Irrevocable trusts remain powerful in estate planning

Flexibility is key with this tried-and-true tool

Irrevocable life insurance trusts are a fundamental finance tool but call for estate planning flexibility. (Photo: iStock) Irrevocable life insurance trusts are a fundamental finance tool but call for estate planning flexibility. (Photo: iStock)

The irrevocable life insurance trust (ILIT) is a fundamental, but complex, estate planning tool.

Generally, they are used to minimize estate taxes for more affluent clients with estates valued above the tax exemption limit of $5.49 million for singles and $10.98 million for married couples. The ILIT can be structured to serve several purposes including:

            • Favorable tax treatment of life insurance proceeds for heirs;
            • A source of cash to settle estate taxes on property or a business; or
            • Setting provisions for the management and control of policy proceeds.

ILITs are funded with gifts by the client, or grantor, and in the case of an irrevocable life insurance trust, the trust is both the owner and beneficiary of the policy.

Related: The rules for revoking an irrevocable trust

For many below the exemption limit, there are several non-tax advantages of ILITs, which still make them a useful planning tool. For example, equalizing an estate for children who are not involved in the family business or setting aside money for children from a previous marriage are both reasons to use an irrevocable trust. This article stresses the need for flexibility in planning with ILITs and some of the ways to achieve that flexibility.

Aim to provide flexibility

As the name suggests, ILITs are irrevocable once executed.  That means once created and an insurance policy has been placed inside it, the grantor can't transfer the policy back into his or her own name. That does not, however, render an ILIT inflexible. The key to building flexibly into an ILIT is working with good legal counsel — someone experienced and well versed in this specific estate planning area.

Related: Estate planning for elderly clients: weighing the issues

With careful drafting, a client’s unique circumstances and concerns can be addressed and incorporated into the trust document.  Financial advisors can aid the process by helping clients to identify their intent and concerns around how the trust proceeds will ultimately be distributed. Married couples may want to help ensure that the surviving spouse retains the greatest possible financial control without sacrificing estate tax savings. On the other hand, second marriage clients might want to place financial restrictions on the surviving spouse in order to provide for children from a first marriage. Identifying these needs and sensitivities are the key to successful trust drafting.

Although an attorney is responsible for the ultimate drafting of the trust, financial advisors should be generally familiar with some of the basic drafting techniques used to maintain trust flexibility and meet client objectives. Be aware that the following methods are discussed here in generalities only. Their use and application may vary depending on the parties to the trust and the specific needs and circumstances of the individuals involved.

Related: 5 tips for digital estate planning

Addressing changes in marital status

The trust may provide that the insured’s spouse ceases to be a beneficiary or trustee in the event of a divorce. The trust often limits the term “spouse” to the person to whom the grantor is married at the date the trust comes into existence.

Although an attorney is responsible for the ultimate drafting of the trust, financial advisors should be generally familiar with some of the basic drafting techniques used to maintain trust flexibility. (Photo: iStock)Although an attorney is responsible for the ultimate drafting of the trust, financial advisors should be generally familiar with some of the basic drafting techniques used to maintain trust flexibility. (Photo: iStock)

Changing or adding a co-trustee

The ability to replace a trustee can be addressed in a number of ways. For example, the trust document can be drafted to give the beneficiary (or all the beneficiaries together) the right to replace a trustee. Often the trust provides for a triggering event – such as the attainment of a certain age or death of a prior trustee — which then results in the beneficiary assuming a trustee or co-trustee role. Where a beneficiary replaces the trustee, additional trust provisions are needed to limit the beneficiary’s powers so as to prevent inclusion of any or all of the trust assets in his/her estate. Developments in estate tax laws have given grantors broad power to replace a trustee without incurring adverse estate tax consequences.

If a trustee is a personal trusted friend but lacks sufficient business acumen or more technical knowledge is needed, an experienced co-trustee — such as a trust company or a trust department of a bank — can be authorized.

Giving broad power to the trustee

By selecting a trustee that understands the grantor’s personal and estate planning objectives, who personally knows the strengths and weaknesses of the trust beneficiaries and who has demonstrated good business judgment, a trust management platform can be built that allows for additional trust flexibility through discretionary trustee decisions. For example, the trustee can be given the power to change non-dispositive provisions — change the custodian of assets, hire a money manager or update the allocation between principal and income.  

The trustee may also be given authority to make principal and/or income distributions to a non-grantor spouse or other non-grantor. This strategy is sometimes referred to as a spousal access trust or access trust and is very useful when approaching clients who may be interested in some of the benefits of ILIT planning but may have concerns around access the trust’s assets.  Again, the main point is to provide some flexibility in the trust.

Related: Addressing beneficiaries in estate planning

Powers of appointment

A limited power of appointment is a powerful tool for building flexibility into an ILIT. A power is considered a limited power of appointment when the power holder (or donee) is authorized to appoint an interest in property only to specified individuals or a class of individuals excluding the donee, the donee’s estate or creditors of the donee or his/her estate. It is possible to create a power that can be exercised either during the lifetime or by means of the will of the power holder.

Through the use of limited powers, the grantor of the ILIT may give considerable control to a non-trustee beneficiary, making it possible for the power holder to change the outcome of the trust in ways the grantor might have wanted if he/she could have foreseen future events. The power holder may be thought of as an agent, delegated by the ILIT grantor to make changes in the distribution plan of the trust as circumstances warrant.

Limited powers of appointment can be used if a grantor is concerned that the trustee may not exercise discretionary powers over the trust or may do so in too restrictive or too generous a manner. A limited power of appointment may allow a surviving spouse to make a distribution of the final balance of a trust, for example, based on beneficiaries attaining certain milestones (graduates from college, gets married, or has a child). A limited power of appointment may also be used when to establish an “asset protection trust” to help provide for a beneficiary in dire financial straits. Finally, a limited power of appointment may be used to appoint property to a charity where the power holder feels the heirs have sufficient assets.

Trusts using powers of appointment must be carefully drafted to avoid creating a “general” power of appointment resulting in estate and gift tax consequences. A general power of appointment allows the power holder to give the interest in the property to anyone he/she chooses, including himself/herself, resulting in the inclusion of the property in the estate of the power holder at his/her death. In addition, the exercise, lapse or release of a general power during the power holder’s life is treated as a gift subject to gift tax.  It is important to remember that, under IRC § 2041(b)(1)(A), if a power may be exercised only in accordance with an ascertainable standard relating to health, education, support, or maintenance, it is not treated as a general power of appointment.  Thus a beneficiary may be given the power to appoint trust assets to himself/herself, subject to an ascertainable standard, without having the assets included in his/her estate. This is a very useful exception where a grantor’s spouse serves as trustee of the ILIT.

Conclusion

The ILIT remains an important planning tool even for clients who may never be subject to federal estate tax. This article has discussed only some of the ways ILITs may be used, emphasized the need for flexibility when implementing ILITs and outlined some of the ways to incorporate flexibility in today’s planning environment. By incorporating ILITs with proper flexibility, this powerful planning tool can remain relevant and produce meaningful results in many situations.

Brett W. Berg serves as Vice President of Advanced Marketing for Prudential’s Individual Life Insurance division.  He can be reached at brett.berg@prudential.com.

Prudential Financial, its affiliates, and their financial professionals do not render tax or legal advice. Since individual needs vary clients should consult with their own tax and legal advisors regarding your personal circumstances.

 

0301795-00001-00

See also:

Trust-owned life insurance = opportunities for insurance professionals

6 trusts you should know about

5 financial tips to navigate through divorce

We’re on Facebook, are you?

Prudential Financial, its affiliates, and their financial professionals do not render tax or legal advice. Since individual needs vary clients should consult with their own tax and legal advisors regarding your personal circumstances.

0301795-00001-00

Page 1 of 2
Single page view Reprints Discuss this story
We welcome your thoughts. Please allow time for your contribution to be approved and posted. Thank you.

Most Recent Videos

Video Library ››