JLM Wealth Strategies: 2014

IRREVOCABLE LIFE INSURANCE TRUSTS

Introduction

The irrevocable life insurance trust is probably the most significant insurance-related estate planning tool available to your clients. The irrevocable nature of the trust can provide estate tax savings while the insurance connection provides a cost effective way to pay estate taxes.

The appeal of an irrevocable life insurance trust is that the death proceeds of the policy are not included in the insured's estate. If kept out of the decedent's estate, the death proceeds will not increase the estate tax burden. The irrevocable life insurance trust is a double winner because, not only are the death proceeds outside the insured's estate, but the proceeds can be available to meet estate liquidity needs.

An irrevocable life insurance trust can be created by irrevocably transferring ownership of a policy to the trust or by having the trust, through its trustee, acquire a life insurance policy owned by the trust. Life insurance trusts are normally not funded with income-producing assets in addition to life insurance. Life insurance is kept separate from income-producing assets in trust because any income would be taxable to the grantor. The grantor of a life insurance trust generally wishes to avoid creating a trust which generates income-tax consequences that can be tracked back to the grantor.

To insure that the life insurance proceeds will be excluded from the insured's estate, the following requirements must be met:

1. The insured must not have any incidents of ownership in the policy.

2. The trust must be irrevocable.

3. The insured(s) should not be the trustee of the trust.

4. The insured should have no beneficial interest or retained power.

5. The insured must survive for at least three years from the date of any policy transfer into the trust; otherwise, the insurance proceeds will be included in the insured's gross estate.

6. The trust document should not require or encourage the trustee to use life insurance proceeds to pay the insured's estate taxes.

The following are some factors for consideration when deciding whether to adopt an irrevocable life insurance trust.

· Greater flexibility in handling distributions of the proceeds and income as compared to insurance settlement options. Contingencies such as divorce, remarriage, children of a second marriage and other events may be anticipated and provided for. Restrictions and limitations on the use of the funds for the beneficiaries may be included in the trust.

· The trustee should be authorized and empowered (but not directed) to lend trust principal to the grantor's executors or to the executors of the grantor's spouse or to purchase assets belonging to either of their estates. If this provision is included in the trust, life insurance can accomplish one of its most useful roles — providing liquidity to an estate and helping its executors to avoid forced sales of estate assets to meet the burden of taxes and administration expenses.

· The insured should never be a trustee of the irrevocable life insurance trust. The insured should assign all rights to the policy to avoid retaining any incidents of ownership.

· Trust beneficiaries may be given a demand right in the trust to take advantage of the annual exclusion for gifts of a present interest. Thought must be given to the notice provision and to the financing of any withdrawal rights so that Crummey powers will not be deemed illusory.

· All policies in the trust should be described accurately, and the description should include the policy number, the name of the carrier, the face amount of the policy, and the name of the insured. The purchase of additional policies should be provided for, if desired.

· Provisions must be included to enable the grantor's estate to obtain a marital deduction if the grantor of the trust dies within three years of the date on which the policies became part of the trust. The trust instrument should provide that the life insurance proceeds payable at the death of the grantor be paid to the grantor's spouse or to a trust that is established for the spouse's benefit and will qualify for the estate tax marital deduction.

How It Works

There are two typical methods of acquiring life insurance in an irrevocable life insurance trust. The first is the transfer by the insured by gift of a policy on the insured's life to the trustee of the trust. The second is to have the trustee purchase the policy directly from the insurance company for the ultimate benefit of the named beneficiaries of the trust.

Assuming that you are starting from scratch, the trust document should be drafted by the client's attorney early in the process so that the trust, through its trustee, can be the applicant, owner and beneficiary of the policy from the start. In effect, this procedure will eliminate three-year-rule concerns, which will be discussed later.

It is not always possible to get things moving fast enough with the client's attorney. When your clients allow you to review their estate and agree that life insurance is the best solution, the insurance purchase becomes the first step. Plans may call for an irrevocable trust to own the policy, but real life says that it may be months until the trust is actually drafted and signed by the client(s). So the main objective is to get the life insurance in force. It would certainly be much better to have the life insurance in force and included in the insured's gross estate than to have the client die without life insurance while waiting for a trust to be drafted.

When the trust is finally in place, the estate owner gifts the policy to the trustee by completing an absolute assignment (without valuable consideration). At the same time, the trustee is named as beneficiary. Now the trustee is owner and beneficiary of the policy and will pay future premium payments when due. The insured will make cash contributions to the trustee on a periodic basis to provide premium payment dollars.

At the time of the client’s death, the life insurance death benefit is paid to the trustee. The provisions of the trust give the trustee the discretion to purchase assets from or loan money to the estate of the decedent. This is the technique used to get cash from the trust to the personal representative of the estate to pay estate settlement costs.

The Three Year Rule

It is important to remember that the transfer of a life insurance policy can trigger the three year rule. The three year rule applies to transfers of a policy within three years of death, whether transferred outright or to an irrevocable trust. Therefore, any transfer of a policy made within three years of death will automatically be included in the decedent's estate.

If the transfer occurred at least three years before the insured’s death, the fact that the insured paid the premiums will not cause the death proceeds to be included in the decedent's estate. The 1987 case, Estate of Leder, stated that no estate tax inclusion will result even if the decedent paid premiums within three years of death, as long as the decedent had no ownership rights in the policy. The key question is whether or not the decedent had any incidents of ownership in the policy, not whether the decedent paid premiums for a previously owned policy.

If the client dies within three years of the policy transfer, the face amount of the insurance would be included in the decedent's gross estate. While this is not desirable, the client is still better off for having additional funds available, even if they are taxed.

One suggested provision to include in the trust would provide that if death occurred within three years of the transfer and the IRS determined that the proceeds were included in the insured's gross estate, the trustee would be directed to immediately pay out the proceeds to the spouse of the decedent. In this way the proceeds would qualify for the marital deduction eliminating any federal estate tax on the proceeds.

Crummey Withdrawal Powers

In addition to estate tax advantages, there are gift tax advantages when an irrevocable life insurance trust is used. The combination of an irrevocable trust and Crummey withdrawal powers results in a tax-advantaged estate planning tool.

A gift, in order to qualify for the annual gift tax exclusion, must be a gift of present interest in property, where the donee can immediately enjoy the property or its income. If the gift is of a future interest in property (a property right that is valid today, but use or enjoyment is postponed until sometime in the future), then no exclusion is allowed. Transfers to irrevocable trusts technically fall into the future interest category, but qualification as a present interest can be obtained if a beneficiary has the right to withdraw or demand trust income.

The annual gift tax exclusion is currently $13,000 ($26,000 if gift-splitting is used) per donee per year. The most common technique for qualifying trust contributions for the annual exclusion is the Crummey demand power (named after the case establishing the power). This power grants the beneficiary the right to demand limited amounts of principal or income is non-cumulative and lapses if not exercised within a stated period of time. The intent is that no withdrawals will be made and that the money will be available for the trustee to use for premium payments.

A Crummey power inserted in a trust allows the beneficiary to withdraw any or all of the donor's annual contribution to the trust. Because the beneficiary, in exercising the demand power, could pass trust funds to himself or herself, the power is deemed a general power of appointment under I.R.C. Section 2514(c). This Code section treats the release of a general power of appointment as a transfer of property to a trust co-beneficiary if there is more than one beneficiary of the trust, and such transfer is subject to gift tax. If the power is not exercised and lapses, the tax code treats this as a taxable gift-over to the trust beneficiaries by the one beneficiary, but only to the extent that the lapse exceeds the greater of $5,000 or 5% of the total value of the assets subject to the power. This limitation of $5,000 or 5% is commonly known as the five-and-five power.

The IRS issued a Private Letter Ruling (PLR 8727003) which restricts the use of Crummey withdrawal powers in some situations. While a Private Letter Ruling is not a binding pronouncement, it can be a sign of things to come. A typical Crummey withdrawal power gives a trust beneficiary a non-cumulative power to withdraw a specified amount of trust corpus. In PLR 8727003, the IRS disallowed the annual gift tax exclusion for transfers where the withdrawal powers were held by persons who did not have a vested interest in the trust. In other words, the IRS held that the gift tax annual exclusion is available only for transfers where the powerholders are vested trust beneficiaries or beneficiaries who have actually exercised their withdrawal rights.

It is necessary to use care in designing Crummey powers. Beneficiaries should be given a substantial interest in the trust because only a remote contingent interest in a remainder of a trust may not be enough to qualify for the annual gift tax exclusion. The IRS is concerned when additional beneficiaries are named in the trust (typically minor grandchildren of the donor) in an effort to avoid federal gift tax through proliferation of annual exclusions without giving these additional beneficiaries a substantial and continuing interest in the trust.

In a different instance, the Tax Court rejected the IRS's narrow view with respect to denying the annual exclusion for withdrawal powers granted to multiple beneficiaries. In the Cristofani case, the grantor set up a trust primarily for the benefit of her two children and secondarily for her five grandchildren, who received contingent remainder interests. She gave $70,000 of property to the trust in each of the two years before her death. Each of the children and the grandchildren had the right to withdraw $10,000 within 15 days after the grantor made a gift to the trust, but none of them did so.

The grantor paid no gift tax on the transfers, claiming the $13,000 annual exclusion for seven recipients (the children and grandchildren). The Tax Court upheld the grantor's claim. Even though no withdrawals were made, the court found that no agreement or understanding existed between the decedent, the trustees and the beneficiaries that the grandchildren would not exercise their withdrawal rights. The IRS acquiesced in result only in the Tax Court's decision in Cristofani. Despite the Tax Court's decision in this case, and the IRS's acquiescence, it is clearly inadvisable to proliferate the number of beneficiaries holding a Crummey power to the point where it becomes clear that gift tax avoidance is the primary motivation.

Care should be exercised to avoid even the appearance of collusion or any prearranged agreement or understanding between the grantor and those with withdrawal powers as to the non-exercise of their powers. Indeed, they should be given to understand that, if circumstances arise which make it appropriate for them to exercise withdrawal power, they should feel free to do so.

The Five-and-Five Power

As mentioned above, the five-and-five power refers to the maximum amount a beneficiary can withdraw or allow to lapse and still retain the benefits of the annual gift tax exclusion. The Code sets up a safe harbor provision which states that if the power is to withdraw the greater of $5,000 or 5% of the trust corpus, the lapse of such power is not considered a gift by the beneficiary.

The $5,000 limitation can raise concern since the annual exclusion is now $13,000. If the beneficiary possessing the withdrawal power has no other beneficial interest in the trust, the lapse in excess of the five-and-five power may be treated as if the beneficiary donated his or her own assets to the other beneficiaries. This would result in a taxable gift which will not qualify for the annual exclusion. Such an outcome, sometimes referred to as the gift-over problem, is generally not what the donor intended when the trust was created.

The five-and-five power raises a conflict between the advantage of the annual gift tax exclusion and the $5,000 or 5% limitation. The conflict lies between the grantor's interest in maximizing the amounts that can be contributed to the trust without incurring gift tax liability and the interests of those holding Crummey powers, who are confronted with a potential gift tax problem on non-withdrawals or lapses, if their power exceeds the five-and-five limitation.

The Gift-Over Problem

The release or lapse of a power of withdrawal in excess of the five-and-five limitation gives rise to a gift by the power holder to other beneficiaries of the trust. If the donor chooses to limit contributions to the trust so as to stay within the five-and-five limitation, he or she may be forced to contribute less than the full amount covered by the annual gift tax exclusion,

The possible gift tax consequences on the lapse of a power of withdrawal are of immediate concern to the holder of the power. The grantor will not be concerned with gift tax consequences on contributions to the trust if the contributions are protected by the annual exclusion for gifts of present interests in amounts of $13,000 or less per beneficiary.

If the holder of the power is the sole income beneficiary and remainder person, the lapse of the power would not be a taxable event. This result follows from the general notion that one cannot make a taxable gift to oneself. The only sure way to avoid the gift-over problem is to stay within the five-and-five limitation.

Hanging Powers

The conflict between the annual gift tax exclusion and the five-and-five limitation used to be solved by giving the beneficiary a hanging power of withdrawal. Hanging powers have been questioned by the IRS. Assuming the use of a hanging power, the withdrawal powers with respect to the property in excess of the five-and-five limitations will hang, or continue in effect from year to year. Under this approach, the withdrawal power, up to the five-and-five limitation, lapses in any given year. This is done by adding a clause to the Crummey provision which converts the withdrawal power (at its expiration) to a special power of appointment. The beneficiary has a cumulative special power of appointment; and the amounts subject to the power are the total amounts that exceed the five-and-five limitations and could have been withdrawn annually but, in fact, were not.

There has been IRS activity with regard to the use of hanging powers. Technical Advice Memorandum 8901004 challenges hanging powers as a means of protecting from gift tax the portion of gifts in trust that exceed the 5 and 5 power. The IRS advised that when a condition or a right of withdrawal provides that the right will not lapse until such lapse will not result in gift tax, the condition is not valid. The IRS stated that the trust provision was a condition subsequent and that any attempt to make the lapse of the power subject to a condition subsequent makes the annual gift tax exclusion unavailable.

Until the resolution of possible controversy with IRS on the issue of hanging powers, planners may wish to design hanging powers to avoid imposing what the IRS considers a condition subsequent. This may be accomplished by drafting a power that does not refer to a lapse or release. Instead the trust can contain a provision that causes powers to lapse only in the amount permitted under IRC Section 2514(e) which is the greater of $5,000 or 5% of the trust principal.

Some planners may wish to ignore Letter Ruling 8901004 and continue to use hanging powers. If a client's advisor thought it was necessary to use a Crummey provision in excess of the five-and five power, then the only option is to use a hanging power. It may be especially appropriate to do so where a large policy of life insurance, demanding a large annual premium payment, is owned by the trust, and the client will need maximum use of annual exclusion gifts. So long as the planner makes the client aware of the risk of IRS challenge (which may not arise for many years after the creation of the trust), and a record is made of the client's informed decision, the planner and the client can take a reasonable risk. In this type of situation, it might be best to use a simple hanging power where the beneficiary retains a general power of appointment over the property that exceeds the five-and-five limitations.

The attack on hanging powers may not be of practical significance where the amount of premium contributed annually does not exceed $5,000 per Crummey beneficiary. For example, a trust obligated to pay a $20,000 annual premium and that has four beneficiaries should not be affected.

The hanging power is advantageous when a modified-premium policy design is used to fund the trust. During the premium paying years, the beneficiaries will allow prior withdrawal amounts in excess of the 5 or 5 limitation to hang. When contributions to the trust for premiums cease, the beneficiaries' hanging powers will begin to lapse in an amount equal to the greater of $5,000 or 5% of the trust assets.

Hanging powers are not without drawbacks. The primary disadvantage is the cumulative nature of the power and the possibility that the holder might exercise it in the future. This differs from the more typical Crummey power which is non-cumulative. The beneficiary's right to withdraw the money in a future year before all powers have lapsed may be of concern to grantors with minor children whose powers do not completely lapse before they reach the age of majority. At majority, the children are able to exercise the withdrawal rights for the first time by themselves.

A second disadvantage relates to the death of the powerholder prior to the lapse of the entire hanging amount. At the time, the amount still subject to the power at the holder's death will be included in the holder's gross estate.

Choice of Trustee

The choice of trustee is an important consideration in setting up a trust. The trustee, as a fiduciary, has the duty to act for the benefit of others with a high degree of loyalty, honesty and accountability. A common concern is deciding between a corporate (and therefore independent) trustee and an individual (often related) trustee. Tax concerns also play a major role in selecting an appropriate trustee for an irrevocable life insurance trust. Estate tax considerations dictate that the insured(s) not serve as trustee of an irrevocable life insurance trust. Also not recommended as trustee would be the insured's spouse.

If an individual trustee is selected, the trust document must provide contingency plans in the event that the original trustee dies or becomes incapacitated. Also, if the individual trustee is a family member, that person is often placed in an uncomfortable position as the possibility for a conflict of interest exists. Other issues to consider in selecting a trustee is that an individual trustee may have difficulty in monitoring changing tax laws and keeping current in order to manage the trust. Also, corporate trustees are under close scrutiny for their actions, whereas individuals may be more vulnerable to breaches of trust.

The selection of trustee will depend on the circumstances of each case. Family situations typically dictate the need of a certain type of trustee. The attorney drafting the trust document would be in a position to advise on the appropriate selection of a trustee.

The Notice Requirement

The trustee has the responsibility to notify the beneficiaries anytime a gift has been made to the trust. For this reason we recommend annual gifts to the trust to pay premiums. Annual gifts of premium will keep the frequency of the notice requirements at a reasonable level. This notice allows the beneficiaries the opportunity to exercise their Crummey withdrawal rights. Notice should be in writing and should state that the beneficiaries shall have a specific time in which to exercise the right. Typically the beneficiaries should be given 30 days to exercise their rights.

In order for the grantor to make use of the annual gift tax exclusion the beneficiaries must have a reasonable opportunity to exercise the power before it lapses. The court cases and rulings have shown us that the Crummey power, the notice requirement and the length of time available for the exercise of the power must all be taken together in order to determine if the grantor is entitled

to favorable gift-tax treatment.

Split-Dollar and Irrevocable Trusts

If your clients are owners of small corporations, you may want to recommend the use of split-dollar in conjunction with their irrevocable trusts. In this type of situation, your clients can use corporate dollars (to be repaid at a later date) to pay life insurance premiums. We recommend the collateral assignment method where the trustee of the irrevocable trust would be the applicant, owner and beneficiary of the life insurance policy and then would collaterally assign an interest in the policy (to the extent of the premiums paid) to the corporation. The trust could pay the economic benefit (Table 38 rates for second-to-die policies while both insureds are alive or term rates for a single life policy) each year that the split-dollar plan is in effect. At some point in the future, the trustee would pay back the corporation and then the assignment would be released. The corporation gets its money back and the trustee has the entire policy proceeds available for estate liquidity needs at the insured's death.

Special consideration must be given to clients who are majority shareholders of their corporations. In order to avoid adverse estate tax consequences, they need to limit the corporation's rights to the policy by using restrictive split-dollar assignments and agreements.

Potential Problem Areas

There are several areas that may cause some problems with regard to irrevocable life insurance trust planning. For instance, what do you need to look out for when you suggest an existing policy currently owned by the insured's spouse be transferred to the trust? What about recommending that a policy owned by a trust be exchanged for another policy and what if the insured then dies within three years of the policy exchange?

(1) What do you need to look out for when you suggest an existing policy currently owned by the insured's spouse be transferred to the trust?

Transfer of life insurance to the non-insured spouse was common before the enactment of the unlimited marital deduction. Many policies are still held in this way. What happens if the owner-spouse wishes to transfer it to a life insurance trust in which he or she will be a beneficiary? Will such a trust escape federal estate tax on his or her death? The answer here is no. Although the policy proceeds will escape estate taxation on the death of the insured spouse, they will be included in the estate of the survivor (the trust's grantor) since the spouse will have retained an interest in the gifted property.

A number of approaches may be considered to remove the policy proceeds from the spouse's estate. The safest way out for a spouse who is the owner of life insurance policies is to create a life insurance trust solely for the benefit of children and grandchildren over which he or she will have no interest whatsoever. If, however, the spouse wants or needs the income from the proceeds after the death of the insured, then the owner-spouse could give the policy to the insured spouse who, after passage of time and without pre-arrangement, might be able to create a life insurance trust naming the spouse as the life income beneficiary. Though there are no rules determining what a proper period of time is, one year may suffice. This approach might be better than doing nothing (which may result in inclusion of all or part of the proceeds in the estate of the surviving spouse).

(2) What about recommending that a policy owned by a trust be exchanged for another policy and what if the insured then dies within three years of the policy exchange?

If the trustee exchanges a life insurance policy held inside an irrevocable life insurance trust for a new policy within three years of the insured's death, will the new policy be included in the insured's estate? No, according to Private Letter Ruling 8819001, where the trustees of the trust applied for the policy and the insured's only involvement was to sign the application and attest to its correctness.

Alternative to Irrevocable Trust

If your clients are opposed to setting up irrevocable life insurance trusts, they may want to name their children as owners and beneficiaries of the life insurance policies on their lives. Through the use of the annual gift tax exclusion, the parents can gift the money to the children so that the children will be able to pay premiums. By having the children own the policies, the death proceeds will be kept out of both of their parents' estates — a desired goal. Even though the proceeds are excluded from the parents’ estates, there are disadvantages to making the children the outright owners of the life insurance policies. These disadvantages include:

1. The children may be immature and misuse their rights of ownership. For example, they may cash the policies prior to the insured's death and use the cash for their own purposes.

2. After the death of the insured, the children may not be willing to use the proceeds for estate liquidity purposes. This is particularly true when the children are not the primary beneficiaries of the estate.

3. If the children are the owners of the policies, the proceeds will become part of their estate for estate tax purposes to the extent they are not spent during lifetime.

4. If the children are the owners, they cannot permit any portion of the proceeds to be available for the surviving spouse's lifetime use without possible gift tax consequences.

Conclusion

The irrevocable life insurance trust can bring about large estate tax savings for those clients with substantial estates. In these cases, the need for liquidity is great and typically these clients already own sufficient personal insurance for basic needs and/or retirement income. Therefore, the use of an irrevocable life insurance trust can be the ideal solution to ensure that estate taxes and expenses do not overrun the client's substantial estate.

This information should not be relied upon as legal advice. The application of principles of law to a client's Individual circumstances should always be performed by competent legal counsel.

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