Life insurance trust
Encyclopedia
A life insurance trust is an irrevocable, non-amendable trust
which is both the owner and beneficiary of one or more life insurance
policies. Upon the death of the insured, the Trustee invests the insurance proceeds and administers the trust for one or more beneficiaries. If the trust owns insurance on the life of a married person, the non-insured spouse and children are often beneficiaries of the insurance trust. If the trust owns "second to die" or survivorship insurance which only pays when both spouses are deceased, only the children would be beneficiaries of the insurance trust.
In the United States
, proper ownership of life insurance
is important if the insurance proceeds are to escape federal estate taxation. If the policy is owned by the insured, the proceeds will be subject to estate tax. (This assumes that the aggregate value of the estate plus the life insurance is large enough to be subject to estate taxes.) To avoid estate taxation, some insureds name a child, spouse or other beneficiary as the owner of the policy.
There are, however, two drawbacks to having insurance proceeds paid outright to a child, spouse or other beneficiary.
The solution to both drawbacks is usually an irrevocable life insurance trust.
If possible, the trustee of the insurance trust should be the original applicant and owner of the insurance. If the insured transfers an existing policy to the insurance trust, the transfer will be recognized by the Internal Revenue Service
only if the insured survives the date of the transfer by not less than three years. IRC §2035. If the insured dies within this three year period, the transfer will be ignored and the proceeds will be included in the insured's taxable estate.
Insurance trusts may be funded or nonfunded. A funded life insurance trust owns both one or more insurance contracts and income producing assets. The income from the assets is used to pay some or all of the premiums. Funded insurance trusts are not commonly used for two reasons:
Customarily, the trustee of the insurance trust is authorized, but not required, to either purchase assets from the insured's estate or loan insurance proceeds to his or her estate. Since the trustee of the insurance trust possesses all incidents of ownership in the insurance policy, the insurance trust provides the insured's estate with liquidity while shielding the insurance proceeds or assets purchased with the proceeds from estate tax when the insured dies, provided the trust has the appropriate Settlor
and trustee.
Trust law
In common law legal systems, a trust is a relationship whereby property is held by one party for the benefit of another...
which is both the owner and beneficiary of one or more life insurance
Life insurance
Life insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger...
policies. Upon the death of the insured, the Trustee invests the insurance proceeds and administers the trust for one or more beneficiaries. If the trust owns insurance on the life of a married person, the non-insured spouse and children are often beneficiaries of the insurance trust. If the trust owns "second to die" or survivorship insurance which only pays when both spouses are deceased, only the children would be beneficiaries of the insurance trust.
In the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, proper ownership of life insurance
Life insurance
Life insurance is a contract between an insurance policy holder and an insurer, where the insurer promises to pay a designated beneficiary a sum of money upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger...
is important if the insurance proceeds are to escape federal estate taxation. If the policy is owned by the insured, the proceeds will be subject to estate tax. (This assumes that the aggregate value of the estate plus the life insurance is large enough to be subject to estate taxes.) To avoid estate taxation, some insureds name a child, spouse or other beneficiary as the owner of the policy.
There are, however, two drawbacks to having insurance proceeds paid outright to a child, spouse or other beneficiary.
- Doing so may be inconsistent with the insured's wishes or the best interests of the beneficiaryBeneficiaryA beneficiary in the broadest sense is a natural person or other legal entity who receives money or other benefits from a benefactor. For example: The beneficiary of a life insurance policy, is the person who receives the payment of the amount of insurance after the death of the insured...
, who might be a minor or lacking in financial sophistication and unable to invest the proceeds wisely. - The insurance proceeds will be included in the beneficiary's taxable estate at his or her subsequent death. If the proceeds are used to pay the insured's estate taxes, it would at first appear that the proceeds could not be on hand to be taxed at the beneficiary's subsequent death. However, using insurance proceeds to pay the insured's estate taxes effectively increases the beneficiary's estate since the beneficiary will not have to sell inherited assets to pay such taxes.
The solution to both drawbacks is usually an irrevocable life insurance trust.
If possible, the trustee of the insurance trust should be the original applicant and owner of the insurance. If the insured transfers an existing policy to the insurance trust, the transfer will be recognized by the Internal Revenue Service
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
only if the insured survives the date of the transfer by not less than three years. IRC §2035. If the insured dies within this three year period, the transfer will be ignored and the proceeds will be included in the insured's taxable estate.
Insurance trusts may be funded or nonfunded. A funded life insurance trust owns both one or more insurance contracts and income producing assets. The income from the assets is used to pay some or all of the premiums. Funded insurance trusts are not commonly used for two reasons:
- the additional gift tax cost of transferring income producing assets to the trust and
- the grantor trust rules of IRC §677(a)(3) cause the grantor to be taxed on the trust’s income. Unfunded insurance trusts own one or more policies of insurance and are funded by annual gifts from the grantor.
Customarily, the trustee of the insurance trust is authorized, but not required, to either purchase assets from the insured's estate or loan insurance proceeds to his or her estate. Since the trustee of the insurance trust possesses all incidents of ownership in the insurance policy, the insurance trust provides the insured's estate with liquidity while shielding the insurance proceeds or assets purchased with the proceeds from estate tax when the insured dies, provided the trust has the appropriate Settlor
Settlor
In law a settlor is a person who settles property on trust law for the benefit of beneficiaries. In some legal systems, a settlor is also referred to as a trustor, or occasionally, a grantor or donor. Where the trust is a testamentary trust, the settlor is usually referred to as the testator...
and trustee.