so that the funds are used in addition to and not in lieu of any government benefits. In a similar fashion, an Irrevocable Trust can protect a second spouse by providing funds for him/her while distributing the rest of the Grantor's estate to children of prior marriage. In the alternative, the Irrevocable Trust can protect the Grantor's children by guaranteeing a specified amount, with the remainder the estate going to a second spouse or other beneficiaries.

The Insurance Policy

In order to ensure that the insurance policy is not included in the Grantor's estate, the Grantor must first execute the Irrevocable Life Insurance Trust and then the Trustee of the Trust applies for the policy on behalf of the Trust. It is important to use a new insurance policy to fund the Trust, because if an existing policy on the life of the Grantor is transferred to the Trust, and the Grantor dies within three years of the transfer, the insurance policy is considered part of the estate of the Grantor and subject to the estate tax. If at the time the Trust is established, the Grantor is not insurable and an existing policy must be used, as long as the Grantor survives for three years the policy will not be included in the Grantor's estate.

An additional requirement of an Irrevocable Life Insurance Trust is the requirement that the Grantor normally make annual gifts to the Trust in order to pay the annual premiums. The Grantor typically wants these annual gifts to count as "present gifts" to take advantage of the Gift Tax Annual Exclusion (presently $13,000.00 per donee). For that to occur, the beneficiary or beneficiaries must have at least a short period of time in which to be able to request that his or her portion of the annual premium be distributed to him or her rather than held in the Trust. For this reason, "Crummey Notices" generally are given to each of the beneficiaries, or their guardians if a beneficiary is a minor. The Crummey Notice, named for a tax case, Crummey vs. Commissioner, explains it that each beneficiary has a right to take his or her pro rata portion of the annual gift. If the beneficiary does not exercise that option within 30 days, that option expires, the gift is considered a “present gift’, and the Trustee can then pay the insurance premium.

An insurance policy taken out by the Trustee can be either a permanent policy or a term policy, except that if the policy is on the life of the Grantor and Grantor's spouse, only permanent policies are available. As with other life insurance policies, there are many funding choices. Some Grantors prefer to front-load premiums (pursuant to allowable insurance guidelines) so as to be able cease gifts to the Trust at a certain point in time and have the policy continue indefinitely. Others, who seek to keep gifts to a minimum, may actually use a term policy. The problem with the term policy is it will end after a certain number of years and if the grantor is uninsurable at that time, the strategy fails. Practically speaking, if there is an insurance need to offset estate taxes, that need is probably always there and a permanent policy should be considered. If there is no longer a need for the policy, or if the Grantor decides not to make additional gifts, the Trustee can cease making premium payments and the policy will lapse. 

Even though the trust itself is irrevocable and its terms cannot be changed, the Trustee and the Trustee's advisors should consider reviewing the life insurance policy on a regular basis to determine if the policy is still appropriate. It is possible a new policy with better provisions or with lower premiums would be a better choice for the situation. The duties of a Trustee of an Irrevocable Life Insurance Trust extend beyond simply providing the Crummey Notices and paying the premiums.

A strategy which is available now but which will expire on December 31, 2012, is to make a large gift to an Irrevocable Trust using the current $5,120,000.00 Lifetime Exclusion and purchase a large single pay premium policy. In the event changes in the law reduce the Lifetime Exclusion to $1,000,000.00, the Grantor has already fully funded the policy and need not make any large gifts thereafter. The strategy melds the time-tested strategy of the Irrevocable Life Insurance Trust with the short-term availability of making large gifts currently in the event that the Lifetime Exclusion is reduced significantly.

Just like the other strategies we have discussed, the Irrevocable Life Insurance Trust is another tool to be used where appropriate and can provide significant protection for specific beneficiaries and offset (at a much lower cost) estate taxes that will likely be paid at the death of the Grantor and Grantor's spouse. As is the case with these other tools, it is important to discuss what options are appropriate with a licensed attorney prior to taking any action.

Trust Funding—Filling the Trust-Bucket to Avoid Probate

As we have previously discussed, executing a Trust creates a legal entity that can own property. However unless steps are taken to transfer property to that entity, even the best-drafted Trust will provide very little value. I have previously referred to a newly executed Living Trust as an empty bucket. The Grantor/Initial Trustee carries the trust-bucket around during their life and makes use of its contents. If the trust-bucket does not have any assets in it, then the bucket is not doing its job. Thankfully, the process of funding a Trust, though sometimes complex, can be completed and provide protection.  Examples of  items to place into the trust-bucket are:

Tangible Personal Property Tangible personal property includes all the property a person owns that is movable; this includes clothing, furniture, and other household goods. Tangible personal property also includes items such as artwork, unique collectibles, firearms, and jewelry. These items are added to the bucket (and thus funded to the trust) through the execution of an Assignment of Personal Property. In our office, when we draft a Living Trust we automatically draft an Assignment of Personal Property. This ensures that before the client leaves we know that their Trust is the owner of their tangible personal property.

Real Estate.  The next item commonly funded to a Living Trust is real estate, such as a residence or vacation home. In order to fund real estate to the Living Trust the Grantor executes a quitclaim deed transferring the property to the Trust. Upon signing the deed, the Trust becomes the owner of the property. State law then requires recording of the deed with the county to ensure a complete record of property ownership exists. It is worth noting that in some circumstance it is more advantageous, primarily for creditor protection, not to fund real estate to a Living Trust. The decision to fund real estate to a Trust is a discussion that each individual needs to have with their attorney to determine what the best course of action is in their particular set of circumstances.

Investment Accounts   The third type of asset to place in the trust-bucket is accounts with financial institutions. Funding these assets to a Living Trust ensures that not only do those accounts pass directly to the beneficiaries without the delay of probate, but also that the Successor Trustee has access to those assets upon the death of the Grantor in order to make any payments that need to be made prior to making distributions to the beneficiaries. A subset of financial account assets frequently handled by banks and financial advisers is life insurance policies, IRAs, and other retirement accounts. These accounts are not funded to the Living Trust during the owner’s life but instead the Living Trust is one of the designated beneficiaries of the accounts at the owner’s death. In the case of life insurance policies, we recommend that the Living Trust be the primary beneficiary for the policy. This ensures this ensures that at the death of the insured party the proceeds from the insurance policy are distributed directly to the Living Trust. As for IRAs, if our clients are married we recommend that they designate their spouse as the primary beneficiary of the IRA, because spouses enjoy preferential distribution treatment, and then name the Living Trust as a contingent beneficiary.

Business Entities.  The final assets commonly funded into a Living Trust are interests in Business Entities such as Companies, Corporations, and Partnerships. The funding of these interests to a Living Trust is completed with an Assignment. This Assignment can occur any time after the signing of the Living Trust, and if the Entity issues stock certificates those certificates need to be updated to reflect that the Living Trust is the owner of the interest. When funding a business interest to a Living Trust it is important to review the Operating Agreement for the business entity to ensure that there is no restriction on transfer of stock to a living trust.

After all this funding is complete, the trust-bucket now contains bank accounts, investment accounts, deeds to real estate, and interests in business entities. Insurance policies and IRAs designate that they pay out directly to the Living Trust and thus those assets drop into the bucket at the death of the owner. All of this ensures that when the Grantor/Initial Trustee passes away and the Successor Trustee comes along to pick up the bucket and follows the instructions written inside it, all of the Grantor’s assets are in the bucket and there is little to no need to deal with the Probate Court.

In the event that a Grantor has not funded an asset to the Living Trust prior to the Grantors death, a properly drafted estate plan will include a Will that designates the Living Trust as the sole beneficiary of the entire probate estate. This means that any asset that needs to pass through the probate process will end up as a Trust asset for the Trustee to distribute pursuant to the terms of the trust. While this will act as a safety net, catching anything that happens to be missed in the initial planning process, like all other circumstances involving a safety net the intention is to never need to make use of that net.

Each individual's circumstances are unique and due to those unique circumstances, it may not benefit an individual to transfer an asset into the name of the trust. These circumstances are one of many reasons that it is important to consult a licensed attorney to assist you with estate planning and to share information openly with that attorney.