More On Tax Planningfrom The Advisor's Professional Library
- Cafeteria Plans The income tax treatment of cafeteria plans is key to their popularity. Learn how to maximize the tax benefits of these “flexible benefit plans”.
- 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.
Flexibility is not a dominant selling point of Irrevocable Life Insurance Trusts–or the life insurance policies that inhabit them. ILITs usually serve a single purpose, for instance providing a liquid fund to pay estate taxes, but a little creativity and flexibility can go a long way with clients who are on the fence. A recent IRS ruling (Revenue Ruling 2011-28, 2011-49 IRB 830) provides a path for at least one type of ILIT flexibility.
There are not a lot of places to work flexibility into the structure of an irrevocable trust; too much flexibility and the value of the trust’s assets will be included in the grantor’s estate. But one area where flexibility can be introduced is in a power of substitution retained by the grantor.
The power of a grantor to substitute trust property for other property of equivalent value is often drafted into a trust for the purpose of conferring grantor trust status on the trust for income tax purposes. Prior IRS guidance established that the substitution power will not result in trust assets being included in the grantor’s estate for estate tax purposes.
Despite that general rule being clear enough, it was still unclear whether substitution power would result in the value of trust assets being included in the grantor’s estate when the trust is an irrevocable trust and the asset is a life insurance policy.
A grantor’s power to substitute in a life insurance trust could be interpreted as giving the grantor an “incident of ownership” in the life insurance policy held by the trust–thus resulting in estate inclusion of the value of the policy. Revenue Ruling 2011-28 provides a definitive answer to that question.
Prior to issuance of the ruling and its companion, Revenue Ruling 2008-22, there had been some uncertainty surrounding whether a substitution power would cause the trust’s assets to be included in the grantor’s gross estate under Section 2036 (property transferred by a grantor with a retained life interest) or 2038 (revocable transfers).
In Revenue Ruling 2008-22, the IRS came to the general conclusion that a grantor’s substitution power will not cause trust assets to be included in the grantor’s estate. Ruling 2011-28 extends Ruling 2008-22 to include a substitution power over a life insurance policy held in an irrevocable life insurance trust.
Conditions on Substitution
In both 2011-28 and 2008-22, the noninclusion rule is subject to two conditions:
- The trustee must have a fiduciary obligation to determine that the property acquired by the grantor and the substituted property are actually equivalent in value.
- The grantor’s “substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.”
In other words, the trust agreement must not allow the trustee to turn a blind eye to a non-equivalent substitution. Without that requirement,
a trust could be drafted letting the grantor strip value out of the trust. By ensuring that the trustee has a “fiduciary obligation” to ensure equivalent value, the beneficiaries can hold the trustee to account if he or she allows the grantor to take action that will prejudice the beneficiaries’ interests in the trust.
The substitution power cannot be “exercised in a manner that can shift benefits among the trust beneficiaries” if either:
- The trustee has both the power (under local law or the trust
Often, grantor status isn’t necessary (or desirable) in a life insurance trust. When the trust is funded with income producing assets that will be used to pay premiums on the policy, it may be appropriate to ensure that the trust is a grantor trust so that the grantor will pay income tax on trust income. Otherwise, the trust may be forced to pay under the trust rate table, which rises to the top 35% level much quicker than the individual rate tables.
But where there is some possibility that an obligation of the trust will be forgiven, generating cancellation of debt income for the trust, grantor status will be highly undesirable. For instance, if the trustee has the power to borrow from the policy and the policy is allowed to lapse while the loans are outstanding, the grantor will be on the hook for the tax bill.
The ruling clears a path for replacing policies in an ILIT without disturbing your client’s estate plan. Outdated, expensive policies no longer have to be an expensive irrevocable mistake. You have an opportunity to put the right policy in place for your client, even where their policy is locked up in an ILIT.
If your client’s ILIT does not permit substitution of the policy by the grantor, there’s hope. Depending on state law, an irrevocable trust can be amended in a couple of ways.
First, does the trustee or someone else have the power to amend the trust under the trust agreement? If the trust agreement doesn’t include an amendment provision or the trustee is unwilling to sign off on an amendment, state law may grant amendment power to the grantor. Usually, state law allows a grantor to amend an irrevocable trust with the consent of everyone who has a beneficial interest in the trust.
For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, AdvisorFX, for a free trial.