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Financial Planning > Trusts and Estates > Trust Planning

The Flexible Irrevocable Trust

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The increased gift tax and generation skipping exemptions provided under the 2010 Tax Act provide a significant opportunity to transfer assets to family members. To take full advantage of these increased exemptions, many wealthy families have been advised to make substantial gifts before the end of 2012, when the increased exemptions are scheduled to expire.

While these gifts are typically made in trust, rather than outright, many clients are hesitant to make gifts, as they are concerned about the irrevocable nature of the trust. They fear that they may later regret their decision as their financial condition, the tax laws or other circumstances may change. However, an irrevocable life insurance trust (ILIT) can be more flexible. If structured correctly, it can better adapt to changing family circumstances and to future changes in tax laws while still preserving the intended tax benefits.

Grantor Powers

Although the grantor cannot change the beneficiaries of the ILIT, the trust agreement could give the grantor the right to cancel or modify a beneficiary’s annual withdrawal rights. This power is important if a beneficiary becomes uncooperative and begins to exercise his or her withdrawal rights. This power is also attractive when the grantor has a sufficient number of beneficiaries to cover the gifts being made to the trust and wishes to cancel a particular beneficiary’s withdrawal right in order to make other gifts to that beneficiary.

Consider giving the grantor (or a beneficiary) the power to remove and replace the trustee. Revenue Ruling 95-58 offers guidance by stating that the grantor’s retention of the power to remove a trustee and appoint a successor trustee who is not related or subordinate to the grantor will not cause inclusion of the trust principal in the grantor’s estate. A family member or an employee would be a related or subordinate party.

Another way for a grantor to gain indirect access to trust assets is through loans from the trustee to the grantor’s spouse. The loan should be evidenced by a promissory note bearing a rate of interest that is at least equal to the Applicable Federal Rate (AFR). Upon the conclusion of the term or the spouse’s death, whichever comes first, the loan and cumulative interest are repaid. If the loan is outstanding at the death of the spouse, this amount should be deductible from the spouse’s gross estate as a bona fide debt.

Beneficiary Powers

A testamentary limited power of appointment (LPOA) allows the beneficiary to change the disposition that would otherwise occur at the beneficiary’s death. A LPOA enables the beneficiary to take a “second look” and, if appropriate, change the dispositive terms of the trust. When properly drafted, this power can be given to a beneficiary without federal transfer tax consequences. 

Giving a beneficiary a testamentary LPOA provides a great deal of flexibility, as it can be designed to allow the holder to:

  1. Include future descendants;
  2. Direct that appointed assets be distributed outright or in further trust;
  3. Provide that it can only be exercised to delay outright distribution to the beneficiaries designated in the trust;
  4. Or limit the power holder to simply reallocating the property among the various trusts created at the power holder’s death.

Another way to make an ILIT more flexible is to provide someone other than the grantor with a lifetime LPOA to distribute trust income or principal (e.g., the policy’s cash value or the policy itself) to a class of appointees. The LPOA would be exercisable in the power holder’s absolute discretion, so long as the power holder cannot appoint trust income or principal to himself, his estate, his creditors or the creditors of his estate — then the assets in the ILIT will not be included in the holder’s estate.

There may be gift tax consequences to the power holder if the holder exercises the living LPOA. If the holder is also a beneficiary of the ILIT, the individual will be treated as having made a gift equal to the present value of all possible distributions to the holder in the year in question. To avoid gift tax consequences, the grantor should name as the power holder a family member or other trusted individual who is not a beneficiary of the ILIT.

Trustee or Trust Protector Powers

Power to amend: It may be desirable to amend an ILIT in order to achieve better tax benefits or allow administration consistent with the grantor’s intent. Clearly, the grantor cannot have the power to amend the trust agreement without adverse estate tax consequences.  

However, the trust agreement can permit an independent trustee or a trust protector (hereafter interchangeably referred to as trustee) to amend the trust subject to specific limitations. Among the powers typically given a trust protector are the abilities to:

  • amend the ILIT to comply with new tax laws;
  • amend the provisions regarding the disposition of income or principal to the beneficiaries;
  • add, remove or change beneficiaries;
  • amend the financial powers of the trustees;
  • and amend the provisions relating to the identity, qualifications, succession and removal of trustees.

To avoid adverse gift and estate tax consequences, the trustee should not be able to confer any beneficial or fiduciary interest to the grantor or be able to confer any beneficial interest to himself/herself, estate, creditors or the creditors of his/her own estate.

The trustee should not be related or subordinate to the grantor to avoid any IRS challenge regarding an implied agreement between the grantor and the trustee as to how the trustee would carry out his/her duties. Lawyers, accountants and unrelated business-minded friends are often good choices for this role.

Power to terminate trust: Changes in the trust and tax laws or in the grantor’s family situation may result in the ILIT no longer serving a useful purpose. Therefore, the trust agreement should permit an independent trustee or a trust protector to terminate the ILIT. If a beneficiary-trustee has the power to terminate the trust in his/her sole discretion and, as a result of such termination, the beneficiary would receive all or a portion of the trust property, the power to terminate could constitute a general power of appointment. Therefore, the power to terminate an ILIT should be held by an independent trustee or trust protector.

Changing trust situs: It may be desirable to have the ability to change a trust’s situs as beneficiaries may move away from the jurisdiction where the grantor established the ILIT and may find it more convenient to deal with a local trustee. In such case, the local trustee may want to administer the trust under local law. Additionally, another state’s laws may be better suited to the purposes and needs of the beneficiaries than the state where the trust was originally established. For example, South Dakota and Alaska have neither a rule against perpetuities nor a state income tax.

Spousal lifetime access trust (SLAT): A SLAT is an ILIT that provides that the non-insured spouse may receive distributions during life as well as upon the death of the insured. The insured/grantor creates an ILIT and makes gifts to the trust using his/her annual exclusions and/or applicable exclusion amount. The trustee, who is preferably an independent trustee, then applies for and purchases an insurance policy on the life of the insured/grantor. If the grantor’s spouse is the sole trustee of the ILIT, then the trustee’s power to distribute trust income and principal to the spouse must be limited to an ascertainable standard (e.g., for health, education, maintenance and support).

Otherwise, the grantor’s spouse will possess a general power of appointment over the trust property, causing it to be included in the spouse’s estate. To ensure that the assets in the ILIT are not included in the grantor’s estate, the trust agreement should prohibit the trustee from using trust assets to relieve the grantor of any legal support obligations to his/her spouse.

The trustee is given the power to distribute trust income and principal to the grantor’s spouse. Coupled with a provision authorizing the trustee to borrow (or surrender) cash values, the grantor’s spouse may have access to the policy’s cash values during the grantor’s lifetime. While this does not give the grantor access to cash values, provisions permitting distributions for the grantor’s spouse provide flexibility.

Provisions to Add Greater Flexibility

Many grantors want the assets in the ILIT to be distributed to the beneficiaries at various ages (e.g., one-half at 25 and the balance at age 30). Unfortunately, upon distribution, the assets will be subject to the claims of a beneficiary’s creditors, including divorced spouses. Consider authorizing the trustee to postpone distributions to a beneficiary beyond the stated ages for certain reasons (e.g., a pending divorce, bankruptcy). Such a provision, coupled with a spendthrift clause, will generally protect the beneficiaries from themselves, their creditors and their predators.

If a trust provides a beneficiary with so much of the income and principal as is necessary for the support of the beneficiary, the trust is referred to as a support trust. If the beneficiary of a support trust is receiving government assistance or becomes eligible for Supplemental Security Income (SSI) after the ILIT is established, then the support trust may be subject to claims for reimbursement by the governing state.

It is advisable to include a provision in the trust agreement that converts a support trust into a discretionary supplemental trust if the beneficiary becomes eligible for government assistance or SSI. A discretionary supplemental trust allows the trustee, at the trustee’s sole discretion, to provide the beneficiary with income and principal, as needed, for the beneficiary’s general welfare without disqualifying the beneficiary for public assistance or subjecting the trust assets to the beneficiary’s creditors.

Grantor Trust for Added Flexibility

Consideration should also be given to designing the trust as a grantor trust. If income-producing assets are gifted to the ILIT to pay premiums, the grantor’s payment of the ILIT’s income taxes will be the equivalent of a tax-free gift to the beneficiaries of the ILIT. The same favorable income tax result would occur if an ILIT sold an asset and incurred a gain on the sale.

Furthermore, if the grantor wishes to sell a policy owned by an existing ILIT to a new ILIT (with provisions more to the grantor’s liking), the IRS has ruled that if both ILITs are grantor trusts, transfers between the two ILITs are disregarded for income tax purposes. Thus, the transfer-for-value rule is not triggered.

Moreover, if the new ILIT is a grantor trust while the existing ILIT is not, the sale of a policy insuring the grantor’s life to the new ILIT does not trigger the transfer-for-value rule because of the exception to that rule for transfers to the insured. In addition, the three-year rule will not apply because that rule only deals with gifts and not bona fide sales for full and adequate consideration.

In the typical ILIT, the grantor’s surviving spouse is often the primary beneficiary after the grantor’s death. The spouse may also be named as a trustee. In addition, the spouse may have a testamentary limited power of appointment over the trust property.

In the event of divorce, most grantors will no longer want their spouse to be a beneficiary, trustee or power holder under their trust. The trust could provide that, in the event of legal separation or divorce, the grantor’s spouse shall be deemed for all purposes of interpreting the trust to have predeceased the grantor.

While adding flexibility to irrevocable trusts should always be considered, it may not be appropriate in every situation. There may be tension between maximizing flexibility and assuring that the grantor’s intent will be maintained. In addition, there are costs to draft additional flexibility into the trust, as the added powers must be drafted to conform to the grantor’s and the beneficiary’s circumstances. Clients should work with their tax and legal advisors to ensure their trust documents are drafted in a manner that best fits their needs.

Ken Cymbal is an assistant vice president in MetLife’s Advanced Markets group and has more than 30 years of experience working in the estate and business planning area. Ken received his law degree and M.B.A .from Ohio State University and is a member of the bar in Ohio and Massachusetts. Contact him at [email protected].

Michele B. Collins is an associate advisor with MetLife’s Advanced Markets group. Michele provides estate, business, retirement and financial planning assistance to MetLife representatives as well as to external organizations. Michele received her law degree from Suffolk University Law School and is a member of the Massachusetts State Bar. Contact her at [email protected].

This article contains general information and MetLife and/or any of its affiliates do not, by means of this publication or otherwise, provide legal or tax advice. This publication is not a substitute for such professional advice and should not be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult your legal and tax counsel.

Pursuant to IRS Circular 230, MetLife is providing you with the following notification: The information contained in this document is not intended to (and cannot) be used by anyone to avoid IRS penalties. This document supports the promotion and marketing of insurance products. You should seek advice based on your particular circumstances from an independent tax advisor. Metropolitan Life Insurance Company, New York, NY 10166.