Using Life Insurance Trusts and Related Taxes in Estate Planning

Is it practical to use life insurance trusts in estate planning?

The terms of using life insurance trusts in estate planning have changed in several ways over the last two decades. Whereas 20 years ago the exemption from the federal gift and estate tax was $600,000 and estate planners routinely advised their clients with life insurance policies to implement a trust to hold them, now that the exemption has increased to $5.45 million, such trusts are not implemented as frequently.
A life insurance trust refers to an irrevocable trust designed to take title of a life insurance policy during the insured’s lifetime in order to protect that policy from being considered part of the owner’s assets.  By creating such a trust, the imposition of federal estate tax on the policy is prevented. There is a limitation to the trust’s efficacy, however, in the form of a 3-year lookback rule as described by the Internal Revenue Code (IRC) Sections 2035(a)(2) and 2042.  What this lookback rule means is that if the life insurance trust has been created within 3 years of the owner’s death, the proceeds of the policy will still be included in the insured’s taxable estate for federal estate tax purposes.
There are complex methods to avoid the 3 year lookback, but they require the services of a highly skilled estate planning attorney who understands all the intricacies of tax and trust law. Typically, there are four methods to avoid estate taxation on the proceeds of the insurance policy at the time of the owner’s death. These are:

  • Gifting the policy to a life insurance trust
  • Gifting the policy to one’s children
  • Selling the policy to an insurance trust that has been structured as a “grantor trust”
  • Acquiring a replacement policy through a life insurance trust and surrendering  or selling the existing policy

The complex aspects of life insurance trusts are best handled by an experienced attorney who is able to decipher and implement elements of the process such as:

  • Crummey withdrawal powers (based on the taxpayer-friendly 1968 U.S. Court of Appeals for the Ninth Circuit case, Crummey v. Commissioner). Crummy withdrawal powers usually provide the children of the insured, and sometimes the insured’s spouse, with the ability to withdraw contributions to the trust annually.
  • Federal generation skipping transfer tax (GST tax) which would apply only when trust assets pass to a beneficiary of the trust, such as a grandchild. The GST tax, which is imposed at the identical rate as the estate tax, is in addition to the estate tax.

For clients with substantial estates, the complications just keep on coming. Whether or not to allocate GST exemptions to life insurance trusts should always be carefully evaluated by an expert in the field who will be able to take into consideration possibilities such as a premature death, a policy that expires before the owner’s death, a policy that does not remain in force in the future, and the possibility that the insured’s assets will unexpectedly increase in the future.

Brian Chew, the managing partner of OC Wills & Trust Attorneys, has extensive experience in the areas of estate planning, asset protection planning, business succession planning, long-term care planning, and veterans’ benefits. By devoting his practice to estate planning matters, he has founded a firm that strives to provide exceptional service to their clients by working closely with individuals and their families to create comprehensive and customized estate plans. For the past twenty five years, Brian has served thousands of clients in the matters of estate planning, wills and trusts. If you have any questions about this article, you can reach Brian Chew here.