146 / Can a life insurance trust result in income tax savings for the grantor?

Income tax savings can be achieved by the creation of an unfunded life insurance trust. Additionally, a life insurance policy creates no currently taxable income regardless of whether it is placed in trust. Income tax savings can result only when income-producing property is placed in trust to fund the premium payments, and only if tax liability is shifted from the grantor to a lower bracket taxpayer – that is, to the trust or to a trust beneficiary.

A funded revocable trust will not result in income tax savings. If the trust is revocable, the income from the funding property will be taxed to the grantor. Even if the trust is irrevocable, however, there are other conditions that will cause the trust income to be taxed to the grantor.

Generally speaking, trust income is taxable to the grantor if the:

(1)     grantor or trustee, or both, can revoke the trust without the beneficiary’s consent;

(2)     trust income is, or in the discretion of the grantor or a non-adverse party, or both, may be (a) distributed to the grantor or the grantor’s spouse, (b) accumulated for future distribution to the grantor or the grantor’s spouse ( Q 148), or (c) applied to pay premiums on insurance on the life of the grantor or the grantor’s spouse ( Q 147);

(3)     income is or may be used for the support of the grantor’s spouse or is actually used for the support of a person whom the grantor is legally obligated to support, or is or may be applied in discharge of any other obligation of the grantor;

(4)     grantor retains certain administrative powers or the power to control beneficial enjoyment of trust principal or income; or

(5)     value of a reversionary interest, at the inception of the trust, exceeds 5 percent of the value of the trust.¹

If the income of the trust is payable to a lineal descendant of the grantor and the trust provides that the grantor’s reversionary interest takes effect only on the death of the beneficiary before the beneficiary attains age 21, the income of the trust will not be taxed to the grantor even though the value of the grantor’s reversionary interest exceeds 5 percent of the value of the trust.²

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Planning Point: One of the more common planning strategies involves the “so-called” sale of life insurance to an “intentionally defective trust” or “IDIT.” The sale to the IDIT can be a very effective estate planning technique, but it should be remembered that income tax earned by the IDIT will remain taxable to the grantor of the trust. While this may not seem problematic at the time the IDIT is created, in some instances, without proper planning and successful investment within the IDIT, situations sometimes arise where the income tax attributable from the IDIT to the grantor can become burdensome. It may be advisable to consider drafting the IDIT so that the grantor trust power (i.e., the retained power causing grantor trust status for income taxes) can be “turned off” at a future point if it no longer makes sense that the grantor pay the trust’s income taxes. Creating an IDIT should only be done with the assistance of a competent tax advisor.

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