Gallet Dreyer & Berkey, LLP | Achieving Tax-Free Life Insurance
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Achieving Tax-Free Life Insurance

February 2020 | By: Asher Rubinstein, Esq. | GDB 2020 Winter Newsletter
If you own or control a life insurance policy, then the proceeds of the policy may be included in your estate at death and subject to estate tax.  This comes as a surprise to many people who are under the impression that life insurance is tax-free. 

To avoid estate tax, we use an Irrevocable Life Insurance Trust (ILIT).  We create an independent trust, with an independent trustee, who will own and control the insurance policy.  Ideally, the trustee solicits and pays for the insurance policy with trust funds, and the trustee administers the trust and its insurance policy, including paying the premiums as they become due.  Pre-existing Insurance policies may be conveyed to the insurance trust, but are subject to a three-year look-back period (i.e., if the transferor of the policies to the trust lives for three more years, the trust is then said to own the policy fully and the policy will be removed from the taxable estate of the transferor). 

When the insured person dies, the insurance company pays the proceeds of the policy into the trust.  The trustee will then distribute the funds to the beneficiaries of the trust, who are usually the family of the insured.  We can draft the trust with specific terms (e.g., mandatory distributions to pay for college; asset protection provisions to protect the trust from creditors and ex-spouses).

The tax savings are significant.  The insurance policy is not considered to be within the estate of the insured (because an independent trustee owned, paid for and controlled the policy), and therefore not subject to estate tax.  The receipt of the insurance proceeds by the trust beneficiaries is not taxable to them.  In this manner, life insurance is tax-free.

There are many rules to understand and traps to avoid.  For example, if a relative of first degree (spouse, sibling, parent or child) is named the trustee of the insurance trust, the IRS might argue that the trustee is too close to the insured and the insured is deemed to control the policy.  The IRS may argue that the policy is still within the estate of the insured and the death benefit subject to estate tax.  In addition, the trustee has to give annual notice to the beneficiaries of the trust, by what is known as a “Crummey” letter, named after an important court case.  Experienced tax and estate planning attorneys can guide you through these requirements and tax traps.