Insurance Policies are Included
in the Owner�s Estate

The irrevocable insurance trust is an estate planning technique that can provide liquidity for the payment of Estate Taxes without the proceeds of the life insurance policy being included in the estate of the insured decedent or that of the insured decedent�s surviving spouse. Many people purchase insurance policies to enable their estates to pay the Estate Taxes which they think will be owed at the time they pass on. Some wealthier individuals also purchase large insurance policies to provide income to the surviving spouse and/or other members of the family in order to replace the loss in earned income of the deceased breadwinner.

However, if an individual is the owner of an insurance policy on the date of his or her death, then the face amount of the policy is included in that individual�s estate. In addition, if an individual has made a gift of the policy to another person or entity, and then that individual dies within three years of the gift, the policy proceeds are also included in the individual�s estate (often referred to as the �three-year rule�).

An example may be of assistance to the reader. If the first spouse to die (�first spouse�) owns a $500,000 insurance policy on his or her life, then the $500,000 of policy proceeds are included in first spouse�s estate for Estate Tax purposes. If first spouse also individually owns $250,000 in other real and personal property, then $750,000 ($500,000 + $250,000) in assets are included in first spouse�s estate. If you reduce this amount by the $675,000 Applicable Exclusion amount (assuming it has not been reduced by lifetime gifts), then the remainder of first spouse�s estate ($75,000) will be passed to the surviving spouse under the marital deduction, which may cause an avoidable Estate Tax problem for the surviving spouse if it brings surviving spouse�s estate�s value over his or her remaining Applicable Exclusion. An insurance trust could eliminate this problem.

How the Irrevocable Life Insurance Trust Works

Under this estate planning technique, an irrevocable trust is created during the owner/insured's life and all existing life insurance policies on his or her life should be transferred into the trust. These transfers should be made as soon as possible in order to avoid the three-year rule. Any new life insurance policies that the insured plans to take out should be applied for and owned by the Trustee of the irrevocable life insurance trust from the outset. The Trustee of the trust is named as the owner and beneficiary of each policy. The insured gives up all his or her rights, title and incidents of ownership in and to the policies to the Trustee.

If the irrevocable insurance trust has been properly drafted, then upon the death of insured, all the insurance proceeds from the life insurance policies held by the trust should be excludable from the gross estate of the decedent/insured. In addition, the income from the policy proceeds may be, but do not have to be, paid to the surviving spouse for life, and the principal of the trust may be, but does not have to be, invaded for the surviving spouse�s benefit as well. When the surviving spouse dies, the money contained in the irrevocable insurance trust should not be included in the surviving spouse�s estate either. All of this, however, supposes that the trust is properly drafted.

Comparison to Spouse Owning Policy

If the owner of the insurance policy makes his or her spouse the owner of an insurance policy payable on the owner�s death, then the proceeds will be taxable in the surviving spouse�s estate upon the surviving spouse�s death. In

addition, any growth on the insurance proceeds from the time the insured died to the death of the surviving spouse will also be taxed.Thus, much of the insurance is not put to the use for which it was purchased, because the government takes part of the insurance proceeds away from the intended beneficiaries.This taxation will not occur if a properly drafted irrevocable insurance trust is used.

An example may be of assistance to the reader. If the first spouse to die (�first spouse�) makes the surviving spouse the owner of a $600,000 insurance policy on the first spouse�s life, then upon the death of the first spouse, the $600,000 of policy proceeds will belong to the surviving spouse. Thus, these policy proceeds and all growth occurring thereafter on the $600,000 (which could be substantial) will be included in the surviving spouse�s estate for Estate Tax purposes upon his or her death. If the surviving spouse also owns $250,000 in other real and personal property at the time of his or her death, then $850,000 ($600,000 + $250,000) in assets are included in his or her estate. If you reduce this amount by the $675,000 Applicable Exclusion amount (assuming it has not been reduced by lifetime gifts), then the remainder of the surviving spouse�s estate ($175,000) may cause an avoidable Estate Tax problem for the surviving spouse. A properly drafted insurance trust could eliminate this problem.

Uses for Life Insurance Contained in an Insurance Trust

 Many people die without the cash on hand to pay their Estate Taxes. This can necessitate that the executor of the deceased�s estate sell family assets such as a home or land to pay the taxes, often at a great loss since any willing buyer would likely be aware of the Estate Tax need. This liquidity problem can be resolved by purchasing life insurance in a life insurance trust.

Different types of life insurance trusts should be used to hold different types of policies depending on the needs of the individual. For example, a widowed woman with adult children would need a single-life policy and a single-life insurance trust. However, a married couple having properly drafted tax-oriented Last Wills and Testaments (�Wills�) would not need the life insurance to pay Estate Taxes until the death of the survivor of them because of the unlimited marital deduction. Thus, a married couple may need second-to-die life insurance and a joint and survivor life insurance trust. (This is not to say that married couples do not need individual life insurance policies. There are many good reasons for married individuals to have such policies, such as providing replacement income to their spouses when one spouse dies.) If both the Wills and the insurance trust are properly drafted, then the trustee of the insurance trust can purchase assets from the executor of the deceased�s estate. This sale should have no adverse income tax consequences. However, following the sale, the executor of the deceased�s estate will have the cash to pay the Estate Taxes. The trustee of the insurance trust will then distribute the purchased assets to the beneficiaries of the insurance trust according to the terms of the trust agreement.

For example, an estate owes $200,000 in Estate Taxes and owns a $200,000 home. An insurance trust on the decedent�s life held a $200,000 policy on the decedent�s life at the time of his death. The trust is for the sole benefit of his son and provides for distribution of all its assets to the son. The executor can sell the land to the trustee and the executor can use the cash to pay the Estate Taxes. The home would then be held by the trust and would be distributed to the son according to the terms of the trust agreement.