The ILIT or Irrevocable Life Insurance Trust has played a major role in estate planning for many years as the best financial method to provide a fund of money that’s highly leveraged, income tax free, estate tax free, gift tax free and generation-skipping transfer tax free.
However, over a period of time, the facts and circumstances of a client’s estate plan will change. The ILIT that served their needs fifteen or twenty years ago may not match their current estate planning desires. The client may wish to add or delete trust beneficiaries, change the trustee or change certain key terms of the trust. These changes cannot be made because an irrevocable trust means exactly that … it’s IRREVOCABLE! The trust cannot be altered, amended, or revoked without adverse estate tax consequences. Possessing any of these rights or any incidents of ownership in the policy will cause the death proceeds to be included in the gross estate for estate tax purposes.
We often get the question, are there any options for transferring a policy out of an ILIT when the terms of the trust no longer meet the client’s planning objectives?
Let’s take a look at 5 planning options that may be able to rescue an old policy owned by an ILIT and still utilize it for current planning purposes.
- The grantor can simply stop making annual gifts to the existing trust to pay premiums. The trustee could take a reduced paid-up policy or the policy could be surrendered completely if the income tax consequences are minimal. Future premium gifts can be made to a new ILIT which meets the client’s current planning objectives.
- The ILIT can sell the policy to the insured grantor for its fair market value (generally the cash value). Then, the grantor can gift the policy ownership to a new ILIT for its gift tax value (generally the cash value). Since the policy ownership is initially transferred to the insured, this is one of the exceptions to the so-called transfer for value rule of IRC Section 101, and the policy death proceeds remain income tax free. However, the insured must survive three years beyond the gift of the policy to the new ILIT to remove the death proceeds from the gross estate for estate tax purposes.
- If the trust terms permit discretionary distributions of trust principal to trust beneficiaries, the policy can be transferred from the trust to the trust beneficiaries (i.e. children of the grantor). The children would become equal owners and equal beneficiaries of the policy. Next, the children could voluntarily transfer policy ownership to the new ILIT where they are beneficiaries. The transfer is estate tax free (insured estate owner never acquires ownership of the policy) and income tax free (a distribution of trust principal is tax free to the trust beneficiaries).
- The existing ILIT can sell the policy to the new ILIT for its fair market value (cash value). Since the policy is never owned by the insured, there is no problem with the three year inclusion rule and the death proceeds remain estate tax free. However, the transfer of ownership to the new ILIT must still meet one of the exceptions to the transfer for value rule to keep the death proceeds income tax free. This result can be accomplished by drafting the new ILIT as a grantor trust for income tax purposes under the guidelines of Rev. Rul. 2007-13. In this case, the policy transfer is considered to be a transfer to the insured for purposes of the transfer for value rule under IRC Section 101. Or, the new ILIT can be a partner, in a partnership where the insured is also a partner. This result is often accomplished by creating a Family Limited Partnership (FLP) and then transferring limited partner shares to the new ILIT. Thus, the new ILIT is now a partner of the insured which meets another exception to the transfer for value rule under IRC Section 101.
- Under certain limited circumstances, a legal merger of the old trust into the new trust can be accomplished if the beneficiaries of both trusts are the same and the beneficiaries lose no vested property rights in such a transfer. A special legal document plus written waivers by the trust beneficiaries is required to effectively create such a merger of trusts.
Contact BSMG Advanced Sales for a discussion of potential rescue techniques that may be considered based on your client’s estate planning objectives.
Russell E. Towers, JD, CLU, ChFC
Vice President, Business & Estate Planning