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).
