Intentionally Defective Trusts Have Non-Tax Benefits Too

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 protected]