Section 6A: Tax-Sensitive Powers Regarding The Beneficiary-Trustee

Who serves as a trustee of the ILIT can have profound income and transfer tax consequences for the grantor and for the trustee, especially if the trustee is a beneficiary of the ILIT. This Chapter discusses what the income, estate, and gift tax consequences are of a beneficiary who serves as a trustee of an ILIT.1 Under no circumstances should an insured ever serve as a trustee of an ILIT!

6A.1 ESTATE TAX ISSUES AND THE BENEFICIARY-TRUSTEE

A beneficiary-trustee’s power to make discretionary distributions to himself or herself as a trust beneficiary without the limitation of an ascertainable standard constitutes a general power of appointment (“the prohibited power”). IRC sections 2041(b)(1)(A) and 2514(c)(1). Additionally, a beneficiary-trustee’s discretionary power over trust property that could be exercised for the benefit of the beneficiary- trustee’s creditors or estate also constitutes a prohibited power.

Practice Point: To avoid the prohibited power being included in the beneficiary-trustee’s gross estate, the beneficiary trustee should disclaim the prohibited power in accordance with IRC section 2518. The beneficiary-trustee may also want to disclaim serving as trustee.2 Having the beneficiary trustee merely decline to serve as trustee (and not make a qualified disclaimer of the prohibited power) may result in a “release” or “lapse” of the prohibited power. A “release” or “lapse” of a general power of appointment will result in the beneficiary-trustee making a taxable gift pursuant to per IRC sections 2514(b) and (e), and/or result in the prohibited power being included in the beneficiary trustee’s gross estate pursuant to IRC sections 2041(a)(2) and (b)(2).

6A.1(a) Death Of Beneficiary-Trustee

If the beneficiary-trustee holds the prohibited power and dies, the trust property will be included in his or her gross estate. IRC section 2041; Treas. Reg. §20.2041-1(b).

6A.1(b) Ascertainable Standards

Examples of ascertainable standards include:

  • Support;
  • Support in reasonable comfort;
  • Maintenance;
  • Maintenance in health and reasonable comfort;
  • Support in his or her accustomed manner of living;
  • Education, including college and professional education;
  • Health;
  • Health, education, support, and maintenance;
  • Medical, dental, hospital, and nursing expenses; and
  • Expenses of invalidism. Treas. Reg. §§20.2041-1(c)(2) and 25.2514- 1(c)(2).

Caution: Distributions for a beneficiary’s “happiness,” “welfare,” “comfort,” or “emergency needs” are not, in and of themselves, ascertainable standards. IRC sections 2041- (b)(1)(A) and 2514(c)(1); Treas. Reg. §§20.2041-1(c)(2) and 25.2514-1(c)(2). Even though state law is determinative in ascertaining the nature and extent of powers held by a decedent,3 do not deviate from the standards enumerated in the Treasury Regulations. Morgan v. Commissioner of Internal Revenue Service, 309 U.S. 78 (1940). See also, Rev. Rul. 77-60, 1977-1 C.B. 282, which states that “[a] power to use property to enable the donee to continue an accustomed mode of living, without further limitation, although predictable and measurable on the basis of past expenditures, does not come within the ascertainable standard prescribed in IRC section 2041(b)(1)(A) since the standard of living may include customary travel, entertainment, luxury items, or other expenditures not required for meeting the donee’s ‘needs for health, education or support.’ Nor does the requirement of a good faith exercise of a power create an ascertainable standard. Good faith exercise of a power is not determinative of its breadth.”

6A.1(c) Negation Of Ascertainable Standard

An ascertainable standard is rendered unascertainable for a beneficiary-trustee “if a trust instrument provides that the determination of the trustee shall be conclusive with respect to the exercise or non-exercise of a power….” Treas. Reg. §25.2511-1(g)(2). Cf, Treas. Reg. §1.674(b)-1(b)(5)(i). Examples of powers that negate an ascertainable standard include:

  • “The trustee’s exercise or nonexercise of powers and discretions in good faith shall be conclusive and binding on all interested parties.”
  • “The trustee shall exercise his or her powers in his or her uncontrolled discretion.” Estate of Friedman, 94 Cal. App. 3d 667, 156 Cal. Rptr. 597 (1979); Independence Bank Waukesha (N.A.) v. U.S., 761 F.2d 442 (7th Cir. 1985).

It may be desirable to limit the beneficiary-trustee’s power.

Drafting Example: No trustee who is a beneficiary of the trust in question shall possess any power or discretion that is “conclusive,” “sole,” “absolute,” or “uncontrolled” with respect to the exercise or non exercise of such power or discretion under that trust; and such beneficiary-trustee’s power or discretion in that regard shall at all times be exercised or not exercised in a reasonable manner, be limited by a reasonably definite standard, and shall be subject to review and judicial scrutiny.

6A.1(d) Co-Trustee With Substantial Adverse Interest

The appointment of a co-trustee (including an independent co-trustee) to serve with the beneficiary-trustee does not protect the beneficiary trustee unless (1) the consent of the co-trustee is required for any discretionary distributions, and (2) the co-trustee has a substantial adverse interest in the trust. IRC section 2041(b)(1)(C)(ii); Treas. Reg. §20.2041-3(c)(2); Priv. Letter Rul. 9030032. See also, IRC section 2514(c)(3)(B). Alternatively, the power to make discretionary distributions can be vested exclusively in the independent co-trustee (who need not have a substantial adverse interest). This will prevent attribution of the prohibited power to the beneficiary-trustee. A person has a “substantial adverse interest” if he or she has a present or future right to obtain a personal benefit from the property that is subject to the power. Estate of Richard C. Maxant v. Commissioner, T.C. Memo 1980-414 (1980). A co-holder of a power is considered to have a substantial adverse interest in the exercise of a power over trust property if the co-holder is the remainder beneficiary of the trust.4 Treas. Reg. §20.2041-3(c)(2), Example 1.

An interest adverse to the exercise of a power is considered as substantial if its value in relation to the total value of the property subject to the power is not insignificant. For this purpose, the interest is to be valued in accordance with the actuarial principles set forth in §20.2031-7 or, if it is not susceptible to valuation under those provisions, in accordance with the general principles set forth in §20.2031-1. A taker in default of appointment under a power has an interest which is adverse to an exercise of the power. A co-holder of the power has no adverse interest merely because of his joint possession of the power nor merely because he is a permissible appointee under a power. However, a coholder of a power is considered as having an adverse interest where he may possess the power after the decedent’s death and may exercise it at that time in favor of himself, his estate, his creditors, or the creditors of his estate. Treas. Reg. §20.2041-3(c)(2).

Practice Point: Having a co-trustee with a substantial adverse interest may still result in the prohibited power being included in the beneficiary-trustee’s gross estate if the adverse-trustee predeceases the beneficiary-trustee and the beneficiary-trustee is the sole remaining trustee.

Drafting Example:

The power to make discretionary distributions of principal or in- come to a beneficiary hereunder who is also a trustee, shall be vested exclusively in (and be exercisable only by) the Independent Trustee.5 If the incumbent trustee is not an Independent Trustee, the incumbent trustee may appoint an Independent Trustee to serve as co-trustee with the incumbent trustee. The Independent Trustee so appointed shall serve concurrently with the appointing trustee until the appointing trustee resigns, dies, or becomes incapacitated and is succeeded by a successor trustee.

6A.1(e) Beneficiary-Trustee’s Power Of Withdrawal

A beneficiary-trustee, or any beneficiary, can be given a power of withdrawal over trust principal and income without the power of withdrawal being included in his or her gross estate provided the beneficiary (the “withdrawal right beneficiary”) does not die during the time period the power of withdrawal is exercisable and the power has not lapsed. The power of withdrawal must be limited to the safe harbor amounts described in IRC sections 2514(e)(1) and (2) and 2041(b)(2), which is currently $5,000 or 5% of the trust estate (five by five). If the withdrawal right beneficiary dies while the power of withdrawal is exercisable (i.e., has not yet lapsed), the amount of the property subject to the right of withdrawal will be included in the beneficiary’s gross estate under IRC section 2041, as a general power of appointment, and the decreased withdrawal right beneficiary will become the “new” transferor of the unlapsed power for GST tax purposes. Any GST tax exemption previously allocated by the grantor will be lost and wasted. Treas. Reg. §26.2652-1(a)(2). Hence, it may not be appropriate to grant a five-by-five withdrawal power to a beneficiary of a trust that comes into existence after the grantor’s death, such as the reverse QTIP Marital Trust, Family Trust, Children’s Trust or Descendants’ Trust, or to the beneficiary of a trust that is designed to be GST tax exempt. However, if such a withdrawal right is granted, consider limiting the withdrawal period to 30 or 60 days to minimize the risk of the beneficiary dying during the period the withdrawal right is exercisable.

6A.1(e)(1) Lapse Of Power Of Withdrawal

Use extreme care when granting withdrawal rights in an amount greater than $5,000 or 5% of the value of the trust assets. IRC section 2514(b) indicates that the exercise or release of a general power of appointment will be treated as a transfer by the individual who released the power. Under IRC section 2514(e), a lapse of a power of appointment is considered a release. A specific exception to this rule is set forth under IRC section 2514(e)(1) and (2), which states that the lapse of a power (in contrast to a release or a waiver of the power) not exceeding $5,000 or 5% of the value of the assets out of which the power can be satisfied, will not be treated as a transfer. What this means is that a lapse of a withdrawal right in excess of the five-by-five limits will constitute both a taxable release under IRC section 2514(b) and an immediate gift of a future interest to the other trust beneficiaries by the withdrawal right beneficiary. As a result of the gift, the withdrawal right beneficiary will become the “new” transferor of the excess amount for GST tax purposes, and any GST tax exemption previously allocated by the grantor will be wasted. Additionally, because the withdrawal right beneficiary has a retained interest in the trust, all or a portion of the value of the trust will be included in that beneficiary’s gross estate upon his or her death. IRC section 2036(a); Treas. Reg. §20.2041-3(d)(4). Furthermore, if the lapse of the excess amount is a completed gift, the withdrawal right beneficiary’s retained interest in the excess amount will be valued at $0 for gift tax purposes if the remainder beneficiaries/donees of the excess amount are members of the withdrawal right beneficiary’s family. IRC section 2702(a)(2). Priv. Letter Rul. 9804047.

The effect of cumulative taxable releases with a retained interest by the beneficiary may result in all (or a significant portion) of the beneficiary’s trust share being included in his or her gross estate. Treas. Reg. §20.2041-3(d)(5). Thus, a power of withdrawal in a trust that comes into existence after the grantor’s death, such as the Family Trust, Children’s Trust, or Descendants’ Trust, should be limited to the five- by-five amount to avoid these disastrous estate and gift tax consequences.

6A.1(f) Beneficiary-Trustee’s Ability To Remove A Co-Trustee And Appoint A Successor Co-Trustee

A beneficiary-trustee’s ability to remove a co-trustee and appoint a successor co-trustee may constitute a general power of appointment under IRC section 2041. See, section 1.3, above, for further discussion on this point.

6A.1(g) Beneficiary-Trustee And Life Insurance

If a beneficiary serves as a trustee of a trust that holds life insurance on that beneficiary’s life, the life insurance proceeds will be includable in that beneficiary-trustee’s gross estate for estate tax purposes. IRC section 2042. This is because the beneficiary, as trustee, will have incidents of ownership in the life insurance policy. Treas. Reg. §§20.2042-1(c). To avoid this result, a beneficiary-trustee should not serve as a trustee of a trust that holds insurance on his or her life, unless a co-trustee is granted all rights and powers over the policy. Also, the beneficiary-trustee (either as a beneficiary or as a trustee) should not have a power of appointment over the life insurance policy. See, Paragraph 7.1(C)(3) of Sample ILIT.

6A.2 GIFT TAX ISSUES AND THE BENEFICIARY-TRUSTEE

The gift tax consequences of a beneficiary-trustee’s discretionary distributions of income or principal to another beneficiary of the same trust are as follows.

6A.2(a) Distributions By Beneficiary-Trustee To Other Beneficiaries

If the beneficiary-trustee makes a wholly discretionary distribution of income or principal to another beneficiary of the same trust of which the beneficiary-trustee is also a wholly discretionary beneficiary, the distribution will constitute a taxable gift by the beneficiary-trustee. IRC section 2514. Also, if the beneficiary-trustee (or any beneficiary) is entitled to income and appoints that income to another beneficiary (or another person), the appointment of the income interest is a taxable gift by the beneficiary-trustee to the other beneficiary. Treas. Reg. §§ 25.2514-1(b)(2) and 25.2514-3(e), Example 1.

6A.2(a)(1) Ascertainable Standard

To avoid the gift problem, the beneficiary-trustee’s power to distribute property to other beneficiaries of the same trust should be limited to an ascertainable standard.6 Treas. Reg. §25.2511-1(g)(2). See, Estate of Ruth B. Regester v. Commissioner, 83 T.C. 1 (1984); Rev. Rul. 79-327, 1979-2 C.B. 342; Treas. Reg. §25.2514-1(b)(2); Priv. Letter Rul. 200243026 (concerning the gift tax consequences of an income beneficiary’s exercise of an intervivos limited power of appointment over trust principal). Alternatively, the power to make discretionary distributions to any trust beneficiary can be vested exclusively in (and be exercisable only by) an independent trustee. This will prevent a gift being made by the beneficiary-trustee.

Drafting Example:

To the extent a beneficiary-trustee has the authority to make discretionary distributions of income and/or principal to another beneficiary from a trust of which such beneficiary-trustee is then also a current trust beneficiary, the discretionary distributions shall be limited by an ascertainable standard related to the distributee beneficiary’s health, education, support, and maintenance in the manner of living to which the distributee beneficiary has been accustomed, considering the resources otherwise available to the distributee beneficiary.

Caution: If the other beneficiary is a person whom the trustee-beneficiary is legally obligated to support (such as a spouse or a minor child), an ascertainable standard concerning distributions to the other trust beneficiary (whom the beneficiary-trustee is legally obligated to support) will not protect the beneficiary-trustee from estate and gift tax consequences. IRC sections 2041(b)(1)(A) and 2514(c)- (1); Treas. Reg. §§20.2041-1(c)(2) and 25.2514-1(c)(2); Rev. Rul. 79-154, 1979-1 C.B. 301.

6A.2(b) Beneficiary-Trustee’s Lapse Of Power Of Withdrawal

If a beneficiary-trustee, or any beneficiary, holds a withdrawal right over trust property that is already sheltered from estate tax (due to the application of the deceased grantor’s applicable exclusion amount), make sure the right of withdrawal lapses within the five-by-five safe harbor limits of IRC sections 2514(e)(1) and (2). Otherwise, the lapse in excess of five by five may result in a gift of a future interest being made by the powerholder to the other trust beneficiaries for the amount in excess of five by five. See, section 8.1(e)(1), above.

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