Life Insurance Can Maximize The Benefit of Credit Shelter Trusts

Increasingly, financial and estate planners are funding credit shelter trusts with life insurance, capitalizing on tax-deferred investment growth, income and estate tax benefits.

For many years, the credit shelter trust (CST) has been a standard component of a married couples estate plan. The CST (also referred to as a “B” trust or family trust) is typically funded upon the first death of husband and wife to use that spouses estate tax exemption amount. (This is $675,000 for the year 2001, but increases incrementally to $3.5 million for 2009 pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001.)

If the CST is drafted and administered properly, the assets in the trust will not be subject to estate tax at either spouses death.

Typically, the surviving spouse is named as income beneficiary of the CST for his or her lifetime, and upon his or her death, the remaining assets are distributed to or held for the benefit of the couples children. If the surviving spouse does not need income from the trust assets to live on, the focus of the investment of the assets should be growth of principal rather than current income. Life insurance on the life of the surviving spouse would be a great choice in this situation.

The appeal of funding a CST with a life insurance policy is the ability to instantly leverage all or part of the trust assets to a larger death benefit that will be income-tax-free and estate-tax-free to the trust beneficiaries.

Also, growth of the policy cash value will be tax-deferred, which is especially important when the policy is owned by a trust because of the highly-compressed income tax brackets that apply to trusts (e.g., 38.6% on income exceeding $8,900 for the remainder of year 2001).

The policy could be funded with a single payment or with periodic payments. For example, the trustee might be able to purchase $700,000 of insurance on a 65-year-old female with a lump sum payment of $300,000. By age 85, the death benefit could increase to almost $900,000 based on an 8% gross rate of return.

Generally, withdrawals up to the policys cost basis and policy loans are not taxable. However, if the policy is funded with a single payment, it will be a modified endowment contract (MEC) for federal income tax purposes in most circumstances. Loans and partial withdrawals from policies that are classified as MECs are taxed on the LIFO (last in/first out) basis.

Also, a 10% penalty tax may be imposed on taxable amounts distributed. However, where access to the cash value in the policy is not important during the life of the surviving spouse, the funding of a CST with a MEC should not be a concern because the cash value will continue to accumulate tax-deferred and the death proceeds will be tax-free.

There are special concerns that must be addressed when the CST is funded with life insurance. First, the trustee must have the authority to purchase life insurance as a trust investment.

Many, if not most trust agreements, have provisions giving the trustee a great deal of discretion with respect to the types of assets that may be purchased, and may even specifically list life insurance on the life of the surviving spouse and/or a trust beneficiary as a permissible trust investment.

If the trust agreement does not provide clear authority for the purchase of life insurance, state law should be reviewed. The trustee could always seek court permission or approval.

When the surviving spouse is the insured, there are certain rules that must be complied with to avoid estate inclusion of the life insurance proceeds on the death of the surviving spouse. The insured spouse must not be the sole trustee of the CST. The insured spouse could be a co-trustee only if the trust agreement delegates all authority over the insurance policy to the other trustee(s) and makes it clear that the insured spouse is to hold no “incidents of ownership” with respect to the policy.

If the surviving spouse must resign as trustee, the resignation should be effective prior to the application for the life insurance policy to avoid the “three-year rule” (the inclusion of the death proceeds in the estate of the surviving spouse if his or her death occurs within three years of resignation as trustee).

A well-drafted trust agreement will include provisions that govern trustee resignation and succession. These provisions should name a successor trustee or give the surviving spouse and/or other persons the authority to name a successor trustee. If the trust agreement is silent on trustee resignation and succession, state law should be reviewed. Court intervention may be necessary.

If the CST is drafted properly, the surviving spouse will never possess a “general power of appointment” over the trust assets (unfettered access to and control over the trust assets for the surviving spouses benefit), because this would result in estate inclusion of those assets at the death of the surviving spouse.

Ordinarily, a surviving spouse may possess a limited power of appointment over CST assets (e.g., the right to withdraw the greater of $5,000 or 5% of the trust assets (“5 and 5″ power); the right to withdraw trust assets for the “health, education, maintenance, and support” of the surviving spouse (“ascertainable standard”); or the right to alter the beneficial interests of the other trust beneficiaries).

However, when life insurance on the life of the surviving spouse is a trust asset, even a limited power of appointment possessed by the surviving spouse over that policy will cause the death proceeds to be included in the estate of the surviving spouse at death.

If the CST grants a limited power of appointment over trust assets to the surviving spouse, this power should be released by the surviving spouse prior to the application for the life insurance policy.

If the power is released subsequent to the issuance of the policy, the “three-year rule” will become applicable from the date of the release. State law should be consulted regarding any restrictions and/or procedural requirements regarding releases of powers of appointment.

A well-drafted trust agreement granting a limited power of appointment to the surviving spouse over CST assets should specifically exclude life insurance policies on the life of the surviving spouse as a trust asset subject to the power. All other trust assets could be subject to the power.

It is important to note that a trustee who is not the surviving spouse may withdraw trust assets (including the cash value of the life insurance policy) for the benefit of the surviving spouse.

The Economic Growth and Tax Relief Reconciliation Act of 2001 ostensibly repeals the estate tax in year 2010. This would appear to make the concept of funding a CST with life insurance less attractive than it was before enactment of the new tax law. However, the new tax law includes a “sunset” provision that reinstates the estate tax as it exists today, effective Jan. 1, 2011.

In order for estate tax repeal to remain in effect after year 2010, Congress will need to pass legislation that restores the provisions of the new tax law before the scheduled expiration date.

However, it is widely believed that Congress will “repeal the estate tax repeal” before 2010. Therefore, exclusion of life insurance proceeds from the taxable estate should remain an important goal. Also, as discussed above, there are significant income tax benefits to funding a CST with life insurance.

In conclusion, it is fair to say that the ultimate beneficiaries of the CST (typically the children) can benefit substantially from the decision to fund a CST with insurance on the life of the surviving spouse.

Richard J. Petrucci Jr., JD, CPA, CFP, is counsel, estate & business planning department, Allmerica Financial. He can be reached via e-mail at RPETRUCCI@ALLMERICA.COM.


Reproduced from National Underwriter Life & Health/Financial Services Edition, November 19, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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