by Steve Goodman
CPA, MBA – President & Chief Executive Officer
Contact Steve today for more info.
Life insurance trusts are a key tool for estate planning attorneys. Trusts enable donors to pass capital from a donor to his/her heirs at an enormous transfer tax savings. Policies held in trusts are not included in a donor’s estate, thereby reducing the estate tax liability. Proceeds from the life insurance policies can be, but must not the required to be, used to pay any estate taxes due upon the donor’s death.
There are non-tax reasons for holding life insurance in trust. These include a surviving spouse’s right of election, flexibility, professional management, and spendthrift protection from the beneficiary’s creditors.
This paper presents an overview of the life insurance trust landscape. Readers seeking additional information are strongly advised to consult with an attorney specializing in estate planning.
Irrevocable Life Insurance Trusts (ILITs)
Irrevocable Life Insurance Trusts, or ILITs, can be a useful way to utilize life insurance. There are two main types of ILITs:
- Standard, or “plain vanilla,” ILIT — With this ILIT, you must hold trust assets during your lifetime — distributions generally aren’t allowed. When you die, assets can be held in the trust or paid out annually to your surviving spouse over his or her lifetime. When the spouse dies, remaining assets are divided and distributed to your heirs and the trust is terminated. If the ILIT is a generation-skipping transfer (or GST) trust, assets can be held in the trust and paid out to grandchildren and great-grandchildren.
- Spousal ILIT — This ILIT is established by the grantor spouse with the non-insured spouse named as a beneficiary. A life insurance policy is purchased by the ILIT trustee on the grantor spouse who pays the premiums. The trustee will have the discretion to make distributions of income and/or principal to beneficiaries during the grantor spouse’s lifetime. If the beneficiary spouse is appointed as the trustee, distributions will be subject to what’s referred to as an “ascertainable standard” such as maintenance, support, health, or education.
So-called “Crummey Powers” — named after a court case involving a taxpayer named Crummey — secure the federal gift tax exclusion for annual gifts to an ILIT. These gifts provide the fund’s trustees need to pay the premiums on the life insurance policy held in the trust.(The annual gift tax exclusion is $15,000 for 2018).Beneficiaries have Crummey power to withdraw annual transfers to the trust for a limited time. Ideally, though, beneficiaries won’t exercise this power so funds are available to pay life insurance premiums.
However, the fact that beneficiaries have the power to withdraw funds means that annual transfers are converted into “gift of present interest” and qualify for the federal gift tax exclusion. If Crummey powers aren’t exercised within the specified time period, they will lapse and the trustee will be free to use funds to pay life insurance premiums.
Multiple Marriage Scenarios
Life insurance can be useful if you have children from a previous marriage by helping you distribute assets equally among all your children. In this scenario, you can use an ILIT to distribute death benefit proceeds to your children from a previous marriage. This way, these children can receive their inheritance before your current spouse dies.
ILITs and Private Split Dollar Policies
Private split dollar is a strategy that can reduce gift taxes when life insurance premiums exceed the insured’s annual gift tax exclusion and lifetime gift tax exemption. This is a premium sharing arrangement, usually between the insured and an ILIT.
The ILIT is the owner and beneficiary of the policy. Meanwhile, the insured (and possibly his or her spouse as well) enters into a private split dollar arrangement with the ILIT to pay the life insurance premiums in exchange for a collateral assignment of the premiums paid or the policy’s cash surrender value, whichever is greater. The ILIT pays the cost of life insurance protection as measured by the economic benefit. Whatever is remaining of the death benefit is paid to the ILIT income-tax and estate-tax free.
Keep in mind that the cost of the economic benefit will increase each year, which could necessitate ending the private split dollar arrangement at some point in the future.
Spousal Lifetime Access Trust (SLAT)
A Spousal Lifetime Access Trust, or SLAT, is another useful way to utilize life insurance. A SLAT is an irrevocable trust that owns permanent life insurance in which the trustee can make distributions to a non-insured spouse during the grantor spouse’s lifetime. The death benefit is not included in the grantor spouse’s estate.
It’s usually best if someone other than the insured serves as the trustee. This may be the grantor’s spouse, another family member, or a close friend. If the grantor’s spouse serves as trustee, discretionary distributions will be subject to an “ascertainable standard” and should be limited to no more than $5,000 a year or five percent of the trust assets, whichever is greater.
Properly drafted, a SLAT will not grant any beneficial interest to the grantor, give the grantor any rights to replace the trustee or provide the grantor with any incidents of ownership in the life insurance policy. Also, the grantor should use his or her own separate property when funding the SLAT. If property owned by the non-insured spouse is contributed to the trust, he or she would be considered the grantor and the property would be included in his or her taxable estate when he or she dies.
There is one major drawback to a SLAT: Access to the trust only comes through the non-insured spouse’s interest as a beneficiary. If this spouse dies before the grantor or if the couple is divorced, access to the trust could be lost. However, a SLAT can be drafted in such a way that if the grantor remarries, his or her new spouse will become the beneficiary. Even if the grantor doesn’t remarry, he or she could still have limited access to trust assets via a loan from the trustee. To avoid problems, distributions from the SLAT should only be used for the benefit of the non-insured spouse.
Consider a husband and wife, each with a SLAT providing income from the trust to the other. As long as both are alive, each draws income from the other spouse’s trust. Should the husband die, the wife’s income would be limited to the husband’s SLAT. She would not have access to his money received from her SLAT, putting her lifestyle in jeopardy.To offset any potential loss of income due to death, the husband’s SLAT buys life insurance. The wife’s SLAT does the same.
Using an A-B Trust for Estate Planning
Using a B trust in an A-B trust estate plan can be a great way to transfer wealth. By doing so, assets can pass to heirs estate tax-free and the surviving spouse will still have access to assets via the trustee. Keep in mind that B trust assets will be subject to income tax and capital gains taxes, and they will not receive a step-up in basis when the surviving spouse dies.
One way to maximize wealth transfer to heirs and minimize income taxes is to leverage the B trust assets with a life insurance policy on the surviving spouse. The trustee would apply for the policy and become the beneficiary — the trustee may be able to access cash value on the spouse’s behalf. When he or she dies, the death benefits are paid to the B trust and distributed according to the trust’s terms. In order for the purchase of life insurance in a B trust to be permissible, the following conditions must be met:
- The trust must allow the purchase of life insurance.
- The insured cannot be the trustee.
- Within nine months of the first spouse’s death, the insured must disclaim any special powers of appointment.
- Within nine months of the first spouse’s death, the surviving spouse must disclaim any rights to withdraw up to $5,000 or five percent of the trust assets annually, whichever is greater.
Dynasty Trusts: Leaving Assets for Future Generations
Some individuals wish to leave an inheritance not only for their children but also for their grandchildren and future generations. A Dynasty Trust can help you accomplish this because, unlike other types of irrevocable trusts, it can continue for many generations. As such, this type of trust can protect assets from gift and estate taxes as well as generation-skipping transfer (GST) tax.
Life insurance is commonly used to fund a Dynasty Trust because it provides the most leverage for wealth transferred to beneficiaries. You will transfer cash to the trust, which the trustee will use to pay the life insurance premiums. The transfers may or may not be subject to gift tax, depending on whether or not you make annual exclusion gifts and/or use your lifetime gift exemption. To avoid GST tax, you must allocate some or all of your GST tax exemption to your Dynasty Trust contributions.
A Dynasty Trust may be indefinite or limited to a certain number of years, depending on applicable state rules. The assets within a Dynasty Trust, including a life insurance policy’s death benefit, are excluded from the taxable estate, so they aren’t subject to estate taxes.
Establishing a Dynasty Trust requires the following:
- appoint a trustee
- name beneficiaries
- decide when beneficiaries will receive assets
- name a corporate trustee or co-trustee, depending on the length of the trust.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.