Englert Financial & Insurance Services - The Flexible ILIT: Drafting Escape Hatches : Article: The Flexible ILIT: Drafting Escape Hatches

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Change

Change is one of the constants in life. Couples are married, children are born, financial ups and downs are pervasive, families come of age, needs never remain constant. As circumstances change, plans must also change.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (“the Act”) was enacted on December 17, 2010. For 2011 and 2012, the Act provides for a $5 million federal gift, estate and generation skipping transfer tax exemption amount (indexed for inflation starting in 2012) and a top gift, estate and GST tax rate of 35%. On January 1, 2013, a $1 million federal gift, estate and GST exemption amount and a maximum gift, estate and GST tax rate of 55% is scheduled to go into effect[1]

With the continuing changes in our every-day lives and the current unsettled state of affairs in our tax code’s prospects, cautious and flexible estate planning has become more than just a good idea, it has become critical.

Irrevocable Life Insurance Trusts (ILITs) are a common planning tool used to provide security to families and liquidity to estates. Whether you have an existing ILIT or are planning to establish one, flexibility should be one of your guiding principles: the flexibility to see the trust terminated if it is no longer needed, or the flexibility to establish a new trust with updated terms that can purchase and “take over” existing life insurance policies should your needs change in other ways. If the terms of an existing trust do not require significant change, it is also possible to establish a new trust and merge it with the existing trust, under the terms of the new trust.

Terminate Trust and Distribute Policy

If circumstances change and your existing ILIT becomes unnecessary, in an ideal world, your best choice of actions may be to terminate the ILIT and simply distribute any existing policies to the current beneficiaries. This may be an approach many would consider should the estate tax repeal be made permanent or the applicable exclusion amount be increased significantly. But a properly drafted ILIT cannot confer this power (a special power of appointment) on the person establishing the trust (the grantor) and still avoid inclusion of the trust assets in the grantor’s estate. To avoid this inclusion issue, only the Trustee or some other independent party can be given this power to terminate and distribute.

Powers Given to Trustee

Beneficiary-Trustee

If the trustee is also one of the beneficiaries of the trust, the special power to terminate the trust and distribute assets to the beneficiaries may be sufficient to be considered a general power of appointment,[2] with possibly significant negative tax implications for the trustee-beneficiary should the power be exercised or released. To avoid this issue, a trust document should prohibit trustee-beneficiaries from exercising any power that would be considered a general power of appointment. If naming a beneficiary as trustee is a part of your plan, you may wish to consider naming a special trustee or other third party (trust protector, discussed below) to hold the power to terminate.

Independent Trustee

An individual or corporate trustee that is considered “independent”[3]should be able to hold and exercise or release thisspecial power without the same negative tax implications. But this is not the only issue to consider. A trustee is under a very high duty to all of the beneficiaries of the trust, a fiduciary duty[4]. This duty may create issues at the termination of the trust between the current beneficiaries and existing or potential future beneficiaries (the remainder beneficiaries.)

To protect a trustee from these potential issues, the trust should contain hold-harmless and indemnification provisions for the trustee. Without these provisions, it is questionable whether an independent trustee would be willing to risk the liability that could be associated with the termination and distribution.

Powers Given to Trust Protector

As stated, the fiduciary duty to the remainder beneficiaries is a very high duty, and, even with “hold harmless” and indemnification language in the trust, a trustee may still be unwilling to accept the liability risk associated with terminating the trust. To avoid this concern, a trust protector can be named to hold the special power, and granted the same hold-harmless and indemnification protections.

A trust protector is an independent additional party to the trust other than the grantor, the normal trustee, and the beneficiaries. A trust protector is given specific powers over the trust, such as the power to remove and replace a trustee, require a trustee to distribute assets to beneficiaries, or establish allocation of distributions to beneficiaries. A trust protector is not the trustee of the trust and, absent bad faith or abuse of discretion, should not be subject to the same limits and court control as the trustee.[5] Considering the power granted, a trust protector should be a highly trusted individual.[6]

It must be noted that unless the trust protector is “unimpeachably independent”, it is possible that a “fraudulent side agreement” could be argued.[7] This argument could lead to the inclusion of the trust in the grantor’s estate, defeating his or her planning goals.

Other Considerations Related to Terminating an ILIT

Common Law of Trusts

Regardless of who holds a power to terminate a trust and distribute the assets, another issue that must be addressed is the common law prohibition against termination of a spendthrift trust.[8] Appropriate language drafted into the spendthrift provision specifically allowing termination of the trust by the special power holder should be sufficient to address this issue.

S-Corporation Stock in ILIT

It is also possible that part of the planning of the ILIT was to place assets into the trust that could generate income within the trust to partially or completely pay any possible life insurance premium costs. A properly drafted ILIT can qualify as a valid stockholder of S-Corporation stock and this type of stock may be held in the ILIT.

The trust should prohibit the special power holder from exercising any power in a way that would either cause the trust to become disqualified as an S-Corporation stock-holder, or that would in any other way cause the termination of the S election of the corporation.

Establish New Trust and Buy Policy from Old Trust

It is possible that a change in your circumstances or the law may cause an existing ILIT to become problematical in some way and yet, the need for an ILIT would remain. One approach to this issue would be to establish a new trust with the necessary provisions to account for the change, fund the new trust and then have the new trust purchase the life insurance policy from the existing trust.

Authority to Sell Policy

A typical ILIT will give the trustee all incidents of ownership over any life insurance policies transferred to the trust or purchased by the trust. These powers should also include the authority to sell any policies held in the trust to any buyer. With this authority in place, a trustee should be able to sell a policy to another trustee, even if the terms of the new trust are significantly different from the terms of the existing trust.

Fiduciary Duty

With the authority to sell, the trustee will also be bound by his or her fiduciary duty (discussed above) to all of the beneficiaries. It is possible that this duty may limit to whom a trustee can sell a policy. If the new trust has the same beneficiaries as the existing trust, this may not be a significant issue. A trustee selling a policy should seek advice from professional advisors to assure this issue is dealt with properly.

Transfer For Value Rule

Generally, life insurance proceeds are not subject to income taxes[9], but if one party purchases a life insurance policy from another, there is possible implication of the transfer for value rule, which may cause income taxation of some portion of the proceeds.[10] Fortunately, the Internal Revenue Service has held in a private letter ruling[11] that sale of a life insurance policy from one grantor trust[12] to another grantor trust with the same grantor does not fall under the transfer for value rule and the proceeds of the policy will remain income tax free.[13] This ruling appears to validate the general approach of using one ILIT with grantor trust status to purchase a policy from another with the same grantor trust status and grantor without causing estate inclusion.

Gift Tax Considerations

It should be noted that implementing this approach might carry gift tax ramifications. If the policy has a high value, the gift to the new trust to fund the purchase of the policy may exceed your available tax-free gifting amount.[14]

For example, if your original ILIT has two beneficiaries, you can make a gift to the trust for up to $26,000 each year (under the 2011 limit.) If your spouse joins in the gift under the IRC’s “gift splitting” provisions[15], your gift can total up to $52,000 to the same two beneficiaries. If the value of the policy is greater than your gift amount, the excess, if gifted in the same year, will be treated as a taxable gift.[16]

Since the annual exclusion amount is based on a calendar year, another option if the policy value exceeds your annual exclusion limit would be to partially fund the new trust in one year, then after December 31^st passes, make further annual exclusion gifts in the next year. This may allow gifting the full purchase amount over a short period of time without exceeding the annual exclusion limit.

The “Old” Trust

If you use the purchase approach to moving an existing policy to a new trust, you will still have both trusts. The original trust will hold the cash received for the policy it sold, and the new trust will hold the policy it purchased. The new trust will carry forward to meet your planning goals, but what happens to the original trust that now holds cash? That will depend upon the terms of the trust. Often, a trustee will be authorized to terminate a trust and distribute the principal to the beneficiaries if the trust balance falls below a certain specified amount. It is also possible that the trustee may have discretionary distribution powers that will allow the cash to be distributed to the beneficiaries. If you are planning a new ILIT, you may wish to discuss this aspect of the trustee’s powers with your professional advisor to assure your options are kept open in a way that is compatible with your specific desires.

Establish a New Trust and Merge with the Old Trust

If an existing trust contains provisions that become an issue, but the changes necessary to address the issue are such that the new trust would be considered substantially similar to the old trust, it may be possible to merge the old trust into the new trust, under the terms of the new trust. The IRS has addressed the merger of trusts and discussed the critical terms considered. If a proposed merger will not result in any change in the quality, value, or timing of any beneficiary's interest in the merged trust, or will not confer any additional powers or beneficial interests upon any of the beneficiaries, merger may be an option.

This material includes a discussion of one or more tax-related topics. This tax-related discussion was prepared to assist in the promotion or marketing of the transactions or matters addressed in this material. It is not intended (and cannot be used by any taxpayer) for the purpose of avoiding any IRS penalties that may be imposed upon the taxpayer.

[1] These considerations apply only to the federal transfer taxes. Any state-level estate or inheritance tax should be evaluated separately.

[2] A power that is exercisable in favor of the person holding the power, his estate, his creditors, or the creditors of his estate. IRC § 2041(b)(1).

[3] Not a beneficiary or associated to a beneficiary or the grantor in certain ways.

[4] “A duty to act for someone else’s benefit, while subordinating one’s personal interests to that of the other person. It is the highest standard of duty implied by the law.” Black’s Law Dictionary 625 (6^th ed. 1990).

[5] 2A The Law of Trusts § 185 (4^th ed. 2001).

[6] A trust protector is often an attorney or accountant.

[7] ESTATES, TRUSTS, & GIFTS - Tax Court Rebuffs IRS View That Power to Remove Trustee Is Retained Control, Journal of Taxation, Mar 1994 Journal of Taxation.

[8] 4 The Law of Trusts § 337.2 (4^th ed. 2001).

[9] IRC § 101(a)(1).

[10] IRC § 101(a)(2).

[11] IRC § 6110(k)(3) provides that “a written determination may not be used or cited as precedent.” This citation is provided as an indication of an analysis that the IRS has applied and may indicate a general approach to the issue that may be followed in other cases.

[12] Grantor Trusts are trusts “whereby the grantor retains control over the income or corpus, or both, to such an extent that such grantor will be treated as the owner of the property and its income for income tax purposes. The result is that the income and deductions attributable to the trust is taxable to the grantor and not to the beneficiary who receives it.” Black’s Law Dictionary 700 (6^th ed. 1990). Note that it is possible for a trust to be considered a grantor trust for income tax purposes and yet NOT be included in the grantor’s estate for estate tax purposes, which is the case with properly drafted grantor ILITs.

[13] PLR 200228019.

[14] IRC § 2503(b) allows annual gifts from one donor to each donee, excluded from gift taxes, in an amount adjusted for inflation in $1000 increments. The “annual exclusion amount” for 2011 is $13,000 and is based on a calendar year.

[15] IRC § 2513.

[16] The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (“the Act”) was enacted on December 17, 2010. For 2011 and 2012, the Act provides for a $5 million federal gift, estate and generation skipping transfer tax exemption amount (indexed for inflation starting in 2012) and a top gift, estate and GST tax rate of 35%. On January 1, 2013, a $1 million federal gift, estate and GST exemption amount and a maximum gift, estate and GST tax rate of 55% is scheduled to go into effect. These considerations apply only to the federal transfer taxes. Any state-level estate or inheritance tax should be evaluated separately.