Life Insurance Trusts

a. Introduction to Life Insurance Trusts
If you own or are thinking of purchasing a substantial life insurance policy on your own life, and are concerned about triggering estate taxes, providing for your family or other persons, or would like to protect the policy, its cash value and death benefit from creditors, then you might consider making sure that no individual person owns the policy, and the benefits of your policy do not pay out into your estate. One way to do that is with a life insurance trust.

A life insurance trust is a trust that owns the eventual proceeds of your life insurance policy. Once you create a life insurance trust, you are no longer the legal owner of the insurance policy-instead, the trust is. As a result, the proceeds are not counted in your estate when you die. But there are specific requirements your trust must meet, discussed below.

The main goal of a life insurance trust is to reduce or eliminate estate taxes and protect the cash value and death benefit from creditors. For those who have a large life insurance policy, the worry is that the life insurance policy will pay out into the estate, increasing its size-and the possibility that the estate may owe estate taxes.

A life insurance trust is an irrevocable trust designed to acquire and own life insurance on the donor’s life.

An irrevocable life insurance trust (ILIT) is an irrevocable trust created to be both the owner and beneficiary of one or more life insurance policies. On the insured’s death, the trustee invests the insurance proceeds and administers the trust for one or more beneficiaries. If the trust owns insurance on a married person’s life, the surviving spouse and children are usually the trust’s beneficiaries. If the trust owns second-to-die insurance, the children would be beneficiaries.

Customarily, the ILIT trustee is authorized, but not required, to either buy assets from or make loans to the insured’s estate. Because the ILIT trustee possesses all incidents of ownership in the policy, the ILIT can provide the insured’s estate with liquidity while shielding the insurance proceeds or assets bought with the proceeds from estate tax when the insured dies, provided the trust has the appropriate settlor and trustee.

Because the trust is irrevocable, the trust assets and insurance proceeds or assets bought with the proceeds are also shielded from creditor claims unless the settlor made a fraudulent conveyance to the trust. In Laycock v Hammer (2006) 141 CA4th 25, the court held that evidence that the decedent indirectly borrowed money from a life insurance policy he had transferred to an ILIT was insufficient to show that the trust was revocable and, therefore, subject to the claims of his creditors. However, an irrevocable trust can be the grantor’s alter ego. Goodrich v Briones (In re Schwarzkopf) (9th Cir 2010) 626 F3d 1032.

b. ILIT Primary Objectives
The primary objectives of an irrevocable life insurance trust (ILIT) are the following:

  • to avoid having the policy proceeds included in the insured’s estate for estate tax purposes. Because the policy’s value typically increases, often dramatically, when the insured dies, a better transfer tax result can almost always be achieved by making gifts of money to a trust that will use the gifts to pay premiums.
  • To protect the policy cash value and death benefit from creditors;
  • To provide a source of funds to be used by the trustee for the benefit of trust beneficiaries for health, education, maintenance, support and any other needs.

c. How Life Insurance Trusts Work
First, you create an irrevocable trust, naming someone else as trustee. Then you transfer the policy into the trust and the trust becomes owner of the policy. You will no longer have any control over the policy, but through the terms of the trust you can determine who will have control, how premiums will be paid, who will benefit from the trust, and how payments should be made to the beneficiary or beneficiaries.

There are three important requirements:

  • The trust must be irrevocable.
  • You cannot be the trustee of the trust.
  • The trust must exist for at least three years before your death.

The first two requirements exist to ensure that you have no control over the policy after you transfer it to the trust. If you do retain control, the IRS will include the policy in your taxable estate. The last requirement is the IRS’s way of prohibiting “last minute” transfers to avoid estate taxes. It seems that it’s okay to avoid estate taxes this way, as long as you plan ahead for it.

d. Paying the Premiums
You can still pay the premiums for the life insurance policy-doing so is not considered an “incident of ownership” by the IRS. Or, you can give money to someone else to pay them. (But watch out for gift taxes!) Or you might consider buying a single premium policy so that no further payments will be due.

1) What does a life insurance trust do?
An irrevocable life insurance trust gives you more control over your insurance policies and the money that is paid from them. It also lets you reduce or even eliminate estate taxes, so more of your estate can go to your loved ones.

2) What are estate taxes?
Estate taxes are different from, and in addition to, probate expenses and final income taxes which are due on the income you receive in the year you die. Federal estate taxes are expensive and they must be paid in cash, usually within nine months after you die. Because few estates have the cash, it has often been necessary to liquidate assets to pay these taxes. But if you plan ahead, estate taxes can be reduced or even eliminated. Life insurance is often a good source of funds to pay estate taxes. And, with a life insurance trust, the life insurance proceeds are not subject to estate taxes, if the trust is properly prepared, implemented and operated.

3) What makes up my net estate?
To determine your current net estate, add your assets then subtract your debts. Insurance policies in which you have any “incidents of ownership” are included in your taxable estate. This includes policies you can borrow against, assign or cancel, or for which you can revoke an assignment, or can name or change the beneficiary. You can see how life insurance can increase the size of your estate and the amount of estate taxes that must be paid.

4) How does an insurance trust reduce estate taxes?
The insurance trust owns your insurance policies for you. Since you don’t personally own the insurance or have any incidents of ownership, it will not be included in your estate — so your estate taxes are reduced. (There is a three-year rule for existing policies, which is explained later.)

5) What are the Benefits of a ILIT?

  • If the trust buys the insurance, it will not be included in your estate. So the proceeds, which are not subject to probate or income taxes, will also be free from estate taxes.
  • Insurance proceeds are available right after you die. So your assets will not have to be liquidated to pay estate taxes.
  • Life insurance can be an inexpensive way to pay estate taxes and other expenses. So you can leave more to your loved ones.
  • The policy, its cash value and death benefit are protected from most creditors

6) How does an irrevocable insurance trust work?
An insurance trust has three components. The grantor is the person creating the trust — that’s you. The trustee you select manages the trust. And the trust beneficiaries you name will receive the trust assets after you die.

The trustee purchases an insurance policy, with you as the insured, and the trust as owner and (usually) beneficiary. When the insurance benefit is paid after your death, the trustee will collect the funds, make them available to pay estate taxes and/or other expenses (including debts, legal fees, probate costs, and income taxes that may be due on IRAs and other retirement benefits), and then distribute them to the trust beneficiaries as you have instructed.

7) Can I be my own trustee?
Not if you want the tax advantages we’ve explained. Some people name their spouse and/or adult children as trustee(s), but often they don’t have enough time or experience. Many people choose their CPA, Banker, Financial Advisor a corporate trustee (bank or trust company) because they are experienced with these trusts. A corporate trustee will make sure the trust is properly administered and the insurance premiums promptly paid.

8) Why not just name someone else as owner of my insurance policy?
If someone else, like your spouse or adult child, owns a policy on your life and dies first, the cash/termination value will be in his/her taxable estate. That doesn’t help much.

In addition, that would make the policy subject to the spouse’s or child’s creditors.

But, more importantly, if someone else owns the policy, you lose control. This person could change the beneficiary, take the cash value, or even cancel the policy, leaving you with no insurance. You may trust this person now, but you could have problems later on. The policy could even be garnished to help satisfy the other person’s creditors. An insurance trust is safer; it lets you reduce estate taxes and keep control.

9) How does an insurance trust give me control?
With an insurance trust, your trust owns the policy. The trustee you select must follow the instructions you put in your trust. And with your insurance trust as beneficiary of the policies, you will even have more control over the proceeds.

For example, your trust could allow the trustee to use the proceeds to make a loan to or purchase assets from your estate or revocable living trust, providing cash to pay taxes and expenses. You could provide your spouse with lifetime income and keep the proceeds out of both of your estates. You could keep the money in the trust for years and have the trustee make distributions as needed to trust beneficiaries, which can include your children and grandchildren. Proceeds that stay in the trust can be protected from courts, creditors (even spouses) and irresponsible spending.

By contrast, if your spouse or children are beneficiaries of the policy, you will have no control over how the money is spent. If your spouse is beneficiary and you die first, all of the proceeds will be in your spouse’s taxable estate; that could create a tax problem. Also, your spouse (not you) will decide who will inherit any remaining money after he or she dies.

An ILIT can also have a Trust Protector. A Trust Protector is someone who looks out for the trust, monitors the trustee and is available to do your wishes if the circumstances for creating the trust change.

10) Are there other benefits to naming the trust as beneficiary of an insurance policy?
Yes. If you name an individual as beneficiary of a policy and that person is incapacitated when you die, the court will probably take control of the money. Most insurance companies will not knowingly pay to an incompetent person, and will usually insist on court supervision. But if your trust is beneficiary of the policy, the trustee can use the proceeds to provide for your loved one without court interference.

11) Who can be beneficiaries of the trust?
You can name any person or organization you wish. Most people name their spouse, children and/or grandchildren.

12) Where does the trustee get the money to purchase a new insurance policy?
From you, as the donor. If you transfer money directly to the trustee, there could be a gift tax. But you can make annual tax-free gifts each beneficiary of your trust. If you give more than what is called the annual exclusion amount, the excess is applied to your federal gift/estate tax exemption.

Instead of making a gift directly to a beneficiary, you give it to the trustee for the benefit of each beneficiary. The trustee notifies each beneficiary that a gift has been received on his/her behalf and, unless the beneficiary elects to receive the gift now, the trustee will invest the funds — by paying the premium on the insurance policy. Each beneficiary must understand the consequences of taking the gift now; for example, it may reduce the trustee’s ability to pay premiums.

13) Are there any restrictions on transferring my existing policies to an insurance trust?
Yes. If you die within three years of the date of the transfer, it will be considered invalid by the IRS and the insurance will be included in your taxable estate. There may also be a gift tax. Be sure to discuss this with your advisor.

14) Can I make any changes to the trust?
An insurance trust is irrevocable, which generally means you cannot make changes to it. However, under the California Probate Code or the trust document itself, decanting provisions, you may be able to make some changes. Further, an ILIT will have a Trust Protector who, at your instruction, can make modifications to the ILIT document, including changing the beneficiaries.

15) When should I set up an insurance trust?
You can set up one at any time. But, remember, if you transfer existing policies to the trust, you must live three years after the transfer for it to be valid for estate tax savings purposes.

16) Should I seek professional assistance?
Yes. If you think an irrevocable insurance trust would be of value to you and your family, contact us.

f. Conclusion
In summary, the benefits of a ILIT are as follows:

  • Provides immediate cash to pay estate taxes and other expenses after death.
  • Reduces estate taxes by removing insurance from your estate.
  • Inexpensive way to pay estate taxes.
  • Proceeds avoid probate and are free from income and estate taxes.
  • Gives you maximum control over insurance policy and how proceeds are used.
  • Can provide income to spouse without insurance proceeds being included in spouse’s estate.
  • Prevents court from controlling insurance proceeds if beneficiary is incapacitated.
  • Protect the life insurance policy from creditors and children’s spouses;
  • Provides a way to pay for your family’s health, education, maintenance and support after you die;
  • Provides a possible cash value that may be drawn upon during your life for you or your family, if the ILIT is drafted with appropriate language.

Also, to keep your policy out of your estate, when you give it to another person you must give up all control over the policy. You cannot change the beneficiaries, borrow against the policy, change or cancel the policy, or do anything else that the IRS might construe as an “incident of ownership.” And, whoever you give the policy to will be able to do all of those things. So you must carefully consider whether you trust that person with the policy. While it’s not right for everyone, some people will decide to proceed this way-if they do, it’s because they absolutely trust the recipient.

About the Author
D. Steven Yahnian has been a member of the California Bar and a practicing Attorney since 1980. He has also been a California CPA since 1984. Mr. Yahnian also holds the CFP® designation.

Mr. Yahnian practices in the following areas of law through YAHNIAN LAW CORPORATION:

  • Estate Planning & Administration
  • Asset Protection Planning
  • Tax Planning, Tax Debt Resolution and Tax Litigation
  • Business & Corporate Law and Planning
  • Real Property Law & Planning

As a CPA/CFP, Mr. Yahnian also has a separate accounting and tax return preparation practice called DSA ACCOUNTING.

Mr. Yahnian is a California State Bar Certified Specialist in the following
• Taxation Law and
• Estate Planning, Trust & Probate Law.

Mr. Yahnian received a B.S. degree in Accounting from USC, a J.D. from Loyola University of Los Angeles School of Law and an LL.M. in Taxation from New York University Law School. He also has a Certificate in Taxation from UCLA (with distinction). Mr. Yahnian also has an MS in Taxation* from UCLA (with Distinction).


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