To view printer-friendly Memorandum, press here: Life Insurance Trusts Mitigate Estate Tax Uncertainties.wpd

Irrevocable life insurance trusts (ILITs) enjoy vastly preferential status under the income and transfer tax laws. Properly structured, proceeds are not included in the insured’s gross estate. Even so, the ILIT trustee can loan cash to the estate (or purchase estate assets) to fund the insured’s estate tax liability. Therefore, the ILIT may also serve as a hedge against estate tax repeal not occurring. Funding an ILIT could produce a small taxable gift. However, since policy proceeds may exceed the premium by a multiple of 100 or more, the virtues of the ILIT are apparent.

The use of Crummey withdrawal powers permits policy premiums paid by the grantor to qualify for the $11,000 per donee annual gift tax exclusion. However, since the lapse of a withdrawal right in excess of $5,000 or 5% of trust assets constitutes a taxable release by the beneficiary holding the power, it may be necessary to use “hanging” Crummey powers, which lapse annually at the rate of “5-and-5.”  PLR 8901004.

Life insurance proceeds are excluded from beneficiaries’ income under § 101. However, the transfer for consideration of a right to receive policy proceeds voids the exclusion. An exception to the “transfer for value” rule exists when the policy retains the same basis in the hands of the transferee. Both the transfer for value rule and the 3-year rule of § 2035, which requires inclusion in the grantor’s estate if the grantor dies within 3 years of making a gratuitous transfer to an ILIT, might be avoided if the grantor sells a policy to a spouse who then gifts the policy to an ILIT. Under § 1041, the spouse would take a transferred basis in the policy, rendering the transfer for value rule inapplicable. Section 2035, which applies only to transfers by the insured, would also be inapplicable in this case. (But see Brown v. U.S, pg. 1, col. 2, discussing applicability of step-transaction doctrine.)

The deleterious effect of the 3-year rule of § 2035 could also be avoided if the ILIT authorizes the trustee to pay the proceeds to the surviving spouse, since the Executor could then claim a marital deduction. However, in such a case if (i) the grantor had allocated GST exemption to the ILIT; and (ii) the Executor makes a reverse QTIP election with respect to the entire marital deduction trust, the Will of the surviving spouse should waive the right to recovery under § 2207A so that the tax is apportioned against the residue of the surviving spouse’s estate. Otherwise, the GST exemption will be wasted.

If the potential application of the 3-year rule cannot be avoided through planning (e.g., there is no spouse), the grantor must decide whether the policy beneficiaries should pay the estate taxes attributable to the proceeds, or whether the tax liability should be borne by the residuary estate. Under § 2206, the Executor is entitled to recover from beneficiaries estate taxes attributable to their bequests. However, even a general provision in the Will requiring that estate taxes be paid by the residuary is sufficient to opt out of the statutory right of recovery. Plainly, the language of the tax apportionment clause of the Will should be carefully considered.

The ILIT should also be drafted to avoid traps which might cause inclusion of insurance proceeds in the grantor’s estate, which would be disastrous. If the grantor is a beneficiary of the ILIT, § 2036 requires inclusion for any retained use or enjoyment of property. The use by the trustee of ILIT property to discharge a legal support obligation of the insured would be such a retained interest, as would a reserved power by the grantor to change a beneficiary or cancel a policy. This list is illustrative rather than exhaustive. IRC § 2038 taxes “revocable transfers” and is triggered when the grantor retains the right to replace the trustee, unless the new trustee is not “related or subordinate to the grantor” within the meaning of § 672(c). Rev. Rul. 95-58.

The retention of a general power of appointment could also result in estate tax inclusion under § 2041 to the grantor or anyone else holding that power. A beneficiary-trustee’s right to make discretionary distributions to himself would constitute a general power, unless limited by an ascertainable standard relating to the beneficiary’s support, maintenance and health. If such discretionary distributions are contemplated, the trust should provide for the appointment of a co-Trustee with a substantial adverse interest whose consent to every such distribution would be required.

The liberalization of GST rules in the 2001 Tax Act makes ILITs attractive as dynastic trust vehicles. Property held by the ILIT can be transmitted to succeeding generations without the imposition of estate or GST tax in the estates of spouses or other beneficiaries. The retroactive allocation of GST exemption for a non-skip beneficiary’s unnatural order of death while the grantor is alive maximizes use of the GST exemption. The Act also allows a “qualified” severance of a trust into multiple trusts, with favorable GST tax consequences, if permitted by state law or the governing instrument.