Loss of Control and Flexibility
When transferring ownership of life insurance to an irrevocable trust, the client must give up: the income produced by any income producing trust assets if the trust has been funded; the use and enjoyment of any property including the life insurance cash values held by the trust or use of the cash values as collateral; the right to name, add, subtract, or change the size or terms of a beneficiary’s interest; the right to regain assets (including life insurance) placed into the trust; and the ability to alter, amend, revoke, or terminate the trust.
The psychological cost of losing this control and flexibility should not be underestimated. Many clients should not set up such trusts, in spite of the tremendous potential death tax savings, because of the offsetting lifetime loss of peace of mind and flexibility. Clients who are relatively young will be faced with a long lifetime of rapidly changing personal and financial circumstances.
Planners must make clients aware of the problems inherent in the event the client’s objectives, client’s or beneficiary’s circumstances, or tax laws change. The client may decide at some future date that he does not like the payout provisions and would like them to be longer (or shorter) or provide more (or less) to a given beneficiary. Counsel may find the powers in the trust instrument are tainted in such a manner that trust assets will be included in the client’s estate. The client may have failed to name enough backup trustees or there may be a personality conflict between the client and the trustee.
Clients must also be made to understand that there is a certain level of paperwork and record keeping that cannot be safely ignored. “Responsibilities of this nature can seem unduly complex and frustrating to the client, who, unless he has been forewarned, may well become unhappy with his attorney for placing him in the situation in the first place.”1
There are up front and continuing cash costs involved with an irrevocable life insurance trust. Obviously, there are legal fees for preparing the trust agreement. These costs range from over $1,000 to more than $10,000 depending on the nature and extent of the client’s assets and the part the irrevocable trust plays in the overall planning process.
Accounting costs must also be considered. As long as the trust is unfunded, no annual income tax returns will be required because the trust will have no income. But records must be kept and an accounting should still be made to trust beneficiaries and the trust must have a taxpayer identification number (TIP).
Professional trustees, such as banks operating as trust companies, often charge an acceptance fee and all charge a fee for management and investment services. Although these fees are typically nominal during the insured’s lifetime (when the trust has little or no assets and the trustee has few responsibilities other than safeguarding the trust document), they can be significant when the trust is swelled with policy proceeds and other assets poured over into the trust at the death of the insured.
There may be a termination fee if the trust is terminated before the insurance policies have matured and the trustee has had the opportunity to recover set up costs.
Loss of Contributions
Yet another consideration is the potential loss of the donor’s contributions out the back door of the trust. Irrevocable life insurance trusts usually require special provisions (Crummey powers) that enable the client’s gifts to the trust to qualify for the gift tax annual exclusion. By definition, these Crummey powers are withdrawal powers. They give the powerholder the legal right to demand specified amounts at given times. If the demand powers are not real, they will not eliminate gift taxes. Yet, if they are real powers, there is always a possibility that money which could and should have been used to pay life insurance premiums will instead be drained off by the power holding beneficiaries. There are techniques and devices to persuade the beneficiary not to exercise this right. But the IRS has been vigorous in attempts to disallow the gift tax annual exclusion in just such situations.
To the extent the annual exclusion cannot shield the premium outlays, the client will first have to use up his unified credit and then pay gift taxes on each transfer.
Although there are potential solutions to problems confronted when dealing with an irrevocable trust, there is no free lunch. Tax savings and additional flexibility comes with a cost. Escape hatches are less than perfect. Yet, in weighing these disadvantages, planners should consider:
- The client can discontinue premium payments, let the policy inside the trust lapse (or use policy cash values to purchase extended term insurance for a limited time or a lower amount of paid up insurance for the insured’s life) and start over with a new trust with new terms and new insurance (assuming insurability at affordable rates).
- Even an irrevocable trust can be revoked by court action assuming the written consent of all (including guardians for minor) beneficiaries. A trust can be revoked, in whole or in part, in many states assuming all persons beneficially interested (i.e., who have a vested interest) agree to the revocation in writing and file a notarized copy of the request for revocation in the appropriate county clerk’s office. The mere state statutory power enabling such a revocation would not be enough to require inclusion of irrevocable trusts in the estates of such persons. However, when the trust terminates, the property may end up back in the client’s estate if there is no specific provision in the trust paying over the assets to beneficiaries named in the event of a premature termination by revocation. The client must then create a new irrevocable trust or make a further disposition of trust assets to remove them from his gross estate.
- Planners should keep in mind that revocation is not automatic and is usually granted only as an escape hatch from unforeseen events occurring subsequent to the creation of a trust. If beneficiaries are below the state age of majority, it will be necessary to have guardians ad litem appointed since the minors cannot consent to the termination or amendment.
- One common objection to the creation of an irrevocable life insurance trust is the loss of the use of life insurance cash values. When a cash value policy is placed in or purchased by an irrevocable trust, the client normally does lose all control over the policy values. The trustee, acting in a fiduciary capacity, is the only party that can utilize those values. But, by giving the trustee the authority to make distributions to the beneficiaries during the grantor’s lifetime, the cash value and/or dividends of the policy can be used during the lifetime of the insured client. In other words, it is possible to draft an irrevocable life insurance trust in such a way that distributions could be made to beneficiaries before the client’s death (including a spousal beneficiary).
- The client could purchase the policies from the trust at their fair market value. This gives the trust a relatively small amount of cash but returns the insurance (transfer for value tax free) back to the client, who can then create a new trust with new terms and contribute the old policies into that new trust. If the policy held extensive cash values, the out of pocket cost of the purchase could be reduced by stripping out all or a portion of the cash values prior to the transfer. Of course, the purchase cannot be guaranteed by requiring such a sale in the trust agreement. A call on trust assets would result in estate tax inclusion. The legal right to purchase a policy would clearly be an incident of ownership.
- A special power of appointment could be inserted from inception into the irrevocable life insurance trust. That power would give the insured’s spouse, an adult child, or someone else the insured implicitly trusts the ability to appoint (direct ownership of) trust property to herself or her children (or anyone else other than back to the insured-grantor, his estate, his creditors, or the creditors of his estate). The authors suggest that the trust bar the holder of the power from using it to pay for any item that could be considered in satisfaction of either spouse’s legal obligation of support. This special power should cause no inclusion in the estate of the holder and, unless the policy is in fact transferred back to the insured-grantor, it should not attract estate tax in his estate. A contingent limited powerholder should also be named.
- The disadvantage of this technique is, if the parties divorce or the holder dies before the grantor-insured, the ability to remove trust assets and appoint them in a direction consistent with the client’s desires is eliminated. Obviously, if there is marital discord at the time of planning, the spouse should not be considered as the holder of this power.
- Name the grantor’s spouse as initial holder of the power to appoint trust assets but provide if: (a) the spouse dies first; (b) the spouse is no longer married to the grantor; or (c) for any reason the spouse no longer has the legal or mental capacity to exercise the power, the limited power would automatically pass to the individual named as contingent holder.
- It is possible to name as beneficiary “my wife if I am legally married at the time of my death, otherwise.” This designation will eliminate payment to an ex-spouse without causing inclusion of the policy proceeds or any other trust property in the insured’s estate.6 In other words, a client’s attorney could question the client exhaustively and attempt to anticipate, in drafting the trust document, every possible circumstance in which the client might want to change the terms. It is clear, for example, that an irrevocable life insurance trust can now safely provide that “Upon a legal separation or divorce, any and all interest my wife, Sadie may have in this trust shall cease.”
- Consider a provision giving the independent trustee sole discretion to terminate the trust in the event that the trust can no longer meet its intended objectives due to unforeseen circumstances. In other words, the trustee (assuming the trustee is a party other than the insured or a beneficiary) can be given a discretionary power to collapse the trust and assign the life insurance or distribute assets to the trust’s beneficiaries, if the trust should become unworkable because of a tax or other legal change or if funds are no longer available to pay premiums. The trustee may also be given the power to distribute trust assets, including life insurance policies and the right to benefits under group term life, in kind.
- The drawbacks here are: (a) the assets in the trust go to the trust’s beneficiaries, perhaps prematurely; and (b) the trustee may be reluctant to exercise this power unless all beneficiaries will sign an agreement that the action is proper and in conformance with the trustee’s fiduciary responsibilities to all beneficiaries.
- The trustee (assuming the trustee is a party other than the insured or a beneficiary) can be given a power to sprinkle or spray income and principal among a class of persons and thus add additional flexibility to the dispositive terms of the trust without adverse tax consequences.
- The trust could provide that, if the grantor died within three years of transferring life insurance held within the trust or if, for any reason, life insurance owned by the trust was includable in the grantor’s estate, the proceeds would be paid to the insured-grantor’s executor. That way, the proceeds could be channeled to the insured’s surviving spouse and qualify for the marital deduction. In fact, the trust could contain a marital clause so that if the client doesn’t want the trust to end upon his death or doesn’t want the proceeds paid to his probate estate, the tax savings objectives can be accomplished within the trust itself.
- The noninsured spouse could create a split dollar arrangement (see Chapter 41) with the trust in which such spouse retains access to policy cash values. This would indirectly give the insured spouse access to policy values without risking estate tax inclusion of the proceeds. The drawback here is the possibility of spousal estrangement.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM