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The Irrevocable Insurance Trust Saves Taxes
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Purpose
The irrevocable insurance trust is a tax-oriented planning
tool. If analysis indicates potential estate tax, it should be
the first tool considered by an individual, the second by a
couple after appropriate use of the credit shelter. See
Tax-saving Estate Planning
Insurance plays an important role in many estate plans. It may
provide liquidity for a family and estate to enable family
support. In larger estates, it may be purchased as a potential
resource for paying estate taxes.
Yet insurance over which you have "incidents of ownership" will
be included in your estate (See The Federal Estate Tax).
Therefore, as much as half such insurance may be used to pay the
tax thereon, cutting its effectiveness.
One solution used to be to have the insurance owned by your
spouse. Even in the past, it was not as effective as the
irrevocable insurance trust, since the proceeds wound up in your
spouse's estate. Today, with an unlimited marital deduction, that
accomplishes no more than to name your spouse as beneficiary of
your insurance.
You might have the insurance owned by your children or other
beneficiaries. Not only does this lose the opportunity to provide
trusts for the benefit of your family (See An Introduction to
Trusts and Give the Advantages of Trusts. It provides potential
conflicts unless owned in the same proportion as the benefits of
your estate plan, and opens multiple doors for confusion.
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Old or New Insurance?
The insurance is owned by the trust. There are two approaches
possible.
If you already own insurance, you can transfer ownership to the
trust. If you die within three years of the transfer, the
insurance will be included in your estate (this applies to any
gift of insurance, whether to an individual or trust).
If you plan to get new insurance, the best approach is to set up
the trust first, make a gift of cash, and have the trustee apply
for and pay for the insurance, and have it initially owned by the
trust. This avoids the three-year rule. The insurance will not be
included in your estate, even if you die the next day.
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In Operation
The main role of the trustee during life is to receive periodic
gifts of the premium amounts (see below) and pay the premiums to
the insurance company.
In general, there are two types of insurance which may be
involved. One is insurance on a single life (such as your or your
spouse). The other is survivor or second-to-die insurance,
payable at the death of the survivor of you and your spouse.
Let's take them in turn.
Your spouse (as well as anyone else) can be trustee during your
life. If you wish, you can provide for a change of trustee at
your death.
The trust can have provisions during your life, which provides
flexibility, but the main impact will be at death. It can provide
benefits for your spouse and children. In effect, it should
probably parallel your shelter trust.
Since the insurance is not included in your estate, it does not
have to pass to your spouse to qualify for the marital deduction
to reduce your tax, which would result in taxation at your
spouse's death. It is completely removed from the tax system.
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Avoid Reciprocity
I strongly advise against couples setting up insurance trusts for
each other. If you set up a trust for yourself, it will be
included in your estate. If you and your spouse set up trusts for
each other, the "reciprocal trust" doctrine will treat you as
having bought the other trust and effectively set them up for
yourselves. My ideal recommendation is that A set up a trust for
B, and B set up a trust for the children (if the children are
provided for, there is less economic need by A) of which A can be
trustee. If a couple do want to provide for each other, it is
possible to make enough differences between the trusts to
hopefully avoid application of the doctrine, but it's risky.
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Second-to-die
If second-to-die insurance is involved, your spouse should not be
trustee or have benefits of the trust (these would constitute
incidents of ownership of insurance on their life). Although such
insurance is often presented for paying estate taxes at the
second death, it is not that simple. The trust cannot pay the
taxes directly or that would make it includible in the estate.
The insurance, in effect, *replaces* the family wealth lost to
taxes. Furthermore, if the estate lacks liquidity to pay the
taxes, the trust can *buy* assets from the estate. The insurance
trust could well wind up with ownership of the close corporation,
and should be planned accordingly.
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"Irrevocability"
Some clients are understandably concerned about the idea of an
"irrevocable" trust. However, this means that *you* cannot change
the trust you set up.
Various persons (spouse -- except in second-to die insurance --
trustee, children) can be given powers of appointment of varying
extent to rewrite the trust. They could even return it to you,
which is undesirable tax-wise. More likely, you'd want a revision
of the terms. This does mean you have to rely on working through
others.
If that tool isn't available (which it may not be in older
trusts) there are ways to arrange a *sale* of the policy from the
old trust to a new trust.
As a practical matter, what is the likelihood of wanting a major
change? If you provide for three children, you may at most want
to cut out one of them. But if the insurance is removed from
taxation, you will provide more for the other two children (as
well as the third) than if you changed taxable insurance to be
payable to two of them.
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Payment Procedures
How do we pay for the insurance? You make periodic gifts to the
trust, having granted Crummey powers to various beneficiaries to
qualify the gifts for the annual exclusion. You should file
annual non-taxable gift tax returns to elect to apply GSTT
exemption to the premiums, thereby excluding the proceeds from
GSTT.
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