Although life insurance proceeds are generally not subject to income tax, the proceeds may be subject to estate tax if the owner and beneficiary of a life insurance policy are not carefully structured. An insured that is subject to potential estate tax should eliminate all of his and his spouse's "incidents of ownership" over their life insurance policies, and neither spouse (nor their estates) should be a beneficiary of the policies. Incidents of ownership include the right to change beneficiaries, the right to borrow against the policies, and the right to the cash surrender value of the policies.
Eliminating incidents of ownership can be easily accomplished by transferring the ownership interest of all policies to children or to an Irrevocable Life Insurance Trust (which can benefit the surviving spouse during his or her life). The beneficiary of each policy should also be changed to the children or to this trust. After a three year waiting period (or immediately for new policies purchased by the children or trust), the life insurance proceeds will not be included in the insured's taxable estate.
Once existing policies are transferred, the insured/transferor makes periodic gifts to the children or trust in an amount sufficient to enable the children or trustee to continue making premium payments. At the insured's death, the insurance proceeds are paid to the children or to the trust and, if to the trust, distributed in accordance with its terms. However, because the insured/transferor had no ownership rights over the policies (and assuming the insured/transferor survives three years after any transfer of policies to the children or the trust), the insurance proceeds are not subject to estate taxation. The result is an estate tax savings of up to 55 percent of the insurance proceeds, and the full insurance proceeds can then be invested to provide income for the insured's survivors.
When implementing this plan, the gift tax consequences of a transfer of life insurance policies (especially those with a cash surrender value) must be carefully considered. Not only will the initial transfer be a gift (in the case of a trust, to the trust beneficiaries), but if the insured wants to continue making annual premium payments, he must make further gifts to the children or to the trust. Typically, these gifts are designed to qualify for the gift tax "annual exclusion."
The gift tax annual exclusion allows each person to give up to $10,000 (for 1999) each year to any number of donees (gift recipients) tax free. These gifts must generally be made outright to the donees. In the case of the trust, one exception to this rule is a transfer in which the trust beneficiaries have immediate rights to withdraw the gift for a limited period of time (usually 30 or 60 days). These withdrawal rights are commonly referred to as "Crummey" powers. Although the trust beneficiaries (or their guardians) must be notified in writing of their withdrawal rights, if the beneficiaries do not exercise these rights, the funds may remain in the trust and be used to make the insurance premium payments as described above.
In the case of a trust, the insured should not be trustee of the trust. Instead, a family member or other trusted friend or advisor is often named as trustee until the trust is funded with the life insurance proceeds at the insured's death. Once the insurance proceeds are received, typically a corporate trustee, named as successor trustee in the trust document, administers the trust for the benefit of the insured's survivors. The use of an individual trustee until the trust is funded can reduce administrative costs. The change in trustees upon the funding of the trust allows professional money managers to step in for investment management purposes.