When used correctly, irrevocable life insurance trusts (ILITs) are amazing tools that can remove life insurance proceeds from a client's estate, protect the proceeds from beneficiaries' creditors, and govern the administration and distribution of the proceeds for the beneficiaries' benefit. Unfortunately, in creating an ILIT, a number of errors may occur, and the ILIT may fail to function as the client or the client's advisors intended. Several strategies are available to eliminate mistakes in old ILITs and avoid mistakes in new ones, resulting in superior planning for the client and increasing appropriate life insurance sales to these vehicles.
Problem 1: Incidents of ownership retained by the grantor. Internal Revenue Code (IRC) Section 2042 also includes in an individual's gross estate the value of all policy proceeds on his or her life receivable by other beneficiaries if the decedent possessed, at the time of death, incidents of ownership, exercisable alone or with any other person. The regulations clarify that "incidents of ownership" refers to the right of the insured or the insured's estate to the economic benefits of the policy. Further, they provide helpful examples about what rights constitute incidents of ownership: the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy. Case law added the right to convert the policy and the right to elect settlement options.
The decedent is considered to have an "incident of ownership" in an insurance policy on his or her life held in trust if, under the terms of the policy, the decedent (either alone or in conjunction with another person or persons) has the power (as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment. It does not matter that the decedent has no beneficial interest in the trust.
Also, if the decedent is the grantor, too much control may result in the trust being included in the insured's gross estate under other sections of the IRC.
Finally, a controlling shareholder will be deemed to possess incidents of ownership over a corporate-owned policy insuring his or her life (causing inclusion of the policy proceeds in his or her estate), unless the proceeds are payable to the corporation or for a valid corporate purpose.
Solution 1: Eliminate all incidents of ownership held directly or indirectly by the insured. The ILIT document should vest all incidents of ownership in the trustee. In addition, the ILIT trustee should not be the grantor. Further, not only the trust, but also the policy and any agreements related to the policy, such as buy-sell agreements and split dollar agreements, should be reviewed to ensure that the insured does not possess incidents of ownership. Finally, limited collateral assignment split dollar agreements, under which the insured has no incidents of ownership, should be used for majority shareholders or those who may become majority shareholders in the future, to avoid attribution of incidents of ownership to the sole or majority stockholder through his stock ownership.
Problem 2: "Three-year rule" issues. Under IRC Section 2035(a), if a decedent owns a life insurance contract and transfers it to an ILIT within the three years prior to death, the life insurance proceeds will be includible in the decedent's gross estate. If your client is considering the transfer of an existing life insurance policy to an ILIT, he or she may have a three-year rule problem.
Solution 2: Avoid or plan for the three-year rule. If the policy is purchased for full and adequate consideration, the three-year rule does not apply. Therefore, to avoid this rule, the transferee may purchase the policy for full and adequate consideration. If a purchase is involved, however, special attention must be given to the transfer-for-value rules of IRC Section 101 to ensure that the policy proceeds do not lose favorable income tax treatment.
If a sale will not be involved, inclusion of a contingent marital deduction in the ILIT document will defer any estate tax payable until the surviving spouse's death. The ILIT should include language that if the policy proceeds are includible in the grantor's gross estate, the trustee may either distribute the proceeds outright to the surviving spouse, or hold them in a trust that qualifies for the estate tax marital deduction. This provision only comes into play if the policy proceeds are includible in the grantor's gross estate.
Problem 3: Application of the reciprocal trust doctrine. Husband and wife each have an ILIT with identical provisions: an income interest for the surviving spouse, and distributions of principal to the spouse for the surviving spouse's health, education, maintenance, and support (HEMS); and upon the death of the surviving spouse, the trust property passes outright or in trust to the remainder beneficiaries. In this scenario, upon the death of husband, the wife's trust may be included in his gross estate under the "reciprocal trust doctrine."
The "reciprocal trust doctrine" applies where the trusts are so interrelated that the grantors are left in the same economic position that they would have been in had they created each other's trusts. As a result, the IRS "uncrosses" the trusts, including the value of the trust created by the surviving spouse in the estate of the first spouse to die.
Solution 3: Ensure that the trusts are slightly different. The reciprocal trust doctrine applies only if the trusts are identical. Ensuring that the terms of one trust are slightly different from the other will avoid unwanted results. For example, in the wife's trust, the husband could be given a limited power of appointment, exercisable by will, to appoint the trust corpus to the couple's descendents. The husband's trust could be drafted without this power.
Problem 4: Crummy Crummey powers. Normally, transfers in trust do not qualify for the gift tax annual exclusion because they are gifts of a "future interest." To make a transfer to a trust a "present interest" (and thus qualify for the annual exclusion), the beneficiary must be given the right to the immediate enjoyment of the property transferred. This is where Crummey powers (named for the 1968 9th Circuit case, Crummey v. Commissioner) come into play.
A Crummey power gives the powerholder the right to withdraw the property transferred to the trust for a certain period of time (frequently 30 days). After the withdrawal period lapses, the trust beneficiary loses the right to withdraw some or all of the property. Crummey powers can create numerous tax and administrative issues.
For tax purposes, a Crummey power is a general power of appointment. IRC Section 2041 includes property in a decedent's estate if the decedent had, at the time of death, a general power of appointment over it, or if a decedent exercised or released a power of appointment over it during the decedent's lifetime. Normally, a lapse of a power of appointment is deemed a release. However, if a lapse is limited to the greater of $5,000 or 5% of the aggregate value of the trust property in any one calendar year, the lapse will not be considered a "release" that will bring the property back into a decedent's gross estate under IRC Section 2041.
Solution 4: Clean up the Crummeys. The amount transferred to the ILIT each year for each beneficiary may be limited to the greater of $5,000 or 5% of the value of the trust property without causing a Section 2041 problem. If there are few Crummey beneficiaries and/or a significant premium, however, this may not supply enough cash to the ILIT to pay the premium. An alternative is a "hanging Crummey power," drafted so that the beneficiary's withdrawal rights only lapse to the extent of the greater of $5,000 or 5% of the value of the trust property. The excess remains subject to the withdrawal power.
In later years, if the policy performs and the cash surrender value grows (and 5% of the value of the trust property begins to get bigger and bigger), the excess withdrawal rights from prior years (i.e. the amount that is hanging) will begin to lapse but will not be considered a release under IRC Section 2041. If a beneficiary should die with the excess subject to a hanging power, the amount subject to such power will be includible in his or her gross estate for tax purposes.
The advisor must pay attention to administrative issues. For example, a waiver of a power of withdrawal constitutes a release that does not qualify for the "lapse" exception described above. Therefore, Crummey withdrawal rights should not be waived but allowed to lapse upon the passage of time. In addition, a signed receipt for each Crummey notice should be kept on file permanently to show that the beneficiary received actual notice of the withdrawal right. Finally, the beneficiaries must have an actual right to withdraw the property subject to the Crummey power, or the withdrawal rights may be considered "illusory." As a result, an ILIT should actually receive cash, hold it for the withdrawal period, and then use it to pay the premium (unless the policy has sufficient cash surrender value to satisfy the beneficiaries' withdrawal rights).
Problem 5: The trust is inflexible and fails to meet the client's needs. Frequently, clients cite the fact that the trust cannot be changed as a reason that they do not want or do not like their ILITs. Because of a change in his or her family situation, a client may want to change the terms of the ILIT. Alternatively, the client may no longer want the parties originally named to serve as trustees or successor trustees. Tax or other laws may have changed, becoming more or less advantageous, and the client would like to adopt or avoid them. Most importantly, the client may worry about locking a policy in a trust, losing access to the policy.
Solution 5: Draft new trusts with flexible provisions and address problems with old trusts. A provision that permits the ILIT trustee to make distributions of trust income and principal to the grantor's spouse (if any) and/or grantor's descendants during the grantor's lifetime serves as a fail-safe, ensuring that the family can access the cash surrender value or even retrieve the policy (as a distribution of principal) from the trust. Further, change of situs provisions can be included to permit the trustee to move the situs of the trust from one state to another in order to take advantage of more favorable state laws.
As for addressing problems with existing trusts, the trust instrument may provide a solution. Can the trustee terminate the trust under any of the provisions of the trust? If so, what will happen to the policy after the trust is terminated, and does this suit the client's objectives? Is there a merger provision in the existing agreement under which the old trust can be merged with a new trust, with the new trust as the "survivor"? Does the manner in which this must be done under the document suit the client's objectives?
If the document does not provide a satisfactory solution, state law might. For example, many states have adopted the uniform trust code that permits a living grantor, in conjunction with the beneficiaries, to terminate an irrevocable trust and permits the trust beneficiaries to determine to whom the trust property shall flow after termination.
If neither the trust document nor state law provides a solution, the grantor may create a new ILIT to purchase the policy from the old trust for its fair market value. Assuming that the transaction is properly structured, it will: (1) not result in an income tax, even if the fair market value of the policy purchased exceeds its basis; (2) not run afoul of the three-year rule, even if the grantor dies within three years of the transaction; and (3) qualify as an exception to the "transfer for value rule" of IRC Section 101 so that the death benefit will remain income-tax-free when received.
Conclusion. Finding and resolving potential issues before they create significant tax or legal issues for your client will result in better outcomes for your client and increased sales opportunities for you.
Kathleen W. Bilderback, JD, LLM, is a partner with Affinity Law Group LLC. She specializes in estate, business, and executive benefits planning and estate and executive compensation planning with life insurance. Ms. Bilderback previously worked in the business and individual services group of the St. Louis law firm Doster, Mickes, James, Ullom, Benson & Guest, LLC, and in the advanced markets group of Metropolitan Life, where she provided training and advanced underwriting support for the top producers of MetLife and its subsidiaries.