The purpose of this memo is to address commonly asked questions about the use of life insurance trusts in an estate plan.
What is the main benefit of having a life insurance trust?
The main benefit is that the proceeds of the life insurance are insulated from estate taxation upon the death of the insured. If you want to provide for your grandchildren, a further benefit is that you are leveraging your gift while exempting the gift from generation skipping taxes. The generation skipping benefits and structure of a life insurance trust are beyond the scope of this memo.
Who is the trustee the life insurance trust?
The insured may not serve as the trustee or co-trustee of the trust. The wife of the insured may serve as the trustee so long as her right to income from the trust is limited (to an “ascertainable standard”) and the spouse has no power to use the trust income to satisfy her legal obligations of support to the children.
Who is the beneficiary of the trust?
Generally, if the trust owns a life insurance policy only on one life (the husband, for example), the beneficiaries would be the spouse and the children. If the trust owns a second to die policy, the children alone are the beneficiaries.
How are the life insurance premiums paid?
The key to effective life insurance trust funding is to transfer cash to the trust (from separate property which is usually transmuted by agreement), which the trustee uses to pay the life insurance premium. So that the gift of cash to the trust constitutes a present interest, which qualifies for the annual gift tax exclusion, the beneficiary child and spouse are given a “Crummey” power to demand the withdrawal of the gift. In other words, the trustee notifies the beneficiary that within the next 60 days he can demand that the gift be given to him rather than used by the trustee to pay the insurance premium.
Are there any potential gift tax or estate tax consequences of giving the beneficiary the “Crummey” power?
If the “Crummey” power allows the beneficiary to withdraw more than the greater of $5,000 or 5% of the trust, the lapse of the power could constitute a taxable gift to the other beneficiaries of the trust. Further, if the beneficiary dies while owning the withdrawal power, the value of the withdrawal right will be included in the beneficiary’s estate. Each situation should be analyzed to determine what steps can be taken to minimize any adverse tax consequences.
What is the procedure to establish and fund the trust?
1. Ideally, the trust agreement is prepared and signed before the application for the insurance is submitted. However, if the application has already been submitted by the insured, a new application by the trustee of the trust can be substituted so long as the insured has not paid for the insurance and the insurance has not been issued.
2. If the insured does not have any separate property, the insured will set up a bank account in his name with his separate property. The spouses will usually enter into a transmutation agreement, and each spouse will open a separate property account. The insured issues a check from his separate account payable to the trustee for an amount in excess of the insurance premium. It is important to keep copies of the checks.
3. The trustee opens a bank account using the tax I.D. number obtained from the IRS on IRS Form SS-4.
4. Once the trustee deposits the check, he or she sends a letter to the beneficiaries notifying them of their right to withdraw the funds (“Crummey” letter).
5. After the expiration of the withdrawal right, the trustee then pays the premium of the life insurance. The trustee is the owner and the beneficiary of the life insurance.