Protecting Life Insurance from Estate Taxes

Life insurance is frequently a large portion of an individual’s estate. Most people are aware that life insurance proceeds are not subject to income tax. However, life insurance proceeds can be subject to federal estate taxes. The general rule is that if the deceased person had any “incidence of ownership”, i.e., the ownership of, the right to control or the right to direct the policy, the proceeds will be includable in that person’s estate for federal estate tax purposes.

The most common situation and one of the most common mistakes is that the wife is made the beneficiary of life insurance on the husband. If the husband had no incidence of ownership over the policy the proceeds would not be includable in his estate and thus no estate taxes. But even if the husband were the owner, since the proceeds are payable to his surviving spouse and since there is an unlimited marital deduction there would be no federal estate taxes in any event. The problem comes when the wife dies. The policy proceeds are cash at that point and are certainly includable in her estate for federal estate tax purposes.

To avoid life insurance proceeds from being taxable in the estates of both the husband and the wife the children or other beneficiaries could be made the owners and beneficiaries of the policy or policies and the proceeds would not be includable in either estate. The problem with this is that we lose control over the policies and we may want the surviving spouse to reap the benefits of the proceeds. The way to accomplish this is to establish during the husband’s lifetime an irrevocable life insurance trust. The policy on the husband is transferred to the trust or a new policy is purchased by the trust and the beneficiary of the policy is the trust. The trust provisions provide that upon the death of the husband the proceeds are delivered to the trustee of the trust who invests them. The trust provides that the surviving spouse is to receive all of the income from the trust for the remainder of her life and the trustee has the discretion to provide additional funds from the principal of the trust to the extent needed by the surviving spouse. The husband had no incidence of ownership over the policy, thus the proceeds are not taxable in his estate. Additionally, the surviving spouse had only an income interest for life with limited rights to principal and thus the remaining proceeds are not taxable in her estate either. The trust finally provides that upon the death of the surviving spouse, the remaining proceeds continue in trust or are distributed to the beneficiaries free of trust. The life insurance proceeds pass ultimately to the heirs of the husband and wife free of any estate taxes.

Because a properly structured irrevocable life insurance trust can result in significant tax savings, the IRS continues to scrutinize their construction and execution carefully. As a general rule, attorneys follow a six step procedure when establishing an irrevocable life insurance trust for their clients:

– Trust document is executed with an independent trustee.
– Obtain a taxpayer identification number for the trust.
– Open a bank account in the name of the trust.
– Do not apply for life insurance until after the trust is in effect.
– Gift the premium to the trustee, deposit it in the bank account and provide Crummey letters to the beneficiary.
– After lapse of Crummey withdrawal rights, trustee pays the premium from the trust bank account.

An existing policy can be transferred into the irrevocable life insurance trust, but the IRS imposes a three year waiting period before recognizing the transfer. Should the client die within the interim, the full death benefit would revert to the decedent’s taxable estate.

Second to die life insurance policies which pay only upon the death of both spouses can be removed from the estates of both spouses by making the children the owners of the policy or by transferring the policy to an irrevocable life insurance trust. Making the children the owners of the policy is certainly the simplest solution but the policy is subject to the rights of their creditors. To protect the policy which often has significant cash value, the policy is placed in a life insurance trust containing “spendthrift” restraints which fully protect it from the rights of the children’s creditors. Additionally, if the proceeds are intended to continue in trust after the second death, the trust could serve this purpose.

A discussion of life insurance is crucial to effective estate planning.

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