PROTECTING YOUR LIFE INSURANCE TRUST FROM TAXES

The Importance of Proper Trust Maintenance

The trustee of an irrevocable life insurance trust (ILIT) must follow numerous rules and regulations laid out by the IRS in order to exclude the ILIT’s policy proceeds from federal and state estate tax. The insured and the trustee should check to see that these rules and regulations are in compliance annually because any significant mistake — even an honest one — may lead the IRS to challenge the trust and tax the life insurance proceeds.

Life Insurance Trust Basics
An ILIT holds one or more life insurance policies on your life. Each year, in order to pay the premiums on the life insurance policy, you must gift money to the ILIT and then your trustee uses this money to pay the premiums. After your death, your trustee will distribute the insurance proceeds according to your instructions.

If established properly, you will not have any control over the life insurance policy itself or any of the assets in the ILIT. Normally, if you do not have control over an asset, it is not taxable for estate tax purposes. The IRS is not happy about the ability of people to pass on vast sums of money without paying tax and they may scrutinize your ILIT for mistakes so it can collect the estate tax. Accordingly, even though you have no control over the assets in your ILIT, it is still important that it is properly maintained.

Funding the ILIT
After the trust document is drafted, the trustee will either purchase an insurance policy on your life or transfer an existing policy into the trust. In either case, the trustee must be the policy’s owner and beneficiary. For policy that is not paid in full, the trustee must open up a bank account for the trust and you must deposit money into the ILIT’s account to cover the premium.

Your gift to the ILIT -- whether cash or an existing insurance policy -- qualifies for the annual gift-tax exclusion of up to $12,000 per beneficiary (for calendar year 2007). If you decide to transfer an insurance policy to the trust via gift, you must figure out the value of the policy. A good rule of them is the value of a term policy is approximately the current year’s premium or the cash surrender value for a whole life policy. (This is not exact however and there are exceptions, so you must get an official valuation from the insurance company - this is known as the interpolated terminal reserve plus a portion of that year's premiums paid by the owner.)

If you transfer an existing policy to your ILIT and you die within three years of that transfer, the proceeds will be included in your estate for estate tax purposes. If you are insurable, the three-year rule can be avoided by gifting cash to the trust and having the trustee purchase a new policy. You can then surrender the old policy and use the cash value, if any, to pay the premiums on the new policy.

Premiums and Crummey Notices
Each year you make a gift to the ILIT, whether to pay the annual premiums or otherwise. The gift will qualify for the annual gift-tax exclusion as long as the IRS considers the gift a gift of a “present interest.” In order for the gift to be deemed a gift of a “present interest”, your trustee must give the beneficiaries a right to withdraw the gift. This is known as a demand right or a Crummey power. (If a beneficiary is a minor, your trustee should send a Crummey notice to their parents or guardians of that minor.)

This notice requirement applies to the first year’s gift as well as every subsequent year’s. If your trustee forgets to send the Crummey notices, the IRS may say that the beneficiaries did not have a “present interest” and include the gifts as part of your taxable estate.

As soon as the withdrawal period lapses -- typically after 30 days and assuming the beneficiaries don’t exercise their withdrawal rights – the trustee can use the money to pay the premium. Due to this time constraint, money should be put into the trust account at least 45 days prior to the premium being due.

There is always a danger that the beneficiary will actually take the money, so you should explain to your beneficiaries that allowing the right to lapse each year without withdrawing the cash is in their long-term best interest.

It should be noted that if the trust owns a second-to-die policy on your and your spouse’s lives, the survivor should continue to make gifts to the ILIT so that the premiums can continue to be paid.

Records and Tax Returns
If the ILIT has gross income in excess of $600 for the year, your trustee is responsible for filing annual income tax return. The trustee should also maintain certain records in the event that the IRS chooses to audit the ILIT’s operation. These records include:
· Copies of all Crummey notices sent to the beneficiaries along with any related correspondence;
· Canceled checks from your individual (or joint checking account for a 2nd to die insurance trust) showing the gifts you made to the ILIT; and
· The trust’s checking account records, showing gift deposits and premium disbursements.

Avoid Incidents of Ownership
To maintain your ILIT’s tax-advantaged status, avoid exercising any control over the trust. In IRS terms, the insured party must not have any “incidents of ownership” during the trust’s life. If you violate this rule, the IRS will include the insurance policy in your estate and tax the proceeds. Incidents of ownership include the ability to:
· Change or add a beneficiary,
· Surrender or cancel the policy,
· Assign the policy or revoke a policy assignment,
· Borrow against the policy or pay premiums with policy loans; or
· Pledge the policy as collateral for a loan.

Mistakes Can Be Costly
Any significant mistake -- even an honest one -- may prompt the IRS to challenge the trust and tax the insurance policy’s proceeds. If you or your trustee has any questions about the proper way to handle your ILIT, please call before you act.

Contribution Notice - Who Signs for a Minor?

Many people create irrevocable life insurance trusts (ILIT) for the benefit of minor children. The common scenario is that the grantor will create an ILIT and his or her spouse will act as trustee of such trust.

Because ILITs are established as Crummey trusts, a contribution notice should be sent out to the beneficiaries whenever a contribution is made to the trust. When the children are minors - who signs off on the notice, the Grantor or the Trustee?

General consensus amongst practitioners is that the Trustee parent should sign the notice under the theory that if the Grantor parent acts as if he or she has a withdrawal power, then he or she is maintaining an impermissible incident of ownership in the trust. Such retention of power might cause the trust to be includible in the Grantor's estate for estate tax purpose, thereby nullifying the reason the trust was probably created in the first place.

For second to die life insurance trusts, neither parent should act as signer for a minor child. Accordingly, to be very safe, a guardian ad litem should be appointed, in a limited capacity, to sign the contribution notices. Practitioners should try to avoid creating second to die life insurance trusts until the designated beneficiaries of the trust have reached the age of majority.

Nuts and Bolts of Life Insurance Trusts

Life Insurance Trusts – The most common form of inter vivos irrevocable trust is the Life Insurance Trust (ILIT). Since the grantor of the trust has no desire to use the proceeds of this trust during his life, and because the value of the insurance at the time of the grantor’s death can be quite high, it is a very popular mechanism for reducing or avoiding a grantor’s estate tax liability.

a. When creating a life insurance trust, it is important to know whether the client will be buying the insurance through the insurance trust or if they will be transferring in an existing insurance policy.

1) If at all possible, the client should always have the trust buy the insurance because:

i It avoids I.R.C. §2035 which states that a person’s gross estate for estate tax purposes includes certain assets that have been transferred out of the person’s estate within three years of death. Accordingly, if a person transfers an insurance policy to an insurance trust and dies within three years of when the gift to the trust was made, the full amount of the proceeds will be subject to both the Federal and New Jersey Estate Taxes.

ii It avoids having to determine the value of the existing policy at the time of the transfer. This value is known as the interpolated terminal reserve.

iii We are sure the insurance actually gets into the trust. All too often a planner creates the insurance trust and then it never gets funded, exposing the practitioner to unnecessary liability.

2) If the client will be contributing existing insurance to a trust:

i The value of the insurance at the time of the transfer is a gift to the Crummey beneficiaries of the trust.

ii Care must be taken when selecting the beneficiaries of the trust to ensure that there are enough beneficiaries to shelter the value of the gift.

iii The trust must be funded with enough liquid assets in the event someone does wish to exercise their withdrawal rights.

b. The trust should be established as a Crummey Trust.

1) A Crummey Trust is named after Clifford Crummey, the first taxpayer to use this type of trust successfully.

2) A Crummey trust is designed to provided a limited withdrawal right to certain beneficiaries in an irrevocable trust so that transfers to the trust are eligible for the annual gift tax exclusion.

3) The more Crummey beneficiaries there are, the greater the gift that may be made to the trust without having to pay a gift tax. Crummey beneficiaries may not just be named at random, because they do have a real right to withdraw the money that is put into the trust.

4) Generally, a 30 day withdrawal right is considered adequate, but there is no clear minimum.

5) Particular care must be taken when drafting the Crummey power to ensure that the power lapses only the extent of the greater of $5000 or 5%. Any greater lapse will be considered a gift by that withdrawal beneficiary to the other beneficiaries of the trust.

6) The trustee should have broad powers to satisfy any withdrawal rights. All Crummey withdrawal rights should be satisfied either against the contribution or the property of the trust, including any insurance policy or fractional interests in the insurance policy. This will provide substance to a Crummey withdrawal right.

c. Tax aspects

1) The trust should generally be created as an Intentionally Defective Grantor trust, I.R.C. §677, so that although the assets of the trust are out of the grantor’s estate, during the life of the Grantor any income received by the trust is taxed to the Grantor rather than being taxed to the trust. This avoids having to file a Form 1041 income tax return for the trust and it provides an additional gift to the beneficiaries in an amount equal to the income taxes actually paid. Frequently this is done with a power to substitute trust assets, other than the insurance, with assets of an equivalent value to the trust in a non fiduciary manner I.R.C. § 675(4).

2) Upon the death of the grantor, the trust will either be taxed as a simple or complex trust depending upon the terms of the trust.

3) The practitioner must consider whether the Grantor’s Generation Skipping Tax Exemption should be allocated to the ILIT. The Code was revised under EGTRRA to provide an automatic allocation of the Grantor’s GST exemption in many cases and this is not always the most desirable result. A grantor may opt in or opt out of having the automatic allocation on a timely filed gift tax return.

d. Planning Considerations

1) The Grantor should NEVER be trustee of his or her own ILIT.

2) It may sound obvious, but it is important to counsel clients that once money goes into an irrevocable trust, the money no longer belongs to them and they will have difficulty getting the money back.

3) If the Trustee is the Grantor’s spouse, care must be taken when making contributions to the trust to ensure that the Trustee spouse is not making any contributions. (i.e. Never contribute joint or community property to the trust or write a check to the trust from a joint account or a business account).

4) ILITs are somewhat expense to establish and maintain for many clients, particularly those who have large estates due strictly to the amount of insurance they buy. Consideration should be given to naming a child as the owner and beneficiary of the policy as a means to save money for the client while receiving many of the same tax benefits.

5) The client should make sure that the insurance premiums are paid on an annual basis to minimize the maintenance fees. If multiple insurance policies are in one trust, try to convince the insurance carriers to have the same due date for the premiums.

6) The life insurance trusts is a particularly useful planning tool for same sex couples and unmarried couples because it provides a means to give the decedent’s significant other a large sum of money tax free, yet control the money’s ultimate destination.

e. Types of Life Insurance - Regardless of whether a client owns a term, whole life, or variable life insurance policy, if the value of the policy and the client’s other assets are in excess of the New Jersey Estate Tax threshold, it is advisable to discuss the benefits of the ILIT.

1) Term Life Insurance – These policies by their nature are designed to last for short period of time to cover a particular type of risk. The premiums on these policies are typically low, and a contribution of an existing policy to an insurance trust is relatively easy because of the low value of the policy.

2) Whole Life Insurance – These policies are designed to build up a cash value to produce a guaranteed return that will ultimately pay for the insurance premium. The premiums can be quite substantial, which is important to know when calculating the number of Crummey beneficiaries that must be named. A contribution of a large whole life policy to an ILIT may result in a gift tax no matter how comprehensive the planning because of the size of the insurance.

3) Variable Life Insurance – This type of policy is similar to the whole life insurance except that instead of having a guaranteed return, the rate is variable. Since most people are not good investors, be wary of advising this product.

4) Second to Die Insurance - A Second to Die Insurance Trust is different from a typical ILIT in one substantial and obvious way - the insurance benefits are not paid until the second to die.

i Practitioners should ensure that neither spouse is ever eligible to serve as trustee nor made a Crummey beneficiary.

ii Since this trust is not for the benefit of the surviving spouse, the clients should be sure that the surviving spouse has enough funds to live on absent the trust funds.

iii These trusts are particularly beneficial for clients interested in dynasty trusts as more insurance can purchased for a lower premium amount.

f. Insurance Trusts Established Pursuant to Divorce or Separation– Frequently Divorce attorneys draft provisions in a separation agreement or a divorce decree that call for an insurance trust to be created for the benefit of the children of the marriage. Terms of the trust are rarely spelled out with any specificity.

1) In the event that the person who is required to be insured passes prior to the creation of an ILIT, the courts can impose a constructive trust for the benefit of the children. (A constructive trust is an implied trust established by operation of law.) The terms of the trust are in the judge’s discretion, rather than in either the form that the decedent, or surviving parent, would want.

2) Planning Considerations

i Frequently a divorce or separation agreement will say what amount of insurance a person should have without any consideration for who should be trustee, the tax consequences or the ages at which the children should have access to the money. Occasionally, inappropriate provisions are included. Thought must be given how to address these concerns, particularly in light of the fact that these two individuals may not be on good terms.

ii Payment for the trust. I have yet to see a divorce decree or separation agreement that contemplates who will actually pay for the insurance trust. This is often a sticking point for many clients.

iii Compliance. Working with an unfriendly trustee or grantor can severely complicate compliance with both the tax laws and properly funding the trust.

g. Management of Insurance Trusts

1) The management of an insurance trust from an investment standpoint is quite simple. Most insurance trusts do not have assets other than the insurance itself.

2) The complexity comes when trying to explain the maintenance and funding requirements of the trust to clients. Further complicating matters, often clients will try to manage the trust completely on their own to save on costs. The practitioner must take extreme care when allowing this to happen because the practitioner will still be potentially liable.

3) Funding the Trust

i Checking accounts must be created in the name of the trust (and if the Grantor does not have an individual checking account, the Grantor may also have to create a checking account to fund the trust). Many practitioners like to get a separate tax identification number for the ILIT. If the trust is an Intentionally Defective Grantor Trust (IDGT), it is not necessary, but it is still a good idea in the event a creditor does an asset search using the Grantor’s Social Security Number.

ii Insurance must either be purchased by the trust or transferred into the trust. This requires completing insurance forms that designate the trust as the owner and beneficiary of the policy.

4) Sending the annual Crummey letter. As soon as practical after the trust is funded, a letter must be sent to the designated Crummey beneficiaries to advise them of their withdrawal rights. These letters should be acknowledged by the beneficiaries (or their guardians) and maintained by the attorney (or trustee).

i After 30 days (or whatever the relevant Crummey time period is) the Trustee may use the gift from the Grantor to pay the insurance proceeds.

5) To avoid problems with I.R.C. §2035 and §2036 (which would bring the insurance back into the gross estate of the Grantor), it is important that the Grantor contains no impermissible control over the trust and should never be the trustee. The Grantor may be given limited ability to hire and fire Trustees.

Irrevocable Trusts

There are many different types of irrevocable trusts. The most popular irrevocable trusts include:

1. life insurance trusts;
2. asset protection trusts;
3. charitable trusts;
4. trusts created upon death (such as QTIP trusts and bypass trusts); and
5. special needs trusts.

Generally, an irrevocable trust is designed to prevent its terms from being modified in the future. As a practical matter, what this means is that a person (the Grantor) creates a document (the Irrevocable Trust) outlining how his or her beneficiaries should receive any assets that are placed into the trust.

The Irrevocable Trust document itself has provisions which state that the Grantor may not make changes or modifications to the trust. Unlike a Revocable Trust, the Grantor of an Irrevocable Trust gives up all control once the trust is created. There are times when such trusts can be later modified, whether by court or by consent of all the beneficiaries, but never by the grantor alone.

Frequently people also create an Irrevocable Trust because once assets are transferred to such trust they will receive favorable estate and inheritance tax treatment. Assets in Irrevocable Trusts receive favorable tax treatment because they are excluded from the gross estate of the grantor at the time of the grantor’s death.

Another reason people also create irrevocable trusts is to provide as a means of protecting the assets in the trusts. By giving up control of the assets (in a non fraudulent way), a potential creditor may not sue the Grantor and try to claim against the assets in the trust.

In most states, including New Jersey, a Grantor may not be a beneficiary of an asset protection trust. However, a few states do allow self settled spendthrift trusts.

Benefits of a Life Insurance Trust

I. What is a Life Insurance Trust?

A. Legal Relationship - A trust is a relationship that exists when one person or an entity (the Trustee) holds legal title to money or property for the benefit of one or more individuals or organizations (the Beneficiaries). The terms of the relationship are decided by the person providing money for the trust (the Grantor), and are usually evidenced in writing.

1. Grantor/Settlor - The Grantor or Settlor is the person or entity that creates the trust by providing the money or insurance to fund it.

2. Trustee - The Trustee is the person or entity that manages the trust assets for the benefit of the beneficiaries of the trust. The trustee is bound by a fiduciary duty to act in the best interests of trust, as directed by the Grantor or Settlor.

3. Beneficiary - A Beneficiary of a trust is a person or entity that is entitled to receive money from the trust. The manner in which a person receives such money varies from trust to trust, and generally a Grantor may put in a range of provisions to restrict a Beneficiary’s access to the money.

B. Design - A life insurance trust is specifically designed to hold life insurance.

1. Irrevocable – Once created, a life insurance trust is almost impossible to change.

2. Loss of Control - Generally, the insured must give up all rights to control the trust and the life insurance policy in favor of a trusted advisor. The Grantor should decide the terms of the trust upfront so that the Trustee may carry out the Grantor’s wishes.

3. Tax - A life insurance trust is typically designed to save money on estate and inheritance taxes. It should also allow the Grantor to use his or her annual gift tax exclusion so that the premium payments are not treated as a taxable gift.

II. What are the benefits of an insurance trust?

A. Reduces estate and inheritance taxes - If life insurance is owned by a trust, and the trust is structured properly, the proceeds from the life insurance will NOT be includible in the taxable estate of the Grantor. Note: A trust must purchase the life insurance, otherwise there is a three year look-back period.

B. Allows for control of assets after you die – Despite the fact that the trust is irrevocable and you lose control once it is established, with proper planning, the trust can allow a Grantor to decide when and how his or her heirs should get the proceeds of the life insurance.

C. Asset protection – By giving money to your heirs in trust, it ensures that your heirs are less likely to squander their inheritance. It also protects it from creditors.

III. Who should consider an insurance trust?

A. Recent Divorcees – Many divorce decrees call for an insurance trust to be established. It benefits the custodial parents by giving them assurance of the existence of the policy. It benefits the non-custodial parent by giving them a voice in when the child gets the money and ensuring that they money benefits the children, and not the person they just divorced.

B. Individuals with Significant Assets – Individuals with substantial wealth may benefit from a life insurance trust as a way to reduce taxes or to create liquidity for an estate that may have other tax or cash flow issues.

C. Individuals with Large Insurance Policies – By itself, a large policy can create estate tax issues, so even if a person is not otherwise wealthy, it makes sense to transfer the wealth you do have with minimum tax consequences.

D. Same Sex Couples – Despite the recent changes in some states, including New Jersey, that benefit same sex couples, many states and the federal government still treat same sex couples as nothing more than friends for tax purposes. Accordingly, a life insurance trust will ensure that your loved one benefits upon your death without a large tax bite.

E. Individuals married to Non-Citizen Spouses – A non citizen spouse is not entitled to the unlimited marital deduction for estate and gift tax purposes. Accordingly, if you are married to a non-citizen spouse, the best way to avoid a large estate tax upon your death is to create a life insurance trust.