Can You Sell Life Insurance Policies to an Irrevocable Trust?

Not only can you sell your life insurance policy to your irrevocable trust, there are some good reasons why you might do so. Your trust – not you – must own your policy to avoid estate taxes on the proceeds when you die. You have various options for achieving this, and selling your existing policy to your trust is one of them.

Transferring a Policy

You can transfer ownership of your life insurance policy to your trust without going through the complicated rules that govern selling it, but this might not help you avoid taxation. Under the terms of Section 2035 of the Internal Revenue Code, you must outlive the transfer by at least three years. Should you die before this time, the IRS will tax the death benefits just as if you had retained the policy in your ownership. You can also incur a gift tax if you transfer it – all for naught if you die within three years – because you’ve given the policy away for free.

Selling the Policy

Selling your life insurance policy to your trust instead allows you to avoid the three-year rule. However, the transaction must be a "bona fide sale for an adequate and full consideration." This means it must be a real sale. The purchase price must be commensurate with its value, and you must take back a promissory note in exchange for the policy. Your trust now owes you money, and this is income to you. You or your estate might incur income taxes on the payments – if you actually accept any payments. Tax law allows a way around this too, however.

Crummey Provisions

In the eyes of the IRS, if you simply forgive the debt your trust owes you, this constitutes a gift – just as if you had transferred the policy without selling it. However, adding a Crummey provision to your trust documents allows you to forgive up to $14,000 of the debt each year per trust beneficiary by using the federal annual gift tax exclusion. Crummey provisions involve a lot of complex rules, so you'll most likely need a professional to help you draft the documents. One such rule is that the total forgiveness can't exceed 5 percent of the value of all the trust's assets or $5,000, whichever is more. Another rule is that your trustee must notify your beneficiaries in writing that they can take withdrawals from the trust equal to the amount of the debt you're forgiving. Regardless of whether they actually take the disbursements, this procedure allows you to use the exclusion for each beneficiary. If any of your beneficiaries actually take the withdrawals, however, your trust may run out of money to pay the policy's premiums, and it might lapse.

Buying a New Policy

You can avoid the dilemmas and details of transfers and Crummey provisions by simply having your trust purchase a new policy on your life. You don't have to outlive this event by three years, although if you gift money to the trust regularly to pay the premiums, you can still use Crummey language to do this so it's tax free. Depending on your age and health, however, you may not qualify for a new policy and may have no option other than to transfer or sell your existing one.