1. What do you mean the proceeds of my life insurance are subject to estate tax? I was always told that life insurance proceeds were tax-free!

a. Life Insurance is not Estate Tax Free. The “tax-free” nature of life insurance proceeds is a common and very dangerous misconception. While it is true that under Section 101(a) of the Internal Revenue Code, a beneficiary on a life insurance policy will generally receive the proceeds free of income taxes, the proceeds are subject to estatetaxes.

b. When Life Insurance is subject to Estate Tax. Section 2042 of the Code provides that the proceeds of any life insurance policy under which you are insured will be “included” in gross estate (and thus potentially subject to estate taxes) if either (1) the proceeds are paid to your estate, or (2) you own the policy or, if you do not own the policy outright, have retained certain “incidents of ownership” at the time of your death. These incidents of ownership include the right to change or add beneficiaries, the right to borrow against the policy’s cash value, or to cancel or surrender the policy.

c. How do you avoid Section 2042? The first prong of Section 2042 is easily avoided. The estate should not be named as a beneficiary, and make sure that you have a current beneficiary designation on file with the insurance company. Your estate may be the default beneficiary under the policy if you fail to name a beneficiary or if your beneficiary predeceases you and there is no contingent beneficiary.

The second prong is tougher to avoid. In most cases, the insured person under a life insurance policy is also the owner. No one questions whether this ownership is appropriate until the insured is terminally ill or already deceased. Because of the “three year rule” (discussed below), it becomes exceedingly difficult to avoid estate taxation of life insurance if the owner/insured is already at death’s door.

2. Except for my life insurance my assets are under the estate tax exemption. Is this something I really need to worry about?

(a) The commentators would have you believe that only the wealthy pay estate taxes. The face value of the policy (not the cash value) often is enough, combined with your other assets, to put you above the estate tax threshold

(b) The federal estate tax exemption is $2,000,000 in 2006, $3,500,000 in 2009, no estate tax in 2010 and $1,000,000 in 2011 and beyond unless Congress changes the law.

(c) Also, the State of Oregon taxes all estates above $1,000,000 so government really has two bites at the apple…

For example, if someone dies in 2006 with $1,600,000 of assets, plus a $1,000,000 term policy payable to his children, then his or her gross estate for federal estate tax purposes will be $2,600,000, which means that the federal estate tax bill could be as much as $250,000! This is true even though the policy had little or no cash value before his death, and the value of his assets before death from a strict balance sheet point of view was much less than the estate tax exemption.

Paying estate tax on life insurance can place a tremendous burden on the surviving family members, not only in terms of the taxes to be paid, but also the financial and emotional costs of administering a “taxable” estate. This requires the preparation and submission of a 20 to 40 page estate tax return with required professional appraisals, waiting many months for IRS and Oregon Department of Revenue clearance before distributing the estate assets, and, at worst case a protracted and draining estate tax audit (although an audit is probably unlikely in this situation).

3. I’m married and my spouse is named as beneficiary of my life insurance. I thought that estate taxes didn’t apply to property left to my spouse.

(a) If you name your spouse as beneficiary of your life insurance, and if your spouse doesn’t die before you and if you’re still married to each other when you die, then thefederal estate tax marital deduction will apply, and no estate taxes will be paid on the life insurance proceeds at that time.

(b) However, this will not avoid the federal estate tax return filing requirement if the proceeds plus your other assets exceed the estate tax threshold ($2,000,000 in 2006,), even if the marital deduction applies and no estate tax is due.

(c) Any proceeds that your spouse doesn’t spend or give away during his or her remaining lifetime may be subject to estate taxes on the death of the spouse, depending value of the surviving spouse’s assets and the federal tax laws at that time.

4. What can be done to avoid taxation of life insurance?

(a) Have the beneficiary own the life insurance. A simple way to avoid tax problems is not to own any life insurance policies on your life. Instead, the rule of thumb for proper ownership is that beneficiary, not the insured, should own the policy.

For example, your children can be the owners and beneficiaries of a policy on your life,pay the premiums themselves, and upon your death, can receive the proceeds free of estate taxes, subject to the “three year rule” discussed below if you originally owned the policy yourself.

(b) What happens if the spouse owns the life insurance? If you’re married and want to insure that the proceeds benefit your spouse, this technique doesn’t help much. If your spouse owns the policy and is named as beneficiary, then any remaining proceeds will be subject to estate taxes upon the spouse’s subsequent death. If the children are the owners and beneficiaries, then the surviving spouse has to rely on the generosity of the kids, which most clients find unpalatable.

(c) Many clients with substantial life insurance choose to establish an Irrevocable Life Insurance Trust to be the owner and beneficiary of the policy. If the trust is properly drafted and administered, and assuming that the three year rule doesn’t apply, the insurance proceeds will not be subject to estate taxes on your death, nor will they be subject to estate taxes on your spouse’s death, and can be held so as to avoid estate taxes in your children’s estates as well.

5. What’s this “three year rule”?

Under Internal Revenue Code Section 2035, if you own or have “incidents of ownership” on an existing life insurance policy on your life, and give away the policy or release the incidents of ownership within three years before your death, then the proceeds will still be included in your estate. This rule was established to avoid last minute “deathbed” transfers to avoid estate taxes.

This rule applies regardless of whether the ownership is transferred to an individual or to a trust. It can be easily avoided with respect to any new policies by ensuring that the policy application is made in the name of and the policy initially issued to the trust or other intended beneficiary.

The best and easiest way to avoid the three-year rule is to take immediate steps to ensure the proper ownership of any significant insurance policy that you currently own and of any policy you purchase in the future.

6. How does an Irrevocable Life Insurance Trust work?

An Irrevocable Life Insurance Trust is a legal agreement between you as Settlor of the Trust and a Trustee or Co-Trustees named in the trust instrument. The Trustee purchases or holds the insurance policies that you contribute to the Trust, pays the premiums, collects the policy proceeds on your death, and administers the trust for the benefit of your spouse and/or family members under the terms of the trust instrument. If the Trust is structured as a spendthrift trust, not only the estate tax benefits discussed here will be achieved, but so will the other creditor protection and tax planning benefits applicable to assets held in trust.

As discussed above, to save estate taxes, the Trust must be named as both the ownerand the beneficiary of the policies during your lifetime.

7. Who can serve as Trustee of the Trust? You may not serve as Trustee of an Irrevocable Life Insurance Trust holding policies on your life, because the trustee powers given under the trust instrument and under state law are considered “incidents of ownership” that will result in estate tax inclusion under Internal Revenue Code Section 2042.

While it is technically permissible for a spouse to serve as Trustee, (assuming that the Trust does not own any policies of which the spouse is an insured), this is generally not recommended or they should serve only as a co-trustee. The Trust should be properly drafted to avoid the spouse’s service as trustee from causing estate tax inclusion in the spouse’s estate.

The Trustee of an Irrevocable Life Insurance Trust is often a relative, close family friend, a financial institution, a trust company or a trusted advisor, such as your CPA, with the surviving spouse becoming Trustee or Co-Trustee after your death.

8. Duties of the Trustee during the lifetime of the Settlor.

(a) Generally, the life insurance trust will own one or more insurance policies and a small cash bank account to use for premium payments.

(b) The Trustee should make sure that the Trust is properly documented as the owner and beneficiary of each policy with the applicable life insurance company.

(c) The Trustee should also coordinate with you on the payment of premiums. A couple of months before a premium is due; you should write a check to the Trustee for the amount of the premium. The Trustee will then deposit the check in a Trust’s bank account, and send the appropriate contribution notices to the trust beneficiaries. The beneficiaries of the trust then have the right for a period of time, usually 30 days, to then pay the premium when due from the Trust bank account. It is very important that they have the right to withdraw the funds. The reason they must have this right is so that the contribution qualifies as a “present gift” under the tax code.

(d) It is very important that the Trustee send the notices of the right of withdrawal each year to the beneficiaries, otherwise the contributions to the trust will not qualify for the annual exclusions (currently $12,000). The IRS has been known to audit returns where the notices have not been sent and consequently, the contributions to the trust did not qualify for the annual exclusion. As a result, the estates can end up being charged with significantly more gift and estate taxes.

(e) If the “Irrevocable Life Insurance Trust is structured as a “defective” (for IRS purposes only) trust it will be considered a “grantor trust” for income tax purposes. In such cases, a separate taxpayer identification number for the Trust is not required during your lifetime, so the Trust bank account can be opened under your personal social security number and any interest income from the account simply be reported on your own 1040. A discussion of the IRS regulations on defective grantor trusts is beyond the scope of this article.

(f) If the Life Insurance Trust is not structured as a grantor trust, a tax identification number is required for the bank account. However, there is usually no income in the life insurance trust before the death of the grantor that would trigger the requirement of filing of a tax return.

(g) Upon death, the Trustee then files the claim with the insurance company, receives the proceeds and administers the proceeds under the terms of the Trust.

9. Is it possible to modify the terms of the Trust after it is set up? Can I fire and replace the Trustee?

(a) To avoid estate taxes, the Trust must be irrevocable and the grantor cannot retain any ability to change the terms of the Trust after it is established. However, you can give a third party, such as an independent Trustee or Trust Protector, the ability to change the terms of the Trust within guidelines that you can set forth in the Trust instrument. Because the personal circumstances of the beneficiaries (not to mention the tax laws!) can change unforeseeably after the Trust is set up, building flexibility in the Trust instrument is a very important and unfortunately often overlooked feature.

10. What are the tax consequences of transferring an existing policy to an Irrevocable Life Insurance Trust? What are the tax consequences of my contributions to the Trust for premium payments?

Generally, the transfer is structured so that there will be a gift in an amount of the cash value of the policy as of the date of transfer. If the policy is a term policy, this amount should be nominal.

Typically, the Trust is drafted so that the beneficiaries of the Trust (i.e., your spouse and children) have temporary withdrawal rights (sometimes referred to as Crummeypowers, which is a reference to the name of the court case which approved their use) with respect to any contribution to the trust, whether it is a contribution of a policy or of cash for premium payments, so that the transfers qualify in whole or part for the annual gift tax exclusion ($12,000 per trust beneficiary in 2006). This withdrawal right is typically drafted to lapse if not exercised within 30 or 60 days after notice of the contribution.

Technical note: For tax reasons, many practitioners draft these powers as “hanging powers” that only lapse to the extent of the greater of $5,000 or 5% of the trust assets, and remain exercisable indefinitely (i.e. “hang” around) to the extent that they exceed this amount. These “hanging powers” accumulate with respect to each contribution, which means that the total withdrawal right after several years can be very large, which can be problematic if a beneficiary dies while the withdrawal right remains outstanding, decides to exercise the power, or has creditor problems.

To the extent that any transfer exceeds your annual exclusion, there will be a taxable gift that will need to be reported on a gift tax return (IRS Form 709), and will use up a portion of your applicable exclusion amount ($1,000,000 for both gift tax purposes in 2007), although no actual gift tax will be payable assuming that you have not used up your applicable gift tax exclusion amount.

In situations where the annual exclusions are not sufficient to cover anticipated trust contributions, there are techniques that can be used to avoid taxable gifts, including taking a loan against a portion of the cash value of a policy prior to contribution to reduce its value for gift tax purposes, and entering into a “split dollar” arrangement, wherein a third party (which can be a family owned business entity or even your spouse under a 1996 IRS private letter ruling) agrees to pay part of the premiums in exchange for an interest in the proceeds when paid.

Special care must be taken to ensure that any transfer of an existing policy does not trigger the “transfer-for-value” rules, which can have potentially disastrous income tax consequences, and professional tax assistance is strongly recommended regarding any such transfer.

11. What is a Second-to-Die Life Insurance Trust?

(a) A second-to-die Life Insurance Trust is an Irrevocable Life Insurance Trust designed to own a second-to-die life insurance policy (also known as a “joint and survivor” policy) that only pays upon the death of the surviving insured. Such a policy is typically purchased to provide cash to pay the anticipated estate taxes on the surviving spouse’s death without having to liquidate estate assets, such as a family business.

(b) If the policy is owned by the insureds, then the proceeds will be subject to estate taxes on the surviving spouse’s death. These taxes can be avoided by having a second-to-die Irrevocable Life Insurance Trust own and be the beneficiary of the policy.

(c) Upon the death of the surviving insured, the Trustee can then typically use the cash proceeds received to purchase assets from the surviving spouse’s estate and/or Living Trust in order to provide the estate with the cash to pay the estate taxes. The Trustee then administers the assets so purchased for the Trust beneficiaries according to the terms of the Trust.

(d) As an alternative, the Trustee can loan cash to the estate if a sale of estate assets is not practicable. However, the Irrevocable Life Insurance Trust cannot permit direct payment of estate taxes from the Trust assets, which can result in subjecting the Trust assets to estate taxes in the surviving spouse’s estate.

12. What is the cost of an Irrevocable Life Insurance Trust?

(a) The cost of setting up and funding the Trust will vary based upon the complexity of the Trust provisions, the number of policies being transferred, and the estate, gift and income tax issues presented.

(b) Usually the initial cost of the Trust will be about $2500 plus some annual maintenance for the notices to the beneficiaries. Since the Trust can possibly double the after-tax proceeds that your beneficiaries will receive, depending upon your estate tax situation, it is a much better value than simply increasing the face value of the policy.

13. Who should prepare my Irrevocable Life Insurance Trust?

We recommend that the Trust be prepared by an experienced attorney specializing in estate tax planning. The issues involving these trusts can be extremely complicated, with numerous traps for the unwary.

Note: much of the material for this article was originally written by Florida tax attorney James F. Gulecas in 2004. It is used with permission and was revised and updated by Robert Le Chevallier of Buckley LeChevallier P.C. 2007. All rights are reserved.