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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