Insurance Trusts (ILIT) Not So Simple

Summary:

Irrevocable life insurance Trusts (“ILITs”) are a
common estate planning tool. Having a trust own your insurance can keep the
proceeds outside your taxable estate, protect the proceeds for your surviving
spouse, partner or children. An ILIT can protect the proceeds from an heir’s
divorce or lawsuit. Physicians and others worried about malpractice claims use ILITs
to hold permanent insurance to build value in the protective envelope of the
trust. But too many people assume insurance trusts are a simple boilerplate
form. That assumption is likely to result in a trust document that is
inadequate and not tailored to their situation, and lax administration of the
trust (after all, it’s simple and standard!). 

Start Simple: Who
Should be Trustee.

The simplest step for an
ILIT is to name the trustee, right? The reality is that administering an ILIT

Isn’t the cake walk most
people think. Insurance must be properly purchased, monitored and reviewed.
Gifts must be accepted and Crummey notices issued (see below). Financing and
other arrangements may have to be monitored. There are a myriad of other
technical administrative issues that could affect an ILIT. Uncle Joe might be a
nice guy, but you’re always safer naming a professional, such as a trust
company, or a long time family CPA, to be certain your ILIT is handled properly.
The fees they’ll charge are modest compared to the problems Uncle Joe
frequently creates. You can always have the Uncle Joe replace the professional
trustee following your death with the ILIT has substantial funds you want him
to administer instead of the trust company or CPA. But that too is probably a
mistake. Instead, have Uncle Joe serve as a co-trustee so that the professional
management of your trust can continue. Be sure your ILIT specifically addresses
compensation for professional trustees since most ILITs have no income and many
have only nominal asset values (e.g., if they only hold term insurance) so that
standard methods of calculation compensation will provide inadequate payment.

Situs-Which State Law
Governs.

There are a host of
important matters that can be affected by the particular state law that governs
your ILIT. Some states have enacted legislation holding trustees harmless for
insurance investment decisions by relieving the trustee from the general
standard of care applicable to a trustee, such as investing with care and
skill, etc. Del. Code Sec. 3302(d). This relieves the trustee of liability for not:
determining if an insurance policy is a proper investment, investigating the
financial strength of the insurance company, exercising any policy option, etc.
If a state other than your state of domicile has statutory protections you want
for your ILIT trustee then issues of nexus (connection to that state) must be
addressed. The surest way is to name an institutional trustee in that state.
Florida law may permit the trustee to delegate insurance management to other
persons without the fiduciary duty of care that would otherwise apply. Fla.
Statutes Sec. 518.112(2).  North
Dakota, Pennsylvania, Wyoming also have favorable statutes. Another approach
may be to list the indemnifications and exceptions in your ILIT document to
minimize the liability your trustee faces (especially if compensation is
minimal). But think carefully, do you really want the trustee to avoid these
responsibilities?

Reciprocal Trust
Doctrine.

If you set up an ILIT with
a $1 million 20 year term policy on your life naming your wife as beneficiary
and co-trustee, and your wife sets up an identical trust naming you as
beneficiary and co-trustee, the two parallel (reciprocal) trusts might be
unwound by application of the reciprocal trust doctrine. Whenever you and your spouse,
or perhaps another family member, are establishing similar ILITs take care to
plan and draft around the reciprocal trust doctrine. See U.S. v. Grace, 395 316 (1969); PLR 9643013; PLR 200426008.  Incorporate as many differences between
the two trusts as possible. While substantive economic differences are
preferred, if not essential, the inclusion of other more administrative
differences may still support the independence of the two trusts. The following
listing does not weigh the strength of the various factors listed:  ■ The parties, e.g. husband and wife, should not be in the same
economic position following the establishment of the two trusts. ■ Give one spouse a “5 and 5” power under one trust,
but don’t include a “5 and 5” power under the second trust.  ■ Include an inter-vivos special power of appointment (“SPA”) under
one trust, but not another. Endeavor to make the power meaningful, not just a reallocation
of assets between the same group of grandchildren.  ■ Include a
testamentary special power of appointment under one trust, but not the other. ■ Include a martial savings clause in one trust, but
not in the other.  ■ Each trust should have different distributions,
e.g., one trust could mandate distributions at specified ages and the other
trust could be a perpetual dynasty trust. ■ Use different distribution standards in each trust, e.g., one trust
could distribute solely based on an ascertainable standard, and the other trust
could use a broad discretionary standard with an independent trustee.  ■ Add an additional beneficiary, like aunt Jane, to one of the trusts,
but not the other. ■ Use different
trustees for each trust. If neither spouse is a trustee or co-trustee and you
have different trustees for each trust this could be a significant factor. ■ Have the trusts signed at different times. ■ Each trust can hold different assets, e.g.,
husband’s trust holds universal life, and wife’s only term insurance). Vary the
amount of insurance coverage and other assets in each trust.  For example the wife’s term policy could
be for $5 million while the husband’s trust only holds $2 million of coverage. ■ Have one trust receive a significant initial
contribute and the second trust merely a nominal initial contribution.

GST Exempt or Not.

Should the trust be GST
exempt or not? Since only about 2% of term insurance policies ever pay-off,
evaluate whether your GST exemption should be wasted on an ILIT holding only
term coverage. Also, even if your ILIT holds permanent insurance that is almost
assuredly going to be maintained in force for the duration, you may have more
important uses of your GST exemption. Plan accordingly. So even if making the
ILIT GST exempt is reasonable, if you have better uses of your exemption, have
the trust drafted in a manner that avoids GST issues. For example, the ILIT
could be drafted in a manner that causes it to be included in your children’s
estate to avoid the GST tax. If it is intended that you will allocate, on your
gift tax return, sufficient generation skipping transfer (“GST”) tax exemption
to the trust to keep it free of GST Tax issues (to create a zero inclusion
ratio) be certain your accountant addresses this on a gift tax return.  See “Potpourri”.

Who is Your Spouse

No, this is not about the
ABC show Wifeswap. But if you set up an irrevocable (can’t be changed)
insurance trust, you need to plan for lots’ of “what-ifs”. At some future point
you may no longer be insurable and you might be divorced, perhaps remarried,
perhaps several times. Who should benefit from your ILIT? Should
“spouse” be defined as a particular person, or as the person married
to you at a specific time (a “floating spouse” clause)?

Divorce.

Under some state’s laws
divorce may automatically terminate your ex-spouse’s interests as a beneficiary
in insurance on your life (or it may not). Should your ILIT override either type
of statute? If you have your spouse automatically terminated as a beneficiary
in the event of divorce and you are required to provide life insurance for his
or her benefit, but you are rated? Precluding the use of the insurance held in
the trust could prove a costly mistake.

Annual Demand (Crummey)
Powers.

If you make gifts to an
ILIT you will have to qualify those gifts for the annual gift tax exclusion
($13,000 in 2009), use up some of your $1M lifetime gift exclusion, or use
alternative financing means to reduce the annual gift impact.  To qualify for the annual gift
exclusion beneficiaries have to be able to obtain the money given currently (a
present interest). This is often accomplished by giving each beneficiary the
right to withdraw new gifts during a window of time and giving them notice,
which they acknowledge, of that right. This technique is called a “Crummey”
power after the court case initially sanctioning it. Consider the number of Crummey
power holders, provide flexibility so as irrevocable trust sufficient annual
gifts can be made to hold likely future increases in insurance to be added to
the trust. Give every power holder sufficient rights under the trust so that
they are more than a mere naked Crummey power holder.

Conclusion.

The above discussion only touched upon a
few of the scores of issues that should be addressed in even a “simple”
insurance trust and plan. If Capital One did insurance trusts as well as credit
cards, their slogan would be “What’s in your ILIT?”