First, no beneficiary of a TOLI should be a settlor. If a beneficiary contributes property to a TOLI, the beneficiary has a retained interest, which will result in inclusion of the TOLI (or a portion of it) in the beneficiary’s taxable estate.
A beneficiary with a retained interest typically arises when community property is used to fund a TOLI that names a spouse as a beneficiary. If this occurs, half of the trust estate will be included in the spouse’s taxable estate when the spouse dies. This unfortunate result can be avoided if the settlor/grantor funds the trust with separate property, which usually requires an agreement to change community property into equal shares of separate property.
Although it is possible to change community property to separate property, it is important that the spouse (named as a beneficiary) not mix the resulting separate property with community property. Otherwise, it could leave the door open to a claim by the IRS that the agreement to change the community property to separate property was illusory (e.g. done for the sole purpose of receiving a tax benefit). Moreover, it is good practice to save the separate property as an emergency fund, rather than spend it the same way you typically would, to avoid the same type of argument by the IRS.
Although it is possible, setting up a TOLI becomes more complicated when an existing policy (already purchased with community assets) is being transferred and you still want to name your spouse as a beneficiary. One strategy is to determine the actual value of the policy (based on IRS approved practices) and have the insured use separate property to make a cash purchase of the noninsured spouse’s interest.