Filed Under:Life Insurance, Life Planning Strategies

The flexible irrevocable trust

If structured correctly, an irrevocable trust can meet changing family needs without sacrificing its tax benefits.

The increased gift tax and generation skipping exemptions provided under the 2010 Tax Act provide a significant opportunity to transfer assets to family members. To take full advantage, many wealthy families have been advised to make substantial gifts before the end of 2012, when the increased exemptions are scheduled to expire.

These gifts are typically made in trust, rather than outright, but many clients may be hesitant to make gifts, out of concern about the irrevocable nature of the trust. They fear that they may later regret their decision, as their financial condition, the tax laws or other circumstances may change. However, an irrevocable life insurance trust (ILIT) can be more flexible. If structured correctly, it can better adapt to changing family circumstances and to future changes in tax laws while still preserving the intended tax benefits.

Beneficiary powers

A testamentary limited power of appointment (LPOA) allows the beneficiary to change the disposition that would otherwise occur at the beneficiary’s death. A LPOA enables the beneficiary to take a second look and, if appropriate, change the dispositive terms of the trust. When properly drafted, this power can be given to a beneficiary without federal transfer tax consequences.

Trustee or trust protector powers

Power to amend: It may be desirable to amend an ILIT in order to achieve better tax benefits or allow administration consistent with the grantor’s intent. Clearly, the grantor cannot have the power to amend the trust agreement without adverse estate tax consequences.

Provisions to add greater flexibility

Many grantors want the assets in the ILIT to be distributed to the beneficiaries at various ages (e.g., one-half at 25 and the balance at age 30). Unfortunately, upon distribution, the assets will be subject to the claims of a beneficiary’s creditors, including divorced spouses. Consider authorizing the trustee to postpone distributions to a beneficiary beyond the stated ages for certain reasons (e.g., a pending divorce, bankruptcy). Such a provision, coupled with a spendthrift clause, will generally protect the beneficiaries from themselves, their creditors and their predators.

Grantor trust for added flexibility

Consideration should also be given to designing the trust as a grantor trust. If income-producing assets are gifted to the ILIT to pay premiums, the grantor’s payment of the ILIT’s income taxes will be the equivalent of a tax-free gift to the beneficiaries of the ILIT. The same favorable income tax result would occur if an ILIT sold an asset and incurred a gain on the sale.

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Nichole Morford

Nichole Morford
Managing Editor

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