Life Insurance Trusts in 2010

January 14, 2010

An irrevocable life insurance trust is an estate planning tool commonly used to prevent life insurance proceeds from being subject to estate tax at the death of the insured. In today’s unpredictable legislative environment, use of standard funding techniques for insurance trusts may have unknown and unintended generation-skipping transfer (GST) tax consequences.

Absent legislation from Congress, the GST tax, like the estate tax, “shall not apply to generation-skipping transfers after Dec. 31, 2009.” The GST tax is scheduled to return Jan. 1, 2011. For grantors and trustees funding or administering life insurance trusts during 2010 and beyond, the temporary suspension of the GST tax regime raises significant questions regarding the best and safest way to pay insurance premiums.

When premium levels permit, gifts from the grantor is a common method of funding the necessary insurance premiums. If such gifts are subject to so-called Crummey rights of withdrawal, they may qualify for the gift tax annual exclusion and not be subject to gift tax. In this respect, 2010 is the same as previous years. The significant difference that arises in 2010 is that because the GST tax does not apply to generation-skipping transfers, including some transfers to trusts, it therefore is not always clear if and how GST exemption can be allocated to those transfers.

In that case, when 2011 arrives and the GST tax returns, the trust may contain assets to which no GST tax exemption was allocated. A trust that was intended to be wholly exempt from GST tax may now be only partially exempt unless a late allocation of GST exemption is made on or after Jan. 1, 2011. A risk in waiting to make a late allocation is that the insured may die in the interim.

This result is unclear, and regardless of the result under current law, Congress may legislatively provide, clarify, or change the treatment of such transfers during 2010. If congressional action is retroactive (and survives constitutional challenge), it is possible that allocations may be made (or may be automatic) as though the lapse in the estate and GST taxes had never occurred.

During this period of uncertainty, one solution is for the trustee to borrow funds from the grantor or a third party to use to pay insurance premiums. If legislation during 2010 reinstates the GST tax or otherwise clarifies these issues for this year, the grantor can make gifts to the trust later in 2010 for the trust to use to pay off the loan. If no legislation is passed during 2010, a loan to the trust eliminates the concern about the trust’s fully exempt status for GST tax purposes for 2011 and beyond, and the grantor may make gifts to the trust in 2011 for the trust to use to pay off the loan. To avoid gift implications, any loan from the grantor or a family member must bear interest at no less than the Applicable Federal Rate as announced by the IRS and in effect at the time of the loan.

Although loans to fund life insurance premiums may be classified as a “split-dollar arrangement,” loans described above should not cause concern as long as the terms of the promissory note are respected and the trust has the ability to pay the principal and interest when due.

Another possible solution is to skip paying premiums during 2010 by using a portion of the policy’s existing cash value to maintain the policy, and then in 2011 to reinstitute the gift program. Life insurance advisors should be consulted before making a decision of this nature.

If loans or policy values instead of gifts are used in 2010 to maintain the insurance, attention should be given to other possible uses of the 2010 gift tax annual exclusions.

For more information on this subject, please contact any of the authors or any member of our Private Wealth Services or Fiduciary Advisory Services groups. Please refer to the McGuireWoods white paper for additional information regarding the impact of the estate tax repeal.

McGuireWoods Private Wealth Services

Private Wealth Services is one of the strongest and largest groups of estate planning professionals in the world with offices in the United States and in strategic foreign cities. The team’s experience and size puts it on the cutting edge of estate planning, tax and probate issue development and analysis.

McGuireWoods Fiduciary Advisory Services

Fiduciary Advisory Services assists financial institutions in an array of areas in which questions or concerns may arise. This includes advising corporate trustees on how to avoid litigation before it arises, and how to address litigation when it does arise.