Life Insurance Trusts Are Still Important

This is the Wealth and Law Podcast, a podcast about the intersection of personal wealth and the legal landscape. We'll take a deep dive into relevant topics. We'll basically teach you what we know, and we'll engage with guests with deep expertise in their field. We hope that you'll enjoy this episode and many more episodes.

So please join us on this journey as we try to bring you relevant information that is both timely and important for you to know in order to engage in this area of the world. Welcome to the Wealth and Law Podcast. Always a pleasure to have you with me. Thank you again for joining.

It's been a good year. It's been a busy year. I'm sure it's been that way for everybody else. But here we are.

We're rolling along. I wanted to talk today about life insurance trusts. And some of where this is coming from is that I really don't think that life insurance is necessarily out of vogue. rogue maybe the the idea of having life insurance has changed from the perspective that i mean it used to be certainly when i first started practicing that everybody had a life insurance trust and the life insurance in the trust was meant to pay estate tax and that can still be true for ultra high net worth families because you know they they have an estate tax problem regardless of what the exemptions are.

But of course, with the estate tax exemption being $15 million per person, adding up to $30 million for spouses, it's less of a concern to find liquidity for estate tax. But you still have liquidity needs in the context of business succession, and you still have income tax considerations because if you don't have an estate tax problem, The income tax is the material issue. And the nice thing about life insurance when properly structured is that if it's a life insurance policy that has a cash value or has sort of an investment component to it, think of your like variable universal life type policies.

Those policies can grow, or the investment component of the policy can grow on an income tax-free basis. you can withdraw essentially your basis in that policy on a on a free tax-free basis you can take loans from the policy that so long as you pay off before you die there's no tax oftentimes the loan rates are very low so the interest rate is very low so you and then and then when you die your beneficiaries receive the death benefit also income tax-free so you know that checks a lot of boxes.

So if you can put some liquidity into a policy and shelter the investments and the income from the investments from continuous taxation, thus perhaps overall in somebody's balance sheet reducing the overall tax hit, it may make sense. And so it's important to not forget about these things because they still do have these really important income tax characteristics to them that can make insurance policies very interesting. And they can, of course, when you die, hopefully you've played this insurance lottery correctly and what your family gets is a windfall of death benefit and the windfall, like I mentioned, is income tax-free to them.

And so it may still be the case that you would want to put that policy inside of a trust. So here comes the life insurance trust. So what is it? It's a it's an irrevocable trust and its purpose, although it doesn't have to be its sole purpose, is to own life insurance on the life of some person, usually the person creating the trust or the settlor of the trust.

So of course if you going to have a trust that owns a life insurance policy then you have to think about a couple of things Number one what is it going to what it going to look like And I would say there basically a very clear dividing line between the options. On the one side are life insurance trusts that have what are referred to as crummy withdrawal powers. And on the other side are life insurance trusts that have no crummy withdraw powers. So a crummy withdraw power, usually when it's drafted in these documents, says something along the lines of if somebody makes a contribution to this trust, then the beneficiaries or some class of them have a right to withdraw up to the annual exclusion amount of those contributions.

So this year, the annual exclusion is $19,000 per person. Sometimes what they say in addition to that is that the rights to withdraw, if not exercised, will lapse, but only up to the lesser of $5,000 or 5% of the value of the trust. Because if you fit within those parameters, then when it lapses, it's not treated as a gift from the beneficiary to the trust. And that can be important for a host of reasons.

One, it can be estate tax planning because if the beneficiary keeps their beneficial interest, but they made a gift to the trust, then the assets of the trust would be included in the beneficiary's estate for estate taxes. and it may have an effect on the credit protection that the trust is meant to give to that beneficiary if a state under its laws would cause that kind of a gift from a beneficiary to a trust to open up the trust to creditor claims. So that's the crummy side, crummy from Crummy v.

Commissioner, which is a court case, a very famous court case that talks about this issue in particular. And why is it that you have to give this right to withdraw? Well, the reason is because if you're going to try to rely on the annual exclusion to shelter transfers to the trust from gift tax, the beneficiary must have a present interest in the thing you gave them, and the present interest is created in the form of this withdrawal power. On the other side of the ledger, the non-crummy side, you're not going to be relying on the annual exclusion amount as a method of putting property into the trust.

And instead, you would either just make outright gifts of property or cash or, you know, liquid assets into the trust that maybe you report on a gift tax return. Or you are going to make a loan to the trust. I don't know why it was hard for me to say loan. Sorry.

But you're going to make a loan to the trust. And so the loan proceeds are then going to be used to invest within the trust and maybe build up the liquidity that then can be used to pay the premium. Very likely it's going to be a combination of the two. If there's a loan involved just for purposes of creating some substance to the economics of the loan, I don't want to say it's obligatory to do it that way.

I don't think it's quite that absolute, but just imagine that you make a loan to a trust and it gives you back a note, but the trust has no assets other than what you gave it. Maybe the IRS could look at that and say, no, that doesn't work for us because we don't think there's any economic substance to this, where the trust is just relying on all of the loan proceeds to exist and then fund the repayment. So, you know, there's some support out there that maybe suggests that that could be an outcome.

Again, I don't want to say that that's definitive, but that's a possibility. So very frequently, if you're going to have a loan, it's going to be some combination. And in fact you can do a combination of a trust with Crummy Powers and make loans to that trust to help sort of build up the inside equity of the trust the investable assets that are housed inside that trust The structure then is again it going to be an irrevocable trust and you're going to have either these crummy powers or there's going to be no crummy powers.

You're going to fund it with a mix of probably gifts and maybe some loans. there there's another consideration in the sort of structural side of things and that is who should be the trustee it is important it is critical in many cases for the trustee to be someone who is not to be insured and the reason for that is if you in many cases have you create a trust and you have an interest, they call them incidents of ownership, you have an interest in the policy of any variety, even as acting as a trustee where you get to call the shots for the insurance policy, then when you die, the proceeds, the death benefit will be included in your estate for estate tax purposes.

A little hidden trick here is if you have a second to die policy and the spouse is the beneficiary and the trustee of the trust, that spouse could have this problem because they have their insurance policy, it insures their life, they're the trustee, and so you could have this problem. One way to get around these issues, although I'm not suggesting making the insured, the trustee under any circumstances, but one way to get around some of these issues that relate to sort of incidents of ownership is to rather than gifting a policy into a trust, let's say the policy already exists and you're trying to get it into the trust now, you could sell the policy.

And the value of the policy is maybe a slightly amorphous thing, but let's just for sake of this conversation, assume that it is what is called the interpolated terminal reserve of the policy, which you can get from the insurance company, they'll tell you. And you get a form 712 and it tells you the interpolated terminal reserve of the policy. And then that sets the value of the policy for purposes of doing this sale. It may not always be that.

There could be other factors that are important, like the health of the insured. And so you may actually have to get a valuation of the policy, a very specific valuation. But That's one way to then get a policy that's outside the trust. Now into the trust, of course, your other option is going to be you're funding the trust with annual exclusion gifts in the case of a crummy trust or just outright gifts.

Maybe there's some loans in there. So the trust now has some liquidity and then the trust will acquire the policy. It is important that the beneficiaries of the trust be people who overall, we'll say, would be interested in insuring the life of the insured. If not, then if it's just sort of like an insurance policy on a random person, then it may not qualify as life insurance under state law regulations.

But within family, this is usually typically not an issue. They call it an insurable interest, but it's usually not an issue. among family members. So the other thing is these trusts are usually created as a vehicle to do some multi-generational planning.

And that also creates some little quirky eventualities. So if you're making annual exclusion gifts and you're relying on the crummy powers to do that. unless the beneficiary must include when they die, the trust assets in their estates, then you do not qualify for the annual exclusion for the generation skipping transfer tax. So if the irrevocable trust that the life insurance trust is supposed to last for multiple generations down to two generations below the settlor of the trust if it has crummy powers then actually what happens is you have a non-taxable gift of the annual exclusion amount to the trust but then you need to allocate the gst exemption it should automatically allocate but it's it's important to keep track of these allocations year over year because sometimes they happen, sometimes they don't.

Sometimes they're tracked well, sometimes they're not. So it's important to keep good records so you know that enough GST exemption has been allocated. But also you have to remember that if GST exemption is being allocated $19,000 a pop year over year to this insurance trust, it's not available to be allocated somewhere else. So for ultra high net worth families where the generation skipping transfer tax is material, you have to know how much GST exemption has been allocated to the trust.

And again, in the case of these crummy trusts, even though you might qualify for the annual exclusion against the gift tax, unless the trust property would be included in the estate of the beneficiary when they die, you don't qualify for the GST tax annual exclusion. So let's sort of think that out. Why would you want that result? Well, you may want to preserve the GST tax exemption for something else, some other trust, some other purpose.

And so in that case, you're already avoiding any kind of gift tax issue by doing the annual exclusion gift to the trust. So that's great. And you can do other gifting somewhere else that are taxable gifts. So beyond the annual exclusion gift.

And on those, you might want to allocate the GST exemption. And then if you qualify for the GST annual exclusion, so now you're not in that case, you're not targeting this particular transaction for GST tax planning because you're doing it somewhere else. You're targeting this as like a freebie, a freebie against the gift tax with the annual exclusion for a gift tax, and then a freebie for GST tax. And if you can do that, then the fact that the trust would be included in the estate of the beneficiary of the trust doesn't really matter because you weren't trying to preserve those assets for GST purposes anyways.

So it's a little tricky thing. I think there are a lot of life insurance trusts out there that had GST exemption allocated to them periodically that maybe wasn't tracked dutifully, and you have to go back and try to create the records if GST tax is material, especially with respect to other trusts in the full family structure, because it can get kind of complex. But remember, as I let in here, even with the high exemptions where maybe estate tax and generation skipping transfer tax are not a huge immediate concern for many well-to-do but not uber-rich families, they still may want to use life insurance as a way to shelter some income for income tax purposes and as a way to do some succession planning.

And in that, you're almost always going to have trusts. For every reason that has nothing to do with taxes, to be perfectly honest, credit protection, management of assets for minors and incapacitated people, the ability to pool assets together efficiently, manage the assets together efficiently. There's just any host of non-tax reasons that would compel you to do one of these life insurance trusts. All right.

So hopefully that was helpful as a reminder or recap or the first time you've ever heard it, whichever it was. Thank you for listening and I will see you next time. hey listeners thanks again for joining me on the podcast it's fun to do it for you if you're enjoying it please subscribe at apple podcast or wherever you get your podcasts subscribe to my blog at wealthandlaw.