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.