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Individuals with large estates often consider using an irrevocable life insurance trust. Under this arrangement, the insurance proceeds are paid to the trust at your death. While you can't avoid the estate tax, an irrevocable life insurance trust can replace the amount of tax paid.
Under this arrangement, the grantor makes annual gifts to the trust, with which the trustee can pay life insurance premiums. In order for these gifts to qualify for the annual gift-tax exclusion (up to $12,000 in 2007), the beneficiaries must have a limited right to withdraw the funds for a short time after the grantor makes the contribution.
While this type of trust can generally be used to hold existing or new policies, using existing policies may involve disadvantages. The transfer of life insurance policy ownership to a trust is treated as a gift of the policy's current cash value. So if there is considerable accumulated cash value in your policies, you may "use up" a part of your $1,000,000 gift tax unified credit equivalent.
Secondly, there is a special estate tax rule for gifts of existing life insurance policies. If death occurs within three years after the gift of a policy, the death benefit will still be subject to estate tax (It is possible to avoid the three-year waiting period with a newly issued policy).
Finally, if you have an outstanding loan against the policy, this is considered a sale of the policy to the trust (transfer for value). The trust ends up having a cost basis in the policy—so the proceeds, when paid, would be subject to income tax, except for the basis (the original loan amount). This actually creates income tax on life insurance proceeds (where ordinarily there is no income tax), so transferring policies with loan balances should be avoided—and a policy with a loan in excess of the policy owner's basis should never be transferred.
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