What is an irrevocable life insurance trust? How does it work?
Life insurance trusts are designed to provide tax free cash to your family when they need it most.
Those who have illiquid or less marketable (easy to sell) assets, will need to find creative ways to pay estate taxes and other debts related to their estate without the risk of having a fire-sale of their hard earned assets. In other words, you don’t want to put your family in a situation where they may be forced to sell real estate or a business at heavily discounted values. This is especially true if the patriarch/matriarch dies suddenly and the family is disorganized or over-leveraged.
For that reason, an irrevocable life insurance trust tends to be a common solution for many business owners, real estate investors, and/or wealthy families to inject liquidity quickly and conveniently into their overall estate plan. Not only does an irrevocable life insurance trust help preserve value, it also gives the inheritors (generally, your children) more flexibility and breathing room to time the sale of such assets (or the ability to hold onto them for the long term).
The biggest benefit of an irrevocable life insurance trust is that it provides virtually immediate cash to the family that is not subject to estate tax (if structured and administered correctly). It does this by making sure the insurance policy (or any asset) held in the irrevocable trust is not considered part of the grantor’s (the creator of the trust’s) estate for estate tax purposes.
This means that the grantor is not viewed as the owner of the trust or its underlying assets for estate tax purposes. However, the grantor could still be viewed as the owner for income tax purposes, which is an important distinction.
How does an irrevocable life insurance trust work?
An irrevocable life insurance trust is generally set up as both the owner and the beneficiary of a life insurance policy. The insured is typically the creator of the trust (the grantor) who is either wealthy and/or owns assets that he doesn’t want to force his family to sell upon his/her death or within a short period of time.
The catch is that the grantor of the trust can not have any “incidents of ownership” over the trust, or else the assets held in trust can be considered part of his/her taxable estate, which defeats the whole purpose of the trust.
Technically, this means your spouse could be the trustee of the trust, but if you both have your own life insurance policies and separate life insurance trusts then you need to be careful to not get caught up in the reciprocal trust doctrine (briefly touched upon an earlier article - What is a SLAT?). You should also be aware that any trustee who is also a beneficiary should generally be restricted to an ascertainable distributions standard (reasonable health, education, maintenance, support) or else risk estate tax inclusion in their own estate.
You also need to be careful to avoid having a subordinate trustee because that opens up the possibility of the IRS arguing that you were, in effect, in control of the trust, or that the trustee was acting as your agent. For that reason, I don’t like naming the spouse as a trustee without having a disinterested, independent, or adverse trustee/beneficiary serving as co-trustee.
Who should serve as a trustee of an irrevocable life insurance trust?
Irrevocable life insurance trusts have to be drafted and administered in a very specific manner. The trustee needs to keep perfect records, make sure notice of withdrawal letters (called Crummey Letters - yes, that’s really what they are called, named after the family involved in litigation over such withdrawal letters). These letters are sent to beneficiaries in a timely manner and make sure funds cycle through the life insurance trust to pay the premiums in a well-coordinated manner. The letters are designed to ensure the notice provisions are properly adhered to and the grantor doesn’t accidentally break the trust (which is a common problem with these trusts).
For example, some grantors make the mistake of paying the life insurance premiums directly from their own bank account (or their spouse’s bank account), because their attorney/advisor didn’t properly instruct them (or because they forgot such instructions). That is a big no-no. The premium payments should always come directly from the trust bank account - never from another person, especially the grantor, directly.
For that reason, you want a trustee who knows what they are doing and is well-organized. CPAs or family accountants are ideal for this role. Financial advisors would be another great option, but unfortunately, many of them (based on my understanding) are not allowed to serve as trustees of their clients’ trusts because of regulations (from either internal company policy or those associated with other governing bodies).
Having your attorney be the trustee is another option, but many attorneys charge ridiculous fees for sending out these letters, however, if your attorney has paralegals administering the trust then maybe it could make economic sense depending on the size of the policy. There are also professional trust companies, but they may have minimums that make it uneconomical for many families.
The last feasible option is having a family member who isn’t named as beneficiary - for example, your younger sibling, cousin, niece, nephew, etc. that you respect and trust to keep things in order. Even though the tasks of managing the trust during your lifetime would be minimal (there are generally no annual filing requirements or anything like that), you would still need to make sure the coordinated annual notices and payments are done correctly to make sure they don’t inadvertently break the trust or make is vulnerable to attack by the IRS for failing to keep proper records.
What are the specific limitations, restrictions, and provisions commonly found in an irrevocable life insurance trust?
Most trusts are specifically drafted so the creator of the trust cannot have any incidents of ownership over the trust. For example, the trust should specifically exclude the grantor from having the ability to change the name of the beneficiary on the life insurance policy, borrow from the policy or pledge it as collateral, to assign a new owner of the policy, or to surrender the policy in order to receive the cash value. This includes having the ability to modify the policy in any way.
Put simply, the grantor should not have any rights or decision making powers over the life insurance policy. Even the money transferred to the trust is ultimately up to the trustee to decide how to use. So it is the trustee, not the grantor, who decides whether to pay the policy or not. And that is only if the children or beneficiaries do not use their withdrawal rights once the money is transferred to the policy.
Creating this gap in powers / authority between the grantor and the life insurance policy is what allows it to avoid being included in the grantor’s estate. If the grantor retains no control over the policy, then it makes it clear that the grantor does not “own” the policy for estate tax purposes.
What if I already own a life insurance policy and want to create an irrevocable life insurance trust?
If you already have an existing life insurance policy and don’t want to cancel it (maybe you wouldn’t be able to get a new policy based on your current health situation), then you can generally transfer or assign the policy to the trust.
Just make sure that your life insurance agent / advisor helps with the transfer to make sure it is done correctly. You will also want to review the potential tax implications of the transfer before making any changes. For example, you generally wouldn’t want to transfer a whole life or variable life insurance policy if that is going to trigger a substantial taxable event - so check with your advisor first.
You should also be aware that there is generally a 3-year lookback on transfers of insurance policies to trust. So if you die before that three years is up, then the insurance proceeds could be considered part of your estate for estate tax purposes. However, if you (meaning your trustee) buy the policy directly in the trust, then there is no 3-year lookback. That is why most prefer to have the trust set up first before getting a life insurance policy.
You should also be aware that if the Grantor trust tax laws change in the future, then it could make these trusts even harder to use (but we’d like to think that such trusts would have grandfathered provisions if created prior to such change in tax law).
Need help with your estate planning?
If you would like to review or update your estate plan, then give me a call at 781 202 6368, email jlento@perennialtrust.com, or click here to schedule your free personal consultation.
I’m always happy to help!
Joseph M. Lento, J.D.
Your Local Estate Planning Attorney
www.PerennialEstatePlanning.com
477 Main Street
Stoneham, MA 02180
