An irrevocable life insurance trust may be either "funded" or "unfunded." That is, the grantor may transfer to the trustassets which will yield or throw off an income, in which casethe trust is "funded," or the grantor may transfer the insurance policy only, in which case the trust is "unfunded."
The purpose of funding an irrevocable life insurance trust is to provide the funds to pay the premiums. If the insured-gran-tor has to pay the premiums out of his own "after-tax dollars," it is likely that it would cost him more than if the trustpays the premiums out of his lesser-tax dollars. However, thetax law requires you to, be very careful in setting up a funded irrevocable life insurance trust. If you are both the grantor ofthe trust and the insured, the Internal Revenue Service willclaim that you must pay the income tax on the premiums paidby the trust. This is considered taxable income to you and not to the trust.
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The complications of a trust of this type emphasize theimportance of consultation with your lawyer and your accountant as well as with your insurance agent. In this kind ofarrangement, it is important and hi fact essential that theinsured and the grantor of the trust be two different people.Thus, if you are the insured, the trust should be funded withassets transferred to the trust by your wife. Then, the grantor and the insured will not be the same person and there are notax implications to you on the basis of the trust paying the lifeinsurance premiums.
If you create an unfunded irrevocable life insurance trust,you will be paying the premiums. Here too, you must exerciseextreme carein the management of the trust. The premiumsmay be somewhat steep, and you want at least to be able totake credit for the dividends. If you reserve the right to thedividends, this will be an incident of ownership and you willhave defeated your initial purpose in transferring the life insurance out of your estate. If you reserve the right to the dividends, at your death the Internal Revenue Service will takethe position that the reservation of the right to receive dividends renders the proceeds calculable in your estate and in-cludable in your taxable estate.
A simple approach in setting up the policy is to elect that dividends be applied to reduction of premium. In doing this,you have divested yourself of that measure of control. Thesafest arrangement, however, is to write into the trust instru ment a provision that the "trustees will have no obligation topay premiums, except that dividends, received or receivableby the trustees, shall be applied to the payment of premiums."This device, however, still leaves open another importantquestion.
Many individuals, in order to reduce to a minimum their premium outlay, like to leave themselves in a position wherethey can borrow against cash value to pay premiums. However, if the right to do this is reserved by the insuredyouguessed itit is an incident of ownership and the proceedsthen become includable in the estate of the insured.
One of the logical answers seems to be: "All right, let thetrust borrow against the cash value." In effect this creates a split dollar arrangement between the insured and the trustee for paying the life insurance premium. However, this raisestwo new problems:
First, where will the trust get the funds to pay the intereston the loan against the cash value?
