Many people are surprised to learn that life insurance proceeds can be subject to estate tax in their estates. However, there are some planning techniques that can be used to remove life insurance from an estate for estate tax purposes.

Inclusion of Insurance for Estate Tax Purposes

If an individual owns a life insurance policy, the value of the policy (if the insured is still living) or the proceeds of the policy (if the insured is the owner) may be subject to estate tax in his or her estate depending upon the size of the estate. This includes group term life insurance provided by an employer. While, as a general rule, the beneficiary of the policy will not be liable for income tax on the proceeds, the policy owner’s estate may owe estate tax on the proceeds.

Like most assets, estate taxation of life insurance proceeds is based in part on the ownership of the life insurance policy. Policies are most commonly, but not always, owned by the insured. Thus, the easiest way to avoid estate taxation of life insurance proceeds on one’s own life is to not own the policy. One of the most common estate planning techniques used to accomplish this is to have the life insurance policy owned by a trust.

Irrevocable Life Insurance Trusts

Not just any trust can be used for this purpose. First, the trust must be irrevocable, meaning that its terms cannot be changed after the trust document is signed. If the insured can change the trust, this right will cause the insurance proceeds to be taxable in the insured’s estate regardless of who owns the policy. Second, the trust should have certain provisions to facilitate the acquisition of a life insurance policy and the payment of policy premiums.

The insured can establish the trust, pick the trustee (who must be someone other than the insured) and set the terms of the trust - that is, how the trust assets will be managed during the lifetime of the insured and how the policy proceeds will be distributed upon the insured’s death. The trustee will own the policy on behalf of the trust, will have the right to designate and change the beneficiary of the policy, which should be the trust itself, and will be responsible for paying the premiums from trust funds. Upon the death of the insured, the trustee will collect the policy proceeds and administer the proceeds as set forth in the trust.

Because the trustee is bound by the terms of the trust, the insured ultimately will have directed the disposition of the policy proceeds even though he or she does not own the policy. This is one added benefit over simply transferring ownership of the policy to another individual to avoid estate taxation of life insurance.

Funding an Irrevocable Life Insurance Trust

If an individual is purchasing a new life insurance policy, it is best to establish the trust first and have the trustee apply for and purchase the policy. If the insured transfers an existing life insurance policy to a trust and then dies within three years of the transfer, the policy will be included in his or her estate for estate tax purposes even though he or she no longer owns the policy. However, if the trustee owns the policy from the outset, this three year rule is inapplicable because the insured never owned the policy.

Of course, if an individual already owns an insurance policy on his or her life and does not want to or is not able to obtain a new policy, he or she can transfer the policy to the trust and “wait out” the three year period from the date of transfer to have the life insurance out of his or her estate. However, if an individual does transfer a pre-existing policy to the trust, that transfer may be subject to the gift tax depending upon the cash value of the policy.

Because the trustee of the insurance trust will be responsible for the payment of the policy premiums, he or she must have a source of funds with which to pay the premiums. The trustee usually gets these funds by means of periodic contributions of cash to the trust by the insured. Such contributions are treated as gifts by the insured to the trust beneficiaries. These gifts will be taxable gifts unless they qualify for the gift tax annual exclusion that allows an individual to give $11,000 per donee (or, for a married donor whose spouse consents to “split” the gift, $22,000), per year free of gift tax. The same is true of payments by an insured individual’s employer for a group insurance policy.

Only gifts of a so-called “present interest” may qualify for the gift tax annual exclusion. Gifts to a trust are not usually gifts of a present interest because the beneficiaries do not have an immediate right to the trust property. Thus, in order to make the insured’s gift to the trust a gift of a present interest, the trust beneficiaries are given the right to withdraw a portion of the gift for a specified period of time. This withdrawal right is commonly referred to as a “Crummey” withdrawal right after the court case which held that such a withdrawal right creates a present interest in the trust.

When the insured (or any other person) makes a gift to the trust, including direct payment of premiums to an insurance company, the trustee must notify each trust beneficiary that he or she has the right to withdraw a portion of that gift. Each beneficiary will then inform the trustee whether he or she intends to withdraw his or her portion of the gift. Generally, beneficiaries do not withdraw these gifts because they understand that their benefit will be greater in the long term if they allow the funds to remain in the trust. After the withdrawal period expires, the cash stays in the trust and the trustee may then use it to pay the policy premiums. The trustee must keep careful records with respect to the notice provided to the trust beneficiaries of their withdrawal rights because qualification for the gift tax annual exclusion requires the beneficiary to have knowledge of his or her withdrawal right.

If the total amount contributed to the trust in any one year is greater than the total gift tax annual exclusions for the trust beneficiaries, this excess will be a taxable gift. However, taxable gifts are first offset by the insured’s remaining lifetime gift tax exemption, if any. Thus, the insured should not have to pay gift tax on these gifts until he or she has made total taxable gifts during his or her lifetime in excess of $1,000,000. In the case of a married individual whose spouse splits the gifts, lifetime gifts may be up to $2,000,000 in the aggregate without the need to pay gift tax.

It is important to note that if the premium payments are made on behalf of the insured, most commonly by an employer, the insured is deemed to have made an indirect gift to the trust of the amount of the premium. In such a case, the trustee would still notify the trust beneficiaries of their right to withdraw a portion of the gift. Even though there is no cash in the trust for the beneficiaries to withdraw, the beneficiaries could withdraw other trust assets in lieu of cash.

Upon the death of the insured, the insurance trust may lend cash to the estate of the insured to pay estate taxes or may purchase assets from the estate. Assets of the trust will be held for the benefit of its beneficiaries, and ultimately will be distributed according to the plan provided for by the insured at the time the trust was created. In this way, an insurance trust can be an important complement to a Will or other estate planning documents in addition to providing a means to hold life insurance outside of the taxable estate.