The Irrevocable Trust
in brief
The Irrevocable Trust
The irrevocable trust is a flexible and well-established estate and tax planning tool. In most cases, the trust
is the owner and beneficiary of a life insurance policy. This brochure summarizes the use of an irrevocable
trust when life insurance is part of the estate plan, including trust design and income and transfer tax
considerations.
Non-Tax Advantages
• Protect and preserve assets from creditors.
•Provide liquidity by allowing the trustee to buy assets from (or lend assets to) the insured’s estate
(the surviving insured’s estate in the case of a second-to-die policy).
•Manage assets where the beneficiaries are unable to do so because of incompetence, minority, or
lack of expertise.
• Avoid probate (court supervision) of the property.
Tax Advantages
• Since the trust is irrevocable, avoid federal estate taxation of the death proceeds.
• Save transfer taxes.
– Pay less tax for lifetime transfers than transfers at death.
–Avoid future estate taxes by excluding trust assets from the estates of the insured’s spouse and
the insured’s children.
–Minimize or avoid the generation-skipping transfer (GST) tax by allowing the insured to
leverage the GST tax lifetime exemption.
• Create income tax-free wealth.
•Replace wealth that passes to charity rather than to family, or that passes to one generation rather
than to another generation. For example, the trust could benefit:
–children and grandchildren if the grantor-insured transfers other assets to charity (e.g., through
charitable remainder trust); or
–children if the grantor-insured designates grandchildren as beneficiaries of a retirement
account.
How It Works – During Life of Insured
Life
Insurance
Cash Gifts
Premiums
Northwestern
Mutual
Irrevocable Trust
Distributions to insured’s
• spouse, and/or
• children
•During his lifetime, the insured executes an irrevocable trust document that names as trustee the
insured’s spouse, adult child, or other third party such as a corporate trust company.
• The trustee applies and pays for a life insurance policy on the insured’s life.
• The policy is issued to the trust as owner and beneficiary of the policy.
• The trustee pays each subsequent premium with a cash gift from the insured.
•During the insured’s lifetime, the trustee can use the policy cash value to make distributions to the
insured’s spouse and/or children according to the terms of the trust.
How It Works – After Death of Insured
Cash
Life
Insurance
Death Proceeds
Insurance Co.
Insured’s
estate
Assets
Irrevocable Trust
Distributions to insured’s
• spouse, and/or
• children
Estate
taxes
Estate beneficiaries
(spouse and children)
•After the insured’s death, the trustee files a claim for and receives the death proceeds on behalf of
the trust.
• The trustee receives the proceeds free of income tax and estate tax.
•If the estate lacks liquidity to pay any estate taxes, the trust can buy assets from (or lend cash to)
the insured’s estate to provide it with cash to pay estate taxes and satisfy other liquidity needs.
•The trustee manages and invests the trust assets (property and/or money) for the benefit of the
insured’s spouse, children, and/or other trust beneficiaries, making distributions to them according
to the terms of the trust.
Placing the Life Insurance Policy into the Trust
•
Trust Exists Before Policy Issued. After the trust is established, the trust applies for the policy, pays the
premium, and names itself as the policy’s owner and the beneficiary.
–This method most clearly avoids the insured having any “incidents of ownership” in the policy,
keeping the death proceeds out of his estate. Internal Revenue Code (I.R.C.) § 2042.
–If the insured recently applied for a policy, the trust could apply for a separate policy and use the
same underwriting information that supported the first policy, so long as the trust’s application is
done within 6 months of the original underwriting. The insured might then relinquish his existing
policy (e.g., exercise free-look).
•
Policy Issued Before Trust Exists – Transfer Ownership. Instead of having the trust buy a new policy,
the insured can transfer ownership of his policy to the trust (by gift or sale).
– Frequently, the insured gives the policy. If so:
 The policy’s value is generally subject to gift tax unless it falls within the annual exclusion. The
value of a new policy usually equals the first premium; for an existing policy the value often
is near the net cash value. Treas. Reg. § 25.2512-6(a). These values can be obtained from a
Form 712 issued by the insurer, but it is ultimately up to the client’s advisors to determine the
policy’s gift tax value.
The death proceeds paid to the trust will be in the insured’s gross estate if he dies within three
years after the gift (the “3 year rule” of I.R.C. §§ 2035 and 2042).
–If the insured sells the policy to the trust for adequate consideration, the “3 year rule” would not
apply. I.R.C. § 2035(d). There also would be no gift tax effects on the policy’s transfer (although
gift tax might have applied if the insured had given cash to the trust earlier). Nonetheless, there
could be income tax effects due to the sale:
Generally, the insured/seller is income taxed to the extent the amount he receives exceeds his
basis in the policy, and the death proceeds are income taxed to the trust due to the “transfer
for value” rule of I.R.C. § 101(a)(2).
Both problems – current tax to insured/seller, and tax on death proceeds to trust – are avoided
if the trust is a “grantor trust” under I.R.C. §§ 671-679 with respect to the insured/seller. See
Rev. Ruls. 85-13 and 2007-13.
–Transfers that are “part gift / part sale” raise multiple issues. An example is when the insured
“gives” a policy with a loan on it. This is equivalent to selling the policy for the loan amount but
giving the net value amount.
If the loan exceeds the insured’s basis, he is income taxed currently on that excess and the
death proceeds will be income taxed per the transfer for value rule.
But both income tax results are avoided if (i) the loan is less than basis or (ii) the trust is a
grantor trust. Even so, the gift tax effect relating to the net cash value and the estate tax
“3 year rule” would remain.
Paying Premiums
• Trustee Pays Premiums. When this occurs, there are generally two methods:
–
Funded Trust. The trust holds more money and/or assets than what is needed to pay the current
premium. The premium can be paid either from trust principal or income (e.g., trust holds stock in
the family business and pays premium with dividends).
–
nfunded Trust. The trust generally holds only the policy and the amount of property or cash
U
needed to pay the current premium. Typically, the insured gives cash to the trust as each premium
is due.
•
Insured Pays Premiums Directly to Insurance Company. Each premium the insured pays directly to
the insurance company is an indirect gift to the trust. This does not, in itself, create an incident of
ownership. See Perry v. Comm’r, 927 F.2d 209 (5th Cir. 1991).
•
Gift Tax. When the insured gives money or assets to the trust to pay premiums, or the insured pays
premiums directly to the insurance company, these are taxable gifts unless an exclusion applies.
–The annual exclusion of $14,000 (2013 figure) per year per donee is available as long as the donee
– the trust beneficiary – has the right to immediately withdraw the amount of the gift, qualifying
it as a gift of a “present interest.” I.R.C. § 2503(b)(1). Pursuant to a famous court case, this
withdrawal right is often referred to as a “Crummey power.”
–If the insured “gift splits” with his spouse, the annual exclusion doubles to $28,000 per donee
per year.
Gift splitting is necessary only if the gift is coming from the grantor/insured’s separately
owned property.
Fortunately, the spouse’s act of gift splitting does not make her an additional grantor to
the trust for estate tax purposes (e.g., under the “grantor with retained interest or power”
provisions of I.R.C. §§ 2036 and 2038). See Rev. Rul. 82-198 and Priv. Ltr. Rul. 200130030.
–Gifts that don’t fall within the annual exclusion can be made and still not trigger a current out-ofpocket gift tax until they exceed the grantor’s lifetime gift tax exemption amount.
The exemption amount is $5.25 million in 2013 (indexed annually).
With gift splitting, during 2013 a grantor can give to a trust $10.5 million in excess of his
annual exclusions and still pay no current out-of-pocket gift tax. This assumes the nongrantor spouse consenting to gift splitting is either (i) not a trust beneficiary, or (ii) is a trust
beneficiary but the portion of the gift to other parties (e.g., children) is ascertainable and
severable from the portion going to the non-grantor spouse. See Rev. Rul. 56-439; and
Treas. Reg. § 25.2513-1(b)(4).
Trust Design and Administration
•The grantor-insured should not serve as trustee, nor should he be a trust beneficiary. To do so
would risk that the value of the trust’s assets, including insurance proceeds, will be in his estate.
I.R.C. §§ 2036, 2038, and 2042.
•The grantor’s spouse, however, generally does not risk estate inclusion even if she holds the following
roles (so long as she is not also a grantor):
–Trust beneficiary. This is true even if she is insured on the policy in the trust (e.g., second-to-die).
See Priv. Ltr. Ruls. 97-48-020 and 96-02-010.
–Trustee, so long as she is not an insured. So she generally should not be trustee if the trust
holds a second-to-die policy. See I.R.C. § 2042. Also, if the non-grantor spouse has ability to
make distributions to herself (e.g., she is both trustee and trust beneficiary), this ability must be
limited by ascertainable standards relating to health, education, maintenance, and support. See
I.R.C. § 2041.
•The grantor-insured’s children and grandchildren (and others) can also be beneficiaries.
•The trust can be drafted flexibly, so that even while the insured is alive the trustee can withdraw from
the policy’s cash value to make distributions to trust beneficiaries. No distributions should be made
that discharge the legal obligations of either the insured or the insured’s spouse.
•Choosing a corporate trustee (rather than an individual trustee) is often wise, as this generally:
– provides greater expertise in trustee administration and asset management.
–avoids strains on family relationships that might arise if the trustee is related to the trust
beneficiaries and is not making distributions as readily as the beneficiaries would like.
–more clearly avoids estate inclusion issues for trust beneficiaries (e.g., non-grantor spouse) who
might otherwise act as trustee.
Summary Chart
Estate Tax Provision
Grantor with
Retained Interest or Power
I.R.C. §§ 2036 and 2038
Incidents of Ownership
I.R.C. § 2042
General Power of
Appointment
I.R.C. § 2041
Estate inclusion for Insured/Grantor?
Estate inclusion for Non-Grantor Spouse?
No – if grantor retains no interest in or
power over trust assets as trustee or
beneficiary.
No – as long as spouse isn’t a grantor, can
avoid estate inclusion even if a trust beneficiary
or trustee.
No – if insured/grantor is not trustee,
and holds no other economic benefits
in policy.
No – if not insured on policy in trust;
No – if trust holds policy insuring non-grantor
spouse (e.g., 2d-to-die), still no inclusion if she
is not trustee and holds no other economic
benefits in policy. Merely being beneficiary of
trust does not create incident of ownership.
No – if insured/grantor holds no power
over any of the trust assets.
No – if power to appoint trust assets to self is
limited by ascertainable standards relating to
health, education, maintenance, and support.
This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might
require the following statements. This information was compiled by The Northwestern Mutual
Life Insurance Company. It is intended solely for the information and education of Northwestern
Mutual, its customers and their own legal or tax advisors. It must not be used as a basis for legal
or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may
be imposed on a taxpayer. Northwestern Mutual and its financial representatives do not give
legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from
an independent legal, accounting, or tax advisor. Tax and other planning developments after the
original date of publication may affect these discussions.
– To comply with Circular 230
Copyright © 2013 by The Northwestern Mutual
Life Insurance Company, Milwaukee, Wisconsin
www.northwesternmutual.com
22-4351 (REV 0613)