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Personal Life Insurance Trusts (Portfolio 807)

Tax Management Portfolio, Personal Life Insurance Trusts, No. 807-2nd, describes the income, estate, and gift tax consequences of establishing a revocable or irrevocable life insurance trust.

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DESCRIPTION

Tax Management Portfolio, Personal Life Insurance Trusts, No. 807-2nd, describes the income, estate, and gift tax consequences of establishing a revocable or irrevocable life insurance trust. This Portfolio analyzes the practical and tax advantages to be gained from the use of life insurance trusts, as well as the principal planning and drafting problems associated with their establishment.
As an estate planning tool, life insurance has no peer. It can create an estate where none otherwise exists or it can provide liquid funds to safeguard existing wealth. The benefits of life insurance as an estate planning tool can be increased through careful planning for the purchase and disposition of the life insurance itself. The personal life insurance trust is the premiere vehicle for achieving maximum flexibility in utilizing the death proceeds of life insurance to accomplish the decedent's personal and tax goals.
This Portfolio discusses the significant advantages that can be achieved through the correct structuring of irrevocable insurance trusts. This Portfolio also addresses other technical problems relating to the disposition in trust of life insurance, including obtaining the annual gift tax exclusion, policy transfer methods (including transfers within three years of the decedent's death), generation-skipping transfer tax allocation issues, and drafting problems and techniques.
For a detailed discussion of the federal estate and gift tax treatment of life insurance generally, see 826 T.M., Life Insurance.
This Portfolio may be cited as Slade, 807-2nd T.M., Personal Life Insurance Trusts.


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AUTHORS

GEORGIANA J. SLADE, ESQ.
Georgiana J. Slade, A.B., Duke University (1982); J.D., Harvard Law School (1985); partner, Milbank, Tweed, Hadley & McCloy (1995–); fellow, American College of Trust and Estate Counsel; prior Chair and current Vice-Chair, Committee on Taxation, Trusts & Estates Section, New York State Bar Association (1999–); affiliate member, Duke University Estate Planning Council; member, New York State Bar Association (1986–); member, American Bar Association (1986–); member, New York State Bar.
The author has co-authored 836 T.M., Partial Interests — GRATs, GRUTs, QPRTs (Section 2702).

TABLE OF CONTENTS

Detailed Analysis

I. General Overview

A. Life Insurance Trusts Generally

B. Forms of Trusts Which May Be Created to Be the Owner and/or Beneficiary of Life Insurance Policy Proceeds

1. Inter Vivos Revocable Trusts

2. Inter Vivos Irrevocable Trust

3. Testamentary Trust

C. Reasons to Create a Life Insurance Trust

1. Reasons for Acquiring Life Insurance

2. When It Is Appropriate for Life Insurance to Be Owned by an Inter Vivos Irrevocable Trust Instead of an Individual

a. Individual Ownership

b. Trust Ownership

D. Forms of Life Insurance Products Which May Be Used to Fund a Life Insurance Trust and Types of Arrangements for Life Insurance Trusts

1. Term Life Insurance

2. Whole Life Insurance

3. Universal Life Insurance

4. Variable Life Insurance

5. Second–to–Die (or Survivorship) Life Insurance

6. Split–Dollar Life Insurance Arrangements

7. Policies Transferred from Qualified Plans

II. Gift Tax Concerns in Creating and Maintaining a Life Insurance Trust

A. Inter Vivos Revocable Trust

1. Contributions by the Grantor

2. Contributions by Individuals Other Than the Grantor

B. Inter Vivos Irrevocable Trust

1. Original Transfer of Policy

a. Fixed Income Interest Trust

b. Trust with Crummey Withdrawal Powers

c. Section 2503(c) Minority Trust

2. Direct and Indirect Contributions to an Inter Vivos Irrevocable Trust for Premium Payment

a. Use of Crummey Powers

(1) What Is a Crummey Power?

(2) Crummey Power Requirements

(a) Beneficial Interest

(b) Notice and Reasonable Opportunity to Exercise

(c) Excluding Beneficiaries from Having Powers of Withdrawal

(d) Special Concerns When Minors Are Beneficiaries

(e) Special Concerns When Trust Asset Is an Employer Group–Term Policy

(f) Need for Liquidity Seed

(3) Tax Consequences of Lapse of Crummey Power and Methods to Avoid Taxable Lapse

(a) Taxable Lapse Above “$5,000 or 5%”

(b) Hanging Power

(c) Trust with Limited Testamentary Power of Appointment

(d) Vested Trust

(e) Funded Trust

(f) Multiple Trusts

b. Use of Section 2503(c) Minority Trust

c. Fixed Income Interest Trust

d. Loan from Grantor

3. Valuation of Gift

III. Estate Tax Concerns in Structuring a Life Insurance Trust

A. Testamentary Trust

1. Inclusion in Grantor's Estate Under Section 2042

2. Use of Marital or Charitable Deduction to Minimize Estate Tax

B. Inter Vivos Revocable Trust

1. Inclusion in Grantor's Estate Under Sections 2036, 2038, and 2042

2. Use of Marital or Charitable Deduction to Minimize Estate Tax

C. Inter Vivos Irrevocable Trust

1. Inclusion in Insured's Estate if Insured Retains Incident of Ownership

a. Definition of Incident of Ownership Under Section 2042(2)

b. Incidents of Ownership When Insured Holds Powers as Trustee

c. Incidents of Ownership When Insured Holds Power to Remove and Replace Trustee

d. Special Concerns Under Section 2042(2) When Second– to–Die Policies Are Held by Trust

2. Inclusion in Grantor's Estate When Proceeds Are “Receivable by the Executor” Pursuant to Section 2042(1)

3. Transfers Within Three Years of Death Under Section 2035

a. General Application of the Three–Year Rule

b. Pre–ERTA “Deemed,” “Beamed,” or “Construc– tive” Transfer Rule

(1) The Infamous Bel Case and the “Deemed” Transfer Rule

(2) Bel's Progeny

c. Eradication of the “Deemed” Transfer Rule by ERTA

(1) Rejection of the “Deemed” Transfer Rule by Leder and Subsequent Cases

(2) Statutory Solution

d. Application of Three–Year Rule to Group–Term Life Insurance

e. Portion of Policy Proceeds Includible When Three–Year Rule Applies

(1) Silverman Doctrine

(2) Sale of the Policy

(3) Use of Back–up Marital Deduction Gift

4. Interest of Insured As Beneficiary in Insurance Trust

a. Creditors' Rights Doctrine

b. Interest of Insured as an Incident of Ownership

IV. Generation–Skipping Transfer Tax Concerns in Structuring a Life Insurance Trust

A. Application of the Generation–Skipping Transfer Tax and Effective Date Rules

B. Use of the Nontaxable Gift Exclusion

1. Scope of Nontaxable Gift Exclusion

2. Application of Nontaxable Gift Exclusion to Traditional Life Insurance Trusts

3. Crummey Powers of Withdrawal and the Nontaxable Gift Exclusion

4. Using Cascading Crummey Powers to Avoid GST Tax

C. Use of the GST Exemption

1. How to Allocate GST Exemption

2. Amount and Timing of GST Exemption

a. Inter Vivos Revocable Trust

b. Inter Vivos Irrevocable Trust

c. Testamentary Trust

D. Shift of Transferor When Beneficiaries Hold Crummey Powers

E. Special Generation–Skipping Transfer Tax Concerns Where Irrevocable Insurance Trust Terminates in Favor of Children

V. Income Taxation of Life Insurance Trusts

A. Inter Vivos Revocable Trust

B. Inter Vivos Irrevocable Trust

1. Income Tax Consequences to Insured as Grantor

2. Income Tax Consequences to Beneficiaries and Grantors Other Than the Insured

3. Grantor v. Powerholders - Who Wins for Income Tax Purposes?

4. Contributions by an Individual Other Than the Insured

C. Transfer–for–Value Considerations

D. Using the Income Tax Treatment of a Grantor Trust in Estate Planning

1. Sale to Cure a Defective Trust

a. Coordination of Powers of Withdrawal Under Both Trusts

b. Borrowing Against the Policy

2. Using a Distribution to Cure a Defective Trust

VI. Use of Irrevocable Insurance Trusts in Split-Dollar Arrangements

A. Introduction

1. Advantages and Disadvantages of a Split-Dollar Arrangement

2. Types of Split-Dollar Arrangements

B. Income Taxation of Split-Dollar Arrangements

C. Gift Tax Concerns

D. Estate Tax Considerations

1. Inclusion of Proceeds Where Employee/Insured Retains Incidents of Ownership in Policy Within the Meaning of Section 2042

2. Application of Three–Year Rule Under Section 2035

VII. State Law Considerations

A. Rights of Creditors to Life Insurance Proceeds

B. Spouse's Right of Election

C. Scope of Supervision by State Court

D. State Estate and Inheritance Taxes

E. Insurable Interest

VIII. Additional Considerations in the Preparation and Administration of a Life Insurance Trust

A. Preparation of a Life Insurance Trust

1. Who Should Be the Trustee?

2. Appointing a Trust Protector

3. Back–up Marital Deduction Gift

4. Administrative Powers to Be Granted to Trustees

5. Building Flexibility into an Insurance Trust

B. Administration of a Life Insurance Trust

1. Funding a Life Insurance Trust

a. Opening a Bank Account

b. Obtaining an Employer Identification Number

c. Purchase or Assignment of Life Insurance Policy

2. Contributions by Grantor

a. Notice to Beneficiary or Waiver of Notice Concerning Crummey Withdrawal Rights

b. Filing Federal Gift (and GST) Tax Return (Form 709) and Allocation of GST Exemption by Grantor

3. Premium Payments

4. Filing Income Tax Returns for Life Insurance Trust

5. Collection of Insurance Proceeds


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Model Irrevocable Life Insurance Trust to Hold Single Life Policy

Worksheet 2 Model Letter to Client Describing Terms of Irrevocable Life Insurance Trust to Hold Single Life Policy

Worksheet 3 Model Irrevocable Life Insurance Trust to Hold Second–to–Die Life Insurance Policy

Worksheet 4 Model Letter to Client Describing Terms of Irrevocable Life Insurance Trust to Hold Second–To–Die Policy.

Worksheet 5 Model Letter to Client Regarding Operation of Trust.

Worksheet 6 Model Crummey Notification Form for Adult Powerholder.

Worksheet 7 Model Crummey Notification Form for Minor Powerholder.

Worksheet 8 Model Waiver of Crummey Notification for Adult Powerholder.

Worksheet 9 Model Waiver of Crummey Notification for Minor Powerholder.

Worksheet 10 Hypothetical Fact Pattern 1 Irrevocable Life Insurance Trust, On Creation and Death of the Grantor

Worksheet 11 Hypothetical Fact Pattern 2 Irrevocable Life Insurance Trust with Crummey Powers, On Funding with Assigned Life Insurance Policy

Worksheet 12 Rev. Rul. 81-7, 1981-1 C.B. 474

Worksheet 13 Rev. Rul. 84-179, 1984-2 C.B. 195

Worksheet 14 Rev. Rul. 85-88, 1985-2 C.B. 201

Worksheet 15 Rev. Rul. 95-58, 1995-2 C.B. 191

Worksheet 16 Excerpts from TAM 8901004, “Hanging Powers.”

Worksheet 17 TAM 9532001, “Waivers.”

Worksheet 18 PLR 9602010, “Insured As Beneficiary Of Trust.”

Bibliography

OFFICIAL

Federal Statutes:

Treasury Regulations:

State Statutes:

Uniform Codes:

Legislative History:

Treasury Rulings:

Cases: Page *

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