Introduction
Irrevocable life insurance Trusts ("ILITs") are a common estate planning tool. Having a trust own your insurance can keep the proceeds outside your taxable estate, protect the proceeds for your surviving spouse, partner or children. An ILIT can protect the proceeds from an heir's divorce or lawsuit. Physicians and others worried about malpractice claims use ILITs to hold permanent insurance to build value in the protective envelope of the trust. But too many people assume insurance trusts are a simple boilerplate form. That assumption is likely to result in a trust document that is inadequate and not tailored to their situation, and lax administration of the trust (after all, it's simple and standard!).
Start Simple: Who Should be Trustee
The simplest step for an ILIT is to name the trustee, right? The reality is that administering an ILIT isn't the cake walk most people think. Insurance must be properly purchased, monitored and reviewed. Gifts must be accepted and Crummey notices issued (see below). Financing and other arrangements may have to be monitored. There are a myriad of other technical administrative issues that could affect an ILIT. Uncle Joe might be a nice guy, but you're always safer naming a professional, such as a trust company, or a long time family CPA, to be certain your ILIT is handled properly. The fees they'll charge are modest compared to the problems Uncle Joe frequently creates. You can always have the Uncle Joe replace the professional trustee following your death with the ILIT has substantial funds you want him to administer instead of the trust company or CPA. But that too is probably a mistake. Instead, have Uncle Joe serve as a co-trustee so that the professional management of your trust can continue. Be sure your ILIT specifically addresses compensation for professional trustees since most ILITs have no income and many have only nominal asset values (e.g., if they only hold term insurance) so that standard methods of calculation compensation will provide inadequate payment.
Situs-Which State Law Governs
There are a host of important matters that can be affected by the particular state law that governs your ILIT. Some states have enacted legislation holding trustees harmless for insurance investment decisions by relieving the trustee from the general standard of care applicable to a trustee, such as investing with care and skill, etc. Del. Code Sec. 3302(d). This relieves the trustee of liability for not: determining if an insurance policy is a proper investment, investigating the financial strength of the insurance company, exercising any policy option, etc. If a state other than your state of domicile has statutory protections you want for your ILIT trustee then issues of nexus (connection to that state) must be addressed. The surest way is to name an institutional trustee in that state. Florida law may permit the trustee to delegate insurance management to other persons without the fiduciary duty of care that would otherwise apply. Fla. Statutes Sec. 518.112(2). North Dakota, Pennsylvania, Wyoming also have favorable statutes. Another approach may be to list the indemnifications and exceptions in your ILIT document to minimize the liability your trustee faces (especially if compensation is minimal). But think carefully, do you really want the trustee to avoid these responsibilities?
Sample Clause: The Trustee is authorized to change, without court approval, the situs and governing law of this Trust, to any state where any current beneficiary of this Trust is domiciled, or where any Trustee is domiciled, by Ninety (90) days written notice to all then current beneficiaries, the Grantor if alive, and then next successor Trustee, if any, named in this Trust.
Sample Clauses:
- Grantor directs that the Trustee not be bound by the above investment policy statement until #the death of Grantor #the death of the last of Grantor and Grantor's spouse.
- No Trustee shall be liable for the retention of any particular insurance policy, nor shall any trustee be responsible, or held accountable, to investigate the merits, risks, etc. of any particular insurance policy or insurance company issuing a policy held by the Trust.
- The Trustee shall not be responsible to determine if any insurance policy or product remains a proper investment for this trust.
- The Trustee shall not be obligated to investigate the financial strength or changes in the financial strength of any life insurance company whose policies are held in this trust.
- The Trustee shall not be liable for the exercise or non-exercise of any policy option available under any insurance policy or contract.
- The Trustee shall not be liable for diversifying or failing to diversify insurance policies or contracts relative to one another or relative to other assets, if any, administered by the Trustee. This provision shall include by way of example and not limitation the failure to spread insurance coverage among various companies rather than concentrating it in one company, or monitoring and managing the asset allocation of funds held inside any variable life insurance policy.
- The Trustee shall not be liable for inquiring, or not inquiring, into the changes in financial condition, asset composition, liquidity needs or health status of the insured under any policy of insurance held under this trust, or which could be held hereunder.
Reciprocal Trust Doctrine
If you set up an ILIT with a $1 million 20 year term policy on your life naming your wife as beneficiary and co-trustee, and your wife sets up an identical trust naming you as beneficiary and co-trustee, the two parallel (reciprocal) trusts might be unwound by application of the reciprocal trust doctrine. Whenever you and your spouse, or perhaps another family member, are establishing similar ILITs take care to plan and draft around the reciprocal trust doctrine. See U.S. v. Grace, 395 316 (1969); PLR 9643013; PLR 200426008. Incorporate as many differences between the two trusts as possible. While substantive economic differences are preferred, if not essential, the inclusion of other more administrative differences may still support the independence of the two trusts. The following listing does not weigh the strength of the various factors listed: ■ The parties, e.g. husband and wife, should not be in the same economic position following the establishment of the two trusts. ■ Give one spouse a "5 and 5" power under one trust, but don't include a "5 and 5" power under the second trust. ■ Include an inter-vivos special power of appointment ("SPA") under one trust, but not another. Endeavor to make the power meaningful, not just a reallocation of assets between the same group of grandchildren. ■ Include a testamentary special power of appointment under one trust, but not the other. ■ Include a martial savings clause in one trust, but not in the other. ■ Each trust should have different distributions, e.g., one trust could mandate distributions at specified ages and the other trust could be a perpetual dynasty trust. ■ Use different distribution standards in each trust, e.g., one trust could distribute solely based on an ascertainable standard, and the other trust could use a broad discretionary standard with an independent trustee. ■ Add an additional beneficiary, like aunt Jane, to one of the trusts, but not the other. ■ Use different trustees for each trust. If neither spouse is a trustee or co-trustee and you have different trustees for each trust this could be a significant factor. ■ Have the trusts signed at different times. ■ Each trust can hold different assets, e.g., husband's trust holds universal life, and wife's only term insurance). Vary the amount of insurance coverage and other assets in each trust. For example the wife's term policy could be for $5 million while the husband's trust only holds $2 million of coverage. ■ Have one trust receive a significant initial contribute and the second trust merely a nominal initial contribution.
GST Exempt or Not
Should the trust be GST exempt or not? Since only about 2% of term insurance policies ever pay-off, evaluate whether your GST exemption should be wasted on an ILIT holding only term coverage. Also, even if your ILIT holds permanent insurance that is almost assuredly going to be maintained in force for the duration, you may have more important uses of your GST exemption. Plan accordingly. So even if making the ILIT GST exempt is reasonable, if you have better uses of your exemption, have the trust drafted in a manner that avoids GST issues. For example, the ILIT could be drafted in a manner that causes it to be included in your children's estate to avoid the GST tax. If it is intended that you will allocate, on your gift tax return, sufficient generation skipping transfer ("GST") tax exemption to the trust to keep it free of GST Tax issues (to create a zero inclusion ratio) be certain your accountant addresses this on a gift tax return. See "Potpourri".
Who is Your Spouse
No, this is not about the ABC show Wifeswap. But if you set up an irrevocable (can't be changed) insurance trust, you need to plan for lots' of "what-ifs". At some future point you may no longer be insurable and you might be divorced, perhaps remarried, perhaps several times. Who should benefit from your ILIT? Should "spouse" be defined as a particular person, or as the person married to you at a specific time (a "floating spouse" clause)?
Divorce
Under some state's laws divorce may automatically terminate your ex-spouse's interests as a beneficiary in insurance on your life (or it may not). Should your ILIT override either type of statute? If you have your spouse automatically terminated as a beneficiary in the event of divorce and you are required to provide life insurance for his or her benefit, but you are rated? Precluding the use of the insurance held in the trust could prove a costly mistake.
Sample Clause: If a divorce judgment is entered into between Grantor and Grantor's spouse, then Grantor's spouse shall be deemed to have predeceased Grantor as effective on the date of such judgment, and all provisions of this Trust Agreement, and any trust formed hereunder, shall be interpreted accordingly.
Sample Clause: If a divorce judgment is entered into between Grantor and Grantor's spouse, Grantor's spouse shall not forfeit any interests as a beneficiary under this trust unless the property settlement or other divorce agreement between the Grantor and Grantor's spouse expressly terminates or restricts such spouse's rights under this Trust#.
Annual Demand (Crummey) Powers
If you make gifts to an ILIT you will have to qualify those gifts for the annual gift tax exclusion ($13,000 in 2009), use up some of your $1M lifetime gift exclusion, or use alternative financing means to reduce the annual gift impact. To qualify for the annual gift exclusion beneficiaries have to be able to obtain the money given currently (a present interest). This is often accomplished by giving each beneficiary the right to withdraw new gifts during a window of time and giving them notice, which they acknowledge, of that right. This technique is called a "Crummey" power after the court case initially sanctioning it. Consider the number of Crummey power holders, provide flexibility so as irrevocable trust sufficient annual gifts can be made to hold likely future increases in insurance to be added to the trust. Give every power holder sufficient rights under the trust so that they are more than a mere naked Crummey power holder.
Conclusion
The above discussion only touched upon a few of the scores of issues that should be addressed in even a "simple" insurance trust and plan. If Capital One did insurance trusts as well as credit cards, their slogan would be "What's in your ILIT?"
While ILIT's are a very common estate planning vehicle, I think "common" has lead to an "oversimplification" so to speak. The oversimplification can also lead to inefficient and ineffective uses, as well as inadequate and flawed estate plans. There are common "shortfalls" that many professionals see with ILIT's. Far too often I've seen "sprinkle" or "spiggot" provisions where substantial monies will be paid out or distributed.
I've also seen "automatic" or default choices as it realtes to domicile (situs) -- and there can be several aspects to this -- tax (income tax) related issues, trustee standards, accountability and liability, state laws vis a vis perpetuity, as well as many others.
As it relates to the insurance component, this is where many ILIT's do in fact fail. As you pointed out, why do we see GST exempt trusts, that exclusively hold term insurance? Yes, the premiums might be initially small, however, many of those premiums increase, and they can increase in much greater percentages, in later years prior to expiration. It is also true that while many term policies have conversion features, nearly as many are not converted. The conversion is labled as a "cost" and as "expensive" and the price does increase with age. However, the desires of many clients, and even some professionals, is to complete the estate plan and avoid using life insurance. While this is a topic for another time, this can be very myopic thinking.
Genrically speaking, I do think it is potentially dangerous to have trust corpus (in the case of permanent life insurance) included in children's estates in order to avoid GST issues. Not always of course, but it should also not be done on an "every single time" approach. If we are looking at this from a narrow focus of an estate planning and estate tax perspective, then most commonly second-to-die life insurance is utilized. While this analysis is outside the scope of this article, far too often, there is an oversimplification and default usage of second-to-die life insurance. From this perspective, except in very few cases, it is very limiting to position the (second-to-die) life insurance in a one-dimensional mode, and simply have it to "just pay the estate taxes" -- and if 100% of the proceeds are used "just" for this, I would look to quantify the true costs of this transaction. The results can be somewhat surprising.
However, let's look at a very common case; if the life insurance proceeds are available to use moving forward. This is often seen in the "wealth replacement" arena, which is often coupled with a charitable remainder trust. We also see this with the use of individual life insurance coverage, which has far greater uses and benefits. Statistically and actuarially speaking, the children will be "receiving" money much earler in life -- much earlier and in much greater amounts than, for example, their parents did. Please note that I do not actually mean "receiving" as the monies should be held in trust and remain in a protected environment.
The children might still "be playing the game" and in an entrepreneurial mode. Thus, the life insurance proceeds -- the capital that is in play -- can grow exponentially! These situations should be examined on a case by case basis as it relates to not only the GST exemption, but the overall estate plan as well.
The "creditors and predators" topic is an important one -- the transfer tax system, potential lawsuits, divorce, state income tax, state laws, management, and more is of course all addressed in a holistic, comprehensive approach.
Martin -- thank you for the excellent article. I think you have brought up several excellent and important points, all of which must be considered and implemented properly. Yes, if Capital One did insurance trusts as well as credit cards, their slogan would be "What's in your ILIT?" -- that is an excellent analogy.
Eric L. Abramson