Inter Vivos Life Insurance Trusts are an important estate planning tool. These Trusts enable a surviving spouse to receive all of the income earned by the proceeds of a life insurance policy after the death of the insured while at the same time exempting the proceeds from estate taxation in the estates of both the insured and the surviving spouse.
The following outline delineates, in point-by-point fashion, the important considerations in establishing Inter Vivos Life Insurance Trusts.
A. To provide the surviving spouse with all of the income earned by life insurance policy proceeds after the death of the insured; and
B. To exempt all of such proceeds from estate taxation at the deaths of both the insured and the surviving spouse, regardless of the order of their deaths. This is especially important if both spouses die within a short time period and leave minor children who survive them.
II. THE PARTIES
The Grantor is usually the insured.
The Trustee is someone who will not be an Income Beneficiary after the Grantor's death. The insured's spouse can be the Trustee if there are severe limitations on the use of trust income and principal (policy proceeds) for the spouse's benefit.
The Income Beneficiaries will usually be some combination of the insured's spouse and children.
The Remaindermen will usually be some combination of the Grantor's children and grandchildren. Typically, the trust terminates at the death of the surviving spouse and the insured's children receive all that is left in the trust. If the children are "too young" to receive those proceeds at that time, the trust can continue until they reach the desired age(s).
A. The Trust is created by the execution of a written agreement between the Grantor and the Trustee. Simultaneously, the Grantor transfers cash, or an existing life insurance policy, to the Trustee. If cash is transferred, the Trustee applies for a new life insurance policy insuring the Grantor's life.
B. As each insurance premium notice is received by the Trustee, the Grantor transfers additional cash to the Trust in an amount which approximates that premium.
C. Every transfer to the Trust is considered a gift for Federal Gift Tax purposes. Contrary to the usual rule, annual gift tax returns will almost surely be required even if the gift is less than $11,000.00.
D. To eliminate any gift tax liability, the trust agreement requires the Trustee to notify each Income Beneficiary every time a new gift is received by the Trust. Each beneficiary has the right to demand that the Trustee distribute his/her share of that gift to him/her, immediately. This opportunity for each Income Beneficiary to compel distribution of his share is called a Crummey Power. It is anticipated (but cannot be required) that the holders of Crummey Powers will not exercise their respective rights of withdrawal, so that the cash will be available to pay the premiums. The Crummey Power must exist, however, for without it, the desired tax consequences will not be achieved.
E. During the Grantor's life, the Trust's only assets will be life insurance policies and a small bank account. Annual trust income tax returns are usually not required.
IV. POST MORTEM
A. When the Grantor/Insured dies, the Trustee collects the insurance policy proceeds. If the procedures described above have been followed, there will no estate taxes payable by virtue of the payment of the policy proceeds, unless the Grantor has transferred a pre-existing policy to the Trust and dies within three years of the date of the transfer.
B. The Trustee will invest the policy proceeds. The trust agreement can give the Trustee as much or as little discretion as to the nature and extent of the investments as the Grantor may desire. The income generated is usually distributed to the surviving spouse. The Trustee (other than the surviving spouse) can be given discretion to distribute income to others as well. The distributee(s) pay income taxes on the income distributed. The trust (which will now be required to file its own income tax returns) gets an income tax deduction for the distributions. Thus the income is taxed only once. If the investments generate tax exempt income (such as municipal bond interest) that income remains tax exempt.
C. In addition to the trust's income, it may be possible to distribute some or all of the Trust's principal to the surviving spouse or others. Whether the spouse can receive principal distributions depends upon whether the spouse is a Trustee, and what the Trustee's powers are. (This subject requires extensive discussion.) However, since the trust principal will pass estate tax free to the next generation upon the death of the surviving spouse, it is advisable to consume the spouse's other assets which will be subjected to estate tax at his/her death, instead, while keeping the trust principal in tact for as long as possible.
D. The trust will terminate, as any other trust would, at a time designated in the trust agreement, usually when the youngest surviving child of the couple has reached an age at which the distribution of the assets would be deemed advisable, but no sooner than the death of the surviving spouse. The Remaindermen will receive those assets free of estate taxes.
E. Current thinking in the area of trust administration is to eliminate the distinction between income and principal of a trust and provide that the Income Beneficiaries of the trust should instead receive a Unitrust Amount. A Unitrust Amount is a fixed percentage of the value of the trust fund determined as of the beginning of each fiscal year of the trust. By eliminating the distinction between income and principal, the Trustee need not be concerned with whether it is advantageous to invest in high yielding, relatively low appreciating assets, as opposed to low yielding, high growth assets. The Income Beneficiary will receive an increasing sum each year so long as the value of the trust's assets grows regardless of the form which that growth may take. Thus, interest, dividends, or capital appreciation of any kind all benefit the Income Beneficiary, as well as the Remaindermen.
We invite you to consult with our estate planning and tax counsel, Elihu I. Rose, to determine whether an Inter Vivos Life Insurance Trust is appropriate for your circumstances
SAHN WARD & Baker, PLLC’s “Legal Advisory” is published with the intent to inform readers of recent developments in the law. It is not intended, nor should it be used, as a substitute for legal advice or opinion which can be rendered only when related to specific fact situations.