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Eastman & Smith Alert - Third-Party Ownership of Life Insurance

6/20/11

Life insurance proceeds on policies owned by the insured are included in the estate of the insured for federal estate tax purposes. If the estate, including life insurance, will exceed the federal exemption (in 2011 and 2012, $5 million for an individual or $10 million for a couple), third-party ownership is advisable to avoid federal estate tax (at 35% in 2011 and 2012) on the life insurance proceeds. There are at least three possible third-party ownership arrangements:

1. An irrevocable life insurance trust (ILIT).The insured grantor creates an ILIT. For a married couple, the non-grantor spouse can be the trustee and a beneficiary. The grantor makes gifts to the ILIT for payment of premiums. In order to qualify the gifts for the annual exclusion ($13,000 per donee), each beneficiary has a pro rata right to withdraw gifts to the ILIT. Upon receipt of a gift, the trustee sends each beneficiary a so-called Crummey notice (named after the court case which approved such a notice) giving the beneficiary a stated time period (typically 30 days) to withdraw the gift, after which time (if the withdrawal right is not exercised) the trustee can pay the premium.

2. Joint ownership by the children (in the case of a second-to-die policy or an unmarried insured). This alternative is simple to establish, but has several potential drawbacks: (i) a child may not cooperate in making the proceeds available for estate taxes (a typical use of such a policy), (ii) if there are multiple children, paying premiums usually requires separate gifts to each child, following by a pooling of the funds, (iii) if a child dies before the insured, ownership of the policy generally passes to the surviving children, which is counter to the per stirpes (down the blood line) distribution used in most estate plans. This last drawback can be avoided by having each child own a separate policy or (if the insurer permits it) having each child name a successor owner and contingent beneficiary for his or her portion.

3. A limited liability company (LLC). The children would form an LLC, and the LLC would own the policy. The children would be the members, and the LLC would typically dissolve upon receipt of the death benefit. Premiums are paid by the insured making gifts to the children and the children making capital contributions to the LLC. Unlike an ILIT, no Crummey notices are required, but, as with joint ownership by the children, the procedure for paying premiums can be somewhat unwieldy.

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