Many advanced planning articles have been written about the tax benefits of intentionally defective trusts, particularly on the topic of sales transactions. Although tax benefits are very important, there are many non-tax benefits as well when such trusts are used in an irrevocable life insurance trust or ILIT.
An intentionally defective grantor trust (IDGT) is an irrevocable trust under which the grantor (or sometimes the beneficiary) is treated as the owner for income tax purposes by the intentional assigning of powers to the grantor that subject the trust to provisions under the grantor trust rules of IRC. ??671-679. The tax consequence is that the grantor is treated as the owner of the trust for income tax purposes, but the underlying assets of the trust are removed from his or her estate.
The word “defective” is applied because most irrevocable trusts are not set up as a grantor trust. An example of a grantor trust is a living trust that is included in the grantor’s estate. The goal of an intentionally defective grantor trust is merely to make the irrevocable trust defective for income tax purposes, while excluding the assets from the grantor’s estate for estate tax purposes.
A grantor will be treated as owner of a trust for income tax purposes if any of the following powers are inserted into the trust:
? The ability to add beneficiaries to the trust agreement after inception, except for children born or adopted afterward, without the consent or approval of an adverse party (i.e., any person having a substantial beneficial interest in the trust, which would be adversely affected by the exercise of a power).
? The ability to appoint trust income and principal during the grantor’s lifetime without the consent or approval of an adverse party.
? The power to substitute or reacquire assets in a non-fiduciary capacity by exchanging assets of equivalent value.
? The power to borrow from all or part of a trust without adequate interest or security. (Only the part of the trust that is subject to this power is income taxable to the grantor.)
? The power to use trust income to make premium payments on an insurance policy on the life of the grantor or the grantor’s spouse without the consent or approval of an adverse party.
Some attorneys will advise that many ILITs are defective for income tax purposes, and thus subject to the grantor trust provisions, because of the power to pay premiums on the life of the grantor. However, this provision is limited in usefulness (or applicability) because the trust must be funded with an income-producing asset that is also funding a policy on the life of the grantor or his or her spouse.
Even then, only the portion of the trust assets that produced the income would be subject to the grantor income tax provisions. Thus, if the policy were no longer needed or desired, yet the grantor wished to use the trust for another planning purpose and wanted to maintain the benefits of the grantor trust provisions, he or she might be unable to do so unless another qualifying provision were also inserted.
Generally, it is ideal for most ILITs to be drafted as IDGTs to maintain flexibility for future unexpected events that may or may not materialize. Following are some non-tax-related reasons to create ILITs as IDGTs that otherwise might not be available for planning purposes:
1. The ability to replace or exchange an existing life insurance policy in a new irrevocable trust. This action might be desired when a certain provision within a trust no longer suits its purposes. It can be done, assuming the existing trust holding the policy is also a grantor trust and has very similar provisions that allow the trustee to decant (pour assets from one trust to another).
A replacement or exchange could also be facilitated through a sale between the two trusts; the transaction would not be income-taxable and would avoid the “transfer for value” rule. If both trusts were not IDGTs, the exchange of cash for a life insurance policy would make the life insurance death benefit taxable.
2. The maintenance of planning flexibility. Establishing the ILIT as an IDGT is advantageous because the trust has value for planning purposes, irrespective of the insurance held within it. Years from now the clients may or may not need or desire the insurance. But the value of the trust for planning purposes might be maintained if, for example, the client uses the trust as a remainder beneficiary for a GRAT or other planning technique, rather than leave assets outright to a beneficiary.
3. You are not sacrificing a benefit to get a benefit. No income taxes would be incurred as a result of the grantor trust status if the ILIT is only used to hold life insurance, and no other assets were held in trust, because the policy cash values grow tax deferred and the death benefit is nontaxable.
With some thoughtful forward thinking and creativity you should be able to present a document that accomplishes the following: (a) addresses your clients needs today; (b) builds in the needed flexibility to address future issues, such as removing the policy from the trust in a tax-efficient manner; and (c) does more than hold a life insurance policy but is available for other planning techniques as they evolve as part of an integrated wealth transfer plan.
Jeremy P. Green, CFP, CLU, CEBS, MSFS, is director of case design-wealth transfer at Carlson Capital Management, Minneapolis, Minn. You may e-mail him at email@example.com