What About Life Insurance Trusts? Over the past several decades, insurance counselors, estate planning attorneys and CPA’s have counseled clients to create Irrevocable Life Insurances Trusts (ILITs) in order to exclude policy death benefits from the insured’s taxable estate. Typically, the insured would create an irrevocable trust with another person or bank as trustee. The trustee would purchase an insurance policy on the grantor’s life. The grantor/insured would continue paying premiums on the policy. Appropriate Crummey notices are sent to various beneficiaries granting them a limited withdrawal right in order to qualify the premium payments for the annual gift tax exclusion.
The trust would be the named beneficiary on the policy. At the death of the insured/grantor, the trustee of the trust would collect the death benefit (free of any estate taxes) and use the proceeds to benefit family and/or provide liquidity to the insured’s estate by purchasing assets which might otherwise be illiquid, such as real estate or interests in a family business.
Does Anybody Care About ILITs Now? With the federal estate tax exemption now $3.5 million per person, or $7.0 million for a married couple, does anyone still care about ILITs? The typical lawyers’ answer to that question is "it depends". For large estates where there will be a federal estate tax on values above $7.0 million, ILITs are still a valuable part of the estate planning arsenal. Of course, if the current "sunset" provisions of the estate tax law become effective starting in 2010, ILITs will become popular again, when the individual estate tax exemption reverts to $1.0 million in 2011 and thereafter. We consider this highly unlikely, as there are currently Bills pending in both the House and Senate to eliminate the "sunset" provision and extend the estate tax on large estates.
However, there are many existing ILITs currently in operation where administrative or financial problems arise.
Problem #1: The first problem we encounter is failure to send Crummey Notices and retain copies. Why is this important? The answer: if there is an estate tax audit, which would be normal for large estates, failure to observe formalities can result in either the inclusion of the death benefits in the insured’s taxable estate, or disqualifying annual premium payments for the annual exclusion, bringing back those amounts into the taxable estate, possibly with penalties for failure to file appropriate gift tax returns.
Problem #2: Problems often arise when an insured determines that he or she does not want to keep paying premiums or when the insured, and his or her advisors, determine that the policy held by the trust is no longer appropriate because death benefits are too high or too low or because cash values are either too high in relation to death benefits, or too low the carry the policy for the desired period of time in the event that premium payments cease. In addition, changes in actuarial tables sometimes mean that less expensive alternatives are available after the trust has been in effect for a few years.
A recent suit against Key Bank in Indiana highlights the hazards of such changes. Key Bank was the trustee of an ILIT holding an insurance policy on an insured in his early 50s with a death benefit of $8.0 million. Without going into detail, the insured decided either to stop paying premiums or pay a lower amount and reduce the death benefit to approximately $2.7 million. Fortunately, Key Bank, operating as the fiduciary, retained an independent consultant to evaluate the old policy and the new policy and the reasons for the change. The change was then implemented. You can imagine the consequences. The insured died unexpectedly. Naturally, the family, upset with the lower death benefits, sued Key Bank for breach of fiduciary duty.
Key Bank won the case, in large part because of their retention of an independent consultant to evaluate these changes. The beneficiaries were not consulted, probably because the trustee of an ILIT is normally tied to, or affiliated with, the insured rather than the beneficiaries. The bank was also assisted in its defense by the fact that death was unexpected and that the insured had passed other physical exams close to the time that these changes were implemented.
However, the case does emphasize a couple of important points about ILITs. First, circumstances change with respect to the insured, insurance premiums, and changes in personal and business financial situations. Second, is the competitive environment and the availability of new policies, sometimes on more favorable terms. Third, and this is important, is that part of the reason for obtaining life insurance in the first place is that death is uncertain. Normally, we don’t know when we are going to die. If we do know, it is usually too late make changes in insurance coverage. (This ignores the now popular "life settlement" market for large existing policies.)
Problem #3: Changes in the trustee. We have run into several instances where the trustee of an ILIT, for whatever reason, is not satisfactory to the insured or the insured’s family or, alternatively, resigns or dies. Changes in trustees sometimes require court approval. At one point several years ago it was difficult to find a bank which would act as trustee of an ILIT because of potential liability. Consequently, even for large insurance policies, individual trustees, lacking expertise in either trust administration or insurance, were appointed. Sometimes the trust does not contain provisions for filling the position of trustee, if a vacancy occurs, or a change is desired. In that case, a court petition is required.
Conclusion. Life is not certain and neither are ILITs. Great care should be taken in the administration of the trust, changes in policies, and the provisions of the trust relating to changing trustees. Banks and trust companies are now more willing to act as trustees, which provides some assurance that the formalities of administration and Crummey letters would be observed. Existing ILITs should be reviewed periodically by experienced attorneys, not just at the behest of an insurance advisor or agent. If you have an ILIT or are thinking of one, please contact Jim Modrall or any of the attorneys listed below for assistance in such review and evaluation.
Donald A. Brandt, Joseph C. Fisher, Thomas R. Alward, Matthew D. Vermetten, Thomas A. Pezzetti, Jr., Susan Jill Rice, Gary D. Popovits, H. Douglas Shepherd, Laura E. Garneau, David H. Rowe, or Nicole R. Graf at (231) 941-9660
©BRANDT, FISHER, ALWARD & PEZZETTI, P.C.
This newsletter is provided for informational purposes and should not be acted upon without professional advice.
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