How to Handle Group Term Life Insurance in An Irrevocable Trust

Group insurance is an ideal type of life insurance to transfer to an irrevocable trust for many reasons. In this article, we will explore a variety of different opportunities that you may be able to benefit from. Some of the reasons that group insurance might be ideal include:

  • A transfer of group term life to an irrevocable life insurance trust makes significant estate tax savings possible at minimal gift tax cost.
  • There is a considerable psychological advantage to the use of group term life with an irrevocable trust; since the premiums are paid for by the insured’s employer, the employee feels the cost is low since little of current value is given up.
  • In the case of an insured who also controls or influences the employee benefit decisions of the corporation, since the employer controls the ability to cancel the master contract—indirectly at least—the employee can terminate the coverage inside of the trust by suggesting that the employer purchase coverage from a new carrier. (However, this control will not be deemed an incident of ownership.) For practical purposes, however, an employee who wishes to remove group insurance from his estate will usually assign all rights in replacement policies, as well as in the original policy (see below).

Virtually all states specifically allow the absolute assignment of group term life insurance. This creates an opportunity to remove huge amounts of insurance from both the estate of the insured employee and the estate of his spouse through a transfer to an irrevocable life insurance trust.

But there are special problems inherent where group term life insurance is contributed to or owned by the irrevocable trust.

Assignability

The insured must divest himself of all incidents of ownership through an absolute assignment. The insurance company’s form should be examined to be sure it transfers all the insured’s rights with respect to the coverage. Be sure to obtain an endorsed copy of the form from the insurance company as evidence that the transfer has, in fact, been officially made. If the date or the existence of the transfer becomes an issue, that endorsed copy will prove that the insurer recognized the change of ownership.

Obviously, the terms of the master contract between the employer and the insurer should allow the assignment. But if there is a prohibition, the master policy should be amended at the employer’s request and documentation retained by the firm’s counsel. State law must also permit the assignment. As mentioned above, almost all states currently allow an insured under group term coverage to make an absolute assignment of all rights.

Assuming both the terms of the policy and state law permit a client to assign interests in group term coverage to an irrevocable trust (or other third party), the transfer should be effective to avoid federal estate tax. Furthermore, the payment of each premium by the employer is not considered to start a new three-year period for purposes of Code section 2035 estate tax inclusion.

Planners must beware, however, of events beyond some employee-clients’ control (e.g., a change by the employer of the group insurance carrier). An assignment with one company typically doesn’t apply to the new coverage with the new insurer.

At first glance, the solution seems obvious; transfer all rights, not only in the current coverage, but also to any future coverage. Assuming the new coverage was purchased without the employee’s direction, was necessitated by the change in the master contract, and was identical in all relevant aspects to the old plan, the IRS will recognize the anticipatory assignment, at least in removing the proceeds from the insured’s estate. This implies that if the amount or terms of coverage was significantly different, the IRS might not consider itself bound to honor the assignment.

More importantly, what havoc might such an anticipatory assignment play on a client who, after having assigned away all future group term coverage, is divorced from his spouse? Not only must the client report Table I costs19 (regardless of who owns the contract) as income and report an amount equal to the Table I costs as gifts, but every time his salary is increased, assuming group coverage is a function of salary, the ex-wife is potentially enriched at the client’s current expense.

Obtaining the Annual Exclusion

Attainment of the annual exclusion is not certain. Although there is no official requirement that the exact property contributed to a trust each year be the property subject to the power, in the opinion of the authors, if the beneficiary can’t get what the grantor puts in, the IRS may someday argue that the withdrawal power is ineffective and the gift tax exclusion should be denied. In the case of an irrevocable trust—where there are no assets except group term life coverage contributed to the trust—the employee-insured-grantor is making only a constructive transfer of premium dollars; premiums are in fact actually paid directly to the insurer by the employee-insured-grantor’s employer. The employee is deemed to have made a gift to the trust for gift tax purposes. The authors feel it is essential that, in such cases, the initial and annual rights of the beneficiary to make withdrawals be satisfiable by any property held by the trust including, but not limited to, group term coverage.

When a client is covered by a large amount of group term insurance, premiums can be substantial. Absent an annual exclusion, the annual gift the client is deemed to make every time his employer pays a premium on coverage absolutely assigned to an irrevocable trust could be costly. For instance, a sixty-one-year-old executive covered by $1,000,000 of taxable group term coverage would be deemed to transfer about $7,920 each year to the donees of his trust. A sixty-five-year-old with the same coverage would be considered to be making gifts of $15,240 each year. 

As mentioned above, a purely tax oriented solution for obtaining the annual exclusion would be to give the donee the right to take the coverage out of the trust and/or give the donee the right to an immediate distribution of the insurance proceeds at the moment of an insured-employee’s death. But if this right is exercised, it would defeat some of the tax and personal objectives the client had when establishing the trust. If the beneficiary in fact exercises the power and takes the coverage during the client’s lifetime, the client has lost all control. Until the master contract is changed to a new carrier or dropped by the employer, the Crummey powerholder (or the person who buys the coverage from him) owns the insurance on the client’s life. If the beneficiary has the right to take the proceeds at the moment of the client’s death, again, the dispositive and limiting objectives of the client are defeated.

To avoid these problems, consider giving the beneficiaries, in addition to the normal Crummey withdrawal right, the right to require the trustee to sell any group term coverage on the insured employee and pay them their share of the sales proceeds. To prevent the policy from ending up in the wrong hands should they in fact exercise this right, the trust would provide that the trustee could sell it only to the insured. The sale price would be an amount exactly equal to the premium paid that year by the employer on the employee’s behalf. In essence, this would give the beneficiaries a withdrawal power operative on the amount of the constructive gift made by the employee client; as soon as the employer pays the premium, the beneficiaries can demand the equivalent of that amount from the trust. The grantor must buy if the trustee exercises his put, but the grantor has no right to compel a sale.

Group Term Life Insurance and Community Property Issues

Planners in community property states (see below) must remember that one-half of the compensation and, therefore, the assets purchased with or because of that portion of the employee’s compensation are considered the property of the nonworking spouse. A retained life estate is held by the nonworking spouse with respect to that one-half. Some authorities have suggested that the nonworking spouse should assign his one-half of the future premium payments made by the employer to the working spouse or have the working spouse reimburse the nonworking spouse from separate property.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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