On Tuesday,
we addressed the technique of funding insurance policies to an Irrevocable
Trust and using the annual gift exclusion to make premium payments. For those
clients with potential estate tax liability this technique allows them to help
fund the estate tax liability at a fraction of the actual cost because policy
proceeds at death that will not be includable in the client's estate will more
than offset the premiums paid during lifetime. When collected by the
Irrevocable Trust, the proceeds can be used to purchase assets from the Living
Trust or loan funds to the Living Trust to pay estate taxes until illiquid
assets are sold.
However, what happens if circumstances change and the
purpose for which the Irrevocable Trust was created no longer exist, or if the
client has a change of heart about owning the policies? Since the trust is
irrevocable, the client cannot unwind the trust through revocation. The client
can however discontinue annual gifts to the trust (and its lifetime trust
beneficiaries), leaving the Trustee of the Irrevocable Trust without any assets
to pay the life insurance premiums. Eventually the insurance coverage will
lapse leaving the trust without any assets, at which point the trust ceases to
exist as a matter of law.
Alternatively, as part of the initial planning for the
Irrevocable Trust, specially added provisions may allow the Grantor to unwind
the trust despite its irrevocable nature. One strategy is to structure the Irrevocable
Trust as a "Grantor Trust”. If properly drafted, the Trust can be treated as
property of the Grantor for the purposes of income tax liability, excludable
from the Grantor's estate for estate tax purposes. If the trust holds only life
insurance there should be no income, presuming the Trustee uses all of the
gifts made to the trust by the client to pay the premiums on the life insurance
owned by the trust, and there should be
no impact on the client’s income tax liability.
The Internal
Revenue Code Sections 671-678 detail the circumstances under which the
grantor trust rules apply. One of those provisions gives the Grantor the right to substitute assets of
equivalent value for the assets held by the trust. This allows the Grantor to
substitute or exchange other assets equaling the value of the insurance policies
contained in the trust for the life insurance policies themselves. Those assets
are still subject to the distribution terms of the trust.
As with any advanced estate planning technique, including
the creation or termination of irrevocable trusts, advice and counsel of
experienced attorneys is important in order to avoid unintended consequences.
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