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It's The Law: Tax Free Life Insurance Trust Can Be A Great Idea

Q: I own a lot of real property and have a good income, but I do not have much in the way of liquid assets. I am worried about payment of estate taxes when I die and just paying the bills. There will not be much cash in my estate and real estate can take a long time to sell. My friend suggested a life insurance trust. How does a life insurance trust work?

A: Life insurance is often used to provide estate liquidity. It can provide funds for paying bills, estate taxes and even income taxes. It can be very useful when the estate has minimal bank accounts or readily sellable stocks or bonds.

Even if the estate has sellable assets, life insurance can be of significant benefit. It might not be a good time to sell assets. Rather than forcing sale of assets to pay bills, life insurance proceeds can allow a more orderly or delayed sale process so assets can appreciate or, as in the case of real property, simply allowing time for sale.

Unfortunately, the death benefits payable under a life insurance policy are includable in your gross estate if you own the policy. That means your estate will pay estate taxes on the life insurance proceeds close to 50% if you have a taxable estate. Taxable estates currently are those with assets in excess of $3,500,000.00. The insurance proceeds will also be included in your estate if the policy is payable to or for the benefit of your estate or the personal representative.

The Internal Revenue Code provides for distribution of up to $1,000,000.00 in life insurance death benefits without payment of estate tax, as long as you do not retain any incidents of ownership in the policy and it is not payable to or for benefit of your estate. Regulations explain that incidents of ownership are not limited to ownership of the policy, but include power to change the beneficiary, surrender or cancel the policy, assign the policy, revoke an assignment, or pledge the policy for a loan or to obtain a policy loan from the insurance company.

A relatively simple way to arrange for life insurance benefits but not have them taxed in your estate is to create an irrevocable life insurance trust.

You can create the trust with almost any kind of life insurance. If you already own a policy and transfer it to the trust, the trust must own the policy for at least 3 years prior to your death or it will be included in your gross estate just like any other asset transferred within 3 years of death.

Because of the recapture, if you think it is a good idea to get a new insurance policy, you should create the trust and get give the trustee money to buy the policy rather than buying a policy and transferring it to the trust. The trust instrument will designate how the insurance will be distributed after you die, which could even include retaining the proceeds during the life of your spouse or until your children reach a certain age, periodic payments of income or principal to various beneficiaries. The trust is relatively flexible and can be designed to accomplish more than liquidity and payment of estate taxes.

Creation and funding of the trust can carry gift tax consequences. If the cash contributed to the trust exceeds the amount that can be given to the trust beneficiaries without requirement of a gift tax return, the creation may use a small portion of your lifetime gift tax exemption (currently $1,000,000.00). If the policy requires payment of annual premiums and will not generate enough policy income to pay the premium, you will also have to make payments to the trust so that it can pay the premiums.

To avoid gift tax implications, the trust will generally include a provision allowing the beneficiaries to withdraw money as you contribute it, which means you are really gifting the money to them. When they do not withdraw the money during what is usually a 30 day window, the funds can be used by the trustee without further claim by the beneficiaries to pay expenses of the trust, including the policy premium. Even if some of the payments to the trust end up being gift taxable, the trust is a highly leveraged investment and an important part of many estate plans.

Creation of an insurance trust is not something that should be done without serious consideration. Selection of an independent trustee is an important aspect. Terms of distribution should be of great concern. Method of payment and actual mechanics of the trust are important considerations that will likely require you to be fully informed and educated. For all of these reasons, I suggest that you discuss your estate plan, including the possibility of creating a life insurance trust, with an experienced estate planning attorney before proceeding further.

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