Irrevocable Life Insurance Trusts
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A Trust is an arrangement in which an individual or an entity, such as a corporation or bank, is given property to hold and manage for the benefit of one or more third parties. The benefits of this kind of arrangement are many. Trusts and Trust-like arrangements created upon the death of a property owner have been utilized for centuries. Such arrangements that take effect during the lifetime of a property owner are a more recent Trust development but essentially serve the same purposes.
The law that governs Trust arrangements today can be traced back through English Law to Roman Law. Current Trust law is complex. It defines the roles and responsibilities of all parties involved in a Trust arrangement, specifies the manner in which Trusts must be written, and sets forth what can and cannot be accomplished with a Trust arrangement. There are many different types of Trusts, each of which serves a specific purpose. One of the most common types of Trusts is the Irrevocable Life Insurance Trust.
Every Trust involves a number of parties:
- At least one individual who transfers property into the Trust
- One party—which can be an individual or bank or other entity—who holds and manages the property received by the Trust
- At least one individual for whose benefit the property is held and managed
The person transferring property into the Trust is almost always the one who creates it. This person is called a Grantor, a settlor, or, more simply, the creator of the Trust. The party who holds and manages the property in a Trust is the Trustee. The individual for whom the property is held and managed is the Beneficiary.
While this description of the participants in a Trust arrangement suggests only a single Grantor, Trustee, or Beneficiary, this is not always the case. It is possible for more than one individual to be the Grantor and transfer property into a single Trust. Depending on the circumstances surrounding the establishment of the Trust and who is chosen to hold and manage the Trust property, it is often more beneficial to have multiple Trustees rather than a single Trustee.
And certainly, since the vast majority of Trusts are created to benefit a Grantor’s spouse and heirs—children, grandchildren, and perhaps even great-grandchildren—there can be multiple Trust Beneficiaries. It is possible as well, however, for a Grantor to establish a Trust solely for personal benefit, in which case there might be as few as two individuals involved in the Trust: a single Grantor, who is also the Beneficiary, and a single Trustee.
The role of the Grantor, which will be discussed later in this course, and the role of the Beneficiary in a Trust arrangement are quite simple. The Grantor transfers property into the Trust, and the Beneficiary receives benefits associated with that property, either from Trust income or from Trust principal. The Beneficiary may receive a benefit immediately or at some specified or unspecified time in the future. The role of the Trustee, however, is more complex. The Trustee serves as intermediary between the other two parties to the Trust and acts in the capacity of a Fiduciary.
When property is transferred into a Trust, the ownership of the property is split into two interests. The first is a nominal or legal ownership interest. This interest is held by the Trustee in a fiduciary capacity. It allows the Trustee to manage the property in the Trust as if the Trustee owned the property personally. The second Ownership Interest is an Equitable or Beneficial Ownership Interest.
This interest vests in the Trust Beneficiaries, except in those Trusts specifically created to benefit the Grantor, only third-party Beneficiaries of the Trust can enjoy benefits from Trust Income or Principal. Aside from receiving a fee for providing services, the Trustee is NOT allowed to benefit personally from any transactions involving Trust assets.
The prohibition against personally benefiting from transactions involving Trust assets is central to the Trustee’s fiduciary role. A fiduciary, as one who manages property for another’s benefit, is obligated to always act in the best interests of Trust Beneficiaries.
A Trustee should be competent; that is, able to fulfill the duties required under the Trust’s provisions, including the ability to manage the assets held in the Trust. This includes both the ability to understand the nature of the assets held in the Trust and to manage those assets personally.
A Trustee must act in the best interests of the Trust Beneficiaries. This may seem simple and straightforward on the surface, but it can become a complex issue for a Trustee to negotiate. For example, it is possible that a transaction that clearly should be undertaken for the benefit of Trust Beneficiaries might have a negative impact on one of the Trustee’s close associates, a member of the Trustee’s family, or perhaps the Trustee personally.
Or, a Trust created to provide income currently to one Beneficiary and principal to another at some future date may raise issues. With each investment decision, the Trustee will have to weigh both the rights of the Trust’s income Beneficiaries and the principal Beneficiaries.
A Trustee also needs to understand the Grantor’s objectives as expressed in the Trust document because the Trustee is under a legal obligation to implement these directions. A Trustee must also be capable of serving, physically, mentally, and emotionally. It is also important to choose a Trustee who can operate as an impartial third party with respect to Beneficiaries and others involved with the Trust assets.
There should be no conflict between the Trustee and others who provide services to the Trust, such as Investment Advisers, whether family members or not. Finally, there should be no conflict between the Trustee and the Beneficiaries, whether over their lifestyle choices, career decisions, personal relationships, or use of Trust assets.
Trust documents are written, or drafted, by qualified attorneys. When a Trust document has been drafted, reviewed, and accepted by a Grantor, the Grantor then executes the document, which means that he or she must sign and date the Trust agreement and have it witnessed by disinterested third parties.
At this point, property can be placed in the Trust. This property is called the Trust Corpus, Principal, or Res, or more simply the Trust assets. When the Trust is established during a Grantor’s lifetime, it is called an Inter Vivos, or Living Trust. When established at death through the Grantor’s will, the Trust is called a Testamentary Trust.
Beneficiaries named in the Trust generally fall into two categories:
Primary and Contingent
Trusts may also contain provisions specifying what property or how much asset value goes to each Beneficiary. Very commonly, however, distributions to family members are done on either a per stripes or a per capita basis. Per stripes means “by the branches or stocks.” Per capita means by the number of “heads” that can be counted.
The general purpose of any Trust arrangement is to hold and manage property. An equally important purpose is to facilitate the transfer of that property to designated Beneficiaries in the most tax-efficient manner.
While there are many reasons why a Trust would be attractive to a property owner, three of them stand out:
- Transfer of control of property – One of the most common reasons to establish a Trust is to provide specialized, competent asset management. This may be critically important if the Beneficiary receives an inheritance but lacks the financial expertise to manage the assets.
- Maintenance of control over property – The creator or Grantors of the Trust can maintain some control over how Trust assets are distributed in the future by including certain provisions in the Irrevocable Trust. For example, The creator can give the Trustee the discretionary power to distribute Trust assets to Beneficiaries in varying amounts, depending on the Beneficiary’s financial needs and can also include provisions in the Trust that direct the Trustee to pay only income to certain Trust Beneficiaries, with the principal to be left to future grandchildren.
- Tax Advantages – Grantors often create Irrevocable Trusts because of the significant income and estate tax advantages these Trusts offer. Notably, the property placed in the Trust typically will not be included in the Grantor’s estate for federal estate tax purposes. Because the value of the estate is lower, the estate tax bill will be reduced, resulting in more cash that’s available to help pay estate settlement costs. In addition, the Trust’s income is generally not taxed to the Grantor, as long as the Grantor retains no interest in the Trust. The Trust itself must pay income tax on accumulated earnings, while the Trust Beneficiaries must pay income tax on Trust income distributed to them.
When an Irrevocable Life Insurance Trust is created, the Grantor completely relinquishes title to the Trust property and does not retain any right to revoke, amend, control, or terminate the Trust. Once an Irrevocable living Trust is established, the Grantor cannot:
- Change the Beneficiaries or change their interests in the Trust
- Receive any income or assets from the Trust
- Direct how the Trust property is invested
- Act as Trustee
- Maintain a reversionary interest in the Trust that exceeds 5 percent of the Trust’s value
There are a number of disadvantages associated with utilizing an Irrevocable Trust in an estate plan:
- The need to pay attorney fees for drafting the Trust
- Potential ongoing fees to a Trustee and for any professionals the Trustee might engage, such as an accountant or investment advisor
- The fact that the Trust is Irrevocable and generally cannot be changed to adapt to changing circumstances, including changes in the Grantor’s wishes
- The need for the Grantor to give up all ownership interests in the property placed in the Trust
A Trust can be an effective way to achieve various estate-planning objectives. For example, many individuals who own Life Insurance policies want to ensure that the proceeds are not included in their estates for estate tax purposes. To accomplish this goal, the owner can transfer an existing policy to an Irrevocable Life Insurance Trust, thereby removing the asset from his or her estate.
Or, a person can purchase a new policy to be owned by the Irrevocable Life Insurance Trust so that the proceeds can be used to pay any estate taxes due at death. However, those who establish Irrevocable Life Insurance Trusts must also be aware of several potential tax issues that can impact their Trusts including the “Kiddie Tax”.
The Non-U.S. Citizen Irrevocable Life Insurance Trust
The estate tax rules that apply to transfers to non-U.S. citizen spouses are different from the rules that affect transfers to spouses who are U.S. citizens. For example, as we learned earlier, the marital deduction allows one spouse to transfer an unlimited amount of property to the other spouse upon death without incurring any estate tax. This means that one spouse can leave his or her entire estate—regardless of size—to the other spouse and not pay federal estate taxes. However, spouses cannot take advantage of the unlimited marital deduction if the surviving spouse is not a U.S. citizen. Instead, once a U.S. citizen spouse has used his or her estate tax exemption, the remainder of his or her estate would be subject to immediate taxation unless it is transferred into a Qualified Domestic Trust (QDOT). A surviving non-U.S. citizen spouse can receive income from a QDOT during his or her lifetime and principal as needed for his or her health, education, maintenance, and support. At the surviving spouse’s death, the QDOT assets pass to the trust remaindermen (i.e., typically children and/or grandchildren), and estate taxes are assessed.
One problem with a QDOT is that it leaves a surviving non-U.S. citizen spouse without any personal resources to manage as he or she sees fit. This problem is sometimes addressed by having the U.S. citizen spouse give the non-U.S. citizen spouse annual gifts that, like annual exclusion amount gifts, can be made free of any immediate tax consequences. These gifts to non-U.S. citizen spouses, however, can be much larger ($152,000 in 2018) and are subject to inflation adjustment.
ILITs in which the non-U.S. citizen spouse is the sole beneficiary are often used to provide the spouse with financial independence.
This approach is simple and straightforward. Funding for the Irrevocable Life Insurance Trust is provided, not by a second-to-die policy, but by a single individual life insurance for expats policy on the life of the U.S. citizen spouse. At the insured’s death, the tax-free proceeds flow into the trust and through the trust into the hands of the non-U.S. citizen spouse. Receipt of these proceeds does not affect the non-U.S. citizen spouse’s right to receive income from the QDOT, although having additional assets will affect his or her ability to obtain principal from the trust under its ascertainable standards provision.
Prohibited Powers Under the Grantor Trust Rules
To avoid having Trust income taxed to the Grantor or Trust property included in the Grantor’s estate, an Irrevocable Life Insurance Trust must conform to the Grantor Trust rules. These rules address a wide range of controls, or powers, that a Grantor might attempt to retain or that might inadvertently or negligently be afforded a Grantor when a Trust is carelessly drafted.
These powers are collectively called Prohibited Powers. A Grantor must, therefore, avoid retaining any of the following rights:
- The right to regain ownership of Trust property at a value that is less than the property’s fair market value at the time of purchase. For example, a Grantor transfers real property located in a rundown neighborhood into a Trust, only to find ten years later—when the Grantor is desperately in need of cash—that the neighborhood is becoming more upscale. The ability to acquire the property from the Trust for a price lower than its current fair market value would make it possible for the Grantor to purchase and then sell the property for a substantial gain.
- The right to borrow Trust income or property at an interest rate that is less than would otherwise be imposed in the current market. Similarly, a Grantor is prohibited from reserving the right to borrow Trust property without providing adequate security for the loan.
- The ability to borrow either Trust assets or the income generated by the assets and not repay the loan completely by the end of the tax year in which the loan was obtained. However, the Grantor may lawfully borrow such assets without violating the Grantor Trust rules if (1) the Grantor obtained the loan at a current market interest rate and was required to post adequate security and (2) the loan was granted by a Trustee who was not under the control of the Grantor, such as a parent, a spouse, a sibling, a child, an employee, a corporation in which the Grantor has any significant voting control, or an employee in a corporation in which the Grantor is an executive.
- The retention of a reversionary interest that exceeds 5 percent of the value of the Trust assets on the date the Trust is executed or if there is more than a 5 percent chance that any powers over the Trust that would cause Trust income to be taxable to the Grantor would revert to the Grantor or the Grantor’s spouse. For example, a 45-year-old Grantor transfers income-producing property into a Trust to shift income from that property into the substantially lower tax bracket of an elderly aunt in need of ongoing support. The Trust allows the property to remain in the Trust for as long as the aunt is alive, with the property then reverting to the Grantor. The age disparity between the Grantor and elderly aunt makes it almost a certainty the property will revert to the Grantor, as opposed to the potential for reversion if a 21-year-old sibling were the Trust Beneficiary. The Grantor’s reversionary interest in the Trust undoubtedly exceeds 5 percent of its value, since his statistical life expectancy is so much greater than his aunt’s.
- The power to revoke the Trust and have Trust assets returned to the Grantor any time before the tenth anniversary of the date the Trust was created if this power is held solely by the Grantor or must be exercised by the Grantor only with the approval or consent of a third party who is not an adverse party to the Trust. An adverse party is someone whose interest would be negatively affected by the action of a Grantor or Trustee. A non-adverse party would be someone with no interest in the Trust or whose interest in the Trust would be unaffected by the action of the Grantor;
- The right to have income used to pay any legal obligations of the Grantor. However, retaining this right will cause the Grantor to be taxed on Trust income only if and when Trust income is actually used for this purpose. The fact that the income might be used is not enough to transfer tax liability to the Grantor;
- The right to control the beneficial enjoyment of the income generated by Trust assets, the assets themselves, or both Trust income and assets, without first obtaining the approval or consent of at least one party whose interest in the Trust—an adverse party—would be negatively affected by the action contemplated by the Grantor; and
- The right to have any income or principal from the Trust distributed to either the Grantor or the Grantor’s spouse without the approval or consent of someone who is an adverse party to the Trust.
With respect to these last two prohibited rights, having either of these rights included in the Trust document will cause income from the Trust to be taxed to the Grantor. Actual distribution of the income is not necessary. Income is also taxable to the Grantor if it can be used to pay Life Insurance premiums on the life of the Grantor or the Grantor’s spouse unless the proceeds of such policy had been irrevocably made payable to a qualified charity.
Permitted Powers Under the Grantor Trust Rules
While a Grantor can avoid adverse tax consequences by strictly following the Grantor Trust rules and relinquishing all dominion and control over property transferred to an Irrevocable Trust, there are some controls that a Grantor can maintain, including:
- The right to use Trust income for the support of the Grantor’s dependents. This right should be contrasted with the right to have Trust income used to satisfy a Grantor’s legal obligations. For example, a Grantor has a legal obligation to provide support for minor children. Using income for this purpose causes the income to be taxable to the Grantor. A Grantor does not, however, have a legal obligation to support a child who has reached the legal age of majority, and use of Trust income to pay expenses for this child will not result in income attribution to the Grantor.
- The right to affect the beneficial enjoyment of Trust property after it has been in the Trust for at least ten years, after which time retention of the power may cause the Grantor to be treated as owner of the Trust and hence subject to income tax liability.
- The right to distribute income or principal from the Trust to charitable organizations and in amounts of the Grantor’s choosing, provided the income and principal have been irrevocably made payable solely for charitable purposes
- The right to utilize principal for the benefit of a Beneficiary if this right is limited by a definite standard in the Trust known as an ascertainable standards clause. This provision gives the Trustee discretion to distribute funds to a Beneficiary based on the Beneficiary’s health, education, maintenance, and support needs.
- the power to postpone the payment of benefits from the Trust for a reasonable period.
- The power to hold back distributions of income or principal from a Trust while one or more Beneficiaries are still minors or are legally disabled. This power would give a Trustee the discretion to withhold payments from a Beneficiary who, for example, might be unable to manage those funds appropriately or who had become a drug addict, an alcoholic, a felon, or a compulsive gambler, or had become mentally or physically incompetent and would need long-term care and asset management services.
- The ability to apportion Trust disbursements and receipts between income and principal. Determining whether Trust earnings are considered income or additions to principal will have a direct impact on how much income is available to distribute to Beneficiaries and whether and how it will be taxed to a Beneficiary. This would obviously be important if a Trust had two classes of Beneficiaries: one to receive only income and the other to receive distributions of principal.
Another important issue that Grantors must consider when creating an Irrevocable Life Insurance Trusts is the implication of having Trust Beneficiaries from two or more generations and the impact the generation-skipping transfer tax (GSTT) will have on such arrangements. Trusts that provide benefits to multiple generations are commonly called dynasty Trusts.
For GSTT purposes, there are two kinds of Generation-Skipping Beneficiaries, or Skip Beneficiaries. A Direct Skip Beneficiary has an immediate unfettered right to use and enjoy the property being transferred. An Indirect Skip Beneficiary receives a transfer indirectly, as in a Trust arrangement. In other words, there is some intermediate step between the transfer of property and the unfettered use and enjoyment of it by the Indirect Skip Beneficiary.
There are two types of distributions from Dynasty Trusts: Taxable Terminations and Taxable Distributions. Taxable Terminations occur either when a Trust terminates or when all of the interests in the Trust are held by Skip Beneficiaries.
For example, let’s assume Gerry Grandfather created a Trust for the benefit of his three children and his six grandchildren. While any of his children are alive, they will receive an equal pro rata share of any income generated by the Trust assets. When the last child dies, the Trust will terminate, and the principal will be distributed in equal shares per stirpes to the three branches of Gerry’s family and within each branch in equal shares to each living grandchild. A taxable termination will therefore occur upon the death of the last of Gerry’s children and when all the interests in the Trust would be held solely by skip Beneficiaries.
Alternatively, Gerry could have established his Trust to provide income to his children in equal shares while they were alive, but with the stipulation that the Trust would remain in effect after the death of the last child until the youngest grandchild attained the age of 45, at which time the Trust would terminate and distribute Trust principal as in the foregoing example.
Until the youngest grandchild attained the age of 45, the Trustee would make the same per stirpes income distributions to the branches of Gerry’s family that were previously being made to the heads of those branches, his children. These would be taxable distributions. When the last grandchild turned 45—a time specified by the Grantor—the taxable termination of the Trust would occur. In other words, a Taxable Distribution occurs when Trust assets are transferred to skip Beneficiaries while the Trust remains in effect, while a Taxable Termination occurs when the Trust ceases to exist.
The common law rule against perpetuities, which applies in some states, is designed to ensure that property placed in Trust will eventually make its way back into the economy so that it can be taxed. The basic rules state that a Trust can remain in effect for the lifetime of someone named in the Trust plus 21 years. At the end of this period, Trusts in those states that follow the rule must be terminated, and Trust property must be distributed.
Annual Exclusion Gifts
Any time one person gives something to another without receiving anything in return, a gift has been made. Gift-giving can have a substantial impact on the intergenerational transfer of wealth. However, the IRS has absolutely no interest in gifts of relatively low value. Keeping track of these kinds of gifts would be nearly impossible, both because they occur so frequently in our everyday interaction with others and because keeping track of such gifts would be difficult for taxpayers and the IRS.
To eliminate dealing with small gifts, the IRS established a threshold under which a gift does not have to be reported for tax purposes. Under current law, individuals can give up to $15,000 each year (known as the annual exclusion amount) to as many individuals as they wish without incurring any gift tax liability. These gifts are made entirely free of gift or estate tax and generate no immediate income tax consequences for either the person making the gift or the person receiving the gift.
Along with the right to make annual exclusion amount gifts, either individually or jointly with a spouse, everyone can also transfer a certain amount of property free of gift or estate transfer tax, either during his or her lifetime or at death, respectively. This is because the federal government provides every taxpayer with three potential tax exemptions. First, spouses who are U.S. citizens can transfer an unlimited amount of property to each other during life and at the first spouse’s death without tax consequences. These transfers are sheltered under what is called the unlimited gift and estate tax marital exemption.
Transfers to someone other than a spouse are treated differently and are subject to a maximum lifetime limit. Prior to the enactment of the Tax Cuts and Jobs Act of 2017, a person could make up to $5 million (indexed) in lifetime gifts to non-spousal Beneficiaries without gift tax liability. This is known as the lifetime gift tax exemption. Any gifts in excess of this amount would be subject to gift tax. Under the Tax Cuts and Jobs Act of 2017, the Lifetime Gift Tax Exemption has been increased to $10 million ($11.18 million in 2018, as indexed for inflation), beginning in 2018 and scheduled to continue through December 31, 2025.
Bequests at a taxpayer’s death are exempt from Federal Estate Tax under the Federal Estate Tax Exemption as long as they do not cumulatively exceed the Exemption Limit ($11.18 million in 2018).