More On Tax Planningfrom The Advisor's Professional Library
- Annuities: Estate Tax The value of certain types of annuities may be included in an estate’s value. Understanding the intricacies of these inclusions is a critically important aspect of estate planning.
- Annuities: Variable Annuities Annuities are hot. The tax rules vary with the circumstances. Advisors must be aware of these intricacies when discussing annuities with clients.
Trusts are a tremendous life insurance selling tool. Many clients aren’t interested in giving a multimillion-dollar cash gift outright to their children and other beneficiaries. A life insurance trust gives them the control they need to satisfy themselves that a life insurance policy is the right estate planning solution for themselves and their families. But control comes at a price; a trustee must be appointed.
Once you’ve shown your clients how a life insurance policy held in trust is the right solution for their particular problems, how do you handle the conversation about appointing a trustee?
You must first review the advantages of life insurance trusts and how they help solve your clients’ biggest estate planning concerns. Then examine the advantages and disadvantages of agreeing to serve as trustee of your clients’ life insurance trusts. This will provide a roadmap for analyzing whether serving as trustee is the right decision for you, your business, and your clients.
The Life Insurance Trust Advantage
Bare life insurance offers insureds the opportunity to name who will receive the policy proceeds, but stops short of giving control over when and how funds will be disbursed. Retained asset accounts go a step further by specifying when proceeds will be paid, but only life insurance trusts offer insureds nearly absolute control over policy proceeds.
Trust beneficiary language gives the insured far greater precision over who will receive payouts than a simple beneficiary designation; an insured has a much higher degree of flexibility when naming beneficiaries of a life insurance trust as opposed to beneficiaries of a life insurance policy.
Another benefit of a trust over a bare policy is that the insured can assert post-mortem control over which proceeds will be distributed to beneficiaries. For instance, the trust instrument can specify that the insured’s children will receive disbursements from the trust only if they graduate from college.
For many clients, a life insurance trust is an essential tool for managing a policy because of its ability to remove the policy from the insured’s estate for income tax purposes and permit the insured to leverage gift and GST tax exemptions to provide their beneficiaries with a high-dollar transfer-tax-free gift.
A trust’s ability to give your clients control over the who, when, and how and to mitigate the transfer taxation of a life insurance policy can make your job easier. But what do you do when the inevitable happens, and your clients ask you to serve as trustee of their life insurance trust? Make your decision with an awareness that serving as trustee may not be worth the goodwill it engenders with your clients.
The Pitfalls of Serving as Trustee of a Life Insurance Trust
Trustees can be the cement that holds together long-term client relationships, making the job ideal for producers who understand the importance of staying active in their clients’ financial lives. But serving as trustee is serious business, with risks and consequences that must be weighed carefully:
- Trustees are charged with managing trust assets, including investments and life insurance policies.
- Investments must be reviewed periodically to determine whether they are appropriate to the purpose of the trust, with an eye toward capital preservation and reasonable income.
- But what standard is applied when a trust holds a life insurance policy? Laymen think of a life insurance policy as a buy and hold proposition that won’t pay off until the insured’s death, but the reality is that trust-owned life insurance is a minefield for trustees.
A trustee’s job is difficult enough, but when the trustee is also the insured’s insurance agent or broker, other issues come into play that increase the trustee’s risk.
Brokers and insurance producers have a duty to provide clients with recommendations that are suitable to the client’s circumstances. In contrast to this intermediate standard of care, trustees are subject to
A serious issue for a trustee in the insurance business is the conflict of interest rules under the fiduciary standard. Generally, a trustee must not enter into transactions with the trust that present a conflict of interest. If a policy must be replaced, conflict of interest issues arise for the trustee if the trustee also acts as the insured’s insurance agent in the transaction. Although the trust instrument can waive conflicts of interest to some extent, whether the waiver is effective depends on its breadth and the laws of the jurisdiction where the trust is situated.
Under the fiduciary standard, a trustee must make prudent investment decisions respecting trust property, including life insurance policies. Who better to analyze policy performance than the life insurance professional who not only sold the policy, but also understands the family’s objectives better than any other professional in their lives?
Despite the natural synergy between the role of life insurance advisor and life insurance trust trustee, it is important to stay cognizant of important distinctions between the two roles. One important consideration to keep in mind is that reviewing a life insurance policy in a fiduciary capacity can be far more involved than the suitability analysis conducted by an insurance agent.
A trustee of a life insurance trust should periodically review the policy owned by the trust to determine whether it is performing up to expectations. If a variable policy is in danger of lapsing due to poor performance, the trustee must determine whether the policy can be exchanged for another policy or policies that better satisfy the trust’s objectives.
But replacing a policy is not as simple as finding the best policy for the job and executing an exchange. Expenses associated with purchasing a new policy and even the renewed two-year contestability period when
a new policy is issued must be taken into account by the trustee.
The decision of whether to replace a policy can be particularly challenging because, in some circumstances, it may be necessary to replace a high face value policy with a policy that has a significantly reduced death benefit. Cochran v. Key Bank, 901 N.E.2d 1128, a 2009 case from Indiana’s highest court, considered a trustee’s decision in such an instance.
The life insurance policies at issue in Cochran were variable universal policies with an aggregate face value of $8 million. The trust also owned an annuity that had been used to fund premium payments
The trustee of Cochran’s life insurance trust, Key Bank, agreed to the exchange. Unfortunately, Cochran died shortly thereafter. His daughters weren’t pleased with the drastically reduced death benefit of the exchanged policies and sued the trustee for breach of fiduciary duty. Although the trustee eventually prevailed, the case illustrates the kind of dangerous confluence of circumstances that can embroil the trustee of a life insurance trust.
Should you serve as trustee for your client's life insurance trust? The ultimate decision is up to you, but consider gracefully refusing the job in favor of an institutional trustee such as a bank’s trust department if you aren’t 100 percent committed to serving in a fiduciary capacity and putting the beneficiaries' interests ahead of your own. Professional trustees are well versed in the strict standard of conduct applicable to trustees, and have the resources to comply with the demands of the job.
Serving as trustee can be a rewarding experience, both personally and professionally, but don’t take the job lightly. Consider securing legal counsel to guide you through the process to help avoid the many pitfalls.
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See also The Law Professor's blog at AdvisorFYI.