Income Tax Implications of Irrevocable Life Insurance Trusts

Typically, an irrevocable life insurance trust will not be funded. Since it holds no income producing assets, generally no income tax problems are created.

In general, if an irrevocable life insurance trust is funded, income it generates is taxed to the trust since it is a separate entity. To the extent income is paid to the trust’s beneficiaries, it is taxed to them rather than to the trust.

However, if the trust is treated as a grantor trust, the income earned by the trust will be taxed to the grantor and any deductions, gains, losses, or credits realized by the trust can be used by the grantor.

The following will cause the trust to be considered a grantor trust:

  1. Retention by the client or the client’s spouse of a reversionary interest (right to receive property back or determine its disposition) in the income or the principal of any portion of a trust, but only if the actuarial value of the retained reversionary interest is greater than 5 percent of the value of the income or principal that may revert.
  2. Retention of the power by the client or the client’s spouse to control the beneficial enjoyment of the income or principal of the trust.
  3. Retention of certain administrative powers by the client or the client’s spouse. These powers include:
    -power to purchase, deal with, or dispose of the income or principal of a trust for less than adequate and full consideration;
    -power to borrow from income or principal without adequate interest or security (an -exception is made where a trust authorizes such loans under a general lending power by a trustee who is not the grantor);
    -if a related or subordinate trustee lends income or principal to the client and the loan is made without adequate collateral or a reasonable rate of interest (and the loan is not repaid before the beginning of the next tax year); or
    -if someone other than the trustee can vote corporate stock held by the trust, or has the power to control the investment of stock or securities held by the trust, or has the power to reacquire the principal of the trust by substituting property of equal value.
  4. Retention of the power by the client or any nonadverse party (including the client’s spouse) to revoke the trust.
  5. If the income of the trust is, or in the discretion of the client or a nonadverse party, may be,
    -distributed to the client or his spouse;
    -held or accumulated for future distribution to the client or his spouse;
    -used to pay premiums on a policy insuring the life of the client or his spouse (since there is little or no income in the typical irrevocable life insurance trust, this should not be a problem); or
    -used to discharge a legal obligation of the client or his spouse.

A trustee, beneficiary, or some party other than the grantor-client can be taxed on the income of a funded irrevocable trust if that person has the power to vest (obtain without conditions or risk of forfeiture) the income or principal of all or a portion of the trust in himself.

When a trust beneficiary allows a Crummey power to lapse, there may be income tax consequences. Unfortunately, the income tax consequences of the lapse of the Crummey withdrawal right are far from certain.

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

Leave a comment

A Quick and Easy Life Insurance Needs Calculator