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February 28, 2017 at 10:55 AM
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:
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- 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.
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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)
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.
