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Estates, Trusts & Gifts

Filing Income Tax Returns for Life Insurance Trusts

As a general rule, life insurance trusts are grantor trusts. Because all the income, credits and deductions of a grantor trust are attributed to a grantor, a trustee does not have to file a Federal income tax return for the trust. The trustee, however, must notify the grantor of the items the grantor must report on his income tax return. On the grantor's death, or if the trust otherwise ceases to be a grantor trust, the trust may have to file Federal and state fiduciary income tax returns and provide its beneficiaries with a Form K-1.

Estate planners often draft intentionally "defective" insurance trusts, under which the grantor is taxed for income tax purposes without causing the inclusion of the proceeds in his gross estate. The intentional deficiencies are generally what make a life insurance trust (which ordinarily would be a complex trust) a grantor trust for tax purposes.

If a life insurance trust qualifies as a grantor trust, it does not have to file tax returns, particularly when the only asset owned by the trust is a life insurance policy on the life of the grantor, the grantor's spouse or both. Generally, the grantor must make annual gifts to the trust, from which it can pay the life insurance premiums. Because the inside "build-up" on a life insurance policy is not taxable, the trustee will have no income to report to the grantor.

If a life insurance trust does not qualify as a grantor trust, it will most likely be a complex trust. If an insurance trust is a complex trust, it must file tax returns based on the regular rules for filing returns. Thus, for example, if the trust's only asset is a life insurance policy, the trust would not have to file income tax returns, because it does not have gross income of $600 or more or any taxable income.

Exhibit 1 presents a checklist for deciding if an insurance trust is a grantor trust or a complex trust.

Exhibit 1: Checklist for Determining If an Insurance Trust Is a Grantor Trust for Income Tax Purposes
Premium payment power
Sec. 677(a)(3) states that a grantor is treated as the owner under Sec. 677(a) of any trust or portion of a trust the income from which can be used, without the consent of an adverse person, to pay the premiums on policies of life insurance on the life of the grantor or the grantor's spouse (except for policies of insurance irrevocably payable for a charitable purpose).
Factors that give a trust grantor trust status for income tax purposes:
  • Does the trust provide for the payment of life insurance premiums out of trust income and/or does the trust give the trustee sufficient authority to pay life insurance premiums out of trust income?
  • Does the trust have income-producing assets (i.e., not life insurance policies)?
  • Can the trustee use trust income to pay life insurance premiums on the life of the grantor and/or grantor's spouse without the approval or consent of any adverse party? (An adverse party is defined as any person with a substantial beneficial interest in the trust that would be adversely affected by the exercise or nonexercise of the power that the person possesses as to the trust.)
Factors that indicate that the trust is a complex trust for income tax purposes:
  • Does the trust prohibit the trustee from using trust income to pay life insurance premiums on the life of the grantor and/or grantor's spouse?
  • Does the trust require that life insurance premiums be paid only out of principal (other than capital gains)?
  • Does the trust give beneficiaries Crummey withdrawal powers? If so, and the trust has income-producing assets, Sec. 678(b) may require that holders with withdrawal powers be treated as owners of a portion of the trust income.
   
Filing requirements  
Grantor trust:
  • No fiduciary tax return is required. The trustee must notify the grantor of the items the grantor must report on his income tax return.
  • If the trust holds only life insurance policies and no income-producing assets, and the premiums are paid via gifts made by the grantor to the trust each year, there will be no income to report.
  • If there are loans against the insurance policies, there are issues as to whether the grantor can deduct the loan interest.
Complex trust:
  • A fiduciary tax return will be required based on whether the trust has gross income of $600 or more or any taxable income.
  • Issues related to beneficiaries with Crummey withdrawal powers are beyond the scope of this discussion. (Tax advisers should be alert to additional complexities if a trust contains Crummey withdrawal powers coupled with taxable income.)
   
Additional trust provisions that cause a grantor to be treated as the trust owner for income tax purposes
Nonadverse trustee's sprinkling power:
Sec. 674 states that the grantor is treated as the owner of a trust if a related nonadverse trustee has the power to distribute income, without a definite standard among a class of trust beneficiaries.
  • Does the trust have a clause that empowers the trustee to pay and distribute all trust income without a definite standard and without the approval of an adverse party?
Nonadverse trustee's power to add beneficiaries:
  • Does the trust allow a nonadverse trustee to add persons other than after-born or after-adopted children to the class of beneficiaries, in addition to having discretion to distribute trust income and principal?
Payment of trust income to the grantor's spouse or discretionary income to the grantor:
Sec. 677 states that the grantor will be treated as the owner of the life insurance policies held by the trust if a nonadverse trustee may pay trust income to (or expend it for the benefit of) the grantor's spouse. Similarly, if a nonadverse trustee may pay all of the trust income to the grantor, the grantor is treated as the trust owner.
  • Does the trust allow for any payments to the grantor or his spouse?
Right to substitute assets:
Sec. 675(4) states that the grantor will be treated as the trust owner if he can reacquire trust assets by substituting assets of equivalent value.
  • Does the trust allow the grantor to reacquire trust assets by substituting equivalent assets?

Often, life insurance companies may request an employer identification number (EIN) from an insurance trust before they will issue a policy in the trust's name. If a trust has an EIN, the IRS may look for a tax return, unless the insurance trust files a first and final tax return with a statement indicating that it qualifies as a grantor trust.

Note: Some grantors or attorneys might still want to file tax returns, even if they are not required. If so, there is no harm in filing a grantor trust tax return that shows no reportable income or deductions.

From Eileen W. Belkin, CPA, Hammel & Company, P.C., Tuscon, AZ

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2000 AICPA