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Many people use an irrevocable life insurance trust to save estate taxes.
If an individual owns life insurance when he or she dies, the life insurance proceeds are subject to estate taxes. John Doe, a widower, has an estate of over $3,000,000. The estimated estate taxes at his death are approximately $675,000. John takes out a $1,000,000 life insurance policy and plans that the life insurance be used to pay the estate taxes. He is the owner of the life insurance. At his death the $1,000,000 life insurance policy is subject to estate tax at a rate of 45-47%. $450,000 to $470,000 of the $1,000,000 goes to pay additional estate tax, with only slightly over $500,000 left to pay the remaining $1,000,000 tax liability.
One way around this is for John Doe not to own the life insurance when he dies. If the insurance is owned by someone else, it is normally not taxable. However, if someone transfers an existing life insurance policy and dies within three years of the transfer, the insurance proceeds are taxable for estate tax purposes. Life insurance is not taxable for income tax purposes.
If someone else initially takes out a life insurance policy on John Doe's life then the three year transfer in contemplation of death does not apply. John Doe's two children could take out the life insurance policy on their father's life with the two children as the owners and beneficiaries of the policy. If the children initially took out the policy then the three year contemplation of death rule does not apply. If the children, not John Doe, is the owner, and the children are the beneficiaries, then the policy proceeds at death are not subject to any estate tax.
Or the parties may set up an irrevocable life insurance trust, which is merely an irrevocable trust. The two children are the trust beneficiaries and one or both of the children are the trustees. "Crummey" provisions are put in the trust so the annual gift tax exemption may be used.
The parents gift annually to the trust sufficient money to pay the annual insurance premium. The trust receives this cash gift, pays the insurance premium, and invests any surplus funds.
At the death of the individual or surviving parent the insurance is paid directly to the trust without any estate taxes and the money is used to pay the estate taxes on assets owned by the individual or surviving parent.
While the above is a simplified explanation it shows the advantages of planning when purchasing life insurance to pay estate taxes.
İMilton Berry Scott, 2005