Your premarital agreement written in California may require that you purchase life insurance for your spouse’s benefit. You may also have children, whether they live in California or not, from a prior marriage for whom you are concerned. If so, you may fulfill your requirement to your spouse while at the same time taking comfort in also providing for your children all under the same insurance policy. Options can and ought to be discussed with a qualified estate tax attorney.
Perhaps you do not want your spouse to have complete control over the policy’s cash value or death benefit so that all of the beneficiaries for whom you are concerned get all the cash which you want them to receive.
Children from your current marriage should not be excluded from receiving a part of your estate upon your death even if the prenuptial agreement is silent on the matter or requires you to provide primarily for your spouse.
A technique should be devised to be sure a distribution upon your death to your children of your current marriage does not give rise to either an estate tax or an individual income tax.
These goals and concerns may be met by using a trust to own the policy and to serve as the primary beneficiary. An irrevocable insurance trust will accomplish these things, and more.
An irrevocable insurance trust is a separate legal entity your attorney creates with your help to own the life insurance and to be the primary beneficiary. The trust can provide that upon your death, your spouse is to receive all of the income generated by the principle and may receive distributions of principle for reasons such as health, education, maintenance, and support.
If someone other that your spouse is the trustee in charge of managing the funds, you may feel better about whether any of these criteria for principle distributions are met. To the extent principle remains in the trust after your spouse’s death because the trustee did not distribute any for nonconforming reasons, your children from a prior marriage can be the beneficiaries of it.
For children of your current marriage, an irrevocable insurance trust may also be handy. You may either use your separate property funds created (or preserved) under your prenuptial agreement or community assets to pay the premiums. The trust is the beneficiary of the death benefit and your children are the beneficiaries of the trust.
In this fashion, you can rest comfortably knowing that no matter what happens with your current marriage, your children will be provided for so long as the insurance is kept in force.
Your premarital agreement may enable you to set up separate property bank accounts in California, one for you and one for your spouse. If the premarital agreement says one spouse should buy life insurance for the benefit of the other, the funds from one account can be used to pay premiums on the insurance covering the life of the other spouse.
This structure’s benefit is to provide a tax shelter covering the death benefit. Upon an insured spouse’s death, the death benefit is kept out of his or her estate when calculating whether estate taxes are due. This is useful when the deceased spouse leaves his or her estate to someone other than the surviving spouse.
There are other ways of sheltering the insurance death benefit from estate taxation. Making a gift of a policy is a common way. While outright gifts can achieve significant tax and nontax benefits, far greater advantages are often possible when such gifts are made through the use of an irrevocable insurance trust.
A gift to a life insurance trust can remove the proceeds from the estates of both the insured and the insured’s spouse, while making the proceeds fully available to the insured’s spouse. Furthermore, these results can be achieved at a very low gift tax cost – or at no cost whatsoever, without reducing the availability of the proceeds to ease liquidity problems in the estate. Obtaining all of these results, of course, requires a well-planned and well-drafted insurance trust.
A gift of life insurance in trust is made by the assignment of all of the incidents of ownership in a life insurance policy to a life insurance trust. The trust must be irrevocable, since a right to revoke the trust would cause any life insurance policies held by it to be included in the insured’s gross estate and subject to estate tax.
The insured typically pays premiums on policies held by an irrevocable insurance trust by annual gifts to the trustee in amounts sufficient for the trustee to pay the premiums. (The trustee is the person or firm which manages trust property and carries out the trust’s terms.)
There are several advantages in making life insurance gifts through an irrevocable trust rather than outright to the beneficiary.
First the insured can provide professional management of the insurance proceeds after death through selection of the trustee. If the donee is immature or simply not used to managing large amounts of cash, this may be the most critical advantage of an irrevocable life insurance trust.
Second, an irrevocable life insurance trust can remove the insurance proceeds from both the insured’s gross estate and that of the surviving spouse, while making a significant amount of the proceeds available to the surviving spouse.
Third, a gift of an insurance policy to a life insurance trust gives the insured more control over the policy than would an outright gift to an individual. An individual donee can give or bequeath the policy to third persons, frustrating the insured’s planned use of the proceeds. The use of a trust assures that the proceeds will be available for the intended purpose.
There are relatively few disadvantages to making gifts of life insurance policies in trust. One disadvantage is the necessity of preparing a simple tax return for the trust if there is reportable income. In addition, most trustees charge a fee for their management services. While these fees may be nominal during the insured’s lifetime (when the trust has assets with a low value), they can be substantial after the insured’s death, depending on the amount under management. Furthermore, if the insured dies within three years of giving the policies to the trust, the policies may be included in the insured’s gross estate and subject to estate taxation.
Whether or not you have a prenuptial agreement, an insurance trust can provide significant tax savings by eliminating the estate tax against all or a portion of the life insurance death benefit.
Call Mitchell A. Port, a tax attorney in California, for a consultation on this and other tax planning ideas. He can be reached at (310) 559-5259.