Using an Irrevocable Trust to Own Life Insurance Policies
Minimizing Estate Taxes
The death benefit proceeds of a life insurance policy owned by the insured are included in the insured’s taxable estate. For individuals with policies that provide for significant death benefit or with otherwise taxable estates, the inclusion of the death benefit proceeds in their taxable estate may result in an estate tax liability. As we noted in our first alert, the estate tax is a separate tax based on the value of an individual’s assets at death and the current estate tax exemption amount is $5,250,000. Further, any assets included in the decedent’s taxable estate that are distributable to a surviving spouse (or charity) are not subject to estate tax. Thus, if the value of assets included in an individual’s taxable estate that are distributed to persons other than a surviving spouse exceed the exemption amount an estate tax may be payable.
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However, married couples should consider the impact the inheritance of the death benefit proceeds of a life insurance policy may have on the surviving spouse’s taxable estate. To the extent that the death benefit proceeds received by the surviving spouse are not consumed (i.e., spent), but instead are retained or invested and appreciate in value, the resulting value will be included in the surviving spouse’s taxable estate.
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As a result of the receipt of the death benefit proceeds from Husband’s life insurance policy, Wife’s estate includes the value of the proceeds and the appreciation on such assets. The result is that Wife’s estate exceeds the estate tax exemption amount (including Husband’s unused exemption amount) and her estate will have an estate tax liability. However, if the life policy had been held in an irrevocable trust, the proceed paid to the irrevocable trust would not be included in Wife’s gross estate, thereby avoiding the imposition of an estate tax on Husband and Wife’s combined gross estates.
Funding Estate Tax Liability
A common use for the proceeds of a life insurance policy is the payment of estate taxes, particularly if an estate is expected to be comprised of illiquid assets (such as real estate or an interest in a closely held business). In this situation, the use of an irrevocable trust can ensure that the death benefit proceeds of the life insurance policy are not also subject to estate tax. However, in using an irrevocable trust for the life insurance policy, it is important that the dispositive provisions of the irrevocable trust coordinate with those of the insured’s estate plan.
The irrevocable trust is a separate entity subject to administration by the trustee in accordance with the trust terms. Similarly, an estate is a separate entity subject to administration by the executor in accordance with the terms of the decedent’s Will (or other estate planning documents). If the proceeds from the life insurance policy paid to the irrevocable trust are to be used to provide liquidity to the estate for taxes (or other expenses), there must be a “mechanism” to allow the payment of the proceeds of the policy to the insured’s estate. This is typically done in one of two ways: 1) a loan from the irrevocable trust to the estate, or 2) a purchase of assets by the irrevocable trust from the estate. Because of this potential future transaction between the estate and irrevocable trust, a few issues should be considered and addressed in connection with the preparation of the estate planning documents:
- The irrevocable trust should authorize the purchase of assets from the estate of the insured, or the loaning of funds to the estate of the insured;
- The Will or other applicable estate planning document should authorize the sale of assets from the estate to the irrevocable trust or the borrowing of funds;
- The dispositive terms of the documents should be consistent to ensure that the assets are not disposed of in a manner inconsistent with the insured’s intent.
With regard to the last issue noted, often, the proceeds from a life insurance policy are thought of as “free cash” and the insured may desire to give the proceeds to other family members, such as grandchildren, who are not the direct beneficiaries of the insured’s estate. In this situation, if the estate needs the liquidity from the life insurance proceeds for estate taxes, then the disbursement of assets will be inconsistent with the insured’s intent. For instance, if the estate has to sell assets to the irrevocable trust that holds the proceeds from the life insurance policy, then the illiquid assets of the estate will be transferred to the irrevocable trust for distribution to the beneficiaries of the irrevocable trust (the grandchildren), while the proceeds received by the estate from the sale of the assets are consumed by estate taxes. In this situation, the assets of the estate are distributed to the beneficiaries of the irrevocable trust and the estate’s assets are depleted.
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Using a Closely Held Business to Own Life Insurance
As discussed in our first alert on this topic, using a closely held business to own life insurance on one of the majority owners will have adverse estate tax consequences. For this reason, life insurance policies should not be owned by a corporation in which the insured has voting control.
Additionally, it may be complex to distribute the proceeds from the life insurance policy to the estate as a shareholder (other than in a redemption transaction). Ultimately, the overall structure and intent of the death benefit proceeds must be evaluated to determine if ownership of the policy in a business is appropriate. Finally, as will be covered in our next alert on this topic, there may be adverse income tax consequences to the ownership of life insurance in a closely held corporation.
The rules regarding the inclusion of a life insurance policy in the insured’s taxable estate are very complex and factually driven.