IRREVOCABLE LIFE INSURANCE TRUSTS- WHEN TO USE THEM AND HOW THEY SHOULD BE SET UP

Background:
The proceeds of insurance on a decedent's life are included in the decedent's gross estate if the estate receives or benefits from the proceeds [Reg. 20.2042-l(a)(l)]. In addition, if, within three years of death, the decedent possessed any incidents of ownership in a life insurance policy, the proceeds are included in the gross estate even if the estate neither receives nor benefits from the proceeds [IRC Sec. 2035(d)(2); Reg. 20.2042-l(c)(l)].

One of the best methods of keeping life insurance proceeds out of an estate and ensuring that the estate has the necessary liquidity is to create an irrevocable life insurance trust. Such a trust can remove assets from the estate of both the person setting up the trust (i.e., the grantor) and the surviving spouse, while at the same time making the insurance proceeds available to meet the needs of the surviving spouse and the decedent's estate.

How The Trust Works
To form a life insurance trust, a client typically creates an irrevocable trust, contributes an existing policy or cash to fund the trust, and names the trustee(s) and beneficiaries. To avoid estate tax on the trust proceeds, the insured generally should not serve as the trustee or retain the right to alter, amend, revoke, or terminate the trust [Rev. Rul. 84-179; IRC Sec. 2038(a)(l)]. The IRS also has a problem with an insured (grantor) retaining the power to remove, without cause, a corporate trustee who can make discretionary distributions (Rev. Rul. 79-353). However, the Tax Court recently said this power alone doesn't cause the trust's assets to be included in the insured's estate (Wall).

Example 1: Joe DeChellis has a net worth of $5 million. He has been advised that he needs more life insurance to provide estate liquidity. Joe creates the DeChellis Family Irrevocable Insurance Trust and names the First National Bank of May (or its successor or assignee) as trustee and his three children as beneficiaries. The trustee uses $20,000 that Joe contributed to the trust to purchase a policy on Joe's life. The proceeds of the policy will be excluded from Joe's estate.

Joe's children could have purchased the policy outright (using money he gifted to them) without changing the tax results [Reg. 25.2503-3(c). Ex. 6]. However, nontax reasons exist for using the trust rather than direct ownership by the kids. A trust can provide protection from the children's creditors (commercial, tort, matrimonial). It is also better suited for planning and providing for various income and remainder interests for the children and grandchildren. Such planning is difficult to do within the confines of a beneficiary designation on a life insurance application. Other advantages, as well as some disadvantages, of irrevocable life insurance trusts are summarized in Attachment I at the end of this Tax Action Memo.

Besides removing life insurance proceeds from the insured's estate, another objective of an irrevocable life insurance trust normally is to provide the insured's estate with liquidity. This objective generally is met by permitting the trustee to (1) purchase assets from the estate at fair market value (FMV), (2) loan money to the estate (with appropriate collateral and a market rate of interest), or (3) do both. The trust should not require the trustee to do these things because the insurance proceeds would then to be treated as benefiting the estate, thus causing the proceeds to be included in the gross estate [Reg. 20.2042-l(a)(l)].

Example 2: An irrevocable life insurance trust originally set up by Lynn Mayfield owned a $3 million policy on her life at the time she died. Her estate, excluding the life insurance policy, is valued at $5 million and consists primarily of real property. After deductions and credits, $2 million of estate tax is due. The trustee of Lynn's life insurance trust buys $2 million of real property from her estate for its FMV. The estate uses the funds to pay the estate tax and has little or no capital gain to recognize because of the Section 1014 basis step-up that occurred at Lynn's death. The insurance trust owns $2 million of real property and $1 million of cash which can be distributed to or held for the benefit of the trust's beneficiaries (who oftentimes are also the estate's beneficiaries). As long as the trust instrument merely permits rather than requires the trustee to purchase estate assets, the estate has gained needed liquidity without dragging the insurance proceeds into the gross estate.

Fixing A Defective Trust
Practitioners may occasionally find an irrevocable insurance trust that has been poorly drafted. For example, a trust may require the trustee to purchase assets from the insured's estate. One possible solution, recently described in a private letter ruling (PLR 9413045), is to sell the policy in the defective trust to a new irrevocable insurance trust. A sale, rather than a gift, is made to avoid the three-year rule [IRC Sec. 2035(b)(l)]. The new trust must be structured as a grantor trust for income tax purposes to avoid the transfer-for-value rule, which can cause a policy's death benefit to be taxable income. As a grantor trust, any income, deductions, gains or losses realized by the trust will pass through to the grantor/insured. Thus, the trust should qualify for the "transfer to the insured" exception to the transfer-for-value rule [IRC Sec. 101(a)(2)]. (Note that the IRS refused to rule on this issue when it issued PLR 9413045.) Although there are numerous ways to structure a trust so that it is treated as a grantor trust for income tax purposes, the method used must be carefully chosen to avoid an estate tax problem. The method approved in PLR 9413045 gave the trust's grantors the right to substitute trust corpus with other property of equal value. The IRS concluded this did not cause the trust's corpus to be included in the estates of either the decedent or his spouse [IRC Sec. 675(4), PLR 9413045, and Estate of Anders Jordahl v. Commissioner].

Generation Skipping Transfer (GST) Tax Rules
When trust beneficiaries include grandchildren or other beneficiaries two or more generations below the grantor (i.e., a skip person), transfers to the trust are subject to both gift and GST tax rules. However, a transfer to a trust which qualifies for the $10,000 gift tax exclusion will not qualify for the GST $10,000 exclusion unless the trust is exclusively for the benefit of one individual during that person's lifetime and the assets of the trust are included in such person's (i.e., the beneficiary's) estate if the beneficiary dies before the trust terminates [IRC Sec. 2642(c)]. Example 5: Harry creates an irrevocable life insurance trust with Crummey powers for the benefit of his two children and five grandchildren. He contributes $35,000 each year to the trust (or $5,000 per beneficiary to stay within the 5 and 5 limit). The $35,000 qualifies for the annual gift tax exclusion but does not qualify for the GST $10,000 exclusion because the trust has more than one beneficiary. As a result, Harry will need to use a portion of his $1 million GST tax exemption to shelter the transfer from tax (see IRC Sec. 2631).