Life insurance trusts.

Life insurance is a vital part of many estate plans. It can help solve many problems that may come up, including maintaining liquidity, providing a source of income for surviving spouses or heirs and funding buy-sell agreements among the owners of closely held businesses.

LIFE INSURANCE PROCEEDS

If payable to or for the benefit of an insured's estate, life insurance proceeds generally are included in his or her estate. The tax consequences depend on the concept of "incidents of ownership" (defined below): If the insured retains incidents of ownership, he or she still is considered the policy's owner.

Incidents of ownership include

* The power to change the beneficiary.

* The power to surrender or cancel the policy.

* The power to assign the policy.

* The power to revoke an assignment.

* The power to pledge the policy for a loan against its surrender value.

* The power to obtain a loan from the insurer against the policy's surrender value.

* The power to retain any of these rights if the beneficiary dies before the grantor or if certain other contingencies occur (also known as a reversionary interest).

* Control of the trust's terms or the payout of income to the beneficiaries (that is, in a fiduciary capacity).

* Ownership of a corporation that is the policy's beneficiary.

USE OF TRUSTS

If properly designed, a trust will be treated as a separate entity from the insured. At the same time, if the proper provisions are included in the trust agreement, the insured still can achieve his or her estate planning objectives, and avoid estate (and maybe even income) taxes.

LIFE INSURANCE TRUSTS

If an individual wishes to establish a trust to own and hold insurance on his or her life for someone else's benefit, certain issues must be considered and resolved.

Inter vivos. The trust should be set up during the insured's lifetime; if established as part of the individual's will, it will not be effective in removing the proceeds from the insured's estate.

Irrevocable. The trust should be irrevocable. If it can be revoked by the insured, the grantor effectively retains control over it. The major disadvantage in establishing an irrevocable trust is that, since the insured does not have an incident of ownership in the trust, he or she no longer has control over the assets in the trust.

Funded versus unfunded. An irrevocable life insurance trust can be either funded or unfunded. With a funded trust, the income generated by the assets involved is used to pay all or part of the insurance premiums. An unfunded trust simply has as its sole asset ownership of the life insurance policy (or policies); gifts must be made to the trust each year to pay the annual insurance premiums.

From an income tax standpoint, the two types of trusts are virtually the same. However, from a gift tax perspective, an unfunded trust may be the better arrangement: In the case of a funded trust, a large gift at the outset may be required (to generate enough income to pay the insurance premiums), which may result in a taxable gift or in the use of the taxpayer's unified credit. By making annual gifts to an unfunded trust to pay the premiums, a taxpayer may be able to qualify each amount under the $10,000 annual exclusion (assuming the gifts are of present interests). In addition (since the trust is irrevocable), the taxpayer setting up a funded trust must be willing to give up control over the assets transferred (and any income generated by those assets).

SELECTING A TRUSTEE

Since the individual setting up the trust retains virtually no control over it, selecting the proper trustee(s) is extremely important. A trustee can be an individual or a corporation (such as a bank or trust company). In any case, the trustee must be competent to administer the trust provisions and duties. In addition, the trustee should have the knowledge necessary to invest the policy proceeds properly on the insured's death.

For a discussion of these and the other issues involved, see "Irrevocable Life Insurance Trusts," by Linda Fiorentini Donato and Bruce Benesh, in the July 1994 issue of The Tax Adviser.

Ed. note. The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.