ALI-ABA Video Law Review ILITs: Drafting and Administering Irrevocable Life Insurance Trusts. December 10, 2007 Live Program/Video Webcast

Transcription

1 1 ALI-ABA Video Law Review ILITs: Drafting and Administering Irrevocable Life Insurance Trusts December 10, 2007 Live Program/Video Webcast Designing and Drafting a More Flexible Irrevocable Life insurance Trust (with Drafting Examples) By Julius H. Giarmarco Giarmarco, Mullins & Horton PC Troy, Michigan

2 2 2

3 3 TABLE OF CONTENTS ARTICLE PAGE I. MAINTAINING ACCESS TO CASH VALUES. 1 II. TYPES OF CRUMMEY NOTICES. 5 III. PAYING PREMIUMS DURING THE CRUMMEY WITHDRAWAL PERIOD. 7 IV. CHANGING CRUMMEY POWERHOLDERS. 9 V. REMOVING AND REPLACING TRUSTEES. 10 VI. POSTPONEMENT CLAUSES. 13 VII. EXCULPATING TRUSTEES. 14 VIII. POWERS OF APPOINTMENT. 16 IX. FIVE AND FIVE POWERS. 19 X. CHANGING TRUST SITUS. 20 XI. BENEFICIARY CONTROLLED TRUSTS. 22 XII. DEFINITION OF SPOUSE. 25 XIII. TRUST PROTECTORS. 26 XIV. DEFECTIVE IS MORE EFFECTIVE. 30 XV. HOW TO CHANGE ILITS WITH SURVIVORSHIP LIFE INSURANCE. 35

4 4 DESIGNING AND DRAFTING A MORE FLEXIBLE IRREVOCABLE LIFE INSURANCE TRUST by Julius H. Giarmarco, J.D., LLM I. MAINTAINING ACCESS TO CASH VALUES. A. Potential Problem. 1. To avoid estate tax at the death of the grantor-insured, the irrevocable life insurance trust (ILIT) must be irrevocable by the grantor, and must prohibit any distributions of trust income or principal to or for the benefit of the grantor. IRC Sections 2036(a)(2), 2038(a)(2), 2041(a)(2) and 2042(2); Treas. Reg. Sections (b)(1) and (c)(3). 2. Because of unexpected future financial needs, changes in the estate tax laws, and/or changes in the grantor s family situation, the grantor may be reluctant to give up complete access to his/her policies (by assigning them to an ILIT). B. Solution: Friendly Power Holder Technique. 1. The ILIT can give the grantor-insured s spouse (unless the trust owns a survivorship policy), the grantor s child or another trusted individual a limited power of appointment (LPA), during the grantor s lifetime, to appoint trust income and principal to anyone other than the powerholder, the powerholder s estate, or the creditors of either. IRC Sections 2041(a) and (b)(1). 2. Alternatively, the class of potential appointees can be limited to the grantor, the grantor s spouse and the grantor s descendants in such manner (in trust or otherwise), but not to the powerholder, the powerholder s estate, or the creditors of either. 3. With such a LPA, the powerholder could appoint the policy back to the grantor-insured or directly to a new ILIT with revised terms. 4. Caution: do not allow any power that would impair an existing Crummey right. 1 See, Chapter 11 of Sebastian V. Grassi, Jr., A Practical Guide to Drafting Irrevocable Life Insurance Trusts (With Sample Forms and Checklists) - Second Edition, ALI/ABA, Philadelphia, PA (2007), (800) ( for additional techniques to provide flexibility to an irrevocable life insurance trust. 1

5 5 C. Avoiding Estate Tax Inclusion. 1. If the policy is returned to the grantor-insured, the death proceeds will be included in the grantor s estate. IRC Section However, the mere existence of the LPA in the ILIT whether or not exercised should not cause the trust property to be included in the grantor s estate. 3. IRC Section 2042(2) includes as an incident of ownership a reversionary interest whose value exceeds 5% of the value of the policy, immediately before the insured s death. a. The possible exercise of the LPA is a reversionary interest held by the insured. b. However, since the LPA is exercisable solely in the powerholder s discretion (rather than a mandatory right or based on an ascertainable standard) the value of the reversionary interest is less than 5%. Treas. Reg. Section (c)(3). 4. IRC Section 2041(a)(2) includes in a decedent s estate property over which the decedent has a general power of appointment at the time of death. But since the LPA is not exercisable by the grantor, Section 2041(a)(2) does not apply. 5. IRC Section 2038(a)(1) requires inclusion of property transferred by a decedent prior to death to the extent that, at the decedent s death, the decedent, alone or in conjunction with any other person, has the power to alter, amend, revoke or terminate the enjoyment of the property. But since the LPA is not exercisable by the grantor, Section 2038(a)(1) does not apply. 6. IRC Section 2036(a)(1) requires inclusion of property transferred by the decedent wherein the decedent retained the possession or enjoyment of or the right to the income from the trust property. a. If the exercise of the LPA is purely discretionary, then IRC Section 2036(a)(1) will not apply. Estate of Wells v. Commissioner, 42 T.C.M T4. b. But if the grantor and the powerholder had an understanding, express or implied, that the powerholder would later distribute the trust property to the grantor, then the grantor will have retained an interest in the trust property under IRC Section 2036(a)(1). Treas. Reg. Section (a). 2

6 6 i. Since the burden to prove no such understanding existed is on the estate, IRC Section 2036(a)(1) presents the greatest estate tax risk to using the LPA technique. ii. However, the LPA technique offers no risk for the grantorinsured who would not otherwise transfer the policy to an ILIT but for the possibility of retaining access to cash values. c. In addition, if the existence of the LPA in the ILIT allows the grantor s creditors to attach the trust property under state law, the grantor will be treated as having retained an interest under IRC Section 2036(a)(1). Treas. Reg. Section (b)(2) i. The reason is that the grantor could incur indebtedness and then relegate his/her creditors to the trust for payment. ii. Therefore, if the grantor lives in such a state, the ILIT should be established in a state with less favorable creditor laws. 7. Revenue Ruling , I.R.B. 7, held that if a grantor trust mandates that the trustee reimburse the grantor for income taxes, the trust assets will be included in the grantor s estate under IRC Section a. However, a discretionary reimbursement clause will not, by itself, cause the trust assets to be included in the grantor s estate under IRC Section b. But the ruling cautions that estate tax may be triggered if, under state law, the discretionary reimbursement clause subjects the trust assets to the claims of the grantor s creditors. c. Therefore, to be safe, it may be advisable to not give the trustee discretionary reimbursement powers (except in self-settled asset protection trust states). D. Gift Tax Consequences Upon Exercise of LPA. 1. If the powerholder is a discretionary income beneficiary of the ILIT, the exercise of the LPA is not a gift to the grantor because the power cannot be valued. Estate of Regester v. Comm r, 83 TC 1(1984). But see PLR (ruling that a holder made a gift when the holder was a potential beneficiary of a discretionary trust). 3

7 7 2. If the powerholder is not a beneficiary of the ILIT, the exercise of the LPA is not a gift to the grantor. Treas. Reg. Section (g)(1). 3. If the powerholder is a mandatory income beneficiary of the ILIT, upon exercise of the LPA the powerholder is making a gift to the grantor equal to the present value of the powerholder s life income interest in the trust. IRC Section 2511(a); Treas. Reg. Section (e) Ex.(3). 4. If the powerholder has the right to receive trust income under an ascertainable standard, the regulations indicate that the holder s failure to distribute income to himself is not a taxable gift under IRC Section Treas. Reg. Section (e) Ex.2. But the IRS could argue that the holder has made a gift of his/her ascertainable right to receive distributions in the future under IRC Section See PLR If the powerholder has the right to receive trust principal as needed under an ascertainable standard, the value of the gift is the present value of all possible distributions on a year-to-year basis. PLR If the grantor s spouse is the powerholder, there will be no gift tax because of the unlimited marital deduction. Other powerholders will be able to use the gift tax annual exclusion. 7. Planning Technique: To avoid gift taxes altogether, name a non-beneficiary as the powerholder. E. Sample Provision. SECTION. LIMITED POWER OF APPOINTMENT During the Grantor s life, the Trustee shall have the limited power (exercisable in a nonfiduciary capacity, either personally or by an attorney-in-fact under a power of attorney, without the consent or approval of any person or entity in a fiduciary capacity) to appoint the principal of the trust to any one or more of the Grantor and the Grantor s descendants (or to a trust for their benefit), whether living at the time of exercise or thereafter born, in whole or in part, or in equal or unequal proportions, subject to the following provisions. The Trustee may, at any time and from time to time during his/her life, by written instrument delivered to the beneficiaries, release such limited power of appointment with respect to any or all of the property subject to such power and/or may further limit the persons or entities in whose favor this power may be exercised or the extent to which this power may be exercised. a. Successor Trustees If the Trustee resigns, is terminated, or cannot serve for any other reason, then the 4

8 8 Trustee s successors in trust shall have the right to exercise this limited power of appointment. b. Qualifications on the Limited Power of Appointment The power shall only be exercisable by the holder of the power, and shall not be exercised in favor of the holder, the holder s estate, the holder s creditors, or the creditors of the holder s estate. The power shall not be exercised by the holder in any manner that would result in an economic benefit to the holder or that would in any manner discharge or reduce any legal obligation of the holder, or any legal obligation of the Grantor or the Grantor s spouse. The power shall not apply to any incidents of ownership with respect to life insurance policies insuring the life of the Trustee which are owned by the trust. The power shall not be effective to the extent it could be considered a general power of appointment because it could be a reciprocal power with someone else holding another power of appointment or power of distribution in this trust or any other trust. The power shall not be exercised by the holder if the value of the principal of the Trust after the exercise would be less than the aggregate amount subject to an unlapsed or outstanding right of withdrawal under this Article after the exercise of the power. II. TYPES OF CRUMMEY NOTICES. A. Potential Problems. 1. No written notice was given to the beneficiaries after the initial gift to the ILIT. 2. ILIT owns a group term policy where premiums are paid directly by insured s employer (typically monthly and in varying amounts). B. Solution. 1. Do not require written notice, but rather reasonable notice. 2. Do not require notice where the beneficiary has actual notice. 3. Allow trustee to use a one-time notice, particularly when ILIT owns a group term policy. 4. Use a one-time notice in conjunction with annual notices as a failsafe. 5

9 9 C. IRS s Position. 1. In PLR the IRS determined that a father s contributions to two trusts qualified for the gift tax annual exclusion where the beneficiary had reasonable notice of the contribution and the right to withdraw the contribution within 30 days. Unfortunately, PLR does not specify what constitutes reasonable notice. 2. No Revenue Rulings or PLRs have required that the trust agreement have a provision requiring the trustee to give written notice. In fact, no notice was given to the beneficiaries in the Crummey case. However, since the taxpayer has the burden of proof, written notice provides permanent evidence. 3. Annual exclusion allowed where beneficiaries were given verbal notice. See Estate of Carolyn W. Holland v Comm r, T.C. Memo Annual exclusion allowed for minor beneficiaries (where their parent was a trustee, beneficiary and their guardian) even though the trustee did not give herself written notice. PLR This is an example of constructive notice. 5. Annual exclusion allowed where grantor s spouse was trustee and had actual notice. PLR A one-time notice has been upheld which identified when future contributions were expected to be made. PLRs , , and In TAM the IRS ruled that it will recognize Crummey withdrawal rights only in those situations in which the donees receive actual current notice of any gifts to the trust. E. Sample Provision. a. In TAM the trust beneficiaries signed a statement waiving their right of withdrawal to the initial contribution, and revocably waived their right to future notices. b. Arguably, a single notice that informs the beneficiary of his or her rights over specific gifts to the trust, and of their dates and amounts is current even though many years have passed. If the gift is made on other dates, however, another notice must be given to create an annual exclusion. 6

10 10 SECTION. NOTICE OF WITHDRAWAL RIGHTS Each Powerholder shall be kept reasonably informed by the donor, the donor s agent or the Trustee of all withdrawable transfers hereto which are made or expected to be made. Such efforts may include annually apprising each Powerholder of his/her rights to withdraw, providing the Powerholder with a single notice sufficient to apprise him/her of his/her current and expected future rights to withdraw, or any other means determined by the donor, the donor s agent or the Trustee to provide each Powerholder with reasonable notice. After receiving such notice from the donor, the donor s agent or the Trustee at least once, any Powerholder, or the legal guardian of any Powerholder, by a written instrument mailed or delivered to the donor, the donor s agent or the Trustee, may permit the donor, the donor s agent or the Trustee to provide such written notices annually (during the first month of each calendar year) in anticipation of transfers to be made during such year or may altogether waive the donor s or the Trustee s obligation to further provide such written notices. In addition, no notice shall be required to be given to any Powerholder who has actual or verbal notice of his/her withdrawal rights. In no event shall the donor, the donor s agent or the Trustee be held liable for failing to give any notice required hereunder, nor shall the failure of any Powerholder to receive such notice be deemed to abrogate his/her withdrawal rights in accordance with the provisions of this Article. A Powerholder s right of withdrawal is not contingent upon such notice. Upon request by any Powerholder, the Trustee shall furnish full, detailed information with respect to any such transfers subject to withdrawal hereunder. III. PAYING PREMIUMS DURING THE CRUMMEY WITHDRAWAL PERIOD. A. Potential Problems. 1. Once the decision has been made to purchase a new policy, the insured does not want to wait until the Crummey withdrawal period ends (usually 30 days) before paying the first premium. 2. In subsequent years, the gift to the trust is made too late to stay safely within the policy s grace period. 3. Under the above situations can the beneficiary waive his/her withdrawal right? B. Tax Consequences. 1. A Crummey power is a general power of appointment. 2. A release of a general power of appointment (created after October 21, 1942) is treated as a gift by the person possessing the power. IRC Section 2514(b). 7

11 11 3. However, IRC Section 2514(e) provides an exemption for gift tax purposes for lapses of powers that do not exceed $5,000 or 5% of the aggregate value (at the time of lapse) of the trust assets subject to the power. 4. The lapse of the Crummey power (in excess of the $5,000/5% exemption) will usually result in a gift over to the other beneficiaries of the trust (unless hanging powers are used or the beneficiary has a limited power of appointment over his/her portion of the trust so as to create an incomplete gift). Moreover, this gift over is not a present interest gift which qualifies for the gift tax annual exclusion. 5. The $5,000/5% safe harbor only applies to a lapse of a general power of appointment. It does not apply to a release of the power. 6. If the IRS decides to treat a beneficiary s waiver of his/her withdrawal power as a release, a taxable gift over would occur. Thus, the Crummey powerholder will have to file a gift tax return and use up a portion of his/her $1,000,000 gift tax exemption. It will also change the identity of the transferor for GST tax purposes. C. Solution. 1. Provide the Crummey powerholder with notice and, in lieu of waiving the notice, have him/her authorize the trustee to use the contributed property to pay premiums during the withdrawal period. 2. If a powerholder were later to decide to exercise his/her withdrawal right, the trustee could do so out of the policy itself, or from other trust assets. D. Sample Provision. Check One: I wish to exercise my withdrawal right. I hereby acknowledge receipt of notification of my power of withdrawal under the above-named Trust and the addition made to the Trust. I consent to use of the addition to pay premiums on any life insurance policy in the Trust prior to the end of the period for the exercise of my power of withdrawal. Further, I understand that additions will be made to the Trust in future years, and I may be given a power of withdrawal with respect to such additions. Unless I notify you to the contrary, you do not need to notify me regarding future additions when I am given a power of withdrawal. 8

12 12 Signature of Beneficiary or his/her Guardian if Beneficiary is a Minor IV. CHANGING CRUMMEY POWERHOLDERS. A. Potential Problems. 1. A Crummey powerholder becomes uncooperative and begins exercising his/her withdrawal rights. 2. The grantor wishes to delete a withdrawal right to a Crummey powerholder so as to make other annual exclusion gifts to that powerholder. B. Solution. 1. In the trust instrument permit the donor to determine (each time a gift is made to the trust) whether the Crummey withdrawal right may be exercised. 2. The donor should also be given the right to determine the amount of exercise and by whom it may be exercised. C. Tax Consequences. 1. PLR involved a Crummey trust that contained a provision which gave the donor of any transfer to the trust the ability to cancel a beneficiary s withdrawal right, to modify the amount subject to withdrawal, and/or change the period during which the beneficiary s withdrawal power could be exercised. 2. The IRS ruled that because the power is exercised at the time the gift is made, it is not a retained power subject to IRC Sections 2036 and D. Sample Provision. SECTION. POWER TO CHANGE WITHDRAWAL RIGHTS Notwithstanding the limitations provided in this Article with respect to withdrawal rights of the Powerholders, the donor making a transfer shall have the right, by acknowledged instrument delivered to the Trustee on or before the date of the specific transfer: (i) to prohibit any or all of the Powerholders from exercising a withdrawal right with respect to such transfer; (ii) to increase or decrease the amount subject to the withdrawal right of any or all of the Powerholders with respect to such transfer, except that the amounts subject to the withdrawal right shall not exceed the value of the property transferred at the time of 9

13 13 transfer; or (iii) to change the period during which any or all of the Powerholders may exercise the withdrawal right, including provisions relating to the lapse of such right, with respect to such transfer. V. REMOVING AND REPLACING TRUSTEES. A. Potential Problems. 1. The grantor and, after the grantor s death or incapacity, the beneficiaries desire to remove a trustee who is unresponsive or ineffective. 2. The grantor and, after the grantor s death or incapacity, the beneficiaries desire to remove a trustee to reduce administration costs. B. Solution. 1. Provide the grantor and the beneficiaries (after the grantor s death or incapacity) in the trust instrument the right to remove and replace trustees. 2. Consider whether or not the grantor s ex-spouse (or the ex-spouse of a descendant of the Grantor) should have the right to remove and replace trustees on behalf of minor children. 3. Provide guidelines as to qualifications of any successor trustee. C. Tax Consequences. 1. Rev. Rul , C.B. 191, reversed Rev. Rul , C.B. 325, and held that a grantor s reservation of an unqualified power to remove and replace a trustee is not a reservation of the trustee s discretionary powers of distribution that might cause trust corpus to be included in the grantor s estate under IRC Sections 2036 and In PLR , the IRS extended its holding in Rev. Rul to beneficiaries who were given the power to remove and replace trustees. 3. However, Rev. Rul also stated that any successor trustee must not be related or subordinate to the grantor (within the meaning of IRC Sec. 672(c)). Thus, a family member or an employee should not be appointed as a successor trustee. 4. Is the use of IRC Sec. 672(c) appropriate? a. IRC Sec. 672(c) is an income tax standard used in the grantor trust 10

14 14 rules. Prior to Rev. Rul , IRC Sec. 672(c) had no estate tax significance. b. The requirement to replace the trustee with someone who is not related or subordinate is also inconsistent with the Tax Court s holding in Estate of Wall, 101 TC 300 (1993). c. The implication in Rev. Rul that a power to remove a trustee and appoint a related or subordinate party as successor trustee is a reservation of the trustee s powers has no support in IRC Sec. 2036(a)(2) or IRC Sec. 2038(a)(1) or the Regulations promulgated thereunder. d. Nevertheless, the prudent course of action is to follow the requirements of Rev. Rul D. Sample Provision. SECTION. THE REMOVAL OF A TRUSTEE The Grantor reserves the right to remove any incumbent Trustee or Co-Trustee and any successor Trustee designated to act in the future and appoint a successor individual or Independent Trustee or a series of successor individual or Independent Trustees or Co- Trustees. As a condition precedent to removing a Trustee or Co-Trustee hereunder, the Grantor must first appoint an Independent Trustee (if no successor Trustee has already been named herein), as such term is defined in subparagraph (c) of this Section. After Grantor s death, or during any period that Grantor is disabled, Grantor s spouse may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a series of successor Independent Trustees or Co-Trustees. As a condition precedent to removing a Trustee or Co-Trustee hereunder, Grantor s spouse shall first appoint an Independent Trustee (if no successor Trustee has already been named herein) or a series of successor Independent Trustees, as such term is defined under subparagraph (c) of this Section. After the death or disability of Grantor s spouse, a majority of the beneficiaries (with any beneficiary under a legal disability acting through his/her Agent) then eligible to receive mandatory or discretionary distributions of net income under this agreement may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a series of successor Independent Trustees or Co-Trustees. In addition, each beneficiary (with any beneficiary under a legal disability acting through his/her Agent) for whom a separate trust is named or established hereunder may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a 11

15 15 series of successor Independent Trustees or Co-Trustees with respect to his/her separate trust. As a condition precedent to removing a Trustee or Co-Trustee hereunder, Grantor s beneficiaries (or their Agent as the case may be) shall first appoint a successor Independent Trustee (if no successor Trustee has already been named herein) or a series of successor Independent Trustees, as such term is defined under subparagraph (c) of this Section. Notwithstanding the foregoing, for all purposes of the trust, a surviving parent of a minor beneficiary who is also the Grantor's ex-spouse by divorce or an exspouse of a descendant of the Grantor by divorce shall not, in his/her capacity as guardian of such beneficiary, or in any other capacity in which he/she may be acting on behalf of such beneficiary, have the power to remove a Trustee, name any successor Trustee or otherwise act on behalf of such beneficiary with respect to any trust created under this Trust Agreement. In no event shall Grantor serve as a Trustee hereunder. a. No Cause for Removal Needed The beneficiaries need not give any Trustee being removed any reason, cause, or ground for such removal. b. Notice of Removal Notice of removal shall be effective when made in writing by either: Personally delivering notice to the Trustee and securing a written receipt, or Mailing notice in the United States mail to the last known address of the Trustee by certified mail, return receipt requested. c. Definition of Independent Trustee As used in this instrument, the term Independent Trustee means a person: (i) who is not related or subordinate (within the meaning of IRC Section 672(c)) to any donor or beneficiary with respect to the trust in question; (ii) who cannot be benefited by the exercise or non-exercise of any power given the Trustee by this Trust Agreement or by law; (iii) who is neither a beneficiary nor a donor of the trust in question; and (iv) who is a Bank or Trust Company or an individual experienced in business, finance or investments or is an attorney or accountant experienced in the areas of trusts or taxes. In the event that any Independent Trustee should for any reason cease to meet such qualifications, he or she shall immediately cease to be a Trustee as though he or she had resigned immediately prior to the occurrence of such disqualification. 12

16 16 VI. POSTPONEMENT CLAUSES. A. Potential Problems. 1. Trust requires mandatory distributions to beneficiaries at stated ages (e.g., 1/3 at ages 25, 30 and 35). 2. Trust provides beneficiary with a power of withdrawal at stated ages (a general power of appointment). 3. At time of distribution or withdrawal, the beneficiary has creditor or personal problems (e.g., malpractice claims, pending divorce, addiction to drugs or alcohol, serious mental or physical disability, etc.) B. Applicable State Law. 1. Generally, a creditor can reach property subject to a general power of appointment if the power is presently exercisable. 2. Exercise of the power is not necessary to expose the assets to the creditor s claim. C. Solution. 1. Make sure trust has a spendthrift provision. 2. Add a provision to the trust instrument allowing the trustee the discretion to postpone distributions under specified circumstances (i.e., pending divorce, serious disability, etc.) 3. Use a Dynasty Trust. 4. Don t allow the beneficiary to be the sole trustee, but allow the beneficiary to remove and replace the co-trustee with someone who is neither related nor subordinate. D. Sample Provision. SECTION. RETENTION OF DISTRIBUTIONS IN TRUST Notwithstanding anything contained herein to the contrary, but subject to the provisions creating a Qualified Subchapter S Trust herein, the following provisions shall apply to all trusts created by this Trust Agreement: 13

17 17 a. Distributions to Existing Beneficiaries. Property otherwise distributable under any trust created under this Trust Agreement to a beneficiary for whom a trust is then held hereunder shall be added to that trust to be held, administered and distributed in accordance with the terms thereof. b. Postponement of Distributions in Trustee s Discretion. The Trustee shall have the power to refuse a withdrawal request (other that a Crummey withdrawal right that has been granted to the beneficiary concerning intervivos gifts made to the trust by a donor) or to postpone any distributions of principal otherwise required to a beneficiary upon or after the beneficiary s attainment of a specified age or the death of a third person (if such withdrawal right exists or distribution direction is provided for with respect to that Trust share), and to postpone the termination of such trust which might otherwise be required, all as if such withdrawal right had not been available, or such age had not been attained, or such death had not occurred, if the Trustee, in its sole discretion, determines that such refusal or postponement is consistent with the Grantor's overall intent. In exercising such discretion, the Grantor authorizes and approve the Trustee's use of such information as may be available and pertinent, such as the beneficiary s serious physical or mental disability, the beneficiary s addiction to drugs or alcohol, the beneficiary s incarceration, a pending divorce, a gambling problem, the beneficiary s involvement in a "cult" type organization, the involvement of the beneficiary as a defendant in a civil or criminal lawsuit or in any bankruptcy proceeding, present or imminent financial difficulty, a serious tax disadvantage in making a distribution, or similar substantial cause. Any such refusal or postponement may be continued by the Trustee from time to time, up to and including the entire lifetime of the beneficiary. The Trustee s exercise of discretion in such refusal or postponement shall be final and binding upon all parties in interest. No Trustee shall at any time be held liable for any action taken or not taken pursuant to this Section, nor shall any Trustee be required to take any affirmative action pursuant hereto, and no Trustee shall be required to inquire into or investigate any beneficiary s status as it may relate to this Section. Notwithstanding anything contained in this Article to the contrary, during any period of time that a beneficiary s distributions are being postponed pursuant to the foregoing provisions, the Trustee may also distribute the income and/or principal of such beneficiary s trust to or for the benefit of the beneficiary s spouse and descendants (if any) for said spouse s and descendants health, education, maintenance and support. The Trustee may make unequal distributions to said spouse and descendants or may at any time make a distribution to fewer than all of them, and shall have no duty to equalize those distributions. VII. EXCULPATING TRUSTEES. A. Potential Problem. 1. Existing policies are assigned to the ILIT, or the grantor applies for a new 14

18 18 policy for the ILIT to acquire. In either case, the trustee was not significantly involved in the selection and/or due diligence process. 2. What is the trustee s liability should the policy underperform or, even worse, non-perform? Arguably, the trustee did not exercise the degree of care and diligence required under the circumstances. 3. Oftentimes the trustee during the grantor s lifetime is a family member, friend, attorney or accountant. At death, a corporate fiduciary replaces the initial trustee. Therefore, this issue could be a trap for the unwary. B. Solution. 1. Add a provision in the trust instrument limiting the trustee s liability with respect to those life insurance policies gifted to the ILIT by the grantor. 2. Indemnify the trustee from any liability resulting from the grantor s (and/or the life insurance agent s) selection of the policies. C. Applicable State Law. 1. The extent to which a trustee s liability for breach of trust can be exculpated under the terms of the trust instrument is a matter of state law. 2. For example, under Section 1008 of the Uniform Trust Code an exculpation clause is unenforceable to the extent that it relieves the trustee of liability for breach of trust committed in bad faith or with reckless indifference to the purposes of the trust or the interests of the beneficiaries. Thus, accordingly to the UTC, a trustee must always comply with a certain minimum standard. D. Sample Provision. SECTION. LIMIT ON TRUSTEE S DUTIES AND RESPONSIBILITIES The Trustee, conclusively and without inquiry or independent investigation, may rely upon the representations of any person selling or in any way associated with the marketing, promotion or sale of a given life insurance policy regarding the relative quality of such policy (as compared to other available policies) or regarding the absolute quality of such policy (without regard to other available policies). Specifically, but not by way of limitation, the Trustee at no time shall have any duty whatsoever (i) to verify that any particular life insurance policy satisfies the requirements for a life insurance contract under IRC Section 7702; (ii) to compare the performance or pricing or the projected performance or pricing of a particular life insurance policy with the performance or pricing or projected performance or pricing of any other life insurance policy which may then be available from any 15

19 19 source; (iii) to assess the appropriateness of purchasing or retaining any life insurance policy as an asset of the trust as compared to other then-available vehicles that are not life insurance policies; or (iv) to investigate the strength or solvency of the company which issued or is offering a given life insurance company policy. The Trustee may retain any life insurance policy purchased by the Trustee or transferred to the Trustee by the Grantor, a predecessor Trustee, or any other person, and the Trustee shall have no duty at any time to make any inquiry or investigation into the advisability of such retention (including, but not limited to, inquiry or investigation into the same or similar matters set forth above). With respect to any such policies retained by the Trustee, the Trustee shall have no liability to the Grantor or to any present or future beneficiary of the Trust for nonproductivity, decline in value or lack of diversification of the trust assets. The fact that the Trustee may have made inquiry regarding any such matter prior to the acquisition of a policy or after the acquisition of such policy shall place no duty upon the Trustee to make any further inquiry, but shall be considered activity beyond the scope of the Trustee s duties. The Trustee shall not be liable to the Grantor nor to any present or future beneficiary of the Trust for any loss or damage suffered in connection with performance or lack of performance of any life insurance policy owned by the Trust or by the insolvency of any life insurance company issuing any such policy. The Trustee s duties and responsibilities with respect to any life insurance policy owned by the Trust, until such policy matures or is surrendered or otherwise disposed of, are to provide safekeeping services with respect to the policy, and to pay premiums as and when they come due or, under the terms of the policy, may be paid, if, but only if, the Trustee has sufficient available funds to do so. Grantor specifically acknowledges that the Trustee would not accept the position of Trustee unless the Trustee s duties, responsibilities, and liabilities were limited as set out herein. VIII. POWERS OF APPOINTMENT. A. Potential Problems. 1. Changes in tax laws make the ILIT s dispositive provisions undesirable. 2. Changes in economic, social and individual circumstances make the trust s dispositive provisions undesirable. 3. Primary beneficiary s descendants become vested. B. Solution. 16

20 20 1. To allow beneficiaries more flexibility to address future circumstances, provide them (in the trust agreement) with a testamentary and/or inter vivos limited power of appointment (LPA) to change the asset allocation that would otherwise apply at the beneficiary s death. 2. A LPA can be drafted broadly or narrowly. a. Class of potential recipients can be as broad as anyone other than the powerholder, his/her estate, or the creditors of either. b. Class of potential recipients can be as narrow as the grantor s descendants (other than the powerholder). c. Class of appointees can include charities and allow income and/or principal to be paid to a beneficiary s spouse (in trust). 3. The LPA can permit property to be appointed outright or in trust. 4. Where the trust property is subject to GST taxes, the beneficiary may be given a general power of appointment (GPA) thereby triggering an estate tax rather than a GST tax. IRC Section 2041(a)(2). C. Tax Consequences. a. However, the lapse of a GPA up to the greater of 5% of the trust assets (subject to the power) or $5,000 does not trigger an estate tax. IRC Section 2041(b)(2). b. Because of the flattening of the federal estate tax rates, paying an estate tax may not be more favorable than paying a GST tax. c. Caution: with a GPA, the powerholder s creditors have an opportunity to attach the assets subject to the power. 1. The broadest class for a nongeneral power of appointment is anyone or more persons or organizations other than the powerholder, his/her estate, or the creditors of either. IRC Sec The existence (or exercise) of a testamentary LPA generally does not have any estate tax consequence to the powerholder. IRC Section 2041(a)(2). 3. However, if a LPA, created after October 21, 1942 (the first power) is exercised to create a second LPA, which can be exercised to postpone the vesting period, the exercise of the first power to create the second power will 17

21 21 result in the trust property being included in the frist powerholder s estate. IRC Section 2041(a)(3) and IRC Section 2514(d). This is the so-called Delaware Tax Trap. 4. If an inter vivos LPA is exercised whereby property is redirected away from a powerholder who is entitled to mandatory distributions of income, a gift has occurred. Treas. Reg. Section (b)(2) and Estate of Regester v. Comm r, 83 T.C. (1984). D. Sample Provision. SECTION. POWER OF APPOINTMENT UPON THE DEATH OF A PRIMARY BENEFICIARY Upon the death of the primary beneficiary, the Trustee shall transfer, convey and pay over the trust estate, as it is then constituted, to or for the benefit of such one or more of the descendants of the Grantor (other than the primary beneficiary, his or her estate or creditors or the creditors of his or her estate) or such religious, scientific, charitable or educational organizations described in IRC Section 501(c)(3), in such proportions and upon such terms and conditions and estates, with the powers, in the manner and at the times as the beneficiary appoints by a valid last will or by a valid living trust agreement which specifically refers to this power, including, without limitation, the granting of a presently exercisable general or limited power of appointment. Provided, however, that the primary beneficiary is prohibited, without the prior written consent of the Trustee, from exercising such power of appointment over any trust created hereunder that has an inclusion ratio of less than one (1) for generation-skipping transfer tax purposes in a manner that would cause Code Section 2041(a)(3) or Code Section 2514(d) to apply by reason of such exercise, and any such exercise shall be void. In addition, the primary beneficiary may appoint an income interest for life (or a term of years) in favor of a spouse of a descendant of the Grantor, the remainder of which shall be payable to or for the benefit of one or more descendants of the Grantor or charity, other than the primary beneficiary, the primary beneficiary s estate and creditors, and the creditors of the primary beneficiary s estate. The primary beneficiary may, at any time and from time to time during his or her life, by a written, acknowledged instrument delivered to the Trustee, release such power of appointment with respect to any or all of the property subject to such power, or may further limit the persons or entities in whose favor or the extent to which this power may be exercised. If the primary beneficiary does not effectively exercise this power of appointment for any reason, in whole or in part, the trust estate, to the extent not effectively appointed by the primary beneficiary, shall, upon his or her death, be disposed of in accordance with the terms and conditions provided herein. 18

22 22 IX. FIVE AND FIVE POWERS. A. Problem. 1. The grantor desires that the beneficiary be the sole trustee of a GST ILIT. Thus, if the beneficiary-trustee is not limited to an ascertainable standard (health, education, support and maintenance), the trust property will be included in the beneficiary s estate as a general power of appointment. IRC Sections 2041 (a)(2) and 2041 (b)(1)(a). 2. The grantor desires that an independent trustee manage the ILIT but would like the beneficiaries to have some degree of unfettered access to trust property. B. Solution. 1. Give the beneficiary the power each year to withdraw the greater of $5,000 or 5% of the aggregate value of the trust property. 2. For estate tax purposes (see Paragraph C(3) below), provide that the $5,000 or 5% power can only be exercised on a particular date or during a particular month. 3. If the trust assets are substantial, consider limiting the power to some lesser amount or to a smaller percentage. 4. The terms of the $5,000 or 5% power should be available only upon the beneficiary attaining a specific age (i.e., 25 or 30 years). 5. Query: Can the grantor protect a beneficiary from creditors by providing that the $5,000 or 5% power may not be exercised involuntarily? In any event, don t permit an involuntary exercise of the $5,000 or 5% power. One way to prevent the involuntary exercise is to require the prior written consent or joinder of an independent Trustee. See, IRC sections 2041(b)(1)(C) and 2514(c)(3). C. Tax consequences (IRC Section 2041). 1. A general power of appointment will not cause federal estate tax inclusion of the entire trust assets if it is limited to the greater of $5,000 or 5% of the aggregate value of the trust property. 2. If the power is not cumulative and lapsed in prior years, the lapsed amounts will not be includible in the beneficiary s estate. 19

23 23 3. The beneficiary s estate will, however, include the property value that the beneficiary could appoint to himself/herself at the time of his/her death (i.e., $5,000 or 5%). But see Paragraph B(2) above for a possible solution to this problem. 4. In PLR the IRS ruled that a $5,000/5% powerholder (who was entitled to all of the trust income quarterly) owned that portion of the trust that was subject to the power during its pendency, and upon the power holder s failure to exercise the power, he/she would be treated as the owner of the trust under IRC Section 677 (income for benefit of grantor) and 678 (person other than grantor treated as owner), because the income of that portion would be ultimately paid to him/her. D. Sample Provision. SECTION. RIGHT TO WITHDRAW PRINCIPAL. After attaining age 30, each Primary Beneficiary of a trust created hereunder shall have the non-cumulative right to withdraw from the principal of his or her trust in any calendar year amounts not to exceed Five Thousand ($5,000) Dollars in the aggregate. In addition, on the last day of any calendar year, if the Primary Beneficiary is then living and has attained age 30, the Primary Beneficiary may withdraw an amount by which five percent (5%) of the then market value of the principal of his or her trust exceeds the principal amounts, if any, previously withdrawn in that year under this Section. All requests for principal distributions pursuant to this Section shall be in writing delivered to the Trustee. The Primary Beneficiary s right of withdrawal hereunder may not be exercised involuntarily. X. CHANGING TRUST SITUS. A. Potential Problems. 1. Beneficiaries move away from jurisdiction where grantor established the ILIT and, therefore, it is more convenient for them to deal with a local trustee (who prefers to apply local law). 2. Another state may have laws which may be more congenial to the purposes and needs of the ILIT than those of the state where the trust was originally established (e.g., jurisdictions with no state income tax). B. Solution. 20

24 24 1. Under the laws of many states, whether or not a trust may be removed from its original jurisdiction is a matter of the grantor s intent. If the grantor s intent is not clear, then the matter becomes one for judicial interpretation. 2. Therefore, provide in the trust agreement that the trustee can change the trust s situs. C. State Income Taxes. 1. The U.S. Supreme Court has held that a state may not assert its taxing jurisdiction if it does not maintain certain minimal contacts with the matter which is subject of the tax. Safe Deposit & Trust Co. v Virginia, 280 U.S. 83 (1929). 2. Therefore, if the trust assets and the trustee are outside the state, the mere fact that the grantor was a state resident when the trust was established is not enough to justify continued taxation. D. Sample Provision. SECTION. TRUST SITUS/APPLICABLE STATE LAW Except as otherwise provided in this sub-paragraph, the validity, construction, administration, meaning and effect, and all rights of beneficiaries under this Agreement (and any other instrument related thereto) shall be governed by the laws of the State of without regard to its conflicts of law principles; provided, however, that all matters pertaining to the Trustee s administration of real property shall be governed by the laws of the situs of such real property, including such jurisdiction s conflict of law principles. The administration, construction, meaning and effect, and rights of beneficiaries under a trust established by the exercise of a power of appointment granted hereunder shall be governed by the laws of whatever jurisdiction may be designated either in such instrument of appointment or in the resulting trust (or, absent such designation, by the laws of the State of ). This Section shall apply regardless of any change of residence of any Trustee or any beneficiary, or the appointment or substitution of a Trustee residing in another jurisdiction. The Trustee may, with the written consent of a majority of the trust s current income beneficiaries who are not incapacitated, change the situs of such trust and elect to have the validity, construction, administration, meaning and effect or rights of beneficiaries of such trust be governed by the laws of another jurisdiction, in or outside the United States (including that jurisdiction s law concerning the maximum duration of trusts). The Trustee may not change the situs of a trust or the trust s governing law in order to limit its existing liability to the beneficiaries. The jurisdiction whose laws govern the validity, construction, administration, meaning and effect, and rights of beneficiaries of any trust may, but 21

25 25 need not, be the same as the situs of the administration of such trust. This Agreement shall be exempt from mandatory registration (although the Trustee may, in its discretion register any trust). XI. BENEFICIARY CONTROLLED TRUSTS A. Potential Problems. 1. Assets left to beneficiaries outright (or at stated ages) are subject to estate taxes (when the beneficiary dies), creditors, divorced spouses and mismanagement. 2. Assets left to beneficiaries outright (or at stated ages) may end up in the hands of in-laws when the grantor preferred they pass to descendants only. B. Solution. 1. Hold assets in trust for beneficiary for the maximum perpetuities period permitted under state law. 2. Make distributions of income and principal totally discretionary rather than mandatory or subject to an enforceable ascertainable standard. 3. Give the beneficiary a testamentary limited power of appointment to rewrite the trust for future generations, and a 5%/$5,000 power (after attaining a stated age). 4. Allow the trustee to acquire assets (including a vacation home or business) as an investment of the trust rather than making distributions to the beneficiary who then acquires the assets. The beneficiary would be allowed rent free use of those assets. 5. Leverage the grantor s GST exemption by allocating the exemption to all gifts of premiums to the ILIT. 6. At a stated age (i.e., 25 to 30) allow the primary beneficiary to become a cotrustee over his/her separate trust share, and to remove and replace his/her cotrustee with someone who is neither related nor subordinate. C. Sample Provision. SECTION. DISTRIBUTION OF TRUSTS FOR THE GRANTOR'S CHILDREN The trust for each child who survives the Grantor shall be distributed as follows: 22

26 26 a. Distribution of Trust for [Name of Beneficiary]. The Trustee, in its sole and absolute discretion, shall apply to, or for the benefit of [Name of Beneficiary], (the "Primary Beneficiary") and the Primary Beneficiary s descendants (hereinafter collectively referred to as the "beneficiaries") as much of the net income and principal from this trust as the Trustee deems advisable for their health, education, maintenance, support, and best interests. Any excess income shall be added to principal. The reference to health, education, support and maintenance is a limitation (ceiling) on such discretionary distributions, and is not an enforceable standard (floor) mandating discretionary distributions. 1. Guidelines for Discretionary Distributions. To the extent that the Grantor has given the Trustee any discretionary authority over the distribution of income or principal to the beneficiaries, (including discretionary distributions limited to a beneficiary s health, education, support and maintenance), the Trustee shall be mindful of, and take into consideration to the extent it deems necessary, any additional sources of income and principal available to the beneficiaries which arise outside of this trust and are known to the Trustee. It is the Grantor's desire that the preservation of principal be a priority for purposes of this trust and that genuine need must be shown by the beneficiaries before the Trustee shall make a discretionary distribution. The Trustee shall, therefore, lend income and principal of this trust to the beneficiaries or buy assets for their use, rather than distributing income or principal outright to beneficiaries, unless the Trustee determines that outright distributions are more appropriate. The Trustee may permit the use of any trust property by any beneficiary without the necessity of any compensation of any kind from the beneficiary to this trust for such use. In this regard, the Trustee may acquire any property, whether real or personal and whether income producing or not, which the Trustee believes desirable for the beneficiary s health, education, maintenance, support and best interests. Such property may include, but shall not be limited to, residential real estate, household furnishings and appliances, artwork and jewelry. In addition, the Trustee can invest trust property in a business in which the Trustee believes the beneficiary has reasonable prospects for success. Without in any way limiting the nature of the discretion conferred upon the Trustee and without imposing any fiduciary duty to do so, it is the Grantor's intention that the Trustee should consider the interests of the Primary Beneficiary as paramount to the interests of the other beneficiaries. A distribution to or for the benefit of a beneficiary shall be charged to this trust rather than against the beneficiary s ultimate share upon the termination of this trust. 2. Right to Withdraw Principal. [See Sample Language in Article IX, above] 23