Irrevocable Life Insurance Trust and Estate Taxes
An irrevocable life insurance trust can be used to save on the Federal Estate Taxes that regular life insurance policies impose on the beneficiaries. The proceeds of a life insurance policy are subject to Estate or "death" taxes, which an irrevocable life insurance trust can reduce or even eliminate.
For example, John Smith has an estate exceeding $3,000,000. However, John is unsure what the estate tax exemption amount will be when he dies, and he is concerned about the estate's ability to pay that tax burden he might leave behind. So John took out a $1,000,000 life insurance policy, which he owns, with the intent that his estate uses the proceeds to pay the estate tax. When John Smith dies, that life insurance policy is itself subject to a substantial estate tax, leaving his heirs with only slightly more than $500,000 to pay the remaining tax liability.
John Smith can get around this by not owning the life insurance policy himself when he dies. The proceeds from the insurance policy are normally not taxed when the policy is owned by someone else. If someone transfers an existing policy and dies within three years of the transfer, however, the proceeds are subject to estate taxes. Any proceeds from a life insurance policy are not subject to income tax, only to estate taxes.
If the policy on John Smith's life was taken out by another, then the three year transfer rule does not apply. His children could take out a life insurance on John, with them owning the policy and being its beneficiaries. In that instance the proceeds of the policy would not be subject to any estate tax.
Another way around the estate tax is for the parties to establish an irrevocable life insurance trust, which is merely an irrevocable trust with a specific name. This trust is set up with the children as the trust beneficiaries and one or more of the children as trustees, and the trust is named as beneficiary of the life insurance policy. Crummey provisions are put in the trust to permit the annual gift exemption. The parents in this case, annually gift the trust with enough money to pay the annual insurance premium. The trust receives this cash gift and pays the insurance premium, and any remaining funds can be invested.
When the individual or surviving parent dies, the trust receives the proceeds of the life insurance policy and is not subject to any estate taxes. When the trust terminates and its assets distributed, they may be used to pay for the estate taxes due on the other assets owned by the individual or surviving parent.
The above example is simplified just to illustrate how careful planning of life insurance can be used to lessen the estate tax burden on survivors.