Back in the old days a Greek philosopher named Sextus Empiricus wrote that, “The wheels of justice grind slowly, but exceedingly fine.” He must have been waiting on some attorney to finish drafting his trust document.
Irrevocable trusts are the most common device used to remove assets from the taxable estate where they are then often leveraged to provide increased value and liquidity by purchasing life insurance on the grantor of the trust. A common problem is the delay that occurs between the time policies are ready for issue and the drafting of the trust by the attorney involved. The circumstance is understandable. Lawyers are busy, too. They strain at the gnat of every detail because they are supposed to and because it is their malpractice insurance that is on the line. And often they are not brought into the process until a carrier is good to go with the coverage to be owned by the yet non-existent trust
But two hard and serious considerations press on an agent and the insured as they await the trust’s birth: first, the insurer’s delivery deadlines and, second, the increasing risk of a change in health as the interim between the offer and placement lengthens
Strong is the temptation for agents to run ahead of their blocking and encourage an insured to take ownership to lock in the underwriting offer and, more important, the death benefit should the worst occur. The bad news is that ownership by the insured incurs many of the tax problems that the trust is meant to avoid. The good news is that, with proper planning, the insured can take ownership of the contract and still avoid the tax pitfalls it might create.
Looking a Gift Horse in the Mouth
The easiest, but least effective, course of action is for the insured to take possession of the policy and then later gift it to the trust. Insured ownership triggers IRC 2035 making the proceeds includible in the estate if the insured dies within 3 years of the transfer. If just a change of health was a concern during the relatively short trust-drafting period then an exchange for a 3-year death watch probably won’t offer appeal. Furthermore, the transfer is a potentially taxable gift in the amount of the fair market value of the policy. Determination of value is a decision for other advisors, but it is helpful to get an opinion from the carrier who will usually report either premiums paid or the policy’s interpolated terminal reserve.
A Sale You Can Trust