A life insurance policy can fund a trust that eventually creates some available cash for future expenditures, such as anticipated estate taxes. Life insurance policies come in many flavors, and they guarantee a reasonably large cash payout down the road for a relatively small investment now.
No matter what type, life insurance policies may be acquired by a trust in two ways: The trustee may purchase a policy on the life of the grantor, or the grantor may transfer ownership of an existing policy into the trust.
Because life insurance trusts are generally not funded with large amounts of cash or securities, the grantor typically gifts a large enough sum into the trust each year to pay the annual premium and any fees and expenses the trust may incur.
The sole asset in the trust (other than small amounts of cash or money market funds) is the insurance owned by the trust on the grantor’s life. When the grantor dies, the face value of the policy pays into the trust, bypassing the grantor’s probate estate entirely.
Policies purchased by the trustee
When you, the trustee, purchase life insurance on the life of the grantor, you’re responsible for contacting an insurance broker and negotiating the terms of the policy. You’ll typically only be doing this if the trust was set up as a vehicle to own life insurance.
Of course, if you’re not an expert on life insurance, you’ll want a third party looking over your shoulder. Some attorneys who work with life insurance trusts have become quite expert at analyzing the benefits of various insurance policies. And you’ll want a highly recommended insurance broker.
In addition to relying on friends’ and family’s recommendations, check with your state’s Secretary of State, who licenses insurance brokers, to make sure that the broker you choose has no black marks on his or her record.
As part of the underwriting process, the grantor may be required to take an insurance-company physical so that the insurance company can determine premiums based on the state of the grantor’s health.
Policies gifted into trust by the grantor
Sometimes, the grantor makes a gift of an existing insurance policy into the trust. It could be a policy on which premiums are still being paid or it could be a paid-up policy, where all the premiums have been paid and the policy remains in force until the grantor’s death.
In either case, an existing policy is an excellent candidate for transfer to the trust because, should the policy remain in the grantor’s hands until death, its face value would be included in the gross estate, and a large percentage of the proceeds from the policy would go to pay estate taxes.
To transfer a life insurance policy into the trust, the grantor must complete and sign an assignment or transfer of policy. Be certain to obtain Form 712, Life Insurance Statement, from the insurance company at the time the grantor makes the transfer. The value on Form 712 is the value the grantor declares on his or her Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
By gifting the policy to the trust, the grantor limits the includable value on his or her estate tax return to the value as of the date of the gift, not the policy’s face value. Because no policy prior to the insured’s death is worth much in comparison to its value after that death, making this transfer now saves tens or even hundreds of thousands of dollars in eventual taxes.
After the transfer, it’s up to you, as trustee, to make sure that the endorsements on the policy (that list of information like whose life is being insured, who owns the policy, and who gets the money when the insured dies) are changed. You need to be certain that the trust is not only named as the owner but is also designated as the beneficiary.
For instance, the new ownership and beneficiary designation should now read something like this: “John Q. Doe and Thomas H. Doe, Trustees, and their successors, of the John M. Smith Irrevocable Trust under trust agreement dated 02/11/13.” And don’t forget to pay those annual premiums if the policy isn’t paid up.
Be sure that you have cash in advance of the payment date every year (from the grantor) to pay the premiums. For a Crummey trust, you’ll need to allow enough time to send Crummey notice letters to the beneficiaries (and let the Crummey notice period expire) after you’ve received the cash and before you pay the premium.
Frequently, transfers into irrevocable life insurance trusts (whether cash for premiums or policies with cash value) trigger the need for the grantor to file Form 709 for each year that he or she makes transfers into the trust in excess of the annual exclusion ($14,000 in 2013).