copyright 2003-2008 Peter Bassing

Prepared by Peter Bassing
Attorney at Law

(Member, California Bar--State Bar No. 63315)
Note: The following discussion is in some instances specific to California law.

The Problem:

When a person dies, the benefits paid under policies of life insurance on his or her life are included in his or her estate for estate tax purposes, if the decedent owned or controlled the life insurance policy. If the policy is the community property of a married couple, usually because the premiums were paid with community property, then one-half of the benefit payable on the death of an insured spouse is included in his or her taxable estate. Often one of the reasons a person will buy a policy of life insurance is to give his or her estate liquidity, that is, ready cash, to pay estate taxes due on other property, sometimes other property that might be difficult or undesirable to sell, such as a family business that is to be kept in the family, or a family farm, ranch or residence. If a benefit of, say, $250,000 from a life insurance policy is included in the taxable estate, only about $150,000 of it will be available to pay the tax on other property, since about $100,000 of it will be needed to pay the tax on itself.

A Solution:

The way around the problem is to have the policy of life insurance owned by someone other than the insured (the person on whose death the benefit is paid). A life insurance policy might be transferred to or purchased by a child or children, for example, who would be named as the beneficiaries of the policy, with gifts from the insured parent to the child which the child could use to pay the premiums. However, unfortunate and unintended consequences may result from this arrangement in the event, say, of a child's divorce and a claim by the ex-daughter or son-in-law-to-be that the policy is community property. Or if a child dies prior to the death of the insured, his or her disposition of the interest in the policy --to his or her spouse, for example-- might not be the same as would have been made by the insured, who might, for example, have provided that grandchildren receive the benefit.

These problems can be avoided if the policy is owned by an irrevocable trust, the terms of which are determined by the insured. If the trust owns the policy, and the insured has no control over it after initially setting it up, the death benefit will not be included in his or her estate. On the other hand, the trust agreement or declaration can provide that the insurance benefits will be available to meet the insured's estate's liquidity requirements by buying its assets or lending it money. The ultimate beneficiaries of the trust will be whomever the insured chose, usually a spouse, children, grandchildren, etc., and various contingencies -- early death of children, for example-- can be dealt with in the trust declaration.

When a trust is designed with the ownership of a policy and its benefits as its principal or only function, it is usually referred to as a "life insurance trust."

The premiums on the policy are paid with gifts to the life insurance trust from the insured and, if the trust is properly drafted, such gifts will qualify for the $11,000 per donee annual exclusion from gift tax liability.

Disadvantages of a Life Insurance Trust:

Life insurance trusts have some drawbacks:

First, is loss of control. As discussed above, if the insured maintains control over the policy, its benefits will be included in his or her taxable estate whoever is designated as the beneficiary or nominally deemed the owner. In order not to have the benefit included in the taxable estate, the insured must have no control over the policy. He or she cannot, for example, retain the right to make change of the policy's beneficiary designations, or to change the terms of the life insurance trust. This disadvantage is present, too, if children, rather than a life insurance trust, own and control the policy.

A second disadvantage is exposure to gift tax liability if the policy given to the trust has value or if gifts of funds to pay premiums are not handled in a way to make them eligible for the $12,000 per year per donee exclusion. Again, this disadvantage would be present if children, rather than a life insurance trust, own and control the policy. A third disadvantage of the trust is that there will be costs associated with its drafting and administration, including legal and accounting fees. While these may not be large in comparison to the estate taxes which might be saved, they might be larger than were children or other beneficiaries to own the policy outright.

While a life insurance trust is no panacea, it may save very substantial amounts of tax otherwise payable by an estate in which life insurance otherwise makes sense.