An irrevocable life insurance trust ("ILIT") is widely recognized as one of the more popular instruments used to implement a gift leveraging program. A threshold problem for the client contemplating an ILIT is the fact that the trust must be "irrevocable" in order to obtain the desired transfer tax benefits. The long-term nature of the increasingly popular "dynasty trust" makes irrevocability an even bigger concern. However, with proper drafting it is possible to plan in advance for changing circumstances in both the grantor's family situation and in the trust and tax laws.
This article will first address trust provisions dealing with the grantor's access to cash values, Crummey powers, and the ability to change the terms of, or to terminate, an ILIT. This article will also discuss provisions that can be included in a trust agreement to afford flexibility in matters concerning trustees, and provisions to protect beneficiaries from creditors, divorced spouses and estate taxes. Sample drafting language for the practitioner's consideration is provided throughout.
GRANTOR'S ACCESS TO CASH VALUES
Spouse as Beneficiary. When holding a single-life policy on the grantor's life, the trustee can be given the power to distribute trust income and principal to the grantor's spouse. Coupled with a provision authorizing the trustee to borrow (or surrender) cash values, the grantor's spouse can have access to the policy's cash values during the grantor's lifetime. While this does not give the grantor direct access to cash values, it does give the grantor indirect access provided the grantor remains married.
If the grantor's spouse is the sole trustee of the ILIT, then the trustee's power to distribute trust income and principal to the spouse must be limited to an ascertainable standard (for health, education, maintenance and support). Otherwise, the grantor's spouse will possess a general power of appointment over the trust property causing it to be included in the spouse's estate. See IRC §2041(a)(2) and (b)(1)(A); Treas. Reg. §20.2041-1(c)(2). To ensure that the assets in the ILIT are not included in the grantor's estate, the trust agreement should prohibit the trustee from using trust assets to relieve the grantor of any legal support obligations to his/her spouse.
It is important that the grantor's spouse not make any gifts to the ILIT. Otherwise, IRC §2036(a)(1) will cause inclusion of the ILIT in the spouse's estate because of the spouse's retained "possession or enjoyment of the property" or the "right to the income from" the trust property. Splitting gifts with the grantor does not implicate IRC §2036(a)(1). See IRC §2513(a)(1). Moreover, IRC §2036(a)(1) does not contain a "spousal unity" rule. Therefore, the spouse's access to trust property is not attributed to the grantor for purposes of that Code Section.
The following sample language might be included in an ILIT to provide the grantor's spouse with access to trust income and principal:
Any amount subject to a withdrawal right which is not withdrawn by the beneficiary of the withdrawal right shall be retained in trust and shall be administered as follows: The Trustee shall pay to or apply for the benefit of my spouse and my descendants as much of the net income and principal of the trust as the Trustee, in its sole and absolute discretion, determines to be necessary or advisable for their education, health, maintenance, and support. Any net income not distributed by the Trustee shall be accumulated and added to the principal of the trust. Any distribution of principal to a beneficiary under this Article shall be considered as a distribution in full or partial satisfaction of such beneficiary's right to withdraw under this Article. The Trustee shall, at all times, give primary consideration to the education, health, maintenance, and support of my spouse, and only thereafter to my descendants. In making distributions pursuant to this Section, the Trustee shall take into consideration, to the extent that the Trustee deems advisable in its sole and absolute discretion, any income or other resources that are available to my beneficiaries outside of the trust and are known to the Trustee. The Trustee may make distributions to or for the benefit of one or more of my beneficiaries to the complete exclusion of my other beneficiaries. Distributions may be made to my beneficiaries in equal or unequal amounts according to their respective needs; provided, however, that my spouse's needs shall be given priority over the needs of my descendants. A distribution to or for the benefit of a descendant of mine shall be charged to the trust as a whole rather than against that beneficiary's ultimate share. No payment or distribution shall be made by the Trustee for the discharge of any of my legal obligations, or otherwise for my monetary benefit. If my spouse has the power to remove a Trustee of this trust, the Trustee shall not distribute any of the principal of the trust that would in any manner discharge my spouse's legal obligation to a beneficiary of the trust. If my spouse is disabled, the Trustee shall ignore this restriction during the period of my spouse's disability, and my spouse shall not have the power to remove a Trustee of the trust.
Spousal Survivorship ILIT. With a survivorship policy, the ILIT must be carefully designed to avoid estate tax inclusion in both spouses' estates. PLR 9748029 demonstrates how to structure an ILIT so that one of the insured spouses can have access to the policy's cash values. First, the spouse with the shorter life expectancy (because of age, illness or gender) should be the grantor of the ILIT, and the other spouse should not be a co-grantor. The non-grantor spouse should not make any gifts to the ILIT. As such, there should be no retained interest by the non-grantor spouse and no estate tax inclusion under IRC §§ 2036(a) and 2038. As noted above, the non-grantor spouse can split gifts to the ILIT with the grantor spouse.
Second, the non-grantor spouse should not serve as the sole trustee of the ILIT. This avoids incidents of ownership held in a fiduciary capacity and thus estate tax inclusion under IRC §2042. However, the issue of incidents of ownership can be avoided by having a co-trustee serve with the non-grantor spouse and by providing in the trust agreement that the non-grantor spouse cannot exercise any incidents of ownership over the policy. See PLR 9348028. The grantor-spouse can name one or more children or other family members to serve as trustee or co-trustee. In addition, as discussed below, the grantor can retain the right to remove and replace trustees.
Third, the non-grantor's spouse's beneficial interest in the ILIT must not include either a general or limited power of appointment, and must be sufficiently restricted to not be an incident of ownership under IRC §2042. An independent co-trustee can provide the non-grantor spouse with income and principal as needed for health, education, maintenance, support, welfare, best interests, etc., without being limited to an ascertainable standard. IRC. Section 2041 and Rev. Rul. 76-368, 1976-2 C.B. 271.
Since the non-grantor spouse should not make gifts to the ILIT, what options are available to assure that funds are available to continue the premiums due under the survivorship policy after the grantor-spouse dies? First, the grantor-spouse's revocable living trust can leave all or part of his/her unused estate tax exemption to the ILIT. Second, the ILIT can be protected from the grantor-spouse's early death by owning a single life policy on the his/her life in an amount sufficient to pay the remaining premiums (see PLR 9451053). Finally, the ILIT can borrow the necessary funds from the grantor-spouse's estate, from the non-grantor spouse, or from a third party.
Limited Power of Appointment. The ILIT can provide someone other than the grantor, during the grantor's lifetime, with an inter-vivos limited power of appointment ("LPA") to distribute trust income or principal (the policy's cash value or the policy itself) to a class of appointees that includes the grantor. The LPA would be exercisable in the power holder's absolute discretion. A successor power holder should also be named if the initial power holder is unable to exercise the LPA. As long as the power holder cannot appoint trust income or principal to himself, his estate, his creditors, or the creditors of his estate, then the assets in the ILIT will not be included in the power holder's estate. IRC 2041(b).
What are the estate tax consequences to the grantor if such a provision is included in the ILIT? Under IRC §2042(2), incidents of ownership includes a reversionary interest whose value immediately before the insured's death exceeds 5% of the value of the trust. Since the LPA is exercisable in the power holder's absolute discretion, the value of the reversionary interest is less than the 5% threshold. Treas. Reg. §20.2042-1(c)(3).
If at the time of the transfer the grantor and the power holder had an understanding, express or implied, that the power holder would later distribute trust income or principal to the grantor, then under IRC §2036(a)(1) the grantor will be treated as having a retained interest in the ILIT causing all of the assets in the ILIT to be included in the grantor's estate. In the event of an IRS challenge, the burden is on the grantor's estate to prove the non-existence of such an understanding. Therefore, the use of this technique will always involve some risk. To hedge against this risk in the case of a married grantor with a single life ILIT, the trust agreement should contain a provision that passes the trust's assets to the grantor's spouse (or to a marital trust) so as to qualify for the marital deduction if the assets are included in the grantor's estate. An example of such a provision might read as follows:
The Trustee shall distribute an amount equal to the value of any asset of this trust which is includible in my gross estate for federal estate tax purposes to my revocable living trust, known as the:
JOHN DOE, Trustee, or his successors in trust, under the JOHN DOE LIVING TRUST, dated ____________, as may be now or hereafter amended.
The amount so distributed shall be added to the property of my living trust and disposed of in accordance with its terms.
If I die and my living trust is not in existence, the Trustee shall distribute the amount called for under this Section to my spouse, if living. If my spouse is not living, then the distribution shall be made to my descendants, per stirpes.
The value of any asset of this trust distributed under this Section shall be its value as finally determined for federal estate tax purposes.
What are the gift tax consequences to the power holder if the power holder exercises the LPA? If the power holder is also a beneficiary of the ILIT, the power holder will be treated as having made a gift equal to the present value of all possible distributions to the power holder in the year in question. See PLRs 200243026, 9419007 and 9451049. If the power holder is the grantor's spouse and the power is exercised in favor of the grantor, then the unlimited gift tax marital deduction will be available to offset the gift. To avoid gift tax consequences, the grantor should name as the power holder a family member or other trusted individual who is not a beneficiary of the ILIT. The LPA should specifically state that it cannot be exercised to the extent it would impair any existing Crummey withdrawal rights.
A provisions similar to the following can be used to provide the trustee with a limited power of appointment:
During the Grantor's life, the Trustee shall have the limited power (exercisable in a non-fiduciary capacity, either personally or by an attorney-in-fact under a power of attorney, without the consent or approval of any person or entity in a fiduciary capacity) to appoint the principal of the trust to any one or more of the Grantor and the Grantor's descendants (or to a trust for their benefit), whether living at the time of exercise or thereafter born, in whole or in part, or in equal or unequal proportions, subject to the following provisions: If the Trustee resigns, is terminated, or cannot serve for any other reason, then the Trustee's successors in trust shall have the right to exercise this limited power of appointment. The power shall only be exercisable by the holder of the power, and shall not be exercised in favor of the holder, the holder's estate, the holder's creditors, or the creditors of the holder's estate. The power shall not be exercised by the holder in any manner that would result in an economic benefit to the holder or that would in any manner discharge or reduce any legal obligation of the holder, or any legal obligation of the Grantor or the Grantor's spouse. The power shall not be exercised by the holder during any period in which a beneficiary has a right of withdrawal under this Article. The power shall not be exercised by the holder if the value of the principal of the Trust after the exercise would be less than the aggregate amount subject to withdrawal from the trust after the exercise.
Loans to the Grantor or Grantor's Spouse. Another way for a grantor to gain access to trust assets is through loans from the trustee. The loan should be evidenced by a promissory note bearing a rate of interest that is at least equal to the Applicable Federal Rate. While it is possible to accrue interest, it is advisable for the grantor to pay interest annually to avoid an IRS challenge that the loan was a sham.
Upon the grantor's death, the loan and cumulative interest are paid back to the ILIT from the grantor's estate and should be deducible from the grantor's gross estate as a bona fide debt. An added benefit of the loan technique is that the interest payments paid by the grantor to the ILIT are removed from his/her estate. If the ILIT is a grantor trust, the interest payments are not subject to income taxes and are essentially a tax-free gift to the beneficiaries of the ILIT. Rev. Rul. 2004-64. In fact, the grantor's power to borrow from the ILIT without adequate security is one of the provisions that creates grantor trust status. IRC §675(2).
Consider adding the following provision to the trustee powers to allow the trustee to make loans to the grantor:
To lend trust funds to such persons and on such terms, including (but not limited to) interest rates, security, and loan duration, as the Trustee deems advisable, but the Trustee may not lend trust funds to the Grantor without an adequate rate of interest.
DEALING WITH CRUMMEY POWERS
Types of Notice. Unless the beneficiaries of the ILIT are given notice of their withdrawal rights, gifts to the ILIT will not be eligible for the annual gift tax exclusion. See Rev. Rul. 83-108, 1983-2 C.B. and Rev. Rul. 81-7., 1981-1 C.B. 474. Written notice to the beneficiaries of their withdrawal rights is the best evidence of notice. The trust agreement should also permit other forms of notice so that if written notice is not given, the IRS cannot automatically treat all gifts made to the ILIT as taxable gifts.
In PLR 199912016, the IRS determined that a father's contributions to two trusts qualified for the gift tax annual exclusion where the beneficiary had "reasonable" notice of the contributions. Unfortunately, PLR 199912016 did not specify what reasonable notice consists of. Therefore, the trust agreement should require any form of reasonable notice, including written notice, verbal notice, constructive notice, "one-time" notices and even no notice when the beneficiary has actual notice.
In Estate of Carolyn W. Holland v Comm'r, T.C. Memo 1997-302, and PLRs 8008040 and 9030005, no other notice was required where the beneficiary had actual notice of gifts made to the trust (i.e., the beneficiary was a trustee, or a minor beneficiary's legal guardian was a trustee). In addition, in PLRs 8143045, 8133070, 8138102 and 8121069 the IRS recognized a one-time notice which identified when future contributions were expected to be made. A one-time notice is particularly useful for ILITs funded with group term policies. In TAM 9532001, the IRS ruled that it will recognize Crummey withdrawal powers only in those situations in which the beneficiaries receive actual "current" notice of any gifts made to the trust. Thus, current written notice should be the goal, but other types of notice should not be omitted from the trust agreement.
A sample Crummey notice clause might read as follows:
Each power holder shall be kept reasonably informed by the donor or the Trustee of all transfers subject to withdrawal hereto which are made or expected to be made. Such efforts may include annually apprising each power holder of his/her rights to withdraw, providing the power holder with a single notice sufficient to apprise him/her of his/her current and expected future rights to withdraw, or any other means determined by the donor or the Trustee to provide each power holder with reasonable notice. After receiving such notice from the donor or the Trustee at least once, any power holder, or the legal guardian of any power holder, by a written instrument mailed or delivered to the donor or the Trustee, may permit the donor or the Trustee to provide such written notices annually (during the first month of each calendar year) in anticipation of transfers to be made during such year or may altogether waive the donor's or the Trustee's obligation to further provide such written notices. In addition, no notice shall be required to be given to any power holder who has actual notice of his/her withdrawal rights. In no event shall the donor or the Trustee be held liable for failing to give any notice required hereunder, nor shall the failure of any power holder to receive such notice be deemed to abrogate his/her withdrawal rights in accordance with the provisions of this Article. A power holder's right of withdrawal is not contingent upon such notice. Upon request by any power holder, the Trustee shall furnish full, detailed information with respect to any such transfers subject to withdrawal hereunder.
Paying Premiums During the Withdrawal Period. The lapse of a Crummey power is a release of a general power of appointment to the extent the lapse exceeds the greater of $5,000 or 5% of trust principal during the calendar year. IRC §2514(3). By limiting a beneficiary's annual withdrawal power to the greater of $5,000 or 5%, or by using so-called "hanging powers" within those same limits, the beneficiary will not be treated as making a "gift back" to the ILIT of the excess amount. Gift back treatment is to be avoided because the amount in question will not be a present interest gift and, therefore, will result in the beneficiary having to file a gift tax return (Form 709) and using up an equivalent portion of his/her $1,000,000 gift tax exemption. In addition, the gift back will cause the beneficiary to be a transferor of the ILIT for generation skipping tax purposes, thereby possibly wasting a portion of any GST allocation made by the grantor to the ILIT.
The $5,000 or 5% exception refers only to a "lapse" of a power, and not to a "release" or "waiver" of a power. IRC §2514(e). Therefore, a Crummey power should never be released or waived. Does this mean the Trustee has to wait until the withdrawal period ends before paying the premium? If so, this could present problems for the initial premium where the trustee does not want to wait for the withdrawal period to expire before putting the policy in force. It can also be a problem where a premium is past due and the remaining grace period is shorter than the withdrawal period specified in the trust agreement.
Although there is no authority on point, it should be possible to provide in both the trust agreement and in the notice letter that the trustee is permitted to use gifts to pay premiums during the withdrawal period. As long as the Crummey withdrawal power is lapsing (as opposed to being released), the $5,000 or 5% exception should be available. In order for the Crummey withdrawal powers to be legitimate, the trust agreement should allow the trustee to access cash values and to transfer a fractional interest in the policy itself to satisfy any exercised withdrawal powers.
Consider adding the following provision to the standard Crummey withdrawal letter.
□ I wish to exercise my withdrawal right.
□ I hereby acknowledge receipt of notification of my power of withdrawal under the above-named Trust and the addition made to the Trust. I consent to use of the addition to pay premiums on any life insurance policy in the Trust prior to the end of the period for the exercise of my power of withdrawal. Further, I understand that additions will be made to the Trust in future years, and I may be given a power of withdrawal with respect to such additions. Unless I notify you to the contrary, you do not need to notify me regarding future additions when I am given a power of withdrawal.
Signature of Beneficiary or his/her Guardian
if Beneficiary is a Minor
Ability to Change Crummey Power Holders. The trust agreement should give the grantor (or any other donor) the right to cancel or modify a beneficiary's (or contingent beneficiary's) annual withdrawal rights for two reasons. First, a beneficiary may become uncooperative and begin exercising his withdrawal rights thereby thwarting the purpose of the ILIT. Second, if the grantor has a sufficient number of beneficiaries to cover the gifts being made to the ILIT, the grantor may wish (from time to time) to cancel a particular beneficiary's withdrawal right in order to make different annual exclusion gifts to that beneficiary.
In PLR 9834004, the IRS approved a provision in an ILIT which gave the grantor the ability to cancel a beneficiary's withdrawal right, to modify the amount subject to withdrawal, and to change the period during which the beneficiary's withdrawal power could be exercised. The IRS ruled that such a provision would not cause any adverse gift or estate tax consequences.
An example of the grantor/donor's ability to change the Crummey power holders might read as follows:
Notwithstanding the limitations provided in this Article with respect to withdrawal rights of the power holders, the donor making a transfer shall have the right, by acknowledged instrument delivered to the Trustee on or before the date of the specific transfer: (i) to prohibit any or all of the power holders from exercising a withdrawal right with respect to such transfer; (ii) to increase or decrease the amount subject to the withdrawal right of any or all of the power holders with respect to such transfer, except that the amounts subject to the withdrawal right shall not exceed the value of the property transferred at the time of transfer; or (iii) to change the period during which any or all of the power holders may exercise the withdrawal right, including provisions relating to the lapse of such right, with respect to such transfer.
CHANGING THE TERMS OF THE TRUST
Power to Amend. It may be desirable to amend an ILIT to achieve positive tax results and allow administration consistent with the grantor's intent when trust and tax laws and family circumstances change. Clearly, the grantor cannot have the power to amend the trust agreement without adverse estate tax consequences. IRC §§2036(a)(2) and 2038(a)(1). However, the trust agreement can permit a "trust protector" to amend the trust agreement subject to specific limitations.
To avoid any IRS challenge that there was an implied agreement between the grantor and the trust protector as to how the trust protector would carry out his duties, the trust protector should not be related or subordinate to the grantor. IRC §2036. Nor should the trust protector be a beneficiary, unless the trust protector's powers are narrowly defined to avoid the trust protector having a general power of appointment. IRC §2041. Lawyers, accountants and unrelated business-minded friends are often good choices for the trust protector role. Finally, the trust protector must be prohibited from exercising any power that would impair existing Crummey withdrawal rights.
Among the powers typically given a trust protector are the power to amend the ILIT to comply with new tax laws; to amend the provisions regarding the disposition of income or principal to the beneficiaries; to add, remove or change beneficiaries; to amend the financial powers of the trustees; and to amend the provisions relating to the identity, qualifications, succession and removal of trustees. To avoid adverse gift and estate tax consequences, the trust protector should not be able to confer any beneficial or fiduciary interest to the grantor. IRC §2036. Nor should the trust protector be able to confer any beneficial interest to himself/herself, his/her estate, his/her creditors, or the creditors of his/her estate. IRC §§2041 and 2514.
Power to Terminate Trust. Changes in the trust and tax laws or in the grantor's family situation may result in the ILIT no longer serving a useful purpose. Therefore, the trust agreement should permit an independent trustee or trust protector to terminate the ILIT. If a beneficiary-trustee has the power to terminate the trust in his/her sole discretion and as a result of such termination the beneficiary would receive all or a portion of the trust property, the power to terminate could constitute a general power of appointment for estate and gift tax purposes. Treas. Reg. §§20.2041-1(b)(1) and 25.2514-1(b)(1). Therefore, the power to terminate an ILIT should be held by an independent trustee or trust protector. In addition, the spendthrift clause in the trust agreement should allow for the trust to be terminated.
Changing Trust Situs. There are several reasons why it may be desirable to change a trust's situs. For example, beneficiaries may move away from the jurisdiction where the grantor established the ILIT and find it more convenient to deal with a local trustee. In such case, the local trustee may want to administer the trust under local law. Additionally, another state's laws may be better suited to the purposes and needs of the beneficiaries than the state where the trust was originally established. For example, South Dakota, Alaska and Delaware have neither a rule against perpetuities nor a state income tax.
If a change of trust situs is not specifically authorized in the trust agreement, a court order may be required. The situs for state income tax purposes is not necessarily the same as for general law purposes. In addition, if changing trust situs changes the quality, value or timing of any of the powers, beneficial interests or rights of a grandfathered GST trust, the trust will lose its grandfathered status. Therefore, a detailed analysis of the state law of the contemplated new jurisdiction is required to ensure a change in trust situs will accomplish the desired objectives. The trust document and the location of the trustees, beneficiaries and trust assets are all factors that determine situs under applicable state law.
The following language is offered to allow a Trust Protector, to amend the trust, to terminate the trust, and/or to change the trust's situs:
The Trust Protector, in the Trust Protector's sole discretion, by written instrument, delivered to the Trustee may (i) terminate any Trust and accelerate the distribution of proceeds to the current income beneficiary or pro-rata to the current income beneficiaries; (ii) amend any Trust (except as to any provision in any Trust which was necessary for a gift tax exclusion) in order to (A) achieve tax advantages, (B) react to changes in the Internal Revenue Code, Treasury Regulations, Revenue Rulings or court cases which adversely affect the tax benefits otherwise available with respect to the Trust, or (C) react to changes in the Internal Revenue Code (including but not limited to the scheduled repeal of the Federal Estate Tax), Treasury Regulations, Revenue Rulings or court cases which present advantages to the beneficiaries of the Trust; (iii) amend the Trust administrative provisions relating to the identity, qualifications, succession, removal, and appointment of the Trustee; (iv) to change the situs and governing law of any trust created hereunder; (v) amend the financial powers of the Trustee; (vi) change the terms of any power of appointment; (vii) change the terms of any spendthrift provision; (viii) restrict in any way determined by the Trust Protector to be beneficial to the trust or a beneficiary, revocably or irrevocably, the future exercise of any power held by any beneficiary or Trustee hereunder; (ix) add or delete a provision granting the discretion to a trustee (who is not related or subordinate to the Grantor as defined in IRC Section 672) to reimburse the appropriate taxing authorities on behalf of the Grantor the amount by which the Grantor's taxes are increased as a result of the inclusion of the gains realized by, or the income from, any trust assets in the Grantor's taxable income; and (x) amend the terms of any Trust created under this instrument with respect to (A) the purposes for which the Trustee may distribute trust income and principal, and the circumstances and factors the Trustee may take into account in making such distributions; and (B) the termination date of the Trust, either by extending or shortening the termination date (but not beyond any applicable perpetuities period).
The Trust Protector may make a permitted amendment retroactively to the inception of the Trust. Any such amendment may be made by an instrument in writing signed by the Trust Protector, and a copy of the amendment shall be delivered to the Trustee and each adult beneficiary of the Trust to whom income may then be payable or permitted to be paid hereunder and to the natural or legal guardian, if any, of each such minor or otherwise legally disabled beneficiary.
Grantor Trust Status and Changing Policies. ILITs should be designed as "grantor" trusts (for income tax purposes only) under IRC §§673 through 677 for several reasons. First, if income producing assets are gifted to the ILIT to provide cash flow 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. Rev. Rul. 2004-64. The same favorable income tax result would occur if an ILIT sold a policy in the life settlement market and incurred a gain on the sale.
Second, if the grantor wishes to sell a policy owned by an existing ILIT to a new ILIT (with provisions more to the grantor's liking), the IRS has ruled that if both ILITs are grantor trusts, transfers between the two ILITs are disregarded for income tax purposes. Rev. Rul. 2007-13. Thus, the transfer-for-value rule of IRC §101(a)(2) is not triggered. Moreover, if the existing ILIT is not a grantor trust but the new ILIT is, the sale of a policy insuring the grantor's life to the new ILIT does not trigger the transfer-for-value rule because of the exception to that rule for transfers to the insured. Rev. Rul. 2007-13. In addition, the three-year rule of IRC §2035 will not apply because that Section only deals with gifts and not to bona fide sales for full and adequate consideration. IRC §2035(b)(1).
When selling policies to or between ILITs, in order to avoid potential gift tax issues and to fall within the bona fide sale exception of IRC §2035(b)(1), the purchase price must be the policy's fair market value. Generally, that value is the policy's interpolated terminal reserve amount plus the unearned premium. Treas. Reg. §25.2512-6(a), Ex. 4. Where the insured is uninsurable or in poor health, the interpolated terminal reserve value may be less than fair market value. See Estate of Pritchard v Comm'r, 4 TC 204 (1944) and Treas. Reg. §25-2512-1. Therefore, in situations where the insured is uninsurable or in poor health, it may be advisable to obtain the fair market value of a policy by pricing the policy in the life settlement market. In addition, if there are potential purchasers for the policy in the after-market, the after-market value may trump the traditional life insurance valuation rules (which predate the life settlement market) in favor of the willing buyer/seller test of Treas. Reg. Sec. 25.2512-1.
Grantor trust status is achieved by intentionally violating one or more of the grantor trust rules of IRC §671 et. seq. so that both the income and principal of the trust are taxed to the grantor. However, care must be taken because some of the provisions that trigger grantor trust status will also cause trust assets to be included in the grantor's gross estate. Therefore, the trust must be designed to avoid inclusion in the grantor's gross estate while still imputing the income tax liability to the grantor. While a number of provisions can be added to a trust to accomplish grantor trust status without estate tax inclusion, the following three provisions are commonly used: (1) the power under IRC §675(4)(C) in the grantor to substitute trust assets with assets of equivalent value; (2) the power in the grantor to borrow from the trust without adequate security; and (3) the power under IRC §674(b)(5) in a nonadverse party to add beneficiaries to the trust (except after-born or after-adopted children). A "nonadverse party" is generally a person who does not have a beneficial interest in the trust. IRC §672(a)-(b). The power to add beneficiaries should not be held by the grantor (or any person related or subordinate to the grantor within the meaning of IRC §672(c) so as to avoid inclusion in the grantor's estate under IRC Section 2036(a)(2).
For many practitioners, the grantor trust "trigger" of choice is the grantor's power to substitute trust property with other property of equivalent value. But there was concern that the power of substitution could cause the value of the trust property to be included in the grantor's estate under either IRC §2036 (transfers with retained life estate) or 2038 (revocable transfers). That concern was laid to rest by Revenue Ruling 2008-22, wherein the IRS ruled that "a grantor's retained power, exercisable in a non-fiduciary capacity, to acquire property held in trust by substituting property of equivalent value will not, by itself, cause the value of the trust corpus to be includible in the grantor's gross estate under either Code Section 2036 [transfers with retained life estate] or Section 2038 [revocable transfers]."
The favorable result described in Revenue Ruling 2008-22 is conditioned on certain limitations and requirements being imposed on the trustee through local law or the trust instrument itself. The trustee must have a fiduciary obligation to ensure that the properties acquired through substitution are equal in value. In addition, the trustee must either have the power to reinvest the trust corpus and a duty of impartiality that would ensure that the substitution power is not being used to shift benefits among beneficiaries, or it must be clear that the nature of the trust's investments or the level of income produced by the trust does not impact the respective interests of the beneficiaries. Revenue Ruling 2008-22 is a very important and helpful ruling. However, care must be taken to meet all the conditions that the IRS set out in the ruling.
Because of some uncertainty created by the IRS regarding the effectiveness of creating grantor trust status, many practitioners recommend including two or three grantor trust powers in the trust agreement. Sample language for establishing (and subsequently revoking) grantor trust status using all three of the power discussed above, assuming the trustee is a nonadverse party (and not related or subordinate to the grantor), might read as follows:
The provisions of this Paragraph shall apply to each trust held under this instrument:
1. Notwithstanding any provision of this Agreement to the contrary, the Grantor may (acting in a non-fiduciary capacity):
a. borrow the trust property without adequate security, at such interest rate as determined by the trustee; and/or
b. reacquire all or any part of the trust property by substituting other property of equivalent value.
Provided, however, that the Grantor may not borrow or reacquire any stock of a controlled corporation as defined in Section 2036(b) of the Code or any property that would cause the Grantor to have an incident of ownership, as defined in Section 2042 of the Code, with respect to any insurance policies on the Grantor's life held as a part of the trust property.
The Grantor's possession and exercise of the power of substitution shall be construed and exercised in a manner consistent with Revenue Ruling 2008-22, 2008-16 IRB 796.
The Grantor may release the foregoing powers, revocably or irrevocably, at any time by a duly acknowledged instrument delivered to the trustee.
2. At any time during the Grantor's lifetime, the [name of powerholder] (acting in a nonfiduciary capacity) may, in [his / her] sole discretion, add any charitable organization as a beneficiary of any trust created hereunder, and determine the terms and conditions under which such charitable organization shall be a beneficiary.
[Name of powerholder] may release the foregoing power to add beneficiaries, revocably or irrevocably, at any time, by a duly acknowledged instrument delivered to the Trustee and to the beneficiaries.
Spendthrift Clause. Nearly every trust agreement will contain a spendthrift provision. A spendthrift clause prevents a beneficiary's creditors from taking the beneficiary's trust property before it is distributed. Most spendthrift clauses not only prohibit creditors from attaching trust assets, but also prohibit the beneficiary from making any assignment of his interest in the trust. However, in order to minimize transfer taxes in the future, it may be advisable to allow the beneficiary to sell and/or gift all or a portion of his beneficial interests to charity, family members and/or other beneficiaries.
The following spendthrift provision is offered as an example:
To the extent permitted by law, a beneficiary's interest hereunder shall not be subject to liabilities or creditor claims or to assignment or anticipation. However, this provision shall not restrict the exercise of a disclaimer or the exercise of a power of appointment or withdrawal right granted by this Agreement, nor shall it prevent or prohibit the termination of a trust or the sale, gift or transfer of beneficial interests to charity or between family members and/or beneficiaries.
DEALING WITH TRUSTEES
Removing and Replacing Trustees. It is usually a good idea to include a provision in an ILIT giving the grantor and, after the grantor's death, the beneficiaries the right to remove and replace trustees. Otherwise, judicial action will be required to remove a trustee who is unresponsive or ineffective, or whose fees are not competitive.
In Rev. Rul. 95-58, the IRS ruled that the grantor's power to remove and replace trustees is not a reservation of the trustee's discretionary powers of distribution that might cause the trust property to be included in the grantor's estate under IRC §2036. Rev. Rul. 95-58 also held that any successor trustee must not be related or subordinate to the grantor within the meaning of IRC §672(c). In PLR 9607008, the IRS extended its holding in Rev. Rul. 95-58 to beneficiaries who are given the right to remove and replace trustees.
Is the use of IRC §672(c) appropriate? IRC §672(c) is an income tax standard used in the grantor trust rules and, prior to Rev. Rul. 95-58, had no estate tax significance. The requirement of a trustee who is not related or subordinate to the grantor or beneficiaries does not have any support under IRC §2036(a)(2) nor §2038(a)(1) or the Regulations promulgated thereunder. In addition, reliance on IRC §672(c) is inconsistent with the Tax Court's holding in Estate of Wall, 101 T.C. 300 (1993). Nevertheless, most clients will be more willing to accept the IRC §672(c) limitation than face a possible IRS challenge.
Sample wording for the removal and replacement of trustees might look like this:
The grantor reserves the right to remove any incumbent Trustee or Co-Trustee and any successor Trustee designated to act in the future and appoint a successor individual or Independent Trustee or a series of successor individual or Independent Trustees or Co-Trustees. As a condition precedent to removing a Trustee or Co-Trustee hereunder, the grantor must first appoint an Independent Trustee (if no successor Trustee has already been named herein), as such term is defined below.
After the grantor's death, or during any period that the grantor is disabled, the grantor's spouse may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a series of successor Independent Trustees or Co-Trustees. As a condition precedent to removing a Trustee or Co-Trustee hereunder, the grantor's spouse shall first appoint an Independent Trustee (if no successor Trustee has already been named herein) or a series of successor Independent Trustees, as such term is defined below.
After the death or disability of the grantor's spouse, a majority of the beneficiaries (with any beneficiary under a legal disability acting through his/her Agent) then eligible to receive mandatory or discretionary distributions of net income under this agreement may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a series of successor Independent Trustees or Co-Trustees. In addition, each beneficiary (with any beneficiary under a legal disability acting through his/her Agent) for whom a separate trust is named or established hereunder may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a series of successor Independent Trustees or Co-Trustees with respect to his/her separate trust. As a condition precedent to removing a Trustee or Co-Trustee hereunder, the grantor's beneficiaries (or their Agent as the case may be) shall first appoint a successor Independent Trustee (if no successor Trustee has already been named herein) or a series of successor Independent Trustees, as such term is defined below. In no event shall the grantor serve as a Trustee hereunder. Notwithstanding the foregoing, at such time as a beneficiary is acting as a co-trustee of a trust named or established hereunder for such beneficiary, the beneficiary need not appoint a replacement for a co-trustee being removed if there is at least one other co-trustee then serving with the beneficiary, it being the grantor's intention that there be at least two co-trustees serving at all times.
The beneficiaries need not give any Trustee being removed any reason, cause, or ground for such removal. Notice of removal shall be effective when made in writing by either: Personally delivering notice to the Trustee and securing a written receipt, or Mailing notice in the United States mail to the last known address of the Trustee by certified mail, return receipt requested.
As used in this instrument, the term "Independent Trustee" means a person: (i) who is not related or subordinate (within the meaning of IRC Section 672(c)) to any donor or beneficiary with respect to the trust in question; (ii) who cannot be benefited by the exercise or non-exercise of any power given the Trustee by this Trust Agreement or by law; (iii) who is neither a beneficiary nor a donor of the trust in question; and (iv) who is experienced in business, finance or investments or is an attorney or accountant experienced in the areas of trusts or taxes. In the event that any Independent Trustee should for any reason cease to meet such qualifications, he or she shall immediately cease to be a Trustee as though he or she had resigned immediately prior to the occurrence of such disqualification.
Liability Protection for Trustees. Many times during the grantor's lifetime, the trustee of an ILIT is a family member or close advisor. If a corporate trustee is named in the trust agreement, the corporate trustee will usually not serve until the grantor's death, at which time the ILIT receives the insurance proceeds. In such cases, the initial trustee may not be qualified to properly select any new policies to be purchased by the ILIT or to evaluate any existing policies transferred to the ILIT.
The terms of a trust generally determine a trustee's duties. In re Estate of Butterfield, 418 Mich 241, 341 NW2d 453 (1983). Generally, the grantor can limit a trustee's liability except for actions committed in bad faith. See Restatement (Second) of Trusts §§164 and 222. Therefore, to protect a non-professional trustee, the trust agreement should contain a provision limiting the trustee's liability with respect to those life insurance policies selected by the grantor. The trust agreement should also indemnify the trustee from any liability resulting from his reliance on a life insurance agent's representations.
Consider the use of the following provision to limit a trustee's liability:
The Trustee, conclusively and without inquiry or independent investigation, may rely upon the representations of any person selling or in any way associated with the marketing, promotion or sale of a given life insurance policy regarding the relative quality of such policy (as compared to other available policies) or regarding the absolute quality of such policy (without regard to other available policies). Specifically, but not by way of limitation, the Trustee at no tie shall have any duty whatsoever (i) to verify that any particular life insurance policy satisfies the requirements for a life insurance contract under IRC Section 7702; (ii) to compare the performance or pricing or the projected performance or pricing of a particular life insurance policy with the performance or pricing or projected performance or pricing of any other life insurance policy which may then be available from any source; (iii) to assess the appropriateness of purchasing or retaining any life insurance policy as an asset of the trust as compared to other then-available vehicles that are not life insurance policies; or (iv) to investigate the strength or solvency of the company which issued or is offering a given life insurance company policy. The Trustee may retain any life insurance policy purchased by the Trustee or transferred to the Trustee by the Grantor, a predecessor Trustee, or any other person, and the Trustee shall have no duty at any time to make any inquiry or investigation into the advisability of such retention (including, but not limited to, inquiry or investigation into the same or similar matters set forth above). With respect to any such policies retained by the Trustee, the Trustee shall have no liability to the Grantor or to any present or future beneficiary of the Trust for non-productivity, decline in value or lack of diversification of the trust assets. The fact that the Trustee may have made inquiry regarding any such matter prior to the acquisition of a policy or after the acquisition of such policy shall place no duty upon the Trustee to make any further inquiry, but shall be considered activity beyond the scope of the Trustee's duties. The Trustee shall not be liable to the Grantor nor to any present or future beneficiary of the Trust for any loss or damage suffered in connection with performance or lack of performance of any life insurance policy owned by the Trust or by the insolvency of any life insurance company issuing any such policy. The Trustee's duties and responsibilities with respect to any life insurance policy owned by the Trust, until such policy matures or is surrendered or otherwise disposed of, are to provide safekeeping services with respect to the policy, and to pay premiums as and when they come due or, under the terms of the policy, may be paid, if, but only if, the Trustee has sufficient available funds to do so. Grantor specifically acknowledges that the Trustee would not accept the position of Trustee unless the Trustee's duties, responsibilities, and liabilities were limited as set out herein.
DEALING WITH BENEFICIARIES
Testamentary Limited Power of Appointment. A testamentary limited power of appointment ("LPA") allows the beneficiary to change the dispositive terms of the trust. An LPA can be used to adapt to changed circumstances that were unknown at the time the trust was drafted. A testamentary LPA is particularly useful in ILITs with generation skipping provisions because of the long duration of the trust. The power can be given to a beneficiary without federal transfer tax consequences. IRC §2041.
Usually, the LPA limits the permissible appointees to the grantor's descendants. However, the appointees may include anyone other than the power holder, the power holder's estate, the power holder's creditors, or the creditors of the power holder's estate. For example, the LPA can include any or all of the following as permissible appointees: charities, spouses of the grantor's descendants, or an income interest for the benefit of a spouse of the grantor's descendants. The LPA can also be designed to allow the power holder to direct that appointed assets be held in further trust for the appointee.
A sample testamentary limited power of appointment clause might read as follows:
Each beneficiary for whom a trust is named shall have the limited testamentary power to appoint the remaining property in his/her trust to, or in trust for the benefit of, a person or persons among my then living descendants, the spouse of a descendant of mine, or such religious, scientific, charitable or educational organizations described in IRC Section 501(c)(3), in such proportions and upon such terms and conditions and estates, with the powers, in the manner and at the times as the beneficiary appoints by a valid last will or by a valid living trust agreement which specifically refers to this power, provided, however, that any property allocated to the spouse of a descendant of mine shall be held in trust and the trust must provide that (i) only income, but not principal, may be distributed to the spouse, (ii) the spouse shall not be a trustee of such trust, (iii) the trust will terminate no later than the spouse's death (and the trust may terminate earlier on events such as the spouse's remarriage or cohabitation with an unrelated person), and (iv) upon termination, the trust property shall be allocated or distributed (in a manner designated by the beneficiary) among my then living descendants.
Creditor Protection. Many grantors want the assets in the ILIT to either be distributed to the beneficiaries at stated ages (e.g. one-third at ages 25, 30 and 35) or they want to permit the ILIT beneficiaries to withdraw assets at those ages. In either case, the trust assets will be subject to the claims of a beneficiary's creditors, including divorced spouses. Therefore, the trust agreement should permit an independent trustee (or co-trustee) to postpone distributions to a beneficiary beyond the stated ages for certain reasons (i.e., a pending divorce, bankruptcy, etc.). Such a provision, coupled with a spendthrift clause, will protect the beneficiaries from their inability, their disability, their creditors and their predators.
The following language is offered to achieve that result:
The Trustee shall have the power to refuse a withdrawal request or to postpone any distributions of principal otherwise required to a beneficiary upon or after the beneficiary's attainment of a specified age or the death of a third person, and to postpone the termination of such trust which might otherwise be required, all as if such withdrawal right had not been available, or such age had not been attained, or such death had not occurred, if the Trustee, in its sole discretion, determines that such refusal or postponement is consistent with my overall intent. In exercising such discretion, I authorize and approve the Trustee's use of such information as may be available and pertinent, such as the beneficiary's serious physical or mental disability, the beneficiary's addiction to drugs or alcohol, the beneficiary's incarceration, a pending divorce, a gambling problem, the beneficiary's involvement in a "cult" type organization, the involvement of the beneficiary as a defendant in a civil or criminal lawsuit or in any bankruptcy proceeding, present or imminent financial difficulty, a serious tax disadvantage in making a distribution, or similar substantial cause. Any such refusal or postponement may be continued by the Trustee from time to time, up to and including the entire lifetime of the beneficiary. The Trustee's exercise of discretion in such refusal or postponement shall be final and binding upon all parties in interest. No Trustee shall at any time be held liable for any action taken or not taken pursuant to this Section, nor shall any Trustee be required to take any affirmative action pursuant hereto, and no Trustee shall be required to inquire into or investigate any beneficiary's status as it may relate to this Section. Notwithstanding anything contained in this Article to the contrary, during any period of time that a beneficiary's distributions are being postponed pursuant to the foregoing provisions, the Trustee may also distribute the income and/or principal of such beneficiary's trust to or for the benefit of the beneficiary's spouse and descendants (if any) for said spouse's and descendants' health, education, maintenance and support. The Trustee may make unequal distributions to said spouse and descendants or may at any time make a distribution to fewer than all of them, and shall have no duty to equalize those distributions.
Beneficiary-Controlled Trusts. In lieu of distributing trust assets to beneficiaries outright, consideration should be given to leaving the assets in trust for the beneficiary's lifetime. With a beneficiary-controlled trust, the beneficiary is a co-trustee over his/her trust and has the right to remove and replace trustees (with someone who is not related or subordinate to the beneficiary, as defined in IRC §672(c)). Having a co-trustee along with the beneficiary ensures that the ILIT's spendthrift clause will be upheld. The trust agreement usually allows the trustees to distribute income and principal to the beneficiary and his/her descendants. In addition, the beneficiary typically is the "primary" beneficiary and, therefore, his/her needs take priority over those of his/her descendants. More importantly, the trust agreement allows the trustee to acquire assets such as vacation homes and art work for the beneficiary's use and enjoyment (without remuneration). The trustees can also use trust assets to invest in a business that can employ the beneficiary.
Upon the beneficiary's death, the assets remaining in the trust can be distributed by the beneficiary according to a testamentary limited power of appointment. If the limited power of appointment is not exercised, the trust property could pass to the beneficiaries' descendants, per stirpes. Subject to the governing rule against perpetuities, the trust can continue for the primary beneficiary's descendants upon the same terms.
There are several advantages to using beneficiary-controlled trusts. First, the assets remaining in trust for the beneficiary's use and enjoyment are protected from creditors, including divorced spouses. Second, the grantor controls who the remaindermen are upon the beneficiary's death, thereby ensuring trust property stays in the family. Third, to the extent of the grantor's generation skipping tax exemption allocated to the ILIT, the assets remaining in the trust are not subject to future estate taxes. Finally, the beneficiary's ability to name a "friendly" trustee and to act as a co-trustee over his/her trust is as close to outright ownership that one can have, while still enjoying protection from creditors, divorce and future estate taxes.
Disabled Beneficiaries. A thorough discussion of the Medicaid program for Supplemental Security Income ("SSI") recipients is beyond the scope of this article. However, if an ILIT provides a beneficiary with so much of the income and principal, or either, as is necessary for the support of the beneficiary, the trust is referred to as a "support" trust. If the beneficiary of a support trust is receiving SSI or becomes eligible for SSI after the ILIT is established, then the support trust may be subject to claims for reimbursement by the governing state.
It is advisable to include a "fail-safe" provision in the trust agreement which "converts" a support trust into a discretionary supplemental trust if the beneficiary becomes eligible for SSI. A discretionary supplemental trust allows the trustee, in the trustee's sole discretion, to provide the beneficiary with income and principal as needed for the beneficiary's general welfare without disqualifying the beneficiary for public assistance. Generally, the discretionary trust provides the beneficiary with basic needs not being covered by public assistance. Since the beneficiary does not have an ascertainable interest in a discretionary trust, the beneficiary's creditors may not be able to reach the assets in the trust.
Consider the use of the following provision to protect a beneficiary receiving governmental assistance:
Whenever a beneficiary (the "disabled beneficiary") of any trust created hereunder is eligible for any public benefits to provide for his/her basic support and maintenance (i.e., SSI, SSDI, Medicaid, etc.), then during the term of such trust, I direct that distributions from such trust shall be used solely for supplementing those benefits which are available to him/her. Inasmuch as possible, the Trustee is to administer such trust so that the disabled beneficiary's eligibility for public governmental assistance programs is not endangered. Under no circumstances shall the disabled beneficiary have the power or authority to demand any distribution from the Trustee, and the Trustee is under no obligation, implied or otherwise, to make any distributions to the disabled beneficiary. Further, the Trustee may withhold distributions to the disabled beneficiary if, in the Trustee's sole discretion, they would not be consistent with my intentions as expressed above. The Trustee has full discretion to spend a disabled beneficiary's trust income or principal, or not to spend it, as the Trustee sees fit. The disabled beneficiary shall have no legal right to the trust's assets, even in the case of an emergency. Notwithstanding anything contained in this Agreement to the contrary, neither the Trustee nor any Trust Protector shall have the right to terminate any trust established for a disabled beneficiary.
Change in Marital Status. In the typical ILIT that holds a policy on a married grantor's life, the grantor's surviving spouse is given a life estate in the trust assets after the grantor's death. The spouse may also be named as a trustee of the ILIT. In addition, the spouse may have a limited power of appointment during the grantor's lifetime over trust property, and the grantor's in-laws may be named as a trustees, power holders, or even beneficiaries or contingent beneficiaries under the trust agreement.
In the event of divorce, most grantors will no longer want their spouse (or their in-laws) to be beneficiaries, trustees or power holders under their ILIT. Therefore, the trust agreement should provide that, in the event of legal separation or divorce, the grantor's spouse and in-laws shall be deemed for all purposes of interpreting the trust agreement to have predeceased the grantor. Alternatively, the grantor's "spouse" can be defined in the trust agreement to mean that person the grantor is married to at the time of the grantor's death.
Sample wording in the event of the grantor's divorce might read as follows:
In the event the grantor and the grantor's spouse become divorced or legally separated, the grantor's spouse and the grantor's spouse's relatives (who are not also the grantor's blood relatives) shall be deemed to have predeceased the grantor for all purposes of interpreting this Agreement (other than for purposes of the "rule against perpetuities" provisions under this Agreement). In the event a descendant of the grantor and the grantor's spouse become divorced or legally separated, such spouse and said spouse's relatives (who are not also the grantor's blood relatives), shall be deemed to have predeceased the grantor for all purposes of this Agreement (other than for purposes of the "rule against perpetuities" provisions under this Agreement).
In drafting an ILIT, attorneys should resist the temptation to draft too "tightly". Language allowing the trustees and beneficiaries to take into account changed circumstances and trust and tax laws is extremely important. While an ILIT appears by its nature to be an inflexible instrument to most clients, it is easy to build flexibility into the ILIT from inception.
THIS ARTICLE MAY NOT BE USED
FOR PENALTY PROTECTION