For families with assets in excess of $4,000,000 in 2007 (assuming wills have been properly prepared), although a Federal Estate tax will have to be paid upon the death of the survivor of the husband and wife, the use of an irrevocable trust can provide the needed liquidity to pay any estate taxes which may be due while the principal of the trust can be beyond the reach of the estate tax provisions itself. Such amount will increase gradually to $ 7,000,000 in 2009, but under the current law revert to $2,000,000 in 2011.
Although in theory any assets may be gifted to a trust which, if properly drafted, will be free of estate tax upon the death of the survivor of husband and wife, there are unique benefits in utilizing life insurance for this purpose especially policies known as second to die or survivorship policies. These policies have a premium cost which almost always is less than the comparable premium cost on the younger of husband and wife and the death benefit is payable when a family's need for liquidity is greatest.
It should be noted that the use of irrevocable trusts are not always necessary to keep the death benefit from life insurance out of the estates of a husband and wife. For example, ownership of policies can be in the name of a couple's children. However, use of the trust provides non-estate tax benefits such as insulation of the assets from problems which may be encountered by the heirs such as divorce, creditor problems or premature death.
A properly drafted trust instrument will authorize, not direct, the trustee to deal with the estate of the grantor (survivor) by either loaning money to the executor to pay estate taxes or purchasing illiquid assets from an estate at fair market value in order to provide the necessary liquidity to pay estate taxes. If the trustee was merely directed to pay estate taxes with the proceeds of insurance, then such proceeds may be includable in the estate. The balance of the trust not needed to provide liquidity to an estate, will, in most cases, be distributed to the heirs in the same proportion as provided in the couples' wills. Because the trust is irrevocable and the grantors retain no "incidents of ownership" in the trust assets, such assets are not includable in their estate and, in effect, the death benefit of the insurance policy passes to the heirs free of federal estate tax.
The irrevocable trust can be funded or unfunded. If funded, the trust will contain, in addition to a life insurance policy, sufficient assets to pay for the premiums due on such policies. The income earned on such assets would still be included on the income tax return of the insured/grantor. IRC Sec. 677 (a)(3). The assets transferred would be subject to gift tax. Therefore, generally, insurance trusts are unfunded. If unfunded, the grantor or other party that pays the annual premiums to keep the insurance in force is deemd to make an annual gift to the beneficiaries of the trust. Quite often, the cash surrender value of the policies held by the trust will be utilized to provide the necessary liquidity to pay the premiums.
The gifts by the insureds of cash to pay premiums constitute gifts subject to the unified gift/estate tax. However, to the extent such gifts are of "a present interest" in property they will be subject to the annual gift tax exclusion of $12,000 per individual ($24,000 if a spouse joins in the gift). For all present interest gifts in excess of $12,000 per donee and all future interest gifts, the donor must apply as much of his unified estate and gift tax credit as is necessary to avoid the payment of tax. However, in order to qualify as a present interest gift, the donee must have immediate use of the property gifted.
In general, a gift to an irrevocable trust would ordinarily be a gift of a future interest because the beneficiaries of the trust will not enjoy the use of the property until some future date. However, if the trust is properly drafted to give the beneficiaries the right to demand possession of the gifted property (premium payments) even if for a limited period of time, then the prevailing opinion is that the gift of premiums will qualify for the annual $12,000 ($24,000) per donee exclusion. These demand rights are known as "Crummey powers" named after the case which established the legitimacy of this procedure. Crummey v. U.S., 397 F.2d 82 CA-9, 1968). Crummey power holders should be actual trust beneficiaries; however, the tax court has allowed annual exclusions for contingent beneficiaries e.g. grandchildren who were given withdrawl rights. Est of Maria Cristofani v. Commissioner 97 TC 74 (1991). The failure of a beneficiary to withdraw the amounts permitted under the Crummey provision will cause a lapse of that power. Lapsed amounts in excess of the greater of 5% of the value of the trust or $5,000 may be considered taxable gifts from the beneficiary to the grantor. However, if the beneficiary is given a limited power to appoint such excess amount, the power is deemed not to lapse and no gift tax would be due.
Generally speaking it is recommended that insureds form irrevocable trusts at the time they decide to obtain second to die life insurance rather than transfer existing insurance into the trust because under IRS Code section 2035 if the insured dies within three years of having transferred incidents of ownership in a life insurance policy, then the life insurance proceeds will be included in the estate of the insured. The three year rule would be inapplicable if the trust were the applicant and original owner of the policy. Careful coordination between life insurance broker and counsel is necessary if avoidance of the three year rule is an issue, because insurance applied for is not always the insurance offered by the insurance company after the application process is completed.
Whether irrevocable life insurance trusts are appropriate for clients can only be determined on a case by case basis after all relevant facts are reviewed by a competent experienced professional.
The above is intended to provide general information not specific legal advice or a recommendation. Legal advice can only be rendered to clients who have a retainer relationship with the law firm. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.