Unwinding Irrevocable Life Insurance Trusts

     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. 

Matt Ferrara

Transferring Insurance Policies to ILITS

Because of the larger estate tax exclusion of $5,000,000 per person (already $5,125,000 because of the cost of living increase), many clients no longer need an Irrevocable Trust to own their life insurance in order to avoid tax on the proceeds at death. However, an Irrevocable Trust is still an important planning tool for those whose estates already exceed the estate tax exclusion or for those whose estates increase in value faster than anticipated. 

            We previously discussed the basic concepts of an Irrevocable Life Insurance Trust (ILIT), but today we want to focus on how policies are transferred to the ILIT.  There is an estate tax rule that requires the inclusion in a decedent’s estate of life insurance transferred within three years of death.  Because of this rule, the ideal planning technique is for Grantor to execute the ILIT and then for the Trustee to apply for new insurance on the life of the ILIT’s Grantor.  If the Trust is the initial owner and beneficiary of the life insurance policy, and the Grantor never had any incidents of ownership in the policy, the three-year inclusion rule does not apply.  

            If there is existing insurance, a client will often set up an ILIT, have the trustee apply for a new policy, and then terminate the old policy when the new policy is issued with the Trust as the owner.  This protects the Grantor if the new insurance application is declined.  There is usually no need to have twice the insurance coverage, but you want to maintain the existing coverage until the new policy is issued and effective.

            Sometimes there is a need for an ILIT, but the Grantor is unable to secure new insurance coverage or the coverage is too expensive because of age or health issues.  At these times you utilize the next best strategy and transfer an existing policy to an ILIT, knowing the three year inclusion rule applies.  You need to remember that the value of the policy at the time of the transfer is a gift.  In addition, any amounts gifted to the ILIT and later used for payment of premiums are gifts.  If the policy transferred is a term policy, there is probably little value other than the unused premiums for the policy year in question.  However, if the policy is an existing permanent policy, there may be significant cash value requiring consideration for gift tax purposes.  The Crummey rules require notice be given to Crummey beneficiaries so that the gift can be considered a present gift and allow use of the annual gift exclusion.  However, if the total of premiums and cash value of transferred policies exceeds the total of Crummey beneficiaries times $14,000, a portion of the gift will not qualify for the annual exclusion.  Any gift in excess of the available annual exclusions is considered a future gift and will use a portion of the Grantor’s lifetime exclusion.

            Planning for policy transfers can be tricky and confusing and should be done with the guidance of professionals qualified in both insurance and tax issues.

Alan Ferrara