Tag Archives: Trust Fundamentals

What Is a Life Insurance Trust?

By Amber Gunn, CTFA and Mariam Hall

As the name suggests, a life insurance trust is a trust designed to own life insurance. This type of trust will most often be irrevocable. An irrevocable life insurance trust, or “ILIT” is a trust created to own and control a life insurance policy while the insured is alive, and then to manage and distribute the proceeds paid out after the insured’s passing according to the terms of the trust and the grantor’s intent. If a couple sets up a life insurance trust jointly, the insurance policy purchased inside the trust is often a “survivorship” or “second to die” policy, which pays the death benefit on the passing of the last surviving spouse.

Funded vs Unfunded Life Insurance Trusts

Life insurance trusts can be either “funded,” where the trust owns both a policy and income earning assets that provide for the payment of insurance premiums, or “unfunded,” where the trust owns the policy and the grantor makes an annual contribution to the trust that is used to pay the insurance premiums.

Funded and unfunded life insurance trusts are effective tools. However, keep in mind that with a funded life insurance trust, the transfers to fund the trust may be subject to the gift tax (when transferring income-producing assets to the trust) and income tax for a grantor trust. Unfunded insurance trusts make use of the grantor’s annual gift tax allowance to maximize tax savings and pay the annual insurance premiums.

Insurance Premium Tax

When establishing a life insurance trust, one of the several factors in deciding where the trust will be domiciled is the insurance premium tax rate in the state where the trust will be located. All states charge some form of tax on insurance premiums, including life insurance premiums. While this tax is rarely noticeable on most insurance products, for large life insurance policies with high annual premium amounts, it can make a big difference. This consideration becomes particularly relevant for annual premium amounts in excess of $100,000 a year, which is usually the case with private placement life insurance.

Insurance premium tax rates vary significantly among states. Alaska and Delaware are two states with particularly competitive insurance premium tax rates for large premium amounts. Alaska’s insurance premium tax rate is 2.7% on the first $100,000 of the premium, and then 0.08% on premium amounts in excess of $100,000. Delaware’s insurance premium tax rate is 2.0% on the first $100,000 of the premium, and premium amounts in excess of $100,000 are tax free. In contrast, most other states average between 1.75% to 2.5% on the entire premium amount, for example, California 2.35%, Nevada 3.5%, Florida 1.75%, New Jersey 2.0%, and New York 2.0%.

Nevada Incomplete Gift Non-Grantor Trusts (NINGs)

What Exactly is a NING Trust?

A NING is a Nevada Trust where gifts are considered “incomplete" for gift and estate tax purposes. Incomplete gifts are so named because the grantor may retain control over or access to the contributed asset. NING trusts are non-grantor trusts, which means that the trust is the taxpayer for income tax purposes. This allows the income from trust assets to be taxed based on the residence of the trustee rather than that of the grantor. For grantors living in a high-income state, like California, this can offer significant tax savings. If, for example, the sale of a highly appreciated asset is anticipated, doing so through a NING could limit the capital gains tax which might be higher if done under the laws of the grantor’s state of residence.

How do NINGs Work?

A NING works exceptionally well if a client lives in a high-income tax jurisdiction and is either looking to eliminate state income taxes or is selling an asset with a significant capital gain.

Here’s how a Nevada Incomplete Gift Non-Grantor Trust strategy works:
1. The grantor transfers an asset or brokerage account with income tax liability to a NING trust. This is often a portfolio of marketable securities or shares in a family business.

2. Once the transfer is complete, the grantor is no longer responsible for the income tax liability because a NING is a non-grantor trust. As a non-grantor trust, the NING will be a separate entity for federal income tax purposes and will file a Form 1041 return.

3. The trust is responsible for the income tax, and since the trust is set up in Nevada, where there is no state income tax, the income earned on the assets in the Nevada Incomplete Gift Non-Grantor Trust trust is not subject to state income tax.

An experienced attorney should draft a NING trust to ensure it is a non-grantor trust per IRS regulations. Having a properly drafted NING Trust is crucial to shift the income tax liability away from the grantor and to the trust.

Example NING Trust Scenario

Let’s say you have a client who is a successful business owner in California and is looking to sell their business for a significant profit. The client has a basis of $500,000 in the business which is now worth $10 million. If the business owner were to sell the business, they would incur a capital gain of approximately $9.5 million.

Given that California has a state income tax rate of 13.3%, in this scenario, your client would be responsible for paying approximately $1.3 million in California state income taxes, not considering any other facts and circumstances. However, if you set up a NING trust for your client and transfer ownership to the trust, the trustee in Nevada could then sell the business, potentially avoiding the $1.3 million in state income taxes. Of course, federal income tax would be applicable whether the grantor or the trust sold the asset. However, significant state income tax savings are possible using an appropriately structured Nevada Incomplete Gift Non-Grantor Trust.

After the sale, the proceeds could be invested by your client’s preferred financial advisor, and as long as the funds remain in the NING trust, there would be no state income tax liability. Additionally, if your client were to move to a state without state income taxes, they could avoid paying any state taxes on the trust distributions. Many clients set up a NING Trust with the intent of moving to a state without state income taxes before they start taking distributions from the trust. Others simply use the NING Trust as a legacy preservation vehicle for their children.

Ideal Candidate for a NING

The ideal candidate for a NING trust is someone who is looking to sell an asset with a significant capital gain and wants to eliminate or reduce state income taxes. This person may also be looking for asset protection and privacy and may be open to establishing a trust in Nevada to take advantage of the other benefits of Nevada’s favorable trust laws, such as asset protection, perpetual trusts, and privacy. Additionally, the ideal candidate may be open to relocating to a state without a state income tax or is interested in using the trust as a legacy preservation vehicle for their heirs.

Ultimately, the suitability of a Nevada Incomplete Gift Non-Grantor Trust will depend on the individual’s unique financial and personal circumstances and should be evaluated with the help of legal, tax, and financial advisors familiar with this advanced planning technique.

Here are some questions you may want to ask your client to see if a NING strategy makes sense for their situation:

Are you a high-income earner in the top tax brackets and live in a state with a high-income tax environment like California, Massachusetts, or New Jersey?
Do you have intangible assets with an embedded large capital gain that you would want to sell?
Do you plan on moving to a state with no state income tax? Do your beneficiaries reside in a state with no state income tax?
Have you done any estate tax planning? (Assets transferred to a NING trust are still includible in the grantor’s estate at death because the gift is “incomplete” for estate and gift tax purposes.)

Considerations for Establishing a NING

A NING works well if it owns intangible assets, such as shares in a business or a brokerage account. However, a Nevada Incomplete Gift Non-Grantor Trust cannot own tangible assets or assets sourced to the state in which the taxpayer resides. For example, if the asset is physically located in a high-income tax state (source income), the strategy will not work. Sometimes, tangible assets can be converted to intangible assets, but this requires additional careful planning with the help of specialized legal and tax advice.

A NING trust may not work for your client, depending on the state in which your client resides and how that state views the taxation of a trust. New York, for example, has enacted a law to negate the use of the NING trust strategy. Other states automatically impose a state income tax if the grantor is a state resident when the trust is established. Therefore, consulting knowledgeable tax and legal advisors is critical to determine whether the Nevada Incomplete Gift Non-Grantor Trust strategy will work for your client.

NINGs are complex trust structures that must be drafted according to specific rules to achieve the planning benefits. Therefore, working with a qualified attorney with experience creating such complex trusts is critical.

Nevada Directed Trusts

Directed trusts are a relatively modern estate planning tool that allow for the separation of investment management and trustee duties. With a directed trust, the trustee has limited responsibilities, and the grantor can appoint outside advisors to manage investments or direct distributions to beneficiaries. Directed trusts have gained popularity in recent years in estate planning. Nevada has become a go-to state for many individuals and families seeking to establish directed trusts due to its excellent directed trust statutes and other favorable trust laws.

What is a Directed Trust?

A directed trust is a trust structure in which the trustee is directed by one or more designated individuals or entities in making certain decisions related to the trust administration. The person or entity that directs the trustee is called the directing party or directing advisor. Some examples of directing parties include an investment advisor, a distribution committee, or a trust protector. The responsibilities of a directed trustee generally involve the following:

Carrying out the instructions given by the directing party.
Maintaining legal ownership of the trust’s assets.
Providing for the preparation of tax returns.
Maintaining trust records.
Accounting to the beneficiaries.

The trust document outlines the specific duties and responsibilities of the directed trustee and other trust participants.

Choosing the Right State: Why Nevada

Nevada has become a popular state for directed trusts due to its favorable trust laws, including its directed trust statutes. Nevada statutes permit directed trusts and provide certain protections for directed trustees. One of these protections is that a directed trustee is not held responsible for the actions of the advisor with discretion under the trust agreement, as long as the trustee acts in good faith and does not engage in willful misconduct or gross negligence.

Additionally, the law in Nevada considers a trust advisor to be a fiduciary by default unless the trust instrument specifies otherwise. This means that the trust advisor is legally obligated to act in the best interests of the beneficiaries and to exercise reasonable care, skill, and caution in carrying out his or her duties.

In addition to its directed trust statutes, Nevada law offers numerous other benefits for modern trust planning, such as no state income tax, asset protection, and the ability to create perpetual trusts.

Directed Trust Structures: Different Responsibilities for Different Roles

In a directed trust, various roles can be defined in the trust instrument. One of the key roles is the investment advisor, who is responsible for directing the trustee on investment decisions. The investment advisor can be a financial advisor, a family member, or even the grantor of the trust. Another critical role is the distribution advisor, who directs the trustee on distribution decisions. The distribution advisor can be the same person as the directing advisor or a different individual altogether. It should be noted however, that in most scenarios, the grantor should not act as distribution advisor.

Sometimes, a trust protector may also be appointed to oversee the trustee’s actions and ensure the trust’s terms are followed correctly. In addition, the trust protector may have other powers defined in the trust, such as removing the trustee and appointing a successor or changing the trust situs.

The roles and responsibilities of each participant are defined in the trust document. Depending on how the trust is drafted, it can be directed for investment, distribution, or both. This means that the directing advisor and distribution advisor can direct the trustee on specific investment choices and distribution decisions, allowing for a more tailored and customized approach to managing and distributing the trust assets.

Modern Trusts: Directed Versus Delegated

Before the inception of the modern-day directed trust, most trusts were drafted the old way: either a single trustee held all powers and responsibilities, or joint trustees shared equal authority and responsibility. The problem with this structure is that trustees, in many cases, were not the best choice for managing the trust assets. At the same time, a manager of a closely held family business or an investment advisor was not fully equipped to undertake all aspects of trust administration. If the trustee lacked the expertise to perform all necessary trustee functions, such as investing trust assets, the trustee’s only option was to delegate those duties to a professional equipped to perform the function. The solution to this problem? Update modern trust laws to allow for the separation of trustee duties and responsibilities – hence the modern-day directed trust.

The main difference between directed and delegated trusts is the trustee’s level of responsibility. In a directed trust, the advisor has the power to direct the trustee, while in a delegated trust, the trustee is responsible for making investment and distribution decisions. In a delegated trust scenario, the trustee is responsible for all trustee duties, including investment and distribution decisions, and can delegate some or all of those duties to other professionals. However, the trustee remains responsible for ensuring the delegated duties are appropriately executed. In contrast, since a directed trust separates the powers and responsibilities between the trustee and other participants, the trustee responsible for carrying out the directives of the other participants is relieved of liability for complying with those directives, unless the trustee acted in bad faith. This division of responsibilities allows for greater flexibility and customization for trust management.

Solving for Separation of Trustee Duties: “Old and Cold” Trust Documents

What about all the trusts drafted without the flexibility of the directed trust? Plenty of “old and cold” trust documents were drafted before the widespread inception of directed trusts. These trusts do not provide for the separation of trustee duties. As a result, regardless of who controls the trust assets, the trustee remains responsible which often results in difficulty finding a trustee willing to serve with an outside investment advisor who manages the trust assets. In these cases, there are generally three options.

Option 1: Decant the Trust to a Directed Trust with Updated Terms or Create a Non-Judicial Settlement Agreement
Nevada has favorable laws which give trustees the ability to decant a trust to one with updated, modern terms that allow for separation of trustee duties. This will involve the help of a skilled trust attorney familiar with complex trust structures. Nevada also has a well-established Non-Judicial Settlement process, which allows interested parties in a trust agreement to correct mistakes, address ambiguities, and change administrative provisions without the need for court approval.
Option 2: Find a Trustee Who Will Delegate
Another option, if the terms of a trust do not provide for the separation of trustee duties, is to find a trustee willing to delegate investment management authority to a non-trustee investment advisor. However, because of the increased liability to the trustee under this arrangement, delegated trusts generally incur higher trust administration fees than directed trusts. In addition, under this arrangement, the trustee is required to take on additional monitoring, due diligence, and oversight actions with respect to the investment activities.
Option 3: Create an “LLC Wrapper” for Trust Assets to be Managed by Non-Trustee Advisor
A third option to mitigate risk for the trustee and allow a non-trustee to manage trust assets is to create an LLC and structure ownership so that the only asset at the trust level is an LLC of which the trust is a sole member. In this scenario, the investment advisor or a family member may be appointed as manager of the LLC and will manage the underlying assets held in the LLC.

Summary

Estate planning attorneys should consider using directed trusts because they can be a valuable tool for clients seeking more control over investment and distribution decisions than traditionally structured trusts. Directed trusts have gained popularity in recent years, and Nevada has become a popular state for directed trusts due to its favorable trust laws. Directed trusts offer flexibility and customization for trust management, allowing for tailored investment and distribution decisions. Compared to delegated trusts, where the trustee is responsible for all trustee duties, directed trusts divide powers and responsibilities between the trustee and other participants. However, as always, it is important to carefully consider all aspects of a trust structure and seek the guidance of legal and financial professionals when creating a trust.

Taxation of Trusts: Basic Terms and Concepts

Grantor or Non-Grantor Trust?

To understand the basic concepts of the taxation of trusts, we must first understand the concept of a grantor trust versus a non-grantor trust. All trusts are either grantor or non-grantor trusts. With a grantor trust, the trust creator retains certain powers over the trust, which may include certain powers over the trust’s assets and income. With a non-grantor trust the trust creator has no interest or control over trust assets. This distinction determines how and to whom a trust is taxed. A grantor trust is taxed to the grantor. With a non-grantor trust, the trust either pays out income to beneficiary(ies) and then taxed at the beneficiary level or is taxed at the trust level for any income accumulated in the trust.

Many plans using trusts are set up to result in trust income being taxed at an individual level (taxed to the grantor or beneficiary) rather than at the trust level (taxed to the trust). This is because the income tax brackets for trusts are significantly compressed, compared to the tax brackets for individuals. A trust reaches the top tax bracket of 37% at only $13,450 of income, as opposed to the individual bracket where the top tax rate is not reached until over $647,850 of income.¹

Grantor Trusts

A grantor trust is a trust over which the grantor has retained certain interests or control. The grantor trust rules in IRC 671-678 prevent the grantor from taking tax advantages from assets that have not left his or her control. The grantor trust rules treat the grantor (or in some cases a beneficiary) as owner of all or a portion of the trust income and losses. The grantor is subject to tax on trust income, even if he or she does not actually receive the income.

In most cases grantor trusts do not file separate income tax returns, as opposed to non-grantor (simple or complex) trusts. Because assets in a grantor trust are still considered the grantor’s property under the grantor trust rules, the grantor generally reports the income from the trust assets using his or her own social security number on the grantor’s Form 1040.²

Revocable vs Irrevocable Trusts

If the grantor retains the ability to revoke the trust and revest the trust assets in the grantor, the trust is revocable, and the income is taxable to the grantor under the grantor trust rules. All revocable trusts are necessarily grantor trusts. Assets in a revocable trust are included in the grantor’s gross estate for federal estate tax purposes. Revocable trusts, also called living trusts, are one of the more frequently misunderstood trust concepts. They are used primarily as a will substitute. Assets in a revocable trust avoid the cost, time, expense, and publicity of probate. Upon the grantor’s passing, a revocable trust becomes irrevocable.

An irrevocable trust is one that, by its terms, cannot be revoked. An irrevocable trust can be either a grantor or non-grantor trust, depending on the terms of the trust and the powers retained by the grantor in the trust. An irrevocable trust is simply one that cannot be revoked, whether or not it qualifies as a grantor trust under IRS rules. All revocable trusts become irrevocable upon the death of the grantor.

Non-Grantor Trusts: Simple or Complex

Non-grantor trusts will generally be classified as either simple or complex for tax purposes. It’s not always an easy distinction between a simple versus complex trust. A trust may be a simple trust for one year and a complex trust for another year.³ In Form 1041, the trustee can identify whether the trust is a simple or complex trust for that particular taxable year.

For non-grantor trusts (simple and complex trusts) the trustee must obtain an employer identification number (EIN) in order to file Form 1041, the US Income Tax Return for Estates and Trusts. A trustee must file Form 1041 if the trust has any taxable income or gross income of $600 or more.

If a trustee makes distributions to the beneficiaries, the trustee must file Schedule K-1 together with Form 1041. Schedule K-1 is the IRS form that reflects the beneficiary’s share of the trust’s income, deductions, and credits. When distributions have been made to beneficiaries, the beneficiary pays the income tax. When income is retained by the trust, the trust pays the income tax. This is important because the beneficiary and trust have different tax brackets. The trust has a higher tax rate than an individual. Thus, the beneficiary will use Schedule K-1 to report his share of the trust income in the beneficiary’s Form 1040.

Criteria for Simple vs Complex Trusts

Under the IRS Code,⁴ a simple trust must pass all three criteria in a taxable year in order to be considered a simple trust (for that tax year):

It must distribute all income to the beneficiaries
It cannot distribute principal
It cannot make distributions to charity

On the other hand, a complex trust is a trust that does any one of the following in a taxable year (for that tax year):

It accumulates income
It distributes principal
It makes charitable distributions

Split Interest Trusts

A third type of non-grantor trust is a split interest trust. A split interest trust is a trust that has both charitable and non-charitable interests. The most common types of split interest trusts are charitable remainder trusts, charitable lead trusts and pooled income funds, each with their own set of rules under the IRS Code.

NOTE: This information is general and educational in nature and is not intended to be and should not be construed as legal or tax advice. Peak Trust Company does not provide legal or tax advice. The taxation of trusts is highly complex in nature and should only be executed under the guidance of appropriately skilled legal and tax counsel.

¹ As of the 2022 tax year.

² In some cases, a grantor trust may have its own employer identification number (EIN), in which case, even though it remains a grantor trust, it should file a form 1041. The return is marked as a grantor trust for federal tax purposes with a note that all income, expense, and other activity is being reported on the grantor’s federal tax return and not the Form 1041. The tax return filing provides the IRS notice that although the grantor trust has its own tax ID number, the income and related trust expenses are reported on the grantor’s federal tax return.

³ 26 CFR § 1.651(a)-1

⁴ 26 CFR § 1.651(a)-1

Key Considerations When Creating a Spousal Lifetime Access Trust

Naming Trustees

The grantor should not serve as trustee. A beneficiary spouse may serve as trustee but would be limited to making distributions to themself under an “ascertainable standard.” An Ascertainable Standard, or “HEMS” allows for distributions to be made for beneficiary needs related to health, education, maintenance, and support.

Naming Beneficiaries

The primary beneficiary is generally the spouse of the grantor; however, siblings, children, grandchildren, and other descendants may also be named as current or remainder beneficiaries.

Naming Trust Protector(s)

Another important consideration is naming a trust protector. While not a fiduciary position, a trusted friend, advisor, institution, or partnership may be assigned as trust protector and given the power to remove a trustee, as well as other duties in the trust agreement. The trust protector may also be responsible for appointing a new trustee if there are none currently acting, or further appointed in the trust document. Often, it is most advantageous to have a non-beneficiary hold this position due to tax considerations and conflicting personal interests in the trust.

Funding the Trust

A SLAT can be funded with a variety of assets; however, it is very important to maintain separate property between the grantor and beneficiary spouse. If the trust is funded with a jointly owned asset, there is a risk that the beneficiary spouse could be perceived as making a gift to the SLAT, which may result in the trust assets being includable in his or her estate, thus wasting the gifting exemption allocated by the grantor.

Drafting Flexibility

SLATs offer the opportunity to take advantage of one’s gift and estate tax exemption while maintaining indirect access to those assets through their spouse. Additional flexibility can also be given to the beneficiary spouse through a limited power of appointment. Other provisions to ensure future flexibility can be included such as expressly allowing for decanting and giving additional powers to a trust protector.

Avoiding Reciprocal Trust Doctrines

In situations where both spouses may be using a SLAT as part of their overall planning, there needs to be distinct differences in terms between the trusts of each spouse. If the trusts are too much alike, there is a risk of the IRS viewing them as a tax-avoidance strategy which would eliminate the positive estate planning tax impact.

Marital Considerations

A SLAT may not be a good idea in difficult marriages. One of the biggest advantages of a SLAT is that the grantor is able to continue enjoying access to the trust assets through the spouse. In the case of a divorce, this benefit is eliminated. To provide some protection for the possibility of divorce, SLATs can be drafted to eliminate a spousal beneficiary in the event of divorce.

State Income Tax

Because a SLAT is a “grantor trust” this means that income earned in the trust is taxed to the grantor. If the grantor is a resident of a state with a state income tax, the grantor will be required to pay state income tax on any income earned by the trust. If income tax planning is a primary purpose of the trust, or the trust holds assets earning a considerable amount of income, other structures such as a domestic asset protection trust (DAPT) or an incomplete non grantor Trust or “ING trust” may better achieve planning goals.

Benefits of a Spousal Lifetime Access Trust (SLAT)

Use Estate and Gift Tax Exemptions

The current estate, gift and generation skipping transfer tax (GST) exemption is a historical all-time high of over $11 million per person. Whether a grantor’s estate is larger than that or much lower, it may make sense to take advantage of as much of the exemption as possible before the current exemptions sunset in 2025 or are changed. As with most irrevocable trusts, completed gifts using the exemption along with any future appreciation are sheltered from future estate and gift taxes.

Reduce or Eliminate Capital Gains Tax

SLATs may help reduce capital gains tax at the time of the grantor’s death. Under current law, if the trust holds appreciated assets, the grantor (or the spouse under Section 1041) could swap (or buy) the appreciated assets out of the trust and into the grantor’s name before death by transferring assets to the trust (typically cash) of an equal value. This is an estate tax neutral transaction since the same value remains in both the trust and grantor's estate. However, the appreciated assets in the hands of the grantor (or spouse) and therefore the grantor or spouse’s estate, will qualify for a step-up in basis at death, thus eliminating the unrealized appreciation or gain. If the estate tax is repealed, it could be replaced by a capital gains tax at death.

Further, a capital gains tax may be implemented for gifts of appreciated assets. Assets transferred to a SLAT before such a change may avoid any capital gains tax by gift. At death, the same swap or substitution power used above can be applied in the opposite manner as a reverse swap. If the grantor has appreciated assets in his or her estate prior to death, the grantor may be able to swap them into the SLAT prior to death and avoid a capital gains tax on death. Under either scenario, it is possible that the SLAT may provide an income tax planning opportunity.

Get Creditor Protection

As an irrevocable trust, SLATs can provide meaningful asset protection from future potential claims of creditors (i.e., protect assets in trust from malpractice claims, beneficiaries’ divorcing spouses and other suits). This protection applies to assets transferred to the trust if not characterized as a fraudulent conveyance. When a SLAT serves as an Irrevocable Life Insurance Trust (ILIT), policy cash values during the insured's life and death benefit proceeds are also protected.

Take Advantage of Grantor Income Tax Ratex

Because SLATs are a “grantor trust” this means that they are taxed to the grantor of the trust. This means that any trust earnings (i.e., dividends, interests, capital gains) are accounted for on the grantor’s personal return. This allows the trust the potential to grow “tax-free” as far as the beneficiaries are concerned, because the grantor is paying the tax bill.

It is often advantageous for trusts to be taxed at an individual level, rather than at the trust level, as the tax brackets for trusts are compressed compared to individual tax brackets for 2022 – a trust will hit the top tax rate of 37% after $13,450 of income, whereas an individual doesn’t reach the top tax rate until they exceed well over $500,000 of income. Another benefit is that the payment of those taxes by the grantor is not considered an additional gift.

Important Considerations for Making Irrevocable Life Insurance Trusts Work

Avoiding Gift Tax
Because contributions to an ILIT are considered gifts to the beneficiaries of the trust, an insurance trust must be properly drafted and appropriately administered by the trustee to avoid gift tax consequences. If an insurance trust is unfunded, the grantor will have to make regular contributions to the trust to cover the insurance premiums. In order for the contributions to qualify for the grantor’s annual gift tax exclusion, notice must be provided to the beneficiaries by the trustee. The notice, often called a Crummey letter, notifies the beneficiaries of their right to withdraw contributions, which, in turn, meets the Internal Revenue Service’s “present interest” requirement for the gift to qualify for the annual gift tax exclusion. The Crummey withdrawal period does lapse, typically 30 days after the date of the gift. The trustee can use the gift/contribution to pay the insurance premiums after the withdrawal right period ends.

Gifting Existing Life Insurance Policies to a Trust
The IRS has a three-year lookback period after an existing life insurance policy is transferred to a trust to determine whether the death benefit can be included in the grantor’s estate. If the grantor contributes an existing policy to a trust, but then passes within the three-year window, the proceeds could revert into the grantor’s estate, thereby defeating a primary purpose of establishing the trust. Another factor to consider is that there may be a gift tax consideration if the existing policy has accumulated cash value. When a trustee purchases a new life insurance policy in the trust after the trust is established, there is no lookback period. When considering the tax consequences of any transfer, a competent tax adviser should be consulted.

Choosing the Right Trustee
The decision of who to appoint as the trustee for a life insurance trust is a critical factor in the success of the estate plan. There are several important duties that the trustee is responsible for carrying out for the purpose of the trust to be achieved. A primary purpose of an insurance trust is often to remove the value of the insurance policy, the annual contributions, and the resulting insurance death benefit proceeds from a grantor’s estate. For this purpose to be achieved, the trustee cannot be the grantor or the grantor’s spouse. The trustee will be responsible for the filing of tax returns, payment of insurance premiums, issuing Crummey notices to beneficiaries to ensure annual contributions qualify for the grantor’s annual gift tax exclusion, and distributing trust proceeds in accordance with the terms of the trust and the grantor’s intent.

An important consideration for choosing the trustee of an insurance trust is the chosen trustee’s ability to manage consistent premium payments, legal responsibilities, tax filings, and notice requirements. Often, a professional or corporate trustee is the best option for an insurance trust because of the level of complexity and administrative work that must be carried out for these trusts.

Deciding a Trust Jurisdiction
Choosing where an insurance trust will be domiciled is an important decision when establishing an insurance trust. Since an irrevocable trust can be domiciled anywhere, it is often advantageous to choose a state that affords the best combination of low insurance premium tax, no state income tax, and the best asset protection laws for irrevocable trusts. In most states, the situs of an irrevocable trust is based on the location of the trustee where the trust administration occurs among other basic requirements that differ slightly from state to state.

How Are Life Insurance Trusts Used?

Provide Liquidity for Estate Administration
A common use for life insurance trusts is to provide an easily accessible source of liquidity for the insured’s estate upon their passing. As is often the case, many assets in an estate are illiquid, such as a house. Also, there is often an immediate need for liquidity after a person’s death. The estate may be required to pay taxes and will incur other administrative and legal costs. Therefore, many financial planners recommend a life insurance trust to provide liquidity for their client’s estate plans. When the insured passes, the life insurance proceeds are paid into the trust that is the policy’s beneficiary. These proceeds can then be used to purchase illiquid assets from the estate, thus providing protection for those assets and cash for the estate’s needs. A real-world example where this strategy might be used is to protect a surviving beneficiary, perhaps the spouse or a child of the insured, from being forced to sell a home on short notice to raise cash.

Minimize Federal Estate Tax Liability
Although life insurance proceeds are usually exempt from income taxes, proceeds are not exempt from estate taxes when the insured personally owns or controls the policy. Compared to personally owning an insurance policy, a key benefit of an ILIT is that the trust is the beneficiary of the policy, and the assets owned by the trust are not considered part of the insured’s taxable estate. For insurance proceeds to pass outside of the insured’s estate, the trust must own and be the beneficiary of the insurance policy.

Maximize Generation-Skipping Transfer Tax (GST) Planning Opportunity
An insurance trust can be used to maximize a grantor’s GST tax exemption by using annual gifts to the trust to fund the insurance premiums. Since insurance proceeds in a properly structured insurance trust are excluded from the grantor’s estate, multiple generations of the family may benefit from the trust’s assets free of GST tax.

Avoid Gift Tax
A life insurance trust can be structured in a way that allows the grantor to maximize their annual gift tax exclusion each year with contributions to the trust. Annual gifting enables the trustee to pay the annual insurance premiums while removing a significant amount of assets from a grantor’s estate over time.

Maintain Government Benefits
If a beneficiary is currently receiving government aid, such a Social Security disability income or Medicaid, a life insurance trust can be used to ensure that life insurance proceeds and ongoing distributions from the trust will not interfere with the beneficiary’s eligibility for government benefits.

Stipulate the Distribution of Funds
With a life insurance trust, the grantor can stipulate in the terms of the trust how the insurance proceeds are to be distributed. The trust can provide the trustee with discretionary powers to make distributions to beneficiaries. This could be useful in incentivizing certain achievements, such as graduating from college, or to protect the assets for the intended beneficiaries in blended family situations.

Protect against Creditors
A properly drafted insurance trust can provide asset protection for the life insurance policies held in trust. An irrevocable trust can provide asset protection from creditors of both the grantor and the beneficiaries. Once distributions are made from the trust to a beneficiary, a creditor of the beneficiary can attach any distribution, but as long as assets are held in trust, they can retain creditor protection. Asset protection laws vary from state to state, and several states, including Alaska, Nevada, and Delaware, offer excellent protections for trusts.

What is a Spousal Lifetime Access Trust (SLAT)?

By Mariam Hall

A Spousal Lifetime Access Trust (SLAT) is an irrevocable trust created by one spouse for the benefit of the other spouse. The grantor uses their gift tax exemption to make a gift to the SLAT for the benefit of their spouse. Similar to other planning techniques to make completed gifts that are outside of the grantor’s estate, the grantor gives up his or her right to the property transferred into the trust while the beneficiary spouse maintains access to that same property.

The goal of a SLAT is to get assets out of a grantor’s estate and into a trust that can provide financial support for one’s spouse while sheltering those assets and any future growth from estate and gift tax. By creating a trust for one’s spouse, the grantor may continue to benefit from the property through the spouse without concern of creditor claims or estate tax inclusion.

Key Considerations When Creating a SLAT

There are several important considerations to keep in mind when setting up a SLAT. For example, who will be the trustee as the grantor should not serve as trustee? Who will the beneficiaries be – Spouse, children, other descendants? Do you want to assign a trust protector and what duties will be assigned to them, such as the power to remove a trustee? How will the trust be funded? Are both spouses using a SLAT? If so, it is very important to avoid reciprocal trust doctrines. Do you need language regarding the possibility of divorce? Learn more here about the key considerations when creating a SLAT.