GPSolo Magazine - March 2006
Estate and Financial Planning
Drafting Flexibility into an Irrevocable Life Insurance Trust
Elements of a typical irrevocable life insurance trust. In designing an ILIT, an attorney makes use of an array of elements, including the following:
• identity of the settlor and trustee;
• statement of the trust’s irrevocability;
• administrative and dispositive provisions;
• beneficiary withdrawal powers to provide for present interest gifts and other powers of appointment;
• powers of the trustee;
• trustee’s powers relating to life insurance;
• provisions for compensating the trustee and appointing a successor;
• directions for administering the trust and accounting for and safeguarding trust assets;
• miscellaneous provisions relating to trust construction, ap-plicable state law, binding agreement, or other items; and
• proper execution of the trust document under applicable state law.
Design tools that can provide flexibility in an ILIT include (1) general and special powers of appointment; (2) distributions or withdrawals within the scope of a specified ascertainable standard; and (3) administrative powers in the trustee. Appointing a trust protector and making the trust a grantor trust for income tax purposes also increase trust flexibility.
Powers of appointment. Property subject to a general power of appointment is includable in the power holder’s gross estate for federal estate tax purposes. For that reason, the grantor of an ILIT cannot retain a general power of appointment and remove the underlying insurance policy from the grantor’s estate.
ILITs, however, commonly grant a general power of appointment to individuals other than the grantor. Most ILITs include Crummey withdrawal powers to ensure that gifts to the trust qualify for the gift tax annual exclusion. Crummey powers are general powers of appointment that partially or wholly lapse within a specified time period.
The lapse of a Crummey withdrawal power in excess of $5,000 or 5 percent of the trust assets, whichever is greater, can cause the power holder to be treated as having made a transfer to the trust for tax purposes. To prevent a lapse of a general power in excess of the so-called five-and-five limits of Code § 2514(e), many planners use a “hanging” power. With a hanging power, the excess amount does not lapse; rather, the power holder maintains a continuing right to exercise the general power of appointment over the excess amount. If the life insurance policy in the ILIT reaches a point at which no more premiums are due and no additional contributions are made to the trust, the “hanging” amount can begin to lapse at the greater of $5,000 or 5 percent of the trust assets subject to the power until no amount is left hanging.
A special power of appointment allows the power holder to transfer certain property to another person, but not to himself, his estate, or creditors of either. A non-grantor spouse can hold a limited power of appointment to alter the beneficial interests of the children. Some planners use limited powers of appointment in lieu of a hanging power to prevent the lapse of a Crummey withdrawal power in excess of the greater of $5,000 or 5 percent.
Spousal access limited to ascertainable standard. Sometimes a grantor would like to have indirect access to trust assets during his lifetime. A planner can accomplish this by giving the trustee the discretionary power to make distributions to the grantor’s spouse for the spouse’s health, education, maintenance, and support. Because the distributions are limited to an ascertainable standard, the power should not cause inclusion in the grantor’s or the grantor’s spouse’s estate. To make sure that transfers to the trust are excluded from the grantor’s estate, the trust document should not relieve the grantor of any support obligations imposed by law.
Loans from the trustee to the grantor or grantor’s spouse. Another way for the grantor to gain access to trust assets is through secured loans from the trustee. The grantor executes a note secured by property pledged by the grantor. The note accrues interest at a fair market rate at least equal to the appropriate applicable federal rate for the type of note and the term of the loan.
When the grantor dies, the cumulative loan and accrued interest are paid back to the trust from the grantor’s estate. The loan and accrued interest payment should be deductible from the insured’s gross estate as a bona fide debt. The effect of this deductible loan and accrued interest payment is to transfer a substantial portion of the decedent’s estate to the trust free from transfer tax.
Trust protector. To add even further flexibility, a trust instrument can name an independent party to act as the “trust protector.” A trust protector holds wide-ranging powers to alter the terms of the trust agreement, sometimes including the power to add, remove, or change beneficiaries or change the distributive provisions of the trust.
Naming a trust protector has its drawbacks. The grantor must trust completely the judgment of the individual appointed as the trust protector. Otherwise, the trust protector potentially may exercise his powers to frustrate the grantor’s intent as expressed in the trust agreement.
Increased flexibility with a grantor trust. Most ILITs qualify as “intentionally defective grantor trusts.” An intentionally defective grantor trust is a grantor trust for income tax purposes, but a transfer to such a trust is a completed transfer for estate and gift tax purposes.
Essentially, the IRS ignores a grantor trust for income tax purposes. The grantor reports the income from a grantor trust on his personal return, instead of on the return of the trust or its beneficiary. If an ILIT holds income-producing property, trust income can be used to pay premiums on the insurance policy. Even though the trust uses the income to pay premiums, the trust income is taxed to the grantor. This has the effect of transferring an amount equal to the income tax from the grantor to the beneficiaries of the trust without having to treat transfers as a gift for gift tax purposes.
Because the grantor and his grantor trust are treated as the same person for income tax purposes, sales of appreciated property by the grantor to the trust do not create an income taxable event. The sale of a life insurance policy to the trust for full and adequate consideration generally avoids the transfer for value rule and may be successful in avoiding application of the three-year rule for estate tax purposes.
An ILIT can be a grantor trust for income tax purposes but not give the grantor powers that will cause assets in the trust to be included in the grantor’s estate for estate tax purposes. Most grantor trust powers, if retained by the grantor personally, would cause the trust assets to be included in the grantor’s estate for estate tax purposes. Certain powers, however, that create a grantor trust for income tax purposes do not simultaneously cause inclusion of trust assets in the grantor’s estate.
Richard C. Baier is an assistant vice president of advanced sales for Jefferson Pilot Financial in Greensboro, North Carolina. He can be reached at email@example.com. Drafting a flexible irrevocable life insurance trust (ILIT) is both an art and a craft. This article looks at trust design features that recognize the changing needs of the trust grantor or beneficiary.
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