Life Insurance Trusts & Their Role in Estate Planning

Estate taxes can significantly reduce the value of an inheritance, especially for wealthy individuals. One effective way to protect an estate from these taxes is through life insurance held in an irrevocable trust. This strategy has been used for decades to provide liquidity for estate taxes without increasing the taxable estate itself. But what happens if the insurance needs to be used for other purposes later on? This post explores how life insurance trusts work, the benefits they offer, and the flexibility available for future planning.

How Life Insurance Trusts Protect Estates from Taxes

When a key person in an estate passes away, the estate may owe substantial taxes. Life insurance can provide the cash needed to pay these taxes, preventing the forced sale of assets. Wealthy taxpayers often use an irrevocable life insurance trust (ILIT) to hold the policy. Here’s how it works:

• The grantor (policy owner) creates the trust and transfers ownership of the life insurance policy to it.

• The trust is funded with gifts from the grantor, which can be protected from gift tax by using annual exclusions or the lifetime exemption.

• The trustee uses these funds to pay the insurance premiums.

• When the insured dies, the policy proceeds go directly to the trust.

• These proceeds are not included in the grantor’s taxable estate.

• The trust then uses the proceeds to pay estate taxes or buy assets from the estate, providing liquidity without triggering additional taxes.

  
  

This setup keeps the life insurance proceeds outside the taxable estate, preserving more wealth for heirs.

Flexibility in Using Life Insurance Inside and Outside the Trust

"While the irrevocable trust protects the insurance proceeds from estate taxes, sometimes the policy may be needed for other purposes later. For example, the grantor might want to use the policy’s cash value or coverage outside the trust. This raises a question: does reserving the right to repurchase the policy bring it back into the taxable estate?"

Experienced insurance advisors often recommend placing the policy in a grantor (or defective) trust that allows the grantor to buy the policy back from the trust. This option provides flexibility for future planning, but it also raises concerns about “incidents of ownership.” If the grantor retains too much control, the IRS could include the policy proceeds in the taxable estate.

What the IRS Says About Repurchasing Rights

IRS Revenue Ruling 2011-28 clarified this issue. It states that the right to repurchase the policy does not create an incident of ownership if two conditions are met:

• The trustee must ensure the purchase price is fair and adequate.

• The transaction cannot shift benefits among the trust beneficiaries.

  
  

This means the trustee must act impartially and the repurchase must be at arm’s length. If these rules are followed, the policy remains outside the taxable estate even if the grantor has the right to buy it back.

Practical Benefits of This Planning Strategy

This approach offers several advantages:

• Estate tax savings: The life insurance proceeds stay out of the taxable estate, reducing estate taxes.

• Liquidity: The trust provides cash to pay estate taxes or buy assets, avoiding forced sales.

• Future flexibility: The grantor can repurchase the policy if needed, preserving insurability for other uses.

• Gift tax protection: Transfers to the trust can use annual exclusions or lifetime exemptions to minimize gift tax.

  
  

For example, a wealthy individual might fund an ILIT with $500,000 in gifts to pay premiums on a $5 million policy. At death, the trust receives the $5 million death benefit, which is used to pay estate taxes. If the grantor later decides to use the policy’s cash value for retirement income, they can repurchase it from the trust under the IRS rules without triggering estate tax inclusion.

Important Considerations and Next Steps

While this strategy offers strong benefits, it requires careful legal and tax planning. The trust documents must be drafted precisely to comply with IRS rules. Trustees must act responsibly to avoid unintended tax consequences.

Anyone considering this approach should:

• Consult with an experienced insurance advisor who becomes part of your estate planning attorney and tax advisor team.

• Review the trust terms to ensure repurchase rights are properly structured.

• Monitor gift tax exclusions and exemptions when funding the trust.

• Plan for trustee duties to maintain fairness and compliance.

  
  
  
  

Life insurance trusts remain a powerful tool for estate tax planning. They provide liquidity, protect wealth, and offer flexibility for future needs. Understanding the IRS guidance on repurchasing rights helps grantors keep options open without risking estate tax inclusion. Talk to your advisor about how this strategy might fit your estate plan and protect your legacy.

CONTACT: js@joesimon.solutions