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Your client may be suffering from irrevocable life insurance trust (ILIT) fatigue. This syndrome occurs when clients question the wisdom of keeping ILITs that have been in place for a number of years. Clients may have this fatigue for a variety of reasons. For example, they may question their choice of beneficiaries or be concerned about how the beneficiaries will use the money. Or they may now have grandchildren whom they didn’t have at the time the ILIT was created.
In certain cases, the ILIT will have to be undone. In others, the ILIT can be left alone. In all cases, the insurance should be re-assessed to see if it is, among other things, performing well or whether another product may now be better than the original one.
Here are some suggestions on how to help a client whose ILIT may no longer be meeting their needs.
Gather Information
The first step is to gather information about the client, including their age, health, lifestyle, assets, family, business interests (if any), tax status and the results they would like to see. Then ask the client for the following documents: (1) the trust; (2) the insurance policy(ies) and any documents related to how the premiums are being paid, such as a split-dollar arrangement. If there’s a split-dollar arrangement, you’ll need to know whether it’s an economic benefit or loan regime, and you’ll need to see the record keeping that goes along with it; and (3) the original “as issued” illustration and a current illustration showing projections of what will happen to the policy going forward based on current assumptions. You should have a knowledgeable insurance agent as part of your team to assess the policy and deal with the carrier regarding any changes.
Common Scenarios
Here are common scenarios that you may come across:
- The client created the ILIT to avoid having to pay estate taxes. But the client no longer has that issue because with the high exemption amount, they now have a nontaxable estate. So the client would like to get the policy out of the ILIT.
- The client wants to keep the ILIT but be able to change the terms, for example, to add beneficiaries.
- The client doesn’t want to make any more taxable gifts to fund the premiums of the ILIT. The client has other uses for those gifts and their lifetime exemption.
- The client wants to transfer ownership of the policy to their children.
Undo the Policy
The client can attempt to get the policy out of the ILIT and into their own name if the ILIT includes a power to substitute assets of equal value in a non-fiduciary capacity.1 To accomplish this substitution, the trustee must get an appraiser qualified to appraise life insurance policies to value the policy. Doing so will help protect the trustee if the beneficiaries later question the value used. The trustee may also have to get a valuation of the asset being substituted for the policy if it’s not cash or marketable securities. The trustee has a fiduciary responsibility to the beneficiaries to make sure the substitution is for equal value. The trustee can’t use Internal Revenue Service Form 712 (Form 712) that the insurance company uses to give the gift or estate value of the policy because that form doesn’t consider the health of the insured. If the insured is unhealthy and has a shortened life expectancy, the policy may be worth more than what’s stated on Form 712 because it’s likely the death benefit will be paid sooner. Sometimes, especially in the case of guaranteed products, the number bears no relation to the actual value because of the method the insurance company uses to calculate that value.
What type of assets can the client use to substitute for the value of the policy? One possibility is a note payable at some date in the future carrying interest at the appropriate applicable federal rate (AFR), which is below the market rate for actual commercial loans. While the trustee may have some problem with using a below-market interest rate because of the fiduciary duty to the beneficiaries, if the client makes it clear they won’t pay any more premiums, the trustee may be persuaded to accept the below-market rate. Otherwise, the trustee will have to find a way of keeping the policy in force without the client contributing to the trust. If the trust includes language to allow it, the trustee may transfer the policy to a spouse who’s a beneficiary. The spouse can then gift the policy to the other spouse. If such a provision isn’t included or if there’s no power to substitute assets, the trustee may have to ask a court to reform the trust to add the provisions, or the trustee can decant the trust if it was created in a jurisdiction that allows decanting. If the ILIT wasn’t created in such a jurisdiction, the trust typically gives the trustee the power to change the situs of the trust to one that does.
Once the insurance policy is no longer part of the trust and is in the client’s own name, the client can change beneficiaries at will. The client can make a revocable trust the owner and beneficiary of the policy or create a testamentary trust as the beneficiary of the insurance policy. Either by the terms of the revocable trust when the client dies or the terms of a trust that’s the beneficiary of the life insurance policy, the proceeds of the life insurance policy can be put beyond the reach of the beneficiaries’ creditors, have the proper beneficiaries and apply standards for beneficiaries receiving distributions. When the client dies, the revocable trust becomes irrevocable. The terms of the trust are now fixed. If the client owns the policy outright and wants to have grandchildren included, they can do that by naming them as contingent or actual beneficiaries with the insurance carrier. If a revocable trust or separate irrevocable trust is the beneficiary, the client can add them through the trust. (Just remember the life insurance is now in the client’s estate so you need to be sensitive to estate and generation-skipping transfer taxes.) Because the insurance policy is in a revocable trust or the beneficiary is a testamentary trust, the terms of the trust can be changed at any time until the insured dies.
Change Terms of ILIT
What if the client doesn’t like the terms of the ILIT but wants to keep the life insurance in the ILIT? In this situation, the trustee can sell the insurance policy to a new ILIT with terms the client likes. To avoid any transfer-for-value consequences, the new trust should be a grantor trust. The trustee still owes a fiduciary duty to the beneficiaries of the first trust so the consideration needs to be bargained for.
As previously noted, the client can also decant the ILIT and set up a new one with different terms. Examples of new terms the client may want to include:
- Don’t require mandatory distributions. The trustee can make distributions related to health, education, maintenance and support. The trust also can allow the trustee to withhold distributions from a beneficiary who’s dealing with issues such as drug use or alcoholism.
- Allow for the addition of grandchildren as beneficiaries, either outright or as remaindermen.
- Allow for distributions for special purposes such as starting a business.
- Allow for distributions to encourage vocational choices that aren’t especially remunerative, such as being a teacher.
- Change the amount that goes to each beneficiary (allowed in some jurisdictions).
As previously discussed, you may want to change the situs of the trust to a more user-friendly jurisdiction that gives the trustee more powers and/ or imposes less income tax on trust assets.
No Taxable Gifts
What if your client doesn’t want to make taxable gifts but instead wants to use their annual gifts for different purposes? If your client is still willing to fund the ILIT, they can use private premium finance (split-dollar loans) for that. Assuming the ILIT is a grantor trust, the client can make a lump-sum or annual loans to fund the premiums. The loan can be for the client’s life. Assuming the client’s life expectancy according to the new government mortality tables is more than nine years, the loan would be at the long-term AFR (2.14% in March 2022). The interest rate is fixed for whatever is the term. Under Treasury Regulations Section 1.7872-15, interest can accrue. Other than the year of the client’s death (when the ILIT becomes a non-grantor trust), there’s no income tax concerns. And because the client is making a loan, the client isn’t making any taxable gifts. The loan plus any accrued interest will be in the client’s estate. If the ILIT isn’t a grantor trust, the client will earn accrued interest as income. Even if the trust is able to pay the interest, the payments will still be taxable to the client. The client may convert the ILIT to a grantor trust.2
Transfer Ownership to Children
The client may want to transfer ownership of the policy to their children. If the trust is the owner, the trustee can distribute the policy to the beneficiaries. If the client doesn’t want it distributed to all the beneficiaries, then ownership will ultimately have to be transferred back to the client first. The children would then need to pay the premiums for the policy. If the client has more than one child, the client may have to split the policy among the children. This avoids any potential gifting issues among the children at the client’s death and makes each child in charge of their own destiny. If the insurance company won’t split the policy, the client can change the ownership so that each child owns a percentage of the policy outright and has control over that percentage. That can be messy if a child decides to make a withdrawal or take a policy loan because it may affect the others. The policy can also be transferred to a trust with the children as trustees and beneficiaries. This leads to the issue of how they act as trustees—do they all have to agree to anything, a majority or just one.
Endnotes
1. Revenue Ruling 2011-28.
2. The conversion of a grantor trust to a non-grantor trust is beyond the scope of this article. For more information, see David L. Case, “Conversion From Non-Grantor to Grantor Trust: Tax Issues,” Estate Planning (February 2019).