Are you a trustee of a life insurance trust? If so, do you know what your fiduciary obligations are? It’s important that you do—so be sure to consider the points in this post.
Let’s start with some basics. If a person owns a life insurance policy on his or her own life, the death benefit will be includible in his/her estate for estate-tax purposes. If the insured’s spouse owns the policy and he/she is the beneficiary, then the proceeds (assuming they are not spent) will be includible in the spouse’s taxable estate. In either case, if the proceeds will likely cause the estate to exceed the estate tax exemption (currently $11,180,000 but scheduled to decline to an indexed $5,000,000), it would be advisable to transfer the ownership of the policy to an irrevocable trust which would then receive the death benefit on the insured’s death. Such a trust would not be subject to estate tax provided the transfer was made more than three years prior to the insured’s death.
Like many other aspects of the tax law, the transfer and administration of an insurance trust is not as simple as it may seem. A number of rules must be followed to obtain the tax benefit of exclusion. In addition, whoever is appointed as trustee has responsibility to administer the trust and its investments prudently. This includes sending periodic “Crummey” notices to the beneficiaries (informing them of their withdrawal rights), paying the insurance premiums on a timely basis and periodically evaluating the performance of the insurance policy. Let’s explore these one at a time.
Sending out Crummey notices. Once a life insurance trust is executed, the trustee will open a bank account to deposit the gifted funds. In some instances, as a practical matter, the donor insured may pay the premium directly to the insurance company. However, since such payment is on behalf of the trust-owned insurance policy, it is deemed a gift to the trust. Generally, gifts to insurance trusts (which are irrevocable) are structured as completed gifts which, but for the annual exclusion (currently $15,000), would use up some of the donor’s lifetime gift exemption. That could be detrimental because many policies are allowed to lapse (particularly term insurance), thus wasting the exemption.
To avoid this wasteful result, the trust will typically include a “Crummey” withdrawal power (named after a 1968 court decision, Crummey vs. Comm.) which provides the beneficiaries with the right to withdraw up to the annual exclusion amount each year. This withdrawal right converts the gift into a present-interest gift and thus qualifies it for the annual exclusion, thereby avoiding use of the lifetime exemption for such amount. So, if there are three beneficiaries of the trust, the donee can make tax-free gifts of $45,000 per year to the trust (provided no other gifts were made to the three beneficiaries during the current year). However, to qualify with this Crummey power, the trustee must send a notice to each beneficiary, preferably each year when a gift to the trust is made. As a matter of best practice, the trustee should retain proof of sending the notices each year. If a beneficiary is a minor, the notice should be sent to the parent or guardian (other than the insured).
Paying the insurance premiums. Continuing with the above scenario, after any and all Crummey notices are given, the trustee should wait 30 days before remitting the gifted funds to pay the insurance premium. Premiums should be paid on time to avoid any lapse or negative consequences affecting the performance of the policy. So the timing must account for factors including the provision of the gift, the deployment of the Crummey notices and the timely payment of the insurance premiums—all tied to the overall responsibility of the trustee.
Evaluating the performance of the policy. If the insurance policy is a universal life or variable life policy, the trustee should evaluate its performance annually as would be done with any investment product. Such policies may underperform their original projections and may thus lapse after many years of premium payments or require significant premium increases to maintain the death benefit. If the policy is a term insurance policy that can be converted into a whole life policy, the trustee should monitor the situation to determine whether such conversion is advantageous.
Once the insured dies, the trustee should file a death benefit claim with the insurance company and receive the proceeds subject to the trust’s dispositive provisions. As the devil is in the details—and trusts can be minefields—trustees should seek proper legal counsel to guide them in the performance of all of their fiduciary duties.