Although life insurance agents and financial planners do not draft documents, an understanding of certain drafting tools and techniques is helpful, if for no other reason than, to provide a backup and a second pair of eyes for the attorney.
An irrevocable life insurance trust should generally contain one or more of the following provisions:
- The right of the Crummey power beneficiaries to make withdrawals extends to contributions to the trust from all sources. This makes it possible for the gifts of persons other than the grantor to qualify for the annual exclusion. It should also extend to both direct and indirect gifts, so that direct premium payments by the grantor (or by an employer) to the insurance company will qualify for the annual exclusion.
- The amount subject to the Crummey power should be limited to the smallest amount that will protect the client’s annual contributions. This will reduce or eliminate the gift tax payable and the gift tax return that must be filed by the Crummey powerholder (and the potential federal estate tax payable) if the holder’s power extends beyond the de minimis $5,000 or 5 percent protected amount and he lets that excess right of withdrawal lapse.
- Require the trustee to give return receipt requested notice of any additions to the principal and keep the right of withdrawal open for at least thirty days. This gives the beneficiary ample opportunity to realistically exercise his withdrawal rights.
- Require that the beneficiary exercise the withdrawal right within a period of time well within the policy’s grace period for payment. This assures that the trustee will have adequate time either to pay the premiums or to notify the grantor or others that the premiums must be paid from a source outside of the trust.
- Require that the beneficiary exercise withdrawal rights in writing.
- Allow any power given to a minor (or otherwise incompetent) beneficiary to be exercised on his behalf by a guardian. It is important to document that the legal right of the minor could, in fact, be exercised on his behalf. But provide that only the named individual or his guardian (or, if incompetent, his conservator) can exercise the power. That way, if the powerholder is declared bankrupt, his trustee cannot make withdrawals.
- Give the trustee the ability to satisfy a demand in-kind (e.g., with a fractional interest in the life insurance policy death benefit) in the event there is not sufficient cash or cash value in the trust.
- Terminate the power of withdrawal upon the insured’s death (except in the case where the trust may hold a survivorship policy, in which case the demand power should continue until the surviving spouse insured dies).
- Name backup powerholders so that, if a primary Crummey powerholder dies, the annual exclusion is not lost.
- Have the grantor irrevocably renounce all rights in any policies or other assets in the trust.
- Be sure the noninsured spouse pays no premiums and contributes no premiums, policies, or any other assets to the trust. If the noninsured spouse pays premiums, she may be considered a co-grantor of the trust. If she is also an income beneficiary of the trust, all or a portion of the proceeds purchased with her contributions may be includable in her estate.
- The trustee should be given a duty to collect proceeds and indemnification for costs involved in a suit if required. Authority should be given to settle any such suit.
- Give the trustee the right, if the insurer allows, to take one or more policy death benefits under the settlement options provided by the insurer.
- In community property states, the grantor should indicate that any insurance contributed to the trust was the separate property of the grantor. If possible, premiums should be paid by the grantor with separate property funds.
- Consider including flexible provisions in the trust (see “Structuring the Trust for ‘What Ifs’” later) to help address the current uncertain estate tax environment and overcome potential client concerns regarding creating an irrevocable trust.
Among the “Do Nots” often suggested in setting up these trusts are:
- Do not require that the trustee purchase life insurance or apply contributions to the trust to be used to buy life insurance or pay life insurance premiums.
- Do not name the trust the “Lotta Doe Life Insurance Trust,” especially, if it is important to document that the trustee acted independently in the purchase of life insurance rather than as the client’s agent and at the client’s direction.
- Do not allow the client to sign the policy application as applicant or owner (unless an informal application is being used to get underwriting started as a prelude to the actual application being completed once the trust is in existence). The client should sign only in the place where it says, “Insured.”
- Do not allow the trustee to merely endorse the client’s contribution to the trust each year and send them directly to the insurance company. It is important that the trustee reduce those funds to possession by cashing each check in a separate checking account in the trust’s name and writing a check drawn against the trust’s account to the insurance company.
Structuring the Trust for “What Ifs”
In real life it is not always possible to structure the transactions as described above in the preferred approach. For instance, the client may have purchased a policy years before discovering the federal estate tax inclusion problem. It may be transferred into the trust too late to escape federal estate tax inclusion, or some other unforeseen problem may cause the proceeds to be included in the client’s estate.
There is an escape or failsafe (or bail-out) contingency provision that can be placed into a trust where the irrevocable trust is to be the recipient of a pre-existing policy. This escape provision can require the trustee to hold any insurance proceeds that are included for any reason in the grantor’s gross estate, and to pay them out in a manner that qualifies the proceeds for the estate tax marital deduction, either a general power of appointment or Qualified Terminable Interest Property (QTIP) deduction. So, if the proceeds are for any reason includable in the insured’s gross estate, this escape clause will eliminate the tax if the insured is, in fact, survived by a U.S. citizen spouse.
Such failsafe trust clauses are extremely important for most insurance trusts created by married grantors, but must be drafted with considerable care. The reason is that tax law requires that the surviving spouse receive the property outright, or in a manner tantamount to outright, to qualify for the marital deduction. Conversely, most life insurance trusts usually limit the powers given to the surviving spouse in order to avoid inclusion in the surviving spouse’s estate, rather than to qualify for the estate tax marital deduction. This eliminates the use of QTIP planning because the QTIP marital deduction is allowed only at the cost of estate tax inclusion of the trust’s assets in the surviving spouse’s estate. So, the drafting attorney must walk the tightrope between estate tax exclusion of the life insurance proceeds, if at all possible, and the obtaining of the marital deduction, if all else fails.
The clause could obtain the marital deduction by providing for:
- outright payment of included insurance proceeds to the surviving spouse;
- an income interest to the surviving spouse coupled with a general power of appointment; or
- payment of the proceeds to a trust the surviving spouse can revoke at will.
Another reason to structure a trust for “What Ifs” has to do with uncertainty regarding the future of the estate tax and the reluctance of some clients to make gifts to irrevocable trusts in light of this uncertainty. In essence, they may be afraid of giving up control before it is absolutely necessary to do so. Or they may be afraid of running out of money. Regardless of what the reason is, there are provisions that can be incorporated into an irrevocable trust (commonly referred to as a flexible ILIT) to make it more flexible and help mitigate client fears. These include:
If the clients are married, make one spouse a beneficiary of the trust and one spouse the grantor of the trust. This would potentially enable the trustee to make distributions to the spousal beneficiary in the event of a financial need. If control is paramount, the spousal beneficiary can also be made the trustee (except in situations where the spousal beneficiary is also insured under a policy owned by the trust). However, if the spousal beneficiary is also the trustee, his or her ability to make distributions to himself or herself must be limited by ascertainable standards (health, education, maintenance, and support (HEMS)).
Any distributions made to the spousal beneficiary could indirectly benefit the grantor spouse via the unlimited marital deduction. Of course, the grantor spouse loses this indirect access should the spousal beneficiary die first or there is a divorce. This risk can be addressed by drafting the trust to benefit the person to whom the grantor is currently married, as opposed to naming that person. In the event that there is a subsequent remarriage by the grantor, the new spouse would then step in and become the lifetime beneficiary of the trust.
For maximum flexibility in conjunction with the use of a spousal beneficiary, use an independent trustee and give the trustee the absolute discretion to make distributions to the spousal beneficiary for any reason, to the exclusion of any other trust beneficiaries (i.e., non-pro rata distributions). This way, distributions would not be limited to HEMS. If the estate tax were to be repealed in the future, it may be possible for the trustee to exercise his or her absolute discretion to distribute the entire assets of the trust to the spousal beneficiary, thus effectively unwinding the trust. However, any trustee considering doing so should carefully consider his or her fiduciary duty to act in the best interest of all trust beneficiaries.
Include a loan provision in the trust that gives the trustee the discretion to make arm’s length loans to the grantor. The terms of the loan must reflect an arm’s length transaction, so the grantor should provide security or collateral for the loan and the trust must charge an interest rate at least equal to the Applicable Federal Rate (AFR). Note that if the loan is still outstanding at the grantor’s death, it should constitute a debt against the estate and reduce the grantor’s taxable estate.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM