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Rex Alan Lowe

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In general, the proceeds of a life insurance policy pass free of probate unless the beneficiary of the policy is the insured person or the insured's estate. If the insured or the insured's estate is the beneficiary, the proceeds of the policy are payable to the insured's estate and are subject to the probate process.

The value of any policies owned by an individual at death are subject to estate taxes. If an individual possesses certain rights (known as incidents of ownership) over a policy insuring his or her own life, the proceeds of the policy are generally included in the individual's gross estate for estate tax purposes at the individual's death.

Frequently, a couple will think they are safe from estate taxes if they own policies on each other. They may not be. Take for example the husband who is the owner and beneficiary of a policy on his wife. The wife dies first. The husband generally receives the proceeds of the life insurance policy free of income and estate taxes, but the funds remaining at his death become part of his gross estate for estate tax purposes.

Life insurance policies are often transferred to an irrevocable life insurance trust, in order to avoid the estate taxes that may result from owning a policy or from holding incidents of ownership in one. Other objectives may also be accomplished by such a transfer.

Pitfalls of Life Insurance in a Trust

The grantor cannot terminate or change the terms of an irrevocable life insurance trust once it is established and he does not have access to the funds in it.

If the insured transfers an existing policy and then dies within the next three years, the proceeds of the policy are includible in the estate for estate tax purposes under the Three Year Rule of IRC Section 2035. To avoid this possible pitfall, the trustee of the life insurance trust often purchases a new policy using cash in the trust, so that the insured is not transferring a policy to the trust.

Frequently, the policy premiums for a policy in trust will be paid by the trust with money received as a gift from the grantor. These transfers to the trust for premium payments may not qualify for the annual $11,000 gift tax exclusion (as of 2005) because they are considered to be gifts of "future interest" rather than a "present interest. " To avoid this possible pitfall, the beneficiaries of the trust are often given a limited power to withdraw funds (known as a "Crummey power"). Proper withdrawal rights generally make the gift a "present interest" and may allow the gift to qualify for the annual gift tax exclusion. Gifts to an irrevocable trust which do not qualify for the annual gift tax exclusion may trigger a gift tax or a reduction in the available Applicable Credit Amount for federal estate tax purposes.

An Irrevocable Life Insurance Trust can be designed for many special purposes.

Although there are numerous ways to create and fund these trusts, usually you make annual gifts to the trust. Based upon current withdrawal rights given to beneficiaries, these gifts are designed to qualify for the gift tax annual exclusion. The trust purchases life insurance on your life using the gifts to pay the premiums. The gifts will help to reduce your taxable estate.

At your death, the life insurance proceeds are paid to the trust as beneficiary. The irrevocable life insurance trust generally receives the policy proceeds free of income taxes (see IRC §101(a)), and with proper planning, the proceeds may be excluded from your estate for estate tax purposes. The trust may use the proceeds to purchase assets from your estate, or to make loans to your estate (provided that there is no obligation to make such loans). The executor uses this cash to help pay estate taxes and expenses. The assets purchased by the trust may then be distributed to the trust beneficiaries-your chosen heirs, or the trust may continue to hold the assets for the benefit of your heirs as provided in the trust agreement.