An irrevocable life insurance trust (ILIT) is an effective estate planning tool. Married couples create ILITs to replace income in the event of an untimely death, pay estate taxes and administration expenses, and equalize inheritances among children. However, these trusts are often criticized as inflexible. A common complaint is that both husband and wife lose access to the life insurance policy’s cash value while they are alive.
An ILIT is an irrevocable trust that is the owner and beneficiary of one or more life insurance contracts. An ILIT cannot be revoked, altered or amended by the grantor (that is, the party creating the ILITusually the insured). If the ILIT is properly drafted and administered, the life insurance death proceeds will not be subject to income taxes and will not be included in the taxable estate of the grantor or the grantor’s spouse. Because ILITs are typically “unfunded,” annual contributions from the grantor go to pay premiums. These annual contributions are sheltered (or partially sheltered) from gift taxes by giving trust beneficiaries a power to withdraw contributions to the ILIT. These powers to withdraw (also known as Crummey powers) cause the contributions to be “present interest gifts” that qualify for the annual exclusion from gift taxes.
A Survivorship ILIT owns and is the beneficiary of survivorship life insurance (also known as “second-to-die”), typically covering a husband and wife. It is designed to provide liquidity for estate taxes and administration expenses after the surviving spouse’s death. This trust design is popular because survivorship life insurance is ordinarily less expensive than single life coverage. And, because of the unlimited marital deduction, most estate taxes are deferred until the death of the surviving spouse. However, a concern with Survivorship ILIT’s is that it is often considered impossible to gain access to the policy’s cash values.
Traditionally, the belief has been that one of the insureds cannot be the beneficiary of an ILIT holding a survivorship policy. To avoid possession of incidents of ownership, which would subject the life insurance death proceeds to be included in the taxable estate, the general understanding is that neither insured spouse could benefit in any way from a survivorship trust. However, by using a special type of Survivorship ILIT, called a “Survivorship Spousal ILIT,” it is possible for one spouse to have access to the cash values during his or her life. Like the Survivorship ILIT, the Survivorship Spousal ILIT is not a new concept. This can be a very effective estate-planning tool, but it is probably not used by enough families.
Two IRS private letter rulings, PLR 9451053 and PLR 9748029, are helpful in illustrating how to design and create a Survivorship Spousal ILIT.
To begin, the Survivorship Spousal ILIT must be established by just one spouse. The grantor spouse is typically the one more likely to die first. [For discussion purposes only, I will assume that’s the husband.]
The other spouse (the non-grantor spouse) is the primary beneficiary. In each of the two PLRs, the non-grantor spouse’s beneficial interest, without a power of appointment (general or limited) was sufficiently restricted so to not be an incident of ownership. The non-grantor spouse can be given the right to receive distributions subject to an “ascertainable standard,” such as “health, education, maintenance, and support,” without causing estate tax inclusion. Or distributions to the beneficiary spouse can be solely within the discretion of the trustee.
The trust should be the applicant, owner and beneficiary of all life insurance policies. If the policy is applied for and owned by the trust from inception, the death proceeds should be excluded from the gross estate, provided the purchase of the insurance was at the discretion of the trustee.
The grantor spouse makes all the actual transfers of property to the trust. The non-grantor spouse may split gifts. This means when a husband or wife makes a gift to a third person, the family can treat it as given one-half by the husband and one-half by the wife. This is true even though only one spouse actually makes the gift, providing the other spouse consents. By gift splitting, the grantor spouse can transfer property equal to two times the annual gift tax exclusion per trust beneficiary without paying a transfer tax.
The trust should limit Crummey withdrawal rights of the non-grantor spouse to $5,000 or 5% of the value of the trust. Under Sec. 2514(e) of the tax code, a lapse of a withdrawal right is considered to be an indirect transfer by the person who allows the lapse to occur only to the extent that the withdrawal right exceeds the greater of $5,000 or 5% of the value of the trust. In PLR 9748029, the IRS ruled that as long as the non-grantor spouse does not make any contributions to the trust “either directly or indirectly,” the value of the trustincluding the insurance policywould not be included in the gross estate of the non-grantor spouse under tax code sections 2036 and 2038. Sections 2036 and 2038 involve a transfer to a trust with a retained interest either in the trust or in the property transferred.
Neither insured can ever become trustee. This avoids estate-tax inclusion from incidents of ownership held in a fiduciary capacity.
Although neither insured can possess a power of appointment, a limited power of appointment can initially be given to an adverse party. This limited power of appointment can be used to appoint the policy back to the grantor spouse.
Advisors interested in this technique should consider providing money to the trust to buy a single-life policy on the grantor spouse’s life. This was the case in PLR 9451053. Here the IRS ruled that, assuming the husband died first, the trust property would not be included in the wife’s estate on her subsequent death, notwithstanding the trustee’s authority to use trust income to pay premiums on a survivorship life insurance policy held by the trust. The IRS reasoned that the wife did not possess any incidents of ownership in the policies.
Carefully planned and properly drafted and administered, the Survivorship Spousal ILIT can accomplish a variety of goals:
- Lifetime distributions. If necessary, the trustee can make distributions to the wife and/or children while both husband and wife are alive, for their health, education, maintenance, and support. The trustee need not wait until the death of the survivor of husband and wife to make distributions from the ILIT.
- Access to the policy’s cash value. The trustee can access the policy’s cash value to finance distributions to wife and/or children.
- Death benefits available to children. Upon the death of the survivor of husband and wife, the ILIT will terminate and the remaining principal will pass to the children. This will provide liquidity to pay estate taxes and administration expenses.
- Children as trustee. Because both husband and wife are insureds, neither spouse should ever be the trustee. However, one or more adult children can be named as trustee. Having such a “friendly” trustee can help achieve maximum estate tax savings, yet still provide flexibility.
Lawrence T. Jones, J.D., is second vice president, advanced sales, for National Life of Vermont. He attended the University of North Carolina in Chapel Hill law school. He can be reached by phone at 802-229-3460 or by e-mail at email@example.com.