Copyright 1996, Marc S. Weissman
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Certified by the California Board of Legal Specialization of The State Bar of California
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LIFE INSURANCE / CHARITABLE TRUST

This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

LIFE INSURANCE

There are normally three reasons to have life insurance:

To care for those whom you would ordinarily support, after your death;
To pay death taxes; and
To convert taxable assets to tax free assets.

TAXATION OF LIFE INSURANCE PROCEEDS

Life insurance proceeds are usually subject to death taxes, depending on the form of ownership. Therefore, proper ownership of a life insurance policy is very important.

If you own insurance (or even retain the right to change the beneficiary of the policy) on your own life, the death proceeds are part of your taxable estate. To put it simply, if you are single, and have a $600,000 policy, and $100,000 of other assets, at your death, your estate will owe $37,000 in taxes. Tax is imposed on a total of $700,000; $600,000 is tax free; the balance is taxed at 37%.

Tax Free Insurance: If the insured does not owns the policy, there are no taxes at his death.

Support of Spouse

If a married couple has insurance to support the widow at the untimely death of the high wage earner husband, there is no tax at his death; anything going to a surviving spouse is tax free.

Support of Children

If the primary intent is to care for children rather than the spouse, tax considerations become more important. Since Life Insurance is usually subject to death taxes, tax protection is vital, or the insurance will cause additional taxation.

Payment of Death Taxes

A single person owns one asset: a home worth $750,000. He wants to leave it to his children. He figures that with an estate of $750,000, he needs a policy for $55,000 to pay the death taxes. However, his death taxes are based on his total assets, which usually includes insurance. Because the insurance is subject to death taxes, on his $805,000 estate death taxes are $76,000. His kids come up short.

Imposition of death tax on insurance causes a vicious circle; buying more insurance causes an increase in both the taxable estate and the taxes. He needs almost $100,000 of insurance to pay tax on the house and the insurance.

Proper Ownership Techniques

There are several methods of avoiding taxation:

The beneficiary may own the policy.
A trusted friend may own the policy.
A Life Insurance Trust may be used.

Young beneficiaries pose a problem. A young child cannot (or should not) be outright beneficiary of a life insurance policy.

1 - Adult Beneficiaries as Owners: Of course, if your children are mature and stable, they may be the owners personally, paying premiums with money you give them. However, a Trust could provide them with asset protection.

2 - Give "Uncle Bob" the policy, and money every year with which Bob pays the premiums. Your child is beneficiary. Bob is subject to gift tax on the proceeds, when you die. Also, there are risks:

Uncle Bob cashes in the policy, or he pockets the money you give him to pay the premiums, and the policy lapses. Actually, this may be immoral of Uncle Bob, but not illegal - it is his policy!
Uncle Bob changes the beneficiary. It's his policy, he can do what he wants.
Uncle Bob gets sued by his own creditor who takes away the policy. Since the policy belongs to Bob, it is subject to attachment by his creditors.
Uncle Bob gets divorced, and his wife gets half the policy.
Uncle Bob dies, his wife inherits the policy and she changes the beneficiary.

3 - A better method is a Life Insurance Trust.

When a Life Insurance Trust is formed, you name a person to manage it. Normally, that will not be you or your spouse.

If you have an existing life insurance policy, you can put that into the Trust, or you can have the Trust buy a new policy. The annual premiums are paid from funds which you contribute.

A Life Insurance Trust is irrevocable. If you form a Trust for the benefit of all of your children equally, and later would like to `disinherit' one child, you cannot change the Trust. All you can do is to stop making gifts to the Trust, leaving it with an insurance policy which lapses due to nonpayment of premiums.

Of course, the major reason to have a Life Insurance Trust is to avoid the risk of ownership by another person, and to ensure that the beneficiaries do not receive substantial assets until they are mature enough to handle them.

CHARITABLE TRUSTS

A Charitable Remainder Trust [CRT] allows the owner to contribute property to a self- controlled Trust. The owner (and his spouse) have the right to take out a predetermined amount of income (set by them) from the Trust during their lifetimes. After the death of both owners, the assets go to their favorite charity.

During the lifetimes of the owners, there are taxes only on their annual withdrawals. Since everything goes to charity when the owner and his spouse have died, the Trust is tax exempt.

The basic plan is as follows:

You have a low cost asset you want to sell, but the tax will be very high. You contribute the asset to a CRT. You manage the Trust and sell assets tax free when you desire.
You set the amount of income you want, with a minimum of 5% per year.
You pay tax only on the money taken out of the Trust each year - no tax is paid on any profit, until it is withdrawn from the Trust.

As with a Living Trust, you are the sole manager. However, you cannot change any terms of the Charitable Trust, other than to appoint a different charity to take the assets at your deaths.

In any year contributions are made to the CRT, you get an income tax charitable deduction, based on your life expectancy and income rate. The charity will not receive the gift until your death. The older you are, the shorter your life expectancy, and the bigger your deduction is.

A CRT will allow the tax free sale of an illiquid asset with a poor cash flow. With no tax to pay, all of the sales proceeds can be re-invested, generating higher after tax annual cash flow.

The drawback to Charitable Trust is that it cannot be changed even in a dire emergency.

Since the charity gets the Trust balance at your death, many people also use an Insurance Trust as a "wealth replacement" vehicle to leave assets tax free to their heirs.

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