Many clients are surprised to learn that life insurance is generally subject to estate tax. This surprise can be very costly for the surviving family members. Life insurance is often intended to be used to pay the estate tax which is due in cash nine (9) months after the date of death. There are very few exceptions to this due date.

Since the life insurance is subject to estate tax, approximately 55% of the death benefit (based on the 2013 estate tax rate) will be used to pay the additional estate tax on the life insurance benefit. For example, a $1,000,000 policy would result in $550,000 in additional estate tax leaving only $450,000 for the surviving family members.

Life insurance policies are an important estate planning tool. Life insurance proceeds are not taxable to the beneficiary because they are treated by the Internal Revenue Service as an inheritance or devise. If planned correctly, the policy and proceeds will not be included in the decedent's estate. Therefore, no estate tax will be owed on the amount received by the beneficiaries. Irrevocable life insurance trusts (ILIT) are the most common method of avoiding a situation where the policy proceeds are brought back in to the decedent's gross estate.

Life insurance policy proceeds are included in the decedent's estate if the insured "owns" the policy. For example, Husband buys an insurance policy on his own life and lists Wife as the beneficiary. Husband pays the policy premiums until he dies. Upon his death, the proceeds are paid to his wife as beneficiary. In this situation, Husband is deemed to "own" the policy because he paid the premiums. Upon Husband's death, the proceeds paid to Wife are included in Husband's gross estate. Therefore, Husband's estate will be pay tax on the amount received by Wife.

The Internal Revenue Service adopts an expanded view of ownership to include the following incidents of ownership.

  • The power to change the beneficiary;
  • The power to surrender or cancel the policy;
  • The power to assign the policy or to revoke an assignment;
  • The power to pledge the policy for a loan; or
  • The power to obtain from the insurer a loan against the surrender value of the policy.

By transferring a life insurance policy into an irrevocable trust, or funding the trust with cash for the purpose of purchasing a life insurance policy on the settler of the trust, the settlor gives up all control over the policy and the insurance proceeds are not included in the gross estate. Therefore, no estate tax is owed on the proceeds that pass to the beneficiaries.

Purchasing a new policy is typically the preferred method of funding the trust. In the event an existing policy is transferred into the trust, the proceeds may be included in the settlor's estate if the transfer took place less than three years prior to the settlor's death.

Any increase in value of the insurance policy is not subject to income tax, and therefore the trust pays no income tax on the policy.

The settlor may continue to pay the premiums on the policy, but may not also be the trustee of the trust that owns the policy on her life. If the settlor does continue to pay the premiums, he should plan for the premium payments to qualify for the annual exclusion for both gift and generation-skipping transfer tax purposes. The trust should not permit trust assets to be used in satisfaction of any legal obligation of the insured. This could result in the Service attributing ownership of the policy to the insured.

Transfers to the trust for the purpose of paying premiums may be structured in such a way that transfers to the trust qualify for the annual exclusion for gift tax purposes. To qualify for the annual gift exclusion, the gift must be one of "present interest." To qualify the gift as a present interest, the settlor may create a Crummey Trust. A Crummey Trust provides that the beneficiaries have a temporary right to withdraw a pro rata portion of any gift made to the trust. This withdrawal right is a "present interest" and enables transfers to the trust to qualify for the annual exclusion. As a gift of present interest, the policy premiums, whether paid by the insured or by a third party, qualify for the annual gift tax exclusion. Call us if you wish to discuss whether a Life Insurance Trust is appropriate for you and your family.

The information in this article is not, nor is it intended to be, legal advice. This article is for informational purposes only and may or may not apply to you. You should consult an attorney for advice regarding your particular circumstances. We invite you to contact us and welcome your calls, letters and electronic mail. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.