By Elizabeth B. Taylor, Director - Estate Market and Barbara A. Bombaci, Director - Advanced Planning
Given the present uncertainty about future transfer tax rules, an estate plan should be drafted to provide as much flexibility as possible so it can adapt to changes.
To a great degree, estate planning is the art of dealing with uncertainty. When will someone die? What will his or her estate be worth at that time? What will happen in the meantime? How will beneficiaries turn out?
Furthermore, the current state of transfer tax legislation adds one more aspect of uncertainty: What will the tax laws be in the future? For most clients, what happens to our transfer tax rules this year or next year is not particularly relevant. Most clients considering their estate plan now are going to live for decades into the future. The transfer tax rules are likely to change multiple times before their estate plan (at least the “at death” portion) is implemented.
One response in the face of so much uncertainty is to do nothing – freeze up. Another, better response is to plan, but with as much flexibility as possible in order for an estate plan to adapt to changes in the future. But with planning that is irrevocable – irrevocable life insurance trusts (ILITs) in particular – flexibility seems impossible. Yet this is not so. With a little creativity, much flexibility can be incorporated into even an ILIT. The discussion that follows explores ten ways to do this.
- Include “more” withdrawal beneficiaries.
A typical ILIT gives a group of people the right to withdraw contributions to the trust so that they have a present interest in the gifts to the trust. Doing this allows the gifts to qualify for the gift tax annual exclusion.1 The group given the withdrawal rights generally includes the donor’s children, perhaps donor’s spouse, and maybe grandchildren (although generation skipping transfer tax issues should be considered). The number of beneficiaries who are given withdrawal rights often depends on the anticipated size of the annual gifts to the trust – i.e., the amount of the premium for the life insurance policy.
For two reasons, consider whether other people should be added as withdrawal beneficiaries. First, in situations where the annual premium is large, annual exclusion gifts to children, spouse, and even grandchildren, may not allow for large enough non-taxable gifts to pay the premium. Second, it may be useful to make larger gifts – and have those additional gifts also qualify for the annual exclusion – in the future.
Clients may have other family members (or friends for that matter) they wish to provide for. If that is the case, consider adding those people as withdrawal beneficiaries. While courts have consistently required nothing more for a gift to qualify for the annual exclusion than a valid withdrawal right that cannot be legally resisted by the trustee2, the Service’s test requires a bit more. The Service has indicated in an Action on Decision in response to the Estate of Cristofani,3 case that it normally will not dispute withdrawal rights given to people who are either (1) current income or (2) vested remainder beneficiaries.4 If adding these “additional” beneficiaries as remainder beneficiaries does not make sense, consider adding them as current permissible income beneficiaries. In fact, if the clients’ intent is to provide for these people, it may make sense (though certainly not necessary from a tax standpoint) to give the trustee the ability to make principal distributions to them as well.
- Do not require the trustee to give notice.
Conventional wisdom is that giving a beneficiary a right to withdraw a gift to an irrevocable trust allows the gift to qualify for the annual exclusion only if the beneficiary receives notice (usually from the trustee) of the gift to the trust and the beneficiary’s right to withdraw. In fact, many articles are dedicated to the discussion of the details of notice – duration, frequency, etc. Courts, however, since the Crummey5 case, have affirmed annual exclusion treatment for gifts where the withdrawal beneficiaries had not received notice and, in the Crummey case, did not even know their withdrawal rights existed.6
Certainly, the trustee generally should give notice of gifts and withdrawal rights to beneficiaries. Doing so is less likely to provoke the Service. But in some circumstances, giving notice may be a bad idea. For example, a beneficiary who has a substance abuse problem may be likely to exercise a withdrawal right if he or she knows about it. Another problematic situation is that of a divorced client with minor children with withdrawal rights; notice would typically be given to the ex-spouse. In these cases, it may be better to not have the trustee give notice. The risk here is that the Service will view the gifts as not qualifying for the annual exclusion. That may be a lesser evil, however, than an almost-certain exercise of a withdrawal right.
To allow for this flexibility, do not include a requirement in the irrevocable trust that the trustee must give notice to the withdrawal beneficiaries. The trustee will want to give notice in most cases, but by not including a requirement that notice be given, the trustee has the flexibility to evaluate each situation and make the best decision.
- Give donors the ability to “toggle” withdrawal rights.
An irrevocable trust will typically name – either specifically or by category – those people who have a right to withdraw contributions to the trust. The donor’s ability, when each gift is made to the trust, to choose which beneficiaries (within that group) have a right of withdrawal for that gift allows the donor to adjust to future changes. Just as allowing the trustee to determine when to give or not give notice, this allows the donor to deny withdrawal rights to beneficiaries where he or she views the probability of exercise to be too great. The Service has ruled privately that this power does not cause estate inclusion for the donor.7
- Allow distributions during the insured’s lifetime.
People often have a narrow view of life insurance: It provides a death benefit. Frequently, however, a life insurance policy has significant cash value in addition to providing a death benefit. This is particularly true with life insurance policies used for estate planning where a permanent policy, rather than a term policy, is often needed. While certainly the intent during planning is that the policy will be used for its death benefit, if circumstances change, it may be helpful to use the policy’s cash value for the benefit of the trust beneficiaries. For example, if assets in the estate go down in value (as they sometime do), the trust beneficiaries may have greater need for policy value currently and the estate may no longer be subject to an estate tax. By drafting the ILIT to allow for distributions during the insured’s lifetime, the trustee will have the flexibility to make use of the policy cash value if circumstances warrant.
- Allow distributions to other trusts.
How often has a client asked to make a change to his or her ILIT? While not impossible – some states’ statutes allow amending an irrevocable trust by petitioning the court or even via decanting statutes – it’s certainly not an easy task. An alternative is to give the trustee of the original ILIT the power to distribute trust assets to a new trust for some or all of the same beneficiaries. A trust provision allowing this power might read as follows:
A provision like this certainly adds flexibility. But it should not be included lightly, as this gives the trustee tremendous power to alter the disposition of the trust.
The trustee may transfer all or part of the trust property to one or more of the trust beneficiaries, or to a trust for the benefit of one or more of the trust beneficiaries. The trust receiving the distribution does not need to have the same terms as the distributing trust.
- Do not require mandatory income distributions.
ILITs, like credit shelter trusts, frequently provide that after the first spouse’s death, all income is to be distributed to the surviving spouse. This may seem sound at first, but consider this question: Are the trust assets the ones the surviving spouse should use first? If the surviving spouse owns other assets outright, they will be included in his or her estate. Thus, those assets typically should be spent first. The assets in the ILIT (or a credit shelter trust for that matter) are not included in the surviving spouse’s estate; why not leave them in the trust to pass to the remainder beneficiaries free of estate tax?
While that analysis makes sense most of the time, in certain situations it makes sense to use trust assets for the surviving spouse’s needs. For instance, a surviving spouse who does not have enough assets of his or her own is unlikely to face an estate tax. Also, the surviving spouse’s other assets may be ones that are better preserved than spent (e.g., perhaps a family vacation home). For these reasons, give the trustee the ability to distribute income to the surviving spouse, but don’t make it mandatory. The trustee can then evaluate the situation and make the best decision.
- Use limited powers of appointment.
Giving someone, other than the donor, a limited power of appointment (i.e., the power to appoint trust assets to anyone other than oneself, one’s creditors, one’s estate, or the creditors of one’s estate) will not cause trust assets to be included in the power holder’s estate (however, see caution, below).8 This allows someone – perhaps the spouse or children – the ability to alter the disposition of the trust assets if circumstances change. For example, a trust may provide that at the second spouse’s death, trust assets are distributed equally among the children. Suppose that a son is later found to have a disability that entitles him to government benefits. If he inherits a share of the trust assets, he will likely be disqualified from those benefits. If the surviving spouse has a limited power of appointment, that spouse could instead appoint the son’s share to a special needs trust.
The power of appointment need not be as broad as it may be – i.e., rather than giving the power to appoint to anyone other than the “forbidden four”, it may allow the power holder to appoint to just the donor’s descendants and trusts for their benefit or to descendants and qualified charities, for example.
Caution. If a trust holds a life insurance policy, giving the insured a limited power of appointment over that policy causes estate inclusion under Section 2042. For example, if the spouse of the donor has a limited power of appointment, the trust should provide that the spouse cannot exercise that power over a life insurance policy on his or her life.
- Consider trustee provisions carefully.
Some ways to incorporate flexibility into an ILIT requires giving the trustee lots of power. This makes it even more important to ensure (1) the trustee and successor trustees are people or entities the clients trust, and (2) there is a clear, well thought out plan for naming successor trustees.
Too often trusts simply name a trustee and a successor with no directions for choosing another successor if the one named is unable to serve. A better plan is to name those people or entities the donor would like to name as trustee and then to indicate a plan for selecting subsequent successors. For example, the trust may permit the majority of the adult income beneficiaries to name the successor. Be careful to limit who may be chosen as a successor trustee; other interest or powers may cause estate inclusion for particular people if serving as trustee.
- Include “standby” special needs provisions.
When a client has a beneficiary who has special needs, it is common to draft the trust for that beneficiary so as not to disqualify him or her for government benefits that have income and asset limits. This is certainly good and common planning. But the client cannot always know when the trust is drafted which beneficiaries may have disabilities in the future – both those resulting from accident or illness and those not diagnosed until later. For that reason, it makes sense to include a trust provision that limits distributions to a beneficiary who is entitled to government benefits so as not to disqualify that beneficiary from benefits.
This is a “better than nothing” solution in that agencies are not fond of these types of provisions and might not respect them (i.e., disqualify the beneficiary from benefits anyway). But there is really no harm in including such a provision: It might work, and at worst, it does not do any harm (because the beneficiary would have been disqualified from benefits anyway).
- Make the trust a grantor trust.
A trust that is a grantor trust under the rules in Sections 671 through 678 is treated as owned by the grantor for income tax purposes. In estate planning, one of the common reasons for designing a trust as a grantor trust is that it allows the grantor to make an “extra” gift to the trust in the form of an income tax payment on the income earned by the trust.9 While this is certainly a good reason to have a grantor trust, most trusts owning just life insurance do not have income while the grantor (typically also the insured) is alive. However, circumstances may change; creating an ILIT as a grantor trust may be helpful if future planning involves transferring income-producing assets to the trust.
Trusts that own, or may own, life insurance should be structured as grantor trusts for an additional reason: transfer for value.10 Making the trust a grantor trust makes the sale of a life insurance policy to the trust not run afoul of the transfer for value rule. This rule results in the life insurance death benefit being subject to income tax. The following examples illustrate the two ways this can happen.
Creating an ILIT as a grantor trust can give lots of flexibility if policies need to be moved around in the future.
Example. A client needs to buy life insurance and wants it to be owned in an ILIT, but the trust will not be drafted for several weeks. The client wants to buy the insurance now but does not want to give it to the trust when the trust is drafted and be faced with estate inclusion if he dies within three years of the gift.11 If the client sells the policy to the trust for its fair market value, the three-year rule will be avoided. This transaction looks a lot like a transfer for value, that is, (1) a transfer (2) of a life insurance policy (3) for valuable consideration. If the ILIT is a grantor trust, the transaction between the client and the trust (i.e., the grantor and his grantor trust) is viewed as a transaction between the client and the client – and is entirely disregarded (i.e., essentially, no transfer). Therefore, no transfer for value occurs.12
Example. A client’s qualified plan owns a life insurance policy on her life. She would like to get the policy out of the plan and into an ILIT, while avoiding the three-year rule. One solution is to have the ILIT buy the policy from the qualified plan. Again, transfer for value appears to be a problem. Here all three elements of a transfer for value are present. (Thus, the transaction is not disregarded; it is between the ILIT and the qualified plan). However, where a transfer is to the insured of the life insurance policy, it meets an exception to the transfer for value rule. Here the policy is going to a trust where the grantor is treated as the owner for income tax purposes. The transfer for value problem does not arise because it is considered a transfer to the insured.13
With thoughtful planning, irrevocable need not mean inflexible. Flexibility in an irrevocable trust, however, has to be built in to the trust at the drafting stage.
2Estate of Cristofani, 97 TC 74 (1991): Estate of Kohlsaat, TCM 1997-212.
3Note 2, supra.
4AOD 1996-010, 7/15/1996.
5 397 F.2d 82. 22 AFTR2d 6023 (CA-9, 1968).
6 See also, e.g., Estate of Holland, TCM 1997-302.
7 Ltr. Rul. 9834004.
8 Section 2041(b)(1).
9Rev. Rul. 2004-64, 2004-2 CB 7.
10 Section 101(a)(2).
11 Section 2035.
12Rev. Rule 2007-13, 2007-1 CB 684.