In many circumstances it is advisable to have life insurance owned by an irrevocable trust, often referred to as an irrevocable life insurance trust (ILIT). The primary tax benefit of having an ILIT own life insurance is to remove the death benefit from the taxable estate of the insured. Accordingly, the death benefit can be used to benefit heirs and be a source of instant liquid cash to pay estate taxes or other obligations associated with the death of the insured.

The general rule of taxation of death proceeds from life insurance is that they are income tax-free, but subject to estate tax in the estate of the insured if the insured had a so-called “incident of ownership.” The most obvious incident of ownership is where the owner of a policy is the insured. There are less obvious incidents of ownership such as being able to change a beneficiary of a policy, being able to borrow from a policy’s cash value, the ability to surrender a policy, or using a policy for collateral.

For example, if a wife owns a life insurance policy of which she is the insured, with a death benefit of $5 million, the death proceeds are part of her gross taxable estate and thus subject to federal and state estate taxes. If her husband is the beneficiary of the policy, then there is no tax due on the wife’s death because of the unlimited marital deduction. The $5 million however, is now part of the husband’s taxable estate. If an ILIT owned the life insurance policy, the entire $5 million would not be subject to estate tax, in either the estate of the wife or the husband.

Another advantage of having an ILIT own, and be the beneficiary of, life insurance is that the death proceeds can remain in trust for the benefit of the insured’s heirs, and thus benefit from continued creditor protection.

In most instances where the estate of the insured will not, even with the insurance, be subject to estate taxes, it does not make sense to have life insurance owned in a trust. Additionally, where it is likely that a surviving spouse/partner will require access to all or substantially all of the death benefit, then trust ownership is generally ill-advised. However, where the estate will be subject to estate taxes and/or the surviving spouse/partner will not require direct access to the death benefit, trust ownership of new or existing life insurance should be considered. The net worth and cash flow needs of the insured and his or her dependents are key factors in making this decision. The age of the insured and the type of insurance may also be relevant factors to consider. For example, a younger insured with both term life insurance and high cash value permanent insurance might benefit from having the term insurance in an ILIT but not the permanent coverage individually owned. The reason why is discussed below.

When handling estate planning for clients, we frequently uncover circumstances where a client has an old life insurance policy that is individually owned. While trust ownership did not make sense 20 years ago when the policy was issued, individual ownership today only serves to increase the size of the insured’s taxable estate. In these situations, it often makes sense to sell or gift the policy to an existing or newly created ILIT. There are income and gift tax issues associated with a gift or a sale of a policy to an ILIT, so legal and tax counsel should be involved, along with an insurance professional.

In general, if a policy is gifted to an ILIT and the insured dies within three years of the gift, the value of the death benefit is included in the taxable estate of the insured and subject to estate tax. (See Internal Revenue Code Section 2035.) This three-year rule can often be avoided by having an ILIT purchase the policy from the insured, rather than the insured gifting the policy to the ILIT. Such a sale might have to be structured carefully or it can be treated as a so-called “transfer for value,” which results in that portion of the death benefit above basis being subject to ordinary income tax. (See Internal Revenue Code Section 101 (a)(2).) The transfer for value rule appears simple on its face: If life insurance is sold or transferred for valuable consideration (any transfer not a gift) then the death benefit is subject to income tax.

There are four main exceptions to the transfer for value rule including a transfer to: the insured, a partner of the insured, a partnership of which the insured is a partner and a corporation of which the insured is a shareholder or officer. Focusing on the first exception, the law is clear that a sale by the insured to an ILIT created by the insured which is a grantor trust is treated, for the purposes of 101 (a)(2), as a transfer to the insured. When selling a policy from an individual to a trust or from one trust to another, professional counsel should review the terms of the trust. If a trust that is purchasing a policy is not a grantor trust, then the sale will be a transfer for value. Options include having the trust and the insured becoming partners of a partnership prior to the sale, or perhaps gifting the policy.

An ILIT can usually be structured so the insured and/or the spouse/partner of the insured can have indirect access to the assets of the ILIT, including any policy cash value. This can be accomplished by naming the spouse/partner as a discretionary beneficiary and/or empowering the trustee to make loans to the grantor. The grantor can even have the power to fire, and hire, the trustee or co-trustee (so long as the new trustee is not subordinate to the grantor). In this manner, the grantor can, to use the expression, have his cake and eat it too. The death benefit is excluded from estate tax, but the grantor and/or the grantor’s spouse/partner, if they need the trust assets, have access to them.

Of course, there are reasons why an insured would not desire trust ownership of a policy. The main detriment of trust ownership of life insurance is that the insured no longer has direct control of the policy. If a policy is purchased primarily for a creditor protected savings vehicle or as a tax-free retirement plan, as opposed to death benefit oriented coverage to pay estate taxes, the insured would likely desire to own the policy. Another example of where ILIT ownership is counterproductive is if the death benefit would be used to fund a credit shelter trust upon the death of the insured. In such an instance, the trustee of the credit shelter trust created under the insured’s last will and testament should be the beneficiary. Naming the insured’s estate as beneficiary of a policy unnecessarily subjects the death proceeds to creditors of the decedent and of the decedent’s estate.

It is prudent to periodically review all life insurance policies to not only check policy performance and carrier strength, but to also consider if the policy owner and beneficiary are in the best interests of the client. •

David B. Bruckman is managing director of Citrin Cooperman Wealth Management, a registered investment adviser that provides personal financial planning, investments and insurance. He can be reached at 212-697-1000 or dbruckman@ccwmlp.com .

Alan Mandeloff is president of Citrin Cooperman Wealth Management, a registered investment adviser that provides personal financial planning, investments and insurance. He can be reached at 215-545-4800 or amandeloff@citrincooperman.com .