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Friday, March 9, 2007

Nuts and Bolts of Life Insurance Trusts

Life Insurance Trusts – The most common form of inter vivos irrevocable trust is the Life Insurance Trust (ILIT). Since the grantor of the trust has no desire to use the proceeds of this trust during his life, and because the value of the insurance at the time of the grantor’s death can be quite high, it is a very popular mechanism for reducing or avoiding a grantor’s estate tax liability.

a. When creating a life insurance trust, it is important to know whether the client will be buying the insurance through the insurance trust or if they will be transferring in an existing insurance policy.

1) If at all possible, the client should always have the trust buy the insurance because:

i It avoids I.R.C. §2035 which states that a person’s gross estate for estate tax purposes includes certain assets that have been transferred out of the person’s estate within three years of death. Accordingly, if a person transfers an insurance policy to an insurance trust and dies within three years of when the gift to the trust was made, the full amount of the proceeds will be subject to both the Federal and New Jersey Estate Taxes.

ii It avoids having to determine the value of the existing policy at the time of the transfer. This value is known as the interpolated terminal reserve.

iii We are sure the insurance actually gets into the trust. All too often a planner creates the insurance trust and then it never gets funded, exposing the practitioner to unnecessary liability.

2) If the client will be contributing existing insurance to a trust:

i The value of the insurance at the time of the transfer is a gift to the Crummey beneficiaries of the trust.

ii Care must be taken when selecting the beneficiaries of the trust to ensure that there are enough beneficiaries to shelter the value of the gift.

iii The trust must be funded with enough liquid assets in the event someone does wish to exercise their withdrawal rights.

b. The trust should be established as a Crummey Trust.

1) A Crummey Trust is named after Clifford Crummey, the first taxpayer to use this type of trust successfully.

2) A Crummey trust is designed to provided a limited withdrawal right to certain beneficiaries in an irrevocable trust so that transfers to the trust are eligible for the annual gift tax exclusion.

3) The more Crummey beneficiaries there are, the greater the gift that may be made to the trust without having to pay a gift tax. Crummey beneficiaries may not just be named at random, because they do have a real right to withdraw the money that is put into the trust.

4) Generally, a 30 day withdrawal right is considered adequate, but there is no clear minimum.

5) Particular care must be taken when drafting the Crummey power to ensure that the power lapses only the extent of the greater of $5000 or 5%. Any greater lapse will be considered a gift by that withdrawal beneficiary to the other beneficiaries of the trust.

6) The trustee should have broad powers to satisfy any withdrawal rights. All Crummey withdrawal rights should be satisfied either against the contribution or the property of the trust, including any insurance policy or fractional interests in the insurance policy. This will provide substance to a Crummey withdrawal right.

c. Tax aspects

1) The trust should generally be created as an Intentionally Defective Grantor trust, I.R.C. §677, so that although the assets of the trust are out of the grantor’s estate, during the life of the Grantor any income received by the trust is taxed to the Grantor rather than being taxed to the trust. This avoids having to file a Form 1041 income tax return for the trust and it provides an additional gift to the beneficiaries in an amount equal to the income taxes actually paid. Frequently this is done with a power to substitute trust assets, other than the insurance, with assets of an equivalent value to the trust in a non fiduciary manner I.R.C. § 675(4).

2) Upon the death of the grantor, the trust will either be taxed as a simple or complex trust depending upon the terms of the trust.

3) The practitioner must consider whether the Grantor’s Generation Skipping Tax Exemption should be allocated to the ILIT. The Code was revised under EGTRRA to provide an automatic allocation of the Grantor’s GST exemption in many cases and this is not always the most desirable result. A grantor may opt in or opt out of having the automatic allocation on a timely filed gift tax return.

d. Planning Considerations

1) The Grantor should NEVER be trustee of his or her own ILIT.

2) It may sound obvious, but it is important to counsel clients that once money goes into an irrevocable trust, the money no longer belongs to them and they will have difficulty getting the money back.

3) If the Trustee is the Grantor’s spouse, care must be taken when making contributions to the trust to ensure that the Trustee spouse is not making any contributions. (i.e. Never contribute joint or community property to the trust or write a check to the trust from a joint account or a business account).

4) ILITs are somewhat expense to establish and maintain for many clients, particularly those who have large estates due strictly to the amount of insurance they buy. Consideration should be given to naming a child as the owner and beneficiary of the policy as a means to save money for the client while receiving many of the same tax benefits.

5) The client should make sure that the insurance premiums are paid on an annual basis to minimize the maintenance fees. If multiple insurance policies are in one trust, try to convince the insurance carriers to have the same due date for the premiums.

6) The life insurance trusts is a particularly useful planning tool for same sex couples and unmarried couples because it provides a means to give the decedent’s significant other a large sum of money tax free, yet control the money’s ultimate destination.

e. Types of Life Insurance - Regardless of whether a client owns a term, whole life, or variable life insurance policy, if the value of the policy and the client’s other assets are in excess of the New Jersey Estate Tax threshold, it is advisable to discuss the benefits of the ILIT.

1) Term Life Insurance – These policies by their nature are designed to last for short period of time to cover a particular type of risk. The premiums on these policies are typically low, and a contribution of an existing policy to an insurance trust is relatively easy because of the low value of the policy.

2) Whole Life Insurance – These policies are designed to build up a cash value to produce a guaranteed return that will ultimately pay for the insurance premium. The premiums can be quite substantial, which is important to know when calculating the number of Crummey beneficiaries that must be named. A contribution of a large whole life policy to an ILIT may result in a gift tax no matter how comprehensive the planning because of the size of the insurance.

3) Variable Life Insurance – This type of policy is similar to the whole life insurance except that instead of having a guaranteed return, the rate is variable. Since most people are not good investors, be wary of advising this product.

4) Second to Die Insurance - A Second to Die Insurance Trust is different from a typical ILIT in one substantial and obvious way - the insurance benefits are not paid until the second to die.

i Practitioners should ensure that neither spouse is ever eligible to serve as trustee nor made a Crummey beneficiary.

ii Since this trust is not for the benefit of the surviving spouse, the clients should be sure that the surviving spouse has enough funds to live on absent the trust funds.

iii These trusts are particularly beneficial for clients interested in dynasty trusts as more insurance can purchased for a lower premium amount.

f. Insurance Trusts Established Pursuant to Divorce or Separation– Frequently Divorce attorneys draft provisions in a separation agreement or a divorce decree that call for an insurance trust to be created for the benefit of the children of the marriage. Terms of the trust are rarely spelled out with any specificity.

1) In the event that the person who is required to be insured passes prior to the creation of an ILIT, the courts can impose a constructive trust for the benefit of the children. (A constructive trust is an implied trust established by operation of law.) The terms of the trust are in the judge’s discretion, rather than in either the form that the decedent, or surviving parent, would want.

2) Planning Considerations

i Frequently a divorce or separation agreement will say what amount of insurance a person should have without any consideration for who should be trustee, the tax consequences or the ages at which the children should have access to the money. Occasionally, inappropriate provisions are included. Thought must be given how to address these concerns, particularly in light of the fact that these two individuals may not be on good terms.

ii Payment for the trust. I have yet to see a divorce decree or separation agreement that contemplates who will actually pay for the insurance trust. This is often a sticking point for many clients.

iii Compliance. Working with an unfriendly trustee or grantor can severely complicate compliance with both the tax laws and properly funding the trust.

g. Management of Insurance Trusts

1) The management of an insurance trust from an investment standpoint is quite simple. Most insurance trusts do not have assets other than the insurance itself.

2) The complexity comes when trying to explain the maintenance and funding requirements of the trust to clients. Further complicating matters, often clients will try to manage the trust completely on their own to save on costs. The practitioner must take extreme care when allowing this to happen because the practitioner will still be potentially liable.

3) Funding the Trust

i Checking accounts must be created in the name of the trust (and if the Grantor does not have an individual checking account, the Grantor may also have to create a checking account to fund the trust). Many practitioners like to get a separate tax identification number for the ILIT. If the trust is an Intentionally Defective Grantor Trust (IDGT), it is not necessary, but it is still a good idea in the event a creditor does an asset search using the Grantor’s Social Security Number.

ii Insurance must either be purchased by the trust or transferred into the trust. This requires completing insurance forms that designate the trust as the owner and beneficiary of the policy.

4) Sending the annual Crummey letter. As soon as practical after the trust is funded, a letter must be sent to the designated Crummey beneficiaries to advise them of their withdrawal rights. These letters should be acknowledged by the beneficiaries (or their guardians) and maintained by the attorney (or trustee).

i After 30 days (or whatever the relevant Crummey time period is) the Trustee may use the gift from the Grantor to pay the insurance proceeds.

5) To avoid problems with I.R.C. §2035 and §2036 (which would bring the insurance back into the gross estate of the Grantor), it is important that the Grantor contains no impermissible control over the trust and should never be the trustee. The Grantor may be given limited ability to hire and fire Trustees.

7 comments:

Joseph said...

Hi Kevin - you say that the IDGT does not have to file a 1041 because it is a grantor trust, what about the NJ-1041? Isnt it true that under NJ law ALL grantor trusts have to file a NJ-1041 with a k-1 going to the grantor?

Thank you

Kevin A. Pollock, J.D., LL.M. said...

Joseph,

Good point. The Trust may have to file a NJ-1041. Admittedly, while the Grantor is alive, I almost never have to because there is never any income. At most, we send in a letter saying that no return is due because we are under the income threshhold. For NJ, this is $10,000. If the only assets of the trust are the insurance and a small bank account, it will not throw off income.

On further note, if there is enough income, the trust may have to file a 1041 depending on which tax ID is used. Many practitioners like to play it safe and get a new tax ID for the trust, thereby requiring the filing of a 1041.

Diane H. Parriott said...

Thank you for a great blog post. Question about the Crummey letters: if the beneficiaries are just the spouse for life and then siblings afterwards, do you typically still include the withdrawal rights language and Crummey letter formalities? I've always been curious about that.

Kevin A. Pollock, J.D., LL.M. said...

Diane,

Whether to include withdrawal rights usually has more to do with the net worth of the Grantor. As you know, each contribution to a trust uses up part of the Grantor's $1,000,000 lifetime exemption if there are no withdrawal rights. So, if there is any danger whatsoever that contributions to the trust would use up too much of the Grantor's lifetime exemption, I add the withdrawal rights.

Prior to the increase in the estate tax exemption amount, I always added the withdrawal rights. Now I am trying to do it on more of a case by case basis.

On a side note - when a spouse is the beneficiary of a trust, and the amount of the premium is less than the annual exclusion amount, it always makes sense to add the withdrawal rights. You can have the spouse acting as trustee and include a provision in the trust that if the trustee is the withdrawal beneficiary, she does not have to send a notice to herself.

Diane H. Parriott said...

Kevin, thanks for a VERY helpful response. I'm a 4th year associate at a boutique TE firm and I feel like there is always so much to learn. I appreciate clear and concise blogs such as yours! Thanks again! Diane

Marie said...

Thanks for the excellent post! I am curious how you would draft the Crummey letters when the ILIT holds an employer-paid life insurance policy that pays premiums twice monthly. Does one annual Crummey letter suffice for all of the premium payments? Thank you very much.

Kevin A. Pollock, J.D., LL.M. said...

Marie,

I'm a bit confused - I have never run into a situation where the employer is paying for an employee's policy that is owned by a life insurance trust.

I guess this would technically be income to the employee and then a gift by the employee to the trust. I would rather have a cleaner transaction where the employer pays the employee and the employee puts the money in directly.

I still think Crummeys would have to be done ever two weeks and the trustee should switch the policy to a different payment term (ideally yearly) to avoid all the hassle.