Section 1A: Benefits Of An Irrevocable Life Insurance Trust

Life insurance is the only asset that Congress has bestowed with “most favored tax” status.1 No other investment provides the potential benefit that life insurance provides. Life insurance is unique2 and enjoys favorable tax status because of the important role it plays in protecting families. As a matter of policy, Congress has decided that life insurance is critical to protecting America’s families and businesses, and it is hoped that status will not change.3 For a “few dollars” of premium an insured can obtain thousands of dollars of life insurance coverage. No other investment provides a “payoff” like life insurance. Pay the first year’s premium, die several months later, and the insured’s beneficiaries receive thousands (possibly millions) of dollars of death benefits—income tax free. Not only does life insurance enjoy special income tax treatment, but when life insurance is owned by an irrevocable life insurance trust (“ILIT”), the death benefits can also be received free of death taxes and generation-skipping transfer taxes, and be used to benefit the insured’s love ones for generations to come. This chapter highlights 22 reasons/benefits4 of using an ILIT.5 ILITs can play an important role if the grantor is the owner of a closely held business, particularly one that is family owned. As will be seen, an ILIT can be structured to accomplish a multitude of objectives, limited only by the grantor’s imagination and cash flow, and the Internal Revenue Code.

1A.1 AVOID INCLUSION OF LIFE INSURANCE PROCEEDS IN INSURED’S GROSS ESTATE

The principal goal of an ILIT is to remove the life insurance proceeds from the insured-grantor’s gross estate for federal estate tax purposes.6 For a grantor to successfully remove transferred property (such as an existing life insurance policy or cash to fund an ILIT) from his or her gross estate, the grantor must:
  1. Make a completed gift of the property transferred to the ILIT. Treas. Reg. §§25.2511-2(b) and (c).7 See, section 3.5, below.
  2. Survive three years after making a gratuitous transfer of the property if the transferred property would otherwise be includable in the grantor’s gross estate under IRC sections 2036, 2037, 2038, and 2042 or if the grantor relinquishes a power over the transferred property. IRC section 2035. See, sections 1.4 and 4.1, below.
  3. Not retain any interest beneficial interest in the transferred property or in the ILIT. IRC section 2036. See, section 4.2, below.
  4. Not provide that the possession or enjoyment of the transferred property can be obtained only by surviving the grantor, and not retain a reversionary interest in the transferred property or in the ILIT that is greater than 5% at the time of the grantor’s death. IRC section 2037.
  5. Not retain the power to alter, amend, revoke, or control the beneficial enjoyment of the transferred property, or the power to alter, amend, or revoke the ILIT. IRC section 2038. See, section 4.3, below.
  6. Not hold a power of appointment over the transferred property or the ILIT. IRC sections 2514 and 2041. See, section 10.15, below.
  7. Not possess any incidents of ownership in any life insurance policies transferred to the ILIT or owned by the ILIT. IRC section 2042. See, section 4.8, below.
  8. Not possess or exercise any powers over the ILIT. See, section 10.15, below.
  9. Not serve as a trustee of the ILIT. See, section 10.16, below.
  10. Not use community property funds to pay for a single life policy. See, section 12.4, below. See, Paragraphs 1.1 and 2.1 of Sample ILIT.
Caution: To avoid the three-year rule of IRC section 2035, a life insurance policy should not be purchased by the ILIT trustee until the ILIT has been executed and funded. See, section 4.12, below, concerning an insured’s “test application” for a life insurance policy. See also, section 12.10, below.

1A.2 INCUR LITTLE OR NO GIFT TAX UPON CREATION OF THE ILIT AND PAYMENT OF SUBSEQUENT PREMIUMS

A Crummey withdrawal right granted to each beneficiary, when used in conjunction with the gift tax annual exclusion amount under IRC section 2503(b) and gift splitting under IRC section 2513 (for married persons), allows the grantor’s payment of premiums to be gift tax free. See, sections 3.5 and 3.10, below. Although a Crummey withdrawal provision may turn a gift of a future interest into a gift of a present interest qualifying for the gift tax annual exclusion under IRC section 2503, a transfer to a trust that qualifies for the gift tax annual exclusion does not automatically qualify for the GST tax exemption purposes. Under the GST rules, a transfer that qualifies for the gift tax annual exclusion constitutes a transfer to a trust (and not a transfer to a beneficiary—even though the beneficiary can withdraw the transfer because of the Crummey withdrawal right). Treas. Reg. §26.2642-1(c)(3). Thus, unless the ILIT is a skip-person trust under IRC sections 2642(c) or 2503(c) (e.g., a trust for a single beneficiary and if the beneficiary dies before the trust terminates, the trust assets must be includable in the beneficiary’s gross estate), the transfer of cash or other property to the trust by the grantor will not be GST exempt and GST tax exemption will have to be allocated to the trust to obtain a zero inclusion ratio. See, section 5.7, below. Additionally, assuming the ILIT is not an IRC section 2642(c) or 2503(c) trust, the Crummey withdrawal right should be limited to a five-by-five power under IRC section 2514(e), unless separate trust shares with testamentary limited powers of appointment exist for each beneficiary or hanging Crummey powers are used. See, sections 3.12 and 3.13, below. Otherwise, the lapse of a withdrawal right greater than five-by-five will cause the excess to be considered as being transferred by the beneficiary. See, section 3.11, below. As a result, the beneficiary becomes the (new) transferor for GST purposes with regard to the excess lapse amount. Treas. Reg. §26.2652- 1(a)(5), Example 5. See, sections 5.20 and 5.21, below. Practice Point: If the grantor’s spouse has a Crummey withdrawal right in excess of five-by-five or is granted a withdrawal right for greater than 60 days from the date of the transfer into the trust, then the grantor will not be able to allocate his or her GST tax exemption because of the estate tax inclusion period (“ETIP”) rules and the spouse’s holding of an impermissible withdrawal right for GST purposes. IRC section 2642(f); Treas. Reg. §26.2632-1(c)(2)(ii). See, section 5.17, below.

1A.3 REMOVE AN EXISTING LIFE INSURANCE POLICY FROM THE INSURED’S GROSS ESTATE AT LITTLE OR NO GIFT TAX COST

The transfer of an existing life insurance policy to an ILIT can generally be accomplished with little or no gift tax having to be paid. This is because the gift tax value of an existing life insurance policy is generally a fraction of its face (i.e., death benefit) value. See, section 3.1, below, concerning the valuation of life insurance policies. Thus, tremendous leveraging occurs when the policy is valued at a fraction of its face value and gift tax annual exclusion Crummey withdrawal rights are used in conjunction with the transfer of the policy to the ILIT. See, section 3.5 below. For example, a married grantor using gift splitting and hanging Crummey withdrawal rights, can gift up to $24,000 per year (in calendar year 2006) per ILIT beneficiary (other than to the grantor’s spouse). See, sections 3.5 and 3.10, below. If the life insurance policy has a low gift tax value at the date of its transfer to the ILIT, and there are enough Crummey withdraw- al right beneficiaries available to “absorb” the policy’s gift tax value, no gift tax will be incurred on the transfer of the policy to the ILIT.

1A.4 MINIMIZE THE ADVERSE TAX CONSEQUENCES OF THE THREE-YEAR RULE OF IRC SECTION 2035

If a life insurance policy that a married grantor transfers to the ILIT is included in the grantor’s gross estate under IRC section 2035 be- cause the grantor dies within three years of the transfer, the ILIT can, under certain circumstances, defer, minimize, or even eliminate the payment of federal estate taxes by the grantor’s estate. See, section 4.1, below. The ILIT trustee could pay or hold the life insurance proceeds in a manner that qualifies for the federal estate tax marital deduction (or qualifies for the charitable estate tax deduction). See, section 11.3, below. See, Paragraph 5.1 of Sample ILIT. If the marital deduction trust is a general power of appointment trust under IRC section 2056(b)(5), the surviving spouse could be granted the power to withdraw principal and use it to make gifts to the grantor’s descendants. See, section 4.13, below. This power of withdrawal would, of course, exist only if the grantor died within three years of the transfer of the life insurance policy to the ILIT. Similarly, a QTIP trustee who is an independent trustee could be granted the power to make discretionary distributions of principal to the surviving spouse, who could then also make gifts. Note however, that under IRC section 2056(b)(7), no one, not even the surviving spouse, can be granted a lifetime power to appoint the QTIP property to anyone but the spouse. This means that there should be no provision allowing the QTIP trustee to make distributions for the purpose of allowing the surviving spouse to make gifts. See, section 4.14, below. Such authority may run afoul of the aforementioned restriction. The surviving spouse could, however, be granted an annual five-by five withdrawal right over the QTIP trust, and the withdrawals could then be gifted by the spouse. See, Paragraph 5.1(A)(2)(a) of Sample ILIT. A contingent marital deduction trust should not be used in conjunction with a second-to-die policy insuring the lives of both spouses. If both spouses die within three years of transferring the policy into the ILIT, absent a bequest of the policy proceeds that qualifies for the charitable estate tax deduction (with a corresponding waiver in the spouses’ will of the estate tax apportionment pro- visions of IRC section 2206)9 the proceeds will be includable in the gross estate of the surviving spouse. If the life insurance proceeds do not qualify for a marital or charitable deduction, consider who should be responsible for the payment of the federal estate taxes attributable to the proceeds that are held by the ILIT. The executor of an insured’s estate is entitled to recover federal estate taxes paid by the estate that are attributable to life insurance proceeds included in the insured’s gross estate. IRC section 2206. See, section 4.15, below. The executor’s right of apportionment/recovery is on a pro rata basis. A decedent can opt out of the recovery/apportionment provisions of IRC section 2206 by stating so in his or her will. A general provision in the decedent’s will to pay all taxes from residue will be sufficient to opt out of the IRC section 2206 apportionment/recovery scheme. To the extent the insured’s estate has other assets sufficient to pay the death taxes attributable to the ILIT proceeds, it may be advantageous for the burden of payment to be shifted from the ILIT to the insured’s estate without any right of apportionment or recovery from the ILIT. This is true particularly if the ILIT has a zero-inclusion ratio for GST tax purposes. By doing so, the previously allocated GST tax exemption (and GST-tax-exempt ILIT property) will remain intact and undiminished by the federal estate tax burden assumed by the decedent’s estate. However, burdening the residue of the insured’s estate may not be appropriate when the residuary beneficiaries are different than the ILIT beneficiaries. Drafting Example For Decedent’s Will: If generation-skipping tax exemption has been allocated to a trust or property that is included in my gross estate for federal estate tax purposes, I direct that any federal estate taxes attributable to such property be paid from the trust or property that does not have an inclusion ratio of zero (0), and if the federal estate taxes exceed the trust or property that does not have an inclusion ratio of zero (0), it is my desire that the balance of the federal estate taxes otherwise apportioned against such trust or property be paid instead from the residue of my estate which is not included in a gift qualifying for the marital or charitable deduction and is so elected/deducted; and if practicable, such payment from the residue shall be with no right of recovery, reimbursement, or contribution (but only to the extent of such payment), it being my desire to preserve the full value of the zero (0) inclusion ratio property, if possible.

1A.4(a) Effect Of The Deemed Transfer Rule

Effective January 1, 1982, the three-year look back rule concerning “gifts in contemplation of death” was repealed pursuant to the Economic Recovery Tax Act of 1981. However, there was some uncertainty if the repeal of that rule also repealed the “deemed trans- fer” rule.10 Subsequent court decisions have struck down the “deemed transfer” rule, and in 1991 the IRS acquiesced in the courts’ abolishment of the rule. See, Estate of Frank Martin Perry, Sr. v. Commissioner, 927 F.2d 209 (5th Cir. 1991); Estate of Eddie L. Headrick v. Commissioner, 93 T.C. 171 (1989), aff’d, 918 F.2d 1236 (6th Cir. 1990); acq. AOD 1991-12 (7/3/1991); Estate of Joseph Leder v. Commissioner, 89 T.C. 235 (1987), aff’d, 893 F.2d 237 (10th Cir. 1989). However, caution may still be advised so as to avoid the imputation that the trustee is merely the agent of the insured/grantor. Thus, do not identify the trust as the “John Doe Irrevocable Life Insurance Trust,” but simply the “John Doe Irrevocable Trust.” Query whether this is merely form over substance. Do not require the trustee to purchase life insurance, but do give the trustee broad discretion with regard to life insurance matters, including the right to indemnification under certain circumstances. See, sections 10.19 and 10.20, below. See, Paragraph 7.1(D) of Sample ILIT. The trustee’s right to indemnification should not give rise to the trustee being an agent of the grantor. Grantors often indemnify trustees with respect to high-risk assets such as closely held businesses and real estate. In fact, many trustees will not serve as trustee of an ILIT without indemnification or some other mechanism of protection, which may be even more costly than the risk of indemnification. The indemnification of the ILIT trustee should not cause the insured to be deemed to have any incidents of ownership over the life insurance policy, since the insured cannot exercise any rights over the policy.

1A.5 PROVIDE THE INSURED WITH GREATER CONTROL OVER THE POLICY AND OVER THE DISPOSITION OF THE LIFE INSURANCE PROCEEDS

The transfer of a life insurance policy to an ILIT gives the insured more control over the policy than if it were gifted outright, and an ILIT provides the insured with more control over the ultimate dis- position of the life insurance proceeds than if the insured named an individual beneficiary. An ILIT provides a solution to the following concerns: (i) how the life insurance death benefit should be paid out by the life insurance company—the trustee will decide which settlement option is suitable,11 (ii) who should share in the life insurance proceeds if the primary beneficiary predeceases the insured (or dies simultaneous with the insured), (iii) how will the proceeds be invested, and by whom, (iv) when should the proceeds be distributed to a beneficiary, and under what circumstances or criteria, (v) how long should the proceeds benefit the insured’s loved ones— years, decades, multiple generations, etc. An ILIT provides the insured with a certain amount of “control from the grave.” Of course, an ILIT should also be drafted with sufficient flexibility to deal with changing and unforeseeable circumstances. See, Chapter 11, below.

1A.6 PROVIDE COORDINATION OF THE INSURED’S ESTATE PLAN

An ILIT can be used to coordinate the disposition of the policy proceeds and the grantor’s other assets and estate planning documents. Coordination through an ILIT (rather than relying on a policy beneficiary designation) ensures that the life insurance proceeds inure to the benefit of the right beneficiaries, regardless of who does not survive the insured. See, Chapter 13, below. Footnotes:  1. Life insurance is the only “tax-free” investment under the Internal Revenue Code. All other investments are potentially subject to income (or capital gains) tax. For example, municipal bonds are essentially “pre-taxed” because their lower rates of return reflect their income tax free feature, and qualified retirement plans and annuities are tax deferred—not tax free. Only with a life insurance policy does the event of death eliminate the income tax. If estate taxes are permanently repealed, the loss of a complete step-up in basis will make life insurance even more attractive. 2. “Life insurance is a unique form of property. There is no other investment vehicle that can as effectively guarantee the delivery of a specific amount of cash at the precise, but unpredictable, moment cash is needed, namely, at death.” Brody, Richey, and Baier, 828 T.M., Compensating Employees with Insurance, section II, B, 2, a (Bureau of National Affairs, Washington, DC). 3. See, Jeffrey A. Baskies, “Could Abuses in the Life Insurance Industry Lead to Penalties?,” 33 Estate Planning 22 (February 2006). 4. Some of the disadvantages of using an ILIT might be (i) the cost of establishing the ILIT, (ii) the complexity of making gifts to an ILIT because of the need for Crummey withdrawal rights or the use of the grantor’s gift tax applicable exclusion amount (currently $1 million), (iii) the ongoing expense of trust administration, including annual Crummey withdrawal right notices, (iv) the possible income tax disadvantages if the ILIT is taxed as a separate taxpayer (and is not taxed as a grantor trust in its entirety), (v) the “irrevocability” of the ILIT and inability to change beneficiaries, (vi) the insured’s lack of control over the life insurance policy, its cash value, and lack of control over the other ILIT assets, and (vii) the potential of IRC section 2035 applying to a policy transferred within 3 years of the insured’s death and the loss of the federal estate tax marital deduction if the ILIT is not drafted carefully. However, by drafting a flexible ILIT, the grantor can maintain some indirect control over the policy. See, Chapter 11, below. 5. [Add Footnotes Here] 6. [Add Footnotes Here] 7. [Add Footnotes Here] 8. 9. 10.