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Irrevocable Life Insurance Trusts
Another tool that some people use to minimize or eliminate estate tax is an irrevocable life insurance trust. Insurance policies owned by the insured at the time of death are included in the insured's federal taxable estate. With an estate tax bracket that can be as much as 45%, one-half of a person's coverage can be lost to the federal government without proper planning. This article will summarize some of the advantages and disadvantages of life insurance trusts.
How is an Irrevocable Life Insurance Trust Established? A person with assets that exceed the federal exclusion amount will establish a trust. We call the person who establishes the trust the "settlor". It is important to keep in mind that although the settlor may already have a living trust, the new life insurance trust is a separate, irrevocable trust.
If the settlor acts as trustee of the life insurance trust, the value of the assets held by the trust will be brought back into the settlor's taxable estate at death. Therefore, the settlor will name another person to act as trustee of the life insurance trust.
The settlor will designate beneficiaries of the trust, and will specify when, and under what terms, each beneficiary will receive his or her share of the trust following the settlor's death.
The trustee will apply for a life insurance policy on the settlor's life. This policy could be on the life of thesettlor alone or, if the settlor is married, it may be a second-to-die policy on the life of thesettlor and his or her spouse. While it is possible to transfer an existing policy into a life insurance trust, the settlor must survive the transfer by three years to qualify for tax exclusion. For this reason, most settlor's apply for new coverage if they are insurable.
Typically, the settlor will have to take steps to qualify for the insurance coverage. This may include taking a physical. After qualifying for the coverage, the settlor will transfer funds to the trustee with which to pay the premium on the policy. Each year, as the premium on the policy becomes due, the settlor will transfer additional funds to the trustee.
At the settlor's death, the proceeds of the insurance policy will be payable to the life insurance trust, and from there, to the settlor's beneficiaries. These proceeds will not be counted in the taxable estate of thesettlor. In this way, the settlor has transferred assets out of his taxable estate and to his intended beneficiaries without incurring the federal estate or gift taxes.
What are the Disadvantages of an Irrevocable Life Insurance Trust? Does this sound too good to be true? There are, in fact, some drawbacks to an irrevocable life insurance trust. First, and most obviously, the trust must be irrevocable in order to allow the settlor to pass the assets of the trust to the intended beneficiaries, outside the settlor's taxable estate. This means that the settlor has to give up all control over the trust. The only control the settlor retains is the ability to stop making future transfers to the trust.
Second, specific steps must be taken in order to qualify the settlor's transfer to trust for the $12,000 (for 2006) per person per year annual exclusion from the federal gift tax. Generally, gifts to trust do not qualify for this $12,000 exclusion. However, if the trust is written so that the intended beneficiaries have a small window of opportunity (for example, 30 days) in which to withdraw their pro-rata share of any transfer, the settlor's transfer of funds to trust will qualify for this exclusion. The right to make a withdrawal is noncumulative, meaning that a beneficiary who does not exercise this right within the prescribed period of time cannot withdraw those funds later. However, if the settlor makes a subsequent transfer to the trust, the beneficiary will have an opportunity to withdraw the beneficiary's pro-rate share of the subsequent transfer.
The trustee must send a notice to the beneficiaries advising them of this right of withdrawal anytime the trustee receives funds from the settlor. If the trustee forgets to do so, the settlor will be liable for federal gift tax.
Finally, if a life insurance trust is not properly drafted, a beneficiary who does not exercise his right to a withdrawal may be treated by the IRS as having made a taxable gift of the amount waived to the other beneficiaries of the trust.
Even with these complications, a well-drafted irrevocable life insurance trust is a good option to consider if your estate is at risk for the federal estate tax.
This summary is intended as a source of general information. If you have questions or desire additional information, please contact Ryan M. Wilson at (517) 377-0897 or rwilson@fraserlawfirm.com.