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Financial Planning > Trusts and Estates > Trust Planning

Techniques for Cutting Off

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When an intended beneficiary of estate assets is no longer in good graces with the owner of the assets, a simple stroke of the pen by the owner is often sufficient to disinherit the disfavor party. But what if those assets are locked inside an irrevocable life trust?

Advisors interviewed by National Underwriter say strategies are available for limiting and, when the trust language permits it, diverting assets entirely from a disfavored beneficiary. Among them: allowing the ILIT policy to lapse; exchanging the contract for a reduced paid-up policy; selling the policy to a new ILIT; and empowering a trustee or trust protector to change the beneficiaries.

The last notwithstanding, most of the options have drawbacks. Stopping premium payments on the policy inside the ILIT, for example, would merely cap the cash value to which disfavored beneficiary is entitled.

Given the prospect of a policy lapse, the ILIT trustee could purchase a reduced paid-up policy with the existing cash value; when the grantor/insured dies, the disfavored beneficiary would receive a lower death benefit than under the original contract. Alternatively, the trustee could surrender the policy and distribute the cash value to the beneficiaries. Dennis De Gideo, a senior advanced markets consultant at Thrivent Financial for Lutherans, Minneapolis, Minn., says the first option is generally preferable to the second because a policy surrender would be subject to income tax.

Better still from the grantor’s perspective would be to cut off the disfavored beneficiary from any cash proceeds. Keith Buck, vice president of strategy, research and development at National Financial Partners Insurance Services Inc., Austin, Tex., says that is possible with ILITs that grant an independent trustee broad powers over the disposition of assets. The trustee could, for example, distribute all assets to a spousal beneficiary, effectively unwinding the trust for other beneficiaries.

“You won’t run into this often,” says Buck. “Most ILITs–probably less than 1%–are this flexible.”

Also underutilized, he adds, are ILITs that provide for a “trust protector”: an individual who, like the independent trustee in the above scenario, is given discretionary power over the trust, including the ability to add or remove beneficiaries. Delaware, New Hampshire, and Nevada, among other states, offer this option.

Tom Commito, vice president of business and industry development at Lincoln Financial Distributors, Philadelphia, Pa., favors this strategy, in part because states that allow for a trust protector also afford the “strongest protection” against confiscation of insurance proceeds by creditors.

Assuming, however, the trust document cannot be modified to redirect assets solely to favored beneficiaries, and that the grantor will not support a reduction of assets for a disfavored beneficiary if favored beneficiaries also stand to lose, then other alternatives will have to be explored. One possibility, says Bruce Tannahill, vice president of business and estate planning at Western Reserve Life, Petersburg, Fla., is to leave the ILIT unchanged, but alter other estate planning documents to cut out the disfavored beneficiary.

But observers point out the ILIT can serve the same purpose through a sale of the trust assets. Under this scenario, the trustee sells the assets in the current ILIT to a new ILIT. Though the sale proceeds would still at least partially benefit the disfavored child, death benefit proceeds from the new ILIT can be directed solely to favored beneficiaries.

To be sure, this technique comes with caveats. To avoid income tax on the death benefit proceeds from the new ILIT, the trustee must invoke an exception to the transfer for value rules of IRC Section 101. Buck says that several IRS private letter ruling allow for this exception in cases involving the sale of a policy from one grantor trust to another.

What happens when the old ILIT is not a grantor trust? “In my opinion, the classification of the current ILIT is not relevant because, under the transfer for value rules, it only matters that you transfer the ILIT to the insured,” says Buck. “And if the new trust is a grantor trust, we’re essentially meeting that requirement.”

Also to be scrutinized are the trustees of the old and new ILITs. A disfavored beneficiary who is, as often happens, also a trustee of the old ILIT, can check the wishes of other beneficiaries and the grantor. A trustee, even if independent, also has to take care to act on behalf of the beneficiaries, rather than the grantor, who has no control of an ILIT’s assets.

The grantor of the new ILIT must also select as its trustee someone other than the trustee of the old ILIT. The reason, Tannahill points outs, is that an individual cannot have “undivided loyalty to different trusts and beneficiaries in dealing with the same policy.”

Yet another pitfall in the transaction is the sale price. Steve Leimberg, CEO of Leimberg Associates, Bryn Mawr, Pa., cautions that disfavored beneficiaries could claim they didn’t get fair market value for their share of their policy sold — then sue the trustee to recover the difference between the amounts received and expected.

To guard against such a claim, Buck counsels that trustees thoroughly document the reasons for the sale and demonstrate that they received fair market value. One way to insure the latter, he says, is to sell the policy in the secondary market.

“A life settlement would secure a higher price for the contract than a sale based on the policy’s interpolated terminal reserve value, which is the definition of fair market value for gift tax purposes,” says Buck. “It may be prudent to sell the policy for the higher [settlement] value if you’re really worried about a disfavored beneficiary complaining.”

Commito thinks otherwise.

“If the only concern is about beneficiaries, then a sale using a note make more sense,” he says. “I would not recommend a life settlement because then the life insurance is gone. And I don’t like to see policies go off the books.”