Q: Should I make my life insurance policies payable to my trust? I've been told that if the proceeds are payable to the trust, they will be taxable. However, that's not what my attorney told me.

A: As a general rule, life insurance proceeds are not subject to the Indiana Inheritance Tax. The exception to this general rule occurs when the proceeds are payable to the decedent's estate, either because he failed to name a beneficiary or because he named the estate beneficiary.

However, a few months ago, the Indiana Probate Bar list server was actively discussing the fact that the Indiana Department of Revenue (DOR) was taking an expanded interoperation of the code section authorizing inheritance tax on life insurance proceeds.

The DOR has apparently decided that if life insurance proceeds are payable to a trust and the trust is authorized to pay administrative expenses or debts of the decedent, the proceeds are subject to Inheritance Tax. I'm not sure if they have issued a regulation justifying their new interpretation or if they are relying on a court decision.

In either case, I think it's kind of a stretch to interpret the code section that way. That's not what the code says. Also, the Indiana Inheritance Tax Return schedule B is the only place on the return that lists life insurance proceeds and the form specifically lists "life insurance payable to estate".

Even the instructions for completing the Inheritance Tax Return only requires listing "life insurance policies on the decedent's life that were payable to decedent's estate." It doesn't say anything about life insurance payable to a trust.

Armed with this, a lot of attorneys continue to take the position that unless life insurance proceeds are payable to the estate, they aren't subject to inheritance tax and are not required to be reported on the Inheritance Tax return.

Other attorneys are taking a more pragmatic approach. To address the DOR's position, attorneys are making drafting adjustments to their trusts. Since the DOR's position seems to be based upon the fact that the life insurance proceeds can be used to pay expenses and debts, attorneys are drafting their trusts so that can't happen.

Many attorneys are adding provisions to their trusts that specifically prohibit a trustee from using life insurance proceeds to pay expenses, debts or claims.

Life insurance proceeds can only be used to fund distributions to beneficiaries.

Personally, the IRS and DOR scare me, so if adding a few lines avoids an audit, I'm on the side for drafting around their position. I'll let someone more competitive and with more time on their hands to fight it out.

Opinions are solely the writer's. Christopher W. Yugo is a member of the Indiana Bar and a vice president and senior trust Officer for First National Bank's Trust Department. Address questions to Yugo in care of The Times, 601 W. 45th Ave., Munster, IN, 46321. Yugo's information is meant to be general in nature. Specific legal, tax, or insurance questions should be referred to your attorney, accountant or estate-planning specialist.