Irrevocable Life Insurance Trusts and Selecting a Trustee

A trustee of an irrevocable life insurance trust must review the trust document for efficacy in meeting both tax and dispositive objectives, set up a trust account, purchase the life insurance, receive premiums from the grantor, notify beneficiaries holding demand powers of their rights each year, and pay premiums to the insurance company. Clients, even though charged only a hundred dollars or so each year for this service, often do not perceive the value they are receiving as worth the cost.

For this and other reasons (such as control), many clients will want to be the trustee themselves or name their spouses as trustees. Both choices are contraindicated because of potential adverse estate tax ramifications and both choices would limit the flexibility that should be built into an irrevocable life insurance trust.

Grantor-insured as trustee – If the grantor-insured is named as trustee, the IRS could argue that even as trustee and in spite of a trustee’s definitional fiduciary obligations, the insured has retained an incident of ownership that causes the insurance proceeds to be includable in his estate. For instance, if the insured is named as trustee, it is likely the IRS will argue that the policy proceeds should be included in the insured-trustee’s estate, even if he holds no interest in the trust as a beneficiary, because of the control (incidents of ownership) he as trustee holds over trust property (the life insurance).9 Furthermore, the discretionary and administrative powers of a trustee, if retained by the insured-grantor, could be held to be rights over the trust’s assets that cause estate tax inclusion. An independent trustee, one who is not a beneficiary and who is not legally subservient to the grantor is the preferable choice for a trustee.

Spouse of insured-grantor as trustee – Could the problem be solved and intrafamily control be maintained by naming the insured’s spouse as trustee? There are no attribution rules that impute the trustee’s incidents of ownership to the insured grantor merely because the two happen to be married. So, it is possible for the insured’s spouse to be the trustee of an irrevocable life insurance trust, assuming such spouse hasn’t made transfers of property into the trust and thereby become a co-grantor. In addition, the spouse should not be the trustee if the trust will own either a single life or survivorship policy insuring the spouse, as the spouse would possess incidents of ownership in the policy via being the trustee, and the policy insuring the spouse would thus be includible in her or her estate pursuant to Code section 2042.

Naming the insured’s spouse as trustee may not be a bad choice during the insured’s lifetime while there are no assets in the trust other than the life insurance policy and the duties of the trustee are practically nonexistent. Then, when the insured dies, the spouse can automatically be removed as trustee and a corporate fiduciary inserted (or added to the surviving spouse who would be prohibited from making the types of decisions which would cause inclusion of the proceeds in her estate). But if the insured’s spouse is given a general power of appointment over the policy in the trust document, the proceeds will be in her estate.4

Here are some guidelines for safely naming a spouse as trustee:

name at least one other (preferably independent) individual or corporate fiduciary as co-trustee;

specifically exclude the surviving spouse from all potential exercises of incidents of ownership in the policy(ies) held by the trust insuring her life;

allow distributions to the surviving spouse from the irrevocable life insurance trust only if and when the principal of the marital trust is exhausted;

forbid any distributions to individuals that would relieve or discharge the spouse from a state legal support obligation (such as the providing of food, clothing, or shelter, or in some states education);

limit the surviving spouse to a special power of appointment over trust assets, but specifically exclude from this power the right to dispose of life insurance on her own life; and

exclude the surviving spouse as trustee from making any decisions involving the distribution of principal or income to herself as a beneficiary except those limited by a health, education, maintenance, and support ascertainable standard.

The authors’ opinion is that the advantages of naming the spouse as trustee are outweighed by the potential tax traps and drafting difficulties. At the least, if a spouse is named, another individual should be named as a co-trustee with the trust wording noted above.

One of the more important issues in a country where there is great geographic mobility (not only of beneficiaries, but also of trust administration personnel) is the question of changing trustees. Can the trust safely provide for replacement of trustees if the beneficiaries move or, for any reason, decide they want a new trustee?

It is clear that the grantor should not be given the power to remove the trustee and become the successor trustee. Even if the grantor never exercises that removal power and even if the removal power is subject to a condition or contingency, such as the trustee’s death, resignation, or malfeasance, which has not yet occurred, the mere existence of the right will cause the inclusion of the trust’s assets in the grantor’s estate.

The IRS claims that a grantor should be considered to hold those powers over a trust that are in fact held by an independent trustee if the grantor has the power to remove the trustee, even if the replacement trustee is legally independent. It is the opinion of the authors that the IRS position is wrong because it imputes to a grantor powers that he can never hold personally. It ignores entirely the independence and fiduciary obligations of the trustee.

As a practical matter, many authorities approach the selection of a trustee by considering the existence of the trust during two time periods: (1) Who should be the trustee during the insured’s lifetime? and (2) Who should be the trustee thereafter?

During the insured’s lifetime, the trustee must be a person who will cooperate with the grantor and the grantor’s family. This criterion may include the attorney, accountant, trusted friend, or adult child of the grantor. Generally, the time commitment (and therefore the trustee’s compensation) is minimal during this stage of trusteeship.

But after the grantor’s death, the trustee’s role changes drastically. At this point, the trustee must invest, safeguard, and manage the insurance proceeds and other funds that may have poured over from the client’s estate into the trust. Those assets must now be administered over a long period of time and countless difficult decisions may be required.

So, in many cases, an individual is selected for the predeath period, while a corporate trustee (with or without individual co-trustees) takes over the burdensome task of trust administration after the death of the grantor. Certainly, a bank or other professional trustee should be named in the trust instrument as a contingent trustee in case the individuals named cannot, or become unwilling or unable to serve.

A corporate trustee during this second phase of the irrevocable trust’s existence avoids all of the potential tax traps, provides continuity of investment, management, and record keeping, and relieves the client’s family and other advisors of a myriad of bothersome and time consuming details. Since the trust may remain in existence for several generations, this continuity can be extremely important. A collateral (but not insignificant) advantage to the use of a corporate fiduciary is that the bank or trust company usually will have highly competent counsel to provide a second opinion and review the trust document and its provisions.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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