Consider the reasons you have a life insurance trust
If your estate is approaching the level where federal estate tax liability is becoming a possibility, an irrevocable trust to hold life insurance policies was traditionally used to remove them from the taxable estate. If nontax reasons for using a trust are present, an irrevocable trust to hold life insurance policies remain an excellent planning tool. Because there is no carryover basis or basis step up issue for a life insurance policy there is no detriment in giving it away during your lifetime.
Reasons to cancel the policy
For the moderately wealthy person, there may not be an appropriate justification for a life insurance trust. There are legal, administrative and tax return preparation costs associated with a trust that may not be necessary. Absent the need for the protective benefits of a trust, consider just giving the life insurance policies to heirs while you are alive. The insured can keep making premium payments as an annual gift, but the policy will be removed from your estate because it is considered a contract under Wyoming law. That means the policy is also not subject to any issues of probate, potential claims of the estates creditors, and the costs and administrative burdens of dealing with the policy after your death.
You may have purchased survivorship life insurance and placed a policy into a trust. The purpose of the insurance was most likely to have a fund to pay federal estate taxes at the second death of a married couple. In light of the increased applicable exclusion and portability, the survivorship life insurance policy may no longer be needed for tax payment purposes. What should you do with the policy and the trust that holds it?
One answer would be to cancel the policy and have the trustee receive the cash value and administer it in accordance with the terms of the trust. That is an easy solution to suggest--but close attention must be paid to the terms of the trust and responsibilities of the trustee.
Other options might be to consider a tax free exchange of the policy under Code Section 1035 for a qualified annuity or another insurance policy that could offer more attractive terms, such as faster cash value build up that can be withdrawn or a payout at the first death of a married couple than the second to die policy offers. Alternatively, keep the existing policy but stop paying additional premiums and make the policy a paid up policy based on the premiums paid to date.
Reasons to keep the life insurance policy in a life insurance trust
If you determine you should have a life insurance trust, include provisions to have it classified as a grantor trust. If the trust will own assets other than cash and life insurance, being deemed a grantor trust will allow the tax free substitution of properties. Even if the trust will hold only life insurance, grantor trust status is still desirable as the trust will not be subject to the transfer for value rule if there is any transfer of the life insurance policies, even if the transfer is made for consideration. Rev. Rul. 2007-13, IRB 2007-11. A substitution power may allow the grantor to remove the policy from the trust in exchange for its then fair market value in cash, and resdesignate beneficiaries in a new trust to remove the benefit of the future policy proceeds from a beneficiary who may have fallen out of favor.
The next Estate Planning Series 7 is what should be done with retirement plan benefits?