Over the past few years, our clients' estate and life insurance planning have become far more complicated than they bargained for. Even if clients' personal situations and objectives were relatively static, which is a bold presumption, factors such as uncertain estate taxation, changes to split-dollar rules, and an investment environment that has impacted negatively on both clients' cash flow and the performance of their life insurance policies, have caused stress cracks in the foundations of many plans. For many of these clients, the same irrevocable life insurance trusts (ILITs) that promised so much benefit when they started are now buffeted by tax, economic and personal factors. In certain cases, the ILIT will have to be undone. In others, the ILIT can be left alone, but the insurance must be reassessed. In still other cases, both the ILIT and the insurance will have to be taken back into the shop.
WHY UNDO AN ILIT?
It's logical to think that if an ILIT has become problematic within a plan, the problem is with the ILIT itself, meaning the way it was drafted. But many ILIT issues are not caused by drafting. Though the ILIT could have been technically sound and appropriately designed when it left the attorney's office, years later problems may loom with regard to the gift or generation-skipping transfer (GST) tax of the grantor's premium gifts. Perhaps the Crummey withdrawal powers now unduly limit annual exclusion treatment for large premiums. Or, as we often see these days, an ILIT that no one thought needed to be a grantor trust for income tax purposes now needs to be exactly that, in order to enable the grantor to respond to any number of things in a tax-efficient manner. Maybe it's not taxes. Maybe the ILIT's terms are no longer satisfactory to a grantor who doesn't get along so well with the kids anymore. Or maybe he likes his kids just fine, but thinks they shouldn't be “troubled” with having so much money all at once. Or maybe the grantor's spouse, a primary beneficiary of the ILIT, now realizes that “in trust” means “out of reach” and she demands change.
In some cases, the ILIT has a built-in remedy, courtesy of various provisions and powers; for example, to remove and replace an unresponsive trustee. And, when the ILIT's terms permit, it can perhaps be transformed into a grantor trust by using trust income to pay premiums. But in many cases, the problem cannot be cured within the four corners of the ILIT, and we have to find a fifth corner.1
While many ILITs are quite satisfactory from the grantor's personal perspective, the overall situation encompassing the ILIT may cause big problems. For example, large premiums that once presented relatively little strain on a grantor's cash flow may now be a burden to a grantor whose cash flow has been reduced by significantly lower investment yields. Or, cash flow is not a problem, but premiums that were projected to vanish well within gift or GST exemptions have not vanished, so the client is going to have to put more money into the ILIT at significant tax cost. These problems can call for a product fix, such as a restructuring of the policy or an exchange for a new policy. But, often, they can call for an ILIT fix as well, like moving the policy to a new and different trust that is defective for income tax purposes so that we can implement gift-tax efficient strategies for funding the trust to cover future premiums.
An excellent example of a situation that can call for fixes to both the ILIT and the product is when the policy is subject to a split-dollar arrangement that doesn't work anymore. In many cases, the ILIT's design can be a significant impediment to resolving the gift and GST issues associated with the wayward split-dollar arrangement. Consider a 1998 vintage collateral assignment split dollar. The policy is owned by an ILIT and premiums have been advanced by the insured's employer. The original game plan was for the employer to advance premiums for, say, 10 years and in the 16th year, the ILIT would dip into the policy and withdraw enough money to repay the employer's premium advances. The Internal Revenue Service changed the rules on these plans in 2002, so that if the client sticks with that plan, the cash value in excess of the premiums advanced by the employer will potentially be taxable income to the grantor/insured and a gift to the ILIT. The grantor would like to recast the plan as a loan in order to take advantage of the safe harbor provision in Notice 2002-8, thereby avoiding income and gift taxation upon termination of the plan when there is plenty of equity in the policy. Unfortunately, the ILIT is not a grantor trust, a fact that sharply limits the grantor's flexibility to design the split-dollar loan and also limits his ability to reduce the eventual gift tax cost of getting out of the arrangement. Thus, a new ILIT might well be needed to salvage the situation. What's more, the existing policy may not be as efficient for the recast arrangement as a newer, more flexible and more competitively designed product. So, a product fix is also in the offing.
Let's consider first the alternatives for moving a policy from an existing ILIT to a new one. Then we'll look at some product-oriented solutions.
The choice of method for migration of a policy from one ILIT to another will depend upon a number of factors, including the terms of the existing ILIT per se as well as on a comparative basis with the terms of the new ILIT, the status of the existing ILIT as a grantor trust and the health of the grantor.
Distribute the Policy to the Beneficiaries — The first strategy to consider is one in which the ILIT distributes the policy to the adult beneficiaries (assuming of course, that the trustee is authorized to do this). Then, the beneficiaries may re-contribute the policy to a new ILIT established by the grantor. On the other hand, the beneficiaries may choose not to do this. We can be fairly sure, however, that they will ask for cash premiums. This strategy is not likely to be satisfactory to a parent/insured who went to the trouble of using an ILIT in the first place because she didn't want the kids to own the policy. What's more, a number of technical and administrative problems can arise when more than one child owns the policy. For example, what happens if one of the children predeceases the insured or gets divorced? So, let's keep looking.
Distribute the Policy to a New ILIT — The existing ILIT might provide that the trustee may distribute trust property to another trust created by the grantor for the same beneficiaries. If so, the grantor can create a new ILIT more suited to his liking and, hopefully, the trustee will distribute the policy to the new trust. This always seems like a nice easy solution, until we find that the trust doesn't have the requisite provisions, state law doesn't seamlessly lend itself to this solution, or the trustee wants sign-offs from everyone who has ever met the grantor.
Sell the Policy to a New ILIT — Another strategy is for the grantor to create and fund a new ILIT that would, in turn, purchase the policy from the old trust. This strategy has great superficial appeal, but there are some technical niceties to be observed here. Whenever a policy is to be sold, meaning that it is to be transferred for valuable consideration, the transfer-for-value rules of Internal Revenue Code Section 101(a)(2) must be considered.
If a policy is transferred for valuable consideration, the proceeds are tax-free only to the extent of the purchase price plus further premiums paid. The remainder of the death benefit is ordinary income. Fortunately, there are exceptions to the transfer-for-value rule. The exceptions that typically will come into play in this context are transfers to the insured or transfers to a partner of the insured.2 But it may not be necessary to determine if an exception applies. The IRS might not see a transfer-for-tax purpose in the first place. For example, in Private Letter Ruling 200518061, the Service found that a sale of a policy by one grantor trust to another was disregarded for income tax purposes. Therefore, even though for valuable consideration, the transfer would not be a transfer for value. Another ruling, PLR 200606027, involved an exchange by one ILIT of two life insurance policies for two other policies held by a second ILIT created by the same grantor (together with a promissory note to make up the difference in value). The IRS noted that although gain would normally be recognized on the exchange of one valuable asset for another, because exchanges between two grantor trusts with the same grantor are generally disregarded for income tax purposes, no gain recognition would be triggered. The assets of both trusts are deemed owned directly by the grantor for these purposes. Therefore, the transfer of two life insurance policies owned by the grantor for two other policies owned by the grantor cannot be an event in which gain or loss is recognized, because no change of ownership has occurred for income tax purposes. The transfer-for-value rule applies only if there is indeed a transfer. The IRS would ignore the “grantor trust to grantor trust” transaction, because both trusts are deemed owned by the same person. Therefore, without a transfer, there cannot be a transfer for valuable consideration.
Note that the IRS' PLRs hinged on the trusts being grantor trusts, which was a representation made by the taxpayers and accepted at face value. Planners have to tread carefully here. Many ILITs are not necessarily grantor trusts. Commentators disagree, for example, as to whether a provision under IRC Section 677(a)(3) allowing the trustee to apply trust income to premium is actually sufficient (in the absence of any other typical grantor trust provisions) to cause the trust to be a grantor trust. Another concern would be the impact of Crummey powers on the (fully) grantor trust status of the trust. It is not entirely clear whether the Crummey power would cause a portion of the (otherwise defective grantor) trust to be taxable to the holder of the power under Section 678(a), notwithstanding the exception for grantor taxation under Section 678(b).
Taxes aside, there may be several impediments to this strategy. The old ILIT may not permit the sale of the policy. Or, the beneficiaries of the ILITs may not be the same and the beneficiaries of the old ILIT believe they were shortchanged by the transaction (that is to say, an inadequate sales price) or the insured died shortly after the transaction (that is to say, a failure to predict the future).
Grantor Purchases Policy From ILIT and Then… Another strategy calls for the grantor to buy the policy from the ILIT for fair and adequate consideration. The sale would be a transfer for valuable consideration, but would fall under the exception for transfers to the insured. If there is gain in the policy, the ILIT will have to recognize that gain unless the ILIT is a grantor trust.3 The ILIT would then have cash to invest or distribute, as the case may be.
The grantor then would have to decide whether to retain the policy or transfer it to the new ILIT. Assuming the grantor wishes to transfer the policy to a new ILIT, he has to decide whether to transfer it by gift or by sale. If he gives the policy to a new ILIT, the transfer will be subject to IRC Section 2035's three-year rule, meaning inclusion in the grantor's estate if he dies within three years of the gift of the policy.
The three-year risk can be addressed in several ways. The ILIT can have a contingent marital clause that would allow the ILIT to qualify the proceeds for the marital deduction if they are “caught” in the estate by Section 2035. However, if the new ILIT can buy a term policy and keep it in force for three years, it would have the cash to cover the tax if the proceeds are snared by Section 2035. If the ILIT owns the term policy, it presumably doesn't need to use the contingent marital deduction and can preserve estate exclusion for both spouses.
Alternatively, the insured could sell the policy to the new ILIT. A sale for adequate and full consideration will avoid the three-year rule.4 But what is adequate and full consideration? Generally, the price is determined by the interpolated terminal reserve plus unexpired premiums. However, if the insured was in poor health, the value of the policy could be considerably greater. The value also could be greater if the policy was marketable in the life settlement market. (See “Sell Your Policy?“ p. 24). Finally, the IRS could conceivably take issue with the price under the guidelines set down in Revenue Procedure 2005-25 that addresses the valuation of life policies in certain situations.
The grantor's sale of the policy to the ILIT raises the transfer-for-value concern. However, if the ILIT is a grantor trust, the result should be the same as we've discussed, namely, the transfer would be disregarded because the grantor would be considered to own the policy before and after the sale.5 In PLR 9041052, the IRS held that a transfer of a policy to a grantor trust would be disregarded. Swanson v. Commissioner6 is also often cited as authority for the position that a grantor/insured's transfer to his grantor trust is tantamount to a transfer to the insured. But a reading of Swanson and its unusual fact pattern leaves many planners reluctant to place much faith in the case and the PLR is just that, merely a private letter ruling. The safer way to avoid the transfer-for-value problem is for the ILIT to be a partner of the grantor/insured, thereby taking advantage of the partnership exception.
The sale could be financed by a note from the ILIT. Here, a typical approach (or at least a typical inquiry) is to sell the policy for the interpolated terminal reserve/cash value, less the amount of annual exclusions applicable to the transfer of the policy to the ILIT. The documentation, meaning the note, is clear and enforceable on its face. However, the grantor will eventually forgive the obligation, perhaps serially. The careful planner will heed PLR 200603002, in which the IRS collapsed the transfer of a policy in a part-gift/part-sale construct into an outright gift. The planner will structure this transaction in an arm's length, business-like fashion between the grantor/insured and the ILIT.
The “Do Over” — Of course, one other strategy is for the insured to simply stop funding the existing ILIT and start over with a new ILIT and new policy. Obviously, the grantor would still have to be insurable at a reasonable enough rate to make this strategy feasible. The existing policy already might be self-sufficient or the trustee might be able to reduce the death benefit enough so it can be supported by the current cash value and no further cash premiums. It depends.
PRODUCT, CASH FLOW
Let's now consider some strategies for dealing with product and cash flow issues, starting with alternatives to outright gifts of premiums.
Split Dollar — In some cases, we might want to consider turning to split dollar, albeit very carefully. If the client has a company that will entertain the notion of advancing premiums under a compensatory split-dollar plan in which the company is actually lending those premiums to the ILIT, then we have a viable source of cash and a means of minimizing the gift tax cost of paying premiums. Of course, the usual caveats regarding a loan-based split-dollar plan apply, and we would want the grantor to appreciate the value of implementing an exit strategy, such as GRAT funding of the ILIT, sooner rather than later. If we don't have a company available — or if we do but we don't want to use the company — we can consider a private split plan with the grantor/insured lending premiums to the ILIT.
Status of the ILIT as a grantor trust is critical here because we don't want the ILIT to be a separate taxpayer from the grantor/insured and have to deal with taxable interest to the grantor. And, as always, we need an exit strategy, meaning a way to repay the loan without depleting the policy.
The next strategies are policy-focused.
The Exchange — The trustee might be able to exchange the policy for a new universal life policy that will support the death benefit with little or no further premiums. The exchange should be tax-free under IRC Section 1035, as long as we have the same owner and same insured, which we would. Still, the ability to do an exchange is exquisitely sensitive to the facts and circumstances.
Life Settlement Option — A variation on the theme is where the trustee sells the current policy in a life settlement transaction and puts all or part of the proceeds into a new policy. Here, the trust sells the policy to a third-party for a price well in excess of the cash surrender value. This approach could generate much more cash for a new policy than the cash value of the current policy would upon an exchange. Conventional wisdom, but not necessarily tax authority, is that the result is return of basis up to premiums paid, ordinary income to the extent cash value exceeds premium paid and then capital gain for the remainder. There are even questions about what constitutes basis in a sale of a policy. Just be sure the grantor understands the potential income tax and cash flow implications of the life settlement, because the cash stays in the ILIT but the tax bill can be passed along to the grantor. Bottom line, this approach can enable the client to stop the premium gifts and increase the amount of insurance in one fell swoop.
The Combo — Finally, let's consider having the old ILIT, which should be a grantor trust, sell the policy in a life settlement and then enter into split-dollar arrangement with the new, well structured ILIT, also a grantor trust, that buys a new policy. The old ILIT will lend the premiums to the new ILIT. Then again, maybe we should wait for the movie.
JUST DO IT
Irrevocable life insurance trusts and the policies they hold have been mainstays of our clients' estate planning. But with rapid changes in the rules, products, and many clients' circumstances, those ILITs and policies may offer opportunities for significant enhancements to our clients' tax and financial planning.
The views expressed in this article are the author's and don't necessarily reflect the views of Ernst & Young LLP. This article should not be construed as legal, tax, accounting or any other professional advice or service. No one should act on the information in it without appropriate professional advice, after a thorough examination of a particular situation's facts.
- For an excellent discussion of structural and judicial alternatives, see Santo Bisignano, Jr., “Stop the Bleeding or How to Repair the ILIT with a Damaged Crummey Power and Other Ailments,” Center for American & International Law 43rd Annual Program, Wills, Trusts and Estate Planning (Sept. 30 to Oct. 1, 2004).
- Internal Revenue Code Section 101(a)(2)(B).
- Revenue Ruling 85-13.
- IRC Section 2035(d).
- Rev. Rul 85-13.
- Swanson v. Commissioner, 518 F.2d 59 (8th Cir. 1975).