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LIFE INSURANCE TRUSTS: THE BASICS
Introduction:
Life insurance has long been a useful estate planning tool, allowing
liquidity to a bereaved family at the most critical moment when a bread
winner may be newly deceased with resultant loss of income. For younger
families, with children depending on the parents, life insurance can make
the difference between poverty and a continuation of a middle class life
style, between children going to college or children forced to work
immediately after high school.
Life insurance can also provide liquidity for buy and sell
agreements for business buyouts, for an
“automatic” savings plan if they develop cash value, and to
provide businesses some cash flow if a key executive dies.
It is vital to have trusted advice as to which of the
myriad types of life insurance are appropriate for the particular
circumstances of the individual or business and which make sense from a
cost benefit analysis. A good broker who knows that the purchase is the
beginning of a long professional relationship is an important tool for
the person seeking to purchase life insurance that is truly useful and
appropriate.
Equally important for family estate planning is to
make sure the life insurance does not end up included in the
decedent’s estate for estate tax purposes. If held incorrectly,
life insurance can result in estate tax being incurred and up to half the
value of the insurance can end up being paid to the government instead of
the beneficiaries.
A useful structure to avoid that danger is the Life
Insurance Trust which is the subject of this brief discussion.
The Basics
The reader should first review the article on Wills and Trusts for
a synopsis of what a trust is. The reader should recall that there are two
types of basic trusts: revocable and irrevocable. Irrevocable means that
the person who creates the trust (the “trustor”) is not
allowed to revoke the trust: the transfer of assets into that trust is a
completed gift to a separate entity which pays its own taxes and, from
the point of view of the United States taxing authorities, is as much a
“tax paying” person as any other person in the United States.
Revocable trusts, which can be terminated at the discretion of the
trustor, are usually ignored by the taxing authorities. They conclude
that if the trustor can revoke at will, there really is no separate
taxable entity and simply tax the trustor for the assets in the trust as
if no trust had been created.
If a life insurance policy is owned by the decedent at
the time of his or her death or, in many circumstances, by the
decedent’s spouse, it can be included as part of the
decedent’s estate. While the level of estate tax varies with other
estate planning tools and while the level of estate tax changes each
year, it is quite possible that this could result in taxes being levied
against the life insurance in excess of forty percent. A million dollar
policy could be reduced to six hundred thousand and, depending on the
State, even less.
But if an irrevocable trust
is created to own the life insurance and the trustee of the trust is not
subject to the effective control of the trustor, the life insurance is
not included in the decedent’s estate. Usually, the trustee is not
in the trustor’s family or an employee of the trustor (so as to
avoid the taxing authorities claiming that the trustee is actually no
more than the alter ego of the trustee and ignoring the trust entity
entirely.) The trustor contributes sums from time to time to the trust
sufficient to purchase the life insurance and keep it in effect. The
trustee then uses the funds to maintain the insurance. The terms of the
trust instruct the trustee as to his or her duties, as explained in the
article on Wills
and Trusts.
After the trustor’s
death, the life insurance is distributed to the trust and the trustee,
pursuant to the trust instrument, is required to pay it out, with no
estate tax, to the designated beneficiaries of the Trust, usually the
children of the trustor, or to hold it in trust until the children reach
a certain age or to pay their college education.
Assuming the correct terms
of the trust have been drafted and obeyed, the distribution will be free
of estate tax.
Cautions:
As with any irrevocable trust, it is
important BEFORE the document is executed, to make sure it provides for
precisely the desires of the trustor. Remember, once the trust is created
and funded, it is truly irrevocable and the trustor no longer has any
right to reclaim the assets or control them other than as described in
the trust instrument which, by its very nature, will not allow the sums
to go back to the trustor since otherwise the tax benefit would never
have been achieved.
Or, as one client put it,
“This is show time and one way, isn’t it?” as he
executed the Trust. Another client
put it with less concern: “Making an irrevocable trust is like
creating a new person…who does what I want.” “Yes,” I responded,
“within limits…but like with any person, once they leave your
full control you can’t just call them back to mother…”
Thus appropriate drafting
and a close consideration of the benefits and detriments of the transfer
must be carefully considered. While avoiding taxes are important, it is
vital to note that if there is any chance the funds could be needed again
by the trustor, the gift may not makes sense. An examination of the
entire estate planning…and financial planning…goals of the
trustor must be undertaken before it is decided to use these clearly
valuable tools.
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