ILIT Myth Busters. 1. Backdating a trust-owned policy causes estate inclusion.

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1 ILIT Myth Busters There are many commonly-held ideas or myths about irrevocable life insurance trusts (ILITs) and their administration. Let s do some mythbusting! 1. Backdating a trust-owned policy causes estate inclusion. Some insurance companies allow the applicant (i.e., the trust) to request a policy date going back to the insured s last birthday age, commonly known as saving age because the premium will be based on the lower saved age. When the trust does this, the policy date can be before the trust existence date. This does not imply that the policy existed in the hands of the insured before the trust applied for the policy. The policy date relates to the calculation of the premium; the issue date 1 reflects when the policy comes into existence. As long as the policy s issue date is on or after the trust s existence, a prior policy date does not cause any estate inclusion. 2. Crummey notices are required to obtain the annual exclusion. Typically, ILIT beneficiaries have Crummey withdrawal rights over gifts to the ILIT so the gifts qualify for the annual exclusion. Many trust documents require that the trust beneficiaries receive notice of these withdrawal rights. However, the Crummey case does not require a notice to the trust beneficiaries. Crummey simply requires that the beneficiaries have a valid right to withdraw that cannot be legally resisted by the trustee. 2 Having said that, should notice not be given? The I.R.S. s mistaken position is that notices are required; 3 so in most situations, it is wise to give notice. However, in some situations, a client may not want to a child with bad habits, a child with a dominating, greedy spouse, etc. Then, don t give the notice. Also, sometimes, the notice is forgotten. Does this mean the annual exclusion has been lost (in any scenario)? Relying on Crummey and cases that followed it, no. To take advantage of this flexibility, have the trust document say nothing about giving notice. The trustee can then give notice except in those cases where it would be undesirable to do so. 1 Northwestern Mutual s issue date is the later of the application date or the date of the nonmedical, paramedical or medical examination. 2 Crummey v. Comm r, 397 F.2d 82 (9th Cir. 1968); Estate of Holland v. Comm r, 73 T.C.M (1997). 3 Rev. Rul. 81-7, C.B See Circular 230 disclosure at the end of this article The Northwestern Mutual Life Insurance Company, Milwaukee, WI

2 3. Money must stay in the trust not be sent to the insurance company until the Crummey power lapses. The thinking goes something like this: the money needs to remain in the trust for the Crummey withdrawal period so the trustee has the money to satisfy any withdrawal request; if the trustee doesn t do so, the gift to the trust is not one of a present interest. 4 Again, let s go back to Crummey all we need are a gift and the trustee s inability to say no to a beneficiary requesting a withdrawal. A decrease in value of the trust assets by the trustee s post-gift actions (i.e., a poker game, unlucky investments, falling market, etc.) does not jeopardize nullify or make bogus that a gift was made and that the trustee cannot legally resist a beneficiary s withdrawal request. Nevertheless, if one is worried about the trustee s ability to make good on a beneficiary s request (due more to a liability issue than a present interest issue), the trustee usually can get money for this purpose by: borrowing money from anyone, including the grantor. 5 using the trust assets. If the request comes in during the policy s free look period, the trustee can get back the entire premium. 6 If the request comes in later, money can be obtained by a surrender (full or partial) of the contract or a loan against the policy. Also, the policy, or a portion of it, can be transferred to the requesting beneficiary. 7 Don t confuse present interest requirements with trustee actions. As for the trustee actions, don t forget there is more than one way for the trustee to get money to satisfy a withdrawal request. 4. The trust must set up its own checking account to which the grantor makes gifts and from which the trustee pays insurance premiums. There are actually three ways for the premiums to be paid: The grantor pays the insurance company directly (withdrawal or check from the grantor s account). The grantor writes a check to the trustee, who endorses the check payable to the insurance company. 4 If this rationale is applied consistently, one would think that the money must remain in the trust during any period in which the withdrawal power hangs, which could be many years in some cases. 5 This assumes the trust authorizes the trustee to borrow a typical trust provision. 6 For a short period after delivery of an insurance policy, the owner can return the policy for a full refund. 7 See (c), Example 6; Rev. Rul , C.B. 300; Priv. Ltr. Ruls (July 29, 1981), (June 25, 1981), (May 21, 1981) and (1981) (beneficiaries ability to withdraw the policy in kind is enough to qualify premiums paid by third parties as present interest gifts) The Northwestern Mutual Life Insurance Company, Milwaukee, WI 2 of 8

3 The grantor writes a check to the trustee, who deposits it into a trust checking account; the trustee then writes a check from the trust checking account to the insurance company. 8 None of these methods causes the death benefit to be included in the grantor s estate. The I.R.S. repeatedly tried to include the death benefit on the basis that the grantor paid the premiums. 9 Case law has rejected this argument and insisted on the transfer of actual incidents of ownership within three years to result in estate inclusion; 10 the decedent's payment of premiums is irrelevant in determining whether the decedent retained any incidents of ownership. 11 The I.R.S. has reluctantly stated that it will not litigate this issue any further the result of the Fifth Circuit awarding attorneys fees to the taxpayer and threatening repeats of this action if the I.R.S. brings another case to court on this issue. 12 Any of the above methods for paying premiums will work; the client s attorney decides which method he is most comfortable with. 5. A beneficiary s withdrawal right is limited to the annual exclusion nothing to worry about. The tradeoff for obtaining the annual exclusion is the potential for a beneficiary to request a withdrawal. Perhaps a measly annual exclusion amount isn t enough to encourage a beneficiary to withdraw. After all, it is usually limited to a short period of time, say 30 days. This measly amount can morph into a significant amount through the use of hanging powers that amount over 5 or 5 which continues to be withdrawable past the lapse date. 13 Assume: an ILIT with one child as the beneficiary; the premium on the insurance in the ILIT is $24,000; and the grantor and his wife elect to gift split the $24,000 gift to the trust. With a hanging power, the amount that continues to be withdrawable at any given time is: Year Continuing Amount 1 $19,000 5 $95, $190, $380,000 8 Many Northwestern Mutual clients pay premiums through an Insurance Service Account (ISA). If the client is the owner of the ISA, then the gift is made when the funds are withdrawn from the ISA to pay the premium. On the other hand, if the trust is the owner of the ISA, the gift is made when the client adds money to the ISA. 9 In 1981, 2035 was changed so that its three year rule only applies to certain transfers (including transfers of life insurance) and not all transfers (such as money). The question then became whether life insurance in an ILIT would still be included in the estate due to direct payment of the premiums or whether the grantor needed to actually have an incident of ownership that was transferred within three years of death. 10 Perry Estate v. Comm r, 927 F. 2d 209 (5th Cir. 1991), aff g T.C. Memo ; Headrick Estate v. Comm r, 918 F.2d 1263 (6th Cir. 1990), aff g 93 T.C. 171 (1989), acq. recommended, A.O.D ; Leder Estate v. Comm r, 893 F.2d 237 (10th Cir. 1989), aff g 89 T.C. 235 (1987). 11 Leder Estate v. Comm r, 893 F.2d 237 (10th Cir. 1989), aff g 89 T.C. 235 (1987). 12 Perry Estate v. Comm r, 931 F.2d 1044 (5th Cir. 1991); A.O.D The lapse of a power of withdrawal which is over $5,000 or 5% ( 5 or 5 ) of the trust assets subject to the power is considered a gift by the power holder. 2514(e) The Northwestern Mutual Life Insurance Company, Milwaukee, WI 3 of 8

4 While $24,000 for 30 days may not be tempting, an increasing amount always subject to withdrawal can be very difficult to resist. While the hanging Crummey power can be dangerous due to the large amount that can be withdrawn, there is another way to deal with this: a testamentary limited power of appointment. With a testamentary limited power of appointment, the amount over the 5 or 5 amount continues to hang, but instead of being withdrawable, the beneficiary has the power of direct the hanging amount only upon his death and only to those beneficiaries whom the grantor has specified; this assuredly eliminates the temptation. This option has the advantage of efficiently using the annual exclusion yet avoiding the situation where the beneficiary can withdraw large amounts. 6. The three year inclusion rule is to be avoided at all costs. The usual procedure is to have the ILIT apply for the insurance. Of course, this cannot be done until the ILIT is signed. If the ILIT is not yet signed, one option is for the insured to own the policy and give it to the ILIT after it is signed. However, most lawyers are adamant that the trust be the only applicant for the insurance in the interest of not having the insurance proceeds subjected to the estate tax if the insured s death occurs within three years of giving the policy to the trust. Let s not let the tax tail wag the dog! Obviously, a decision has been made that insurance is needed. This should be the overriding consideration. The danger in waiting until the trust is signed is that the grantor may die without any insurance protection, or, more likely and equally devastating, may become uninsurable. Here s one way to analyze this. Joe needs $5 million of insurance; the annual premium is $56,000. He wants an ILIT to own the insurance. If he waits until the trust is prepared and dies before that, there is no death benefit. On the other hand, if he applies for the insurance and dies before the trust is prepared (or during the three year inclusion period), the insurance proceeds are subject to estate tax. The family nets $2.75 million (assuming 45% estate tax), which is $2.75 million more than the family receives if Joe waits and dies before the trust is drafted. Any financial planner will tell you that the rate of return is greater with insurance and estate inclusion than without insurance and no estate inclusion! Keep in mind that, once Joe owns the policy, there is a way to transfer the policy to the ILIT without having a three year estate inclusion problem see #7 below. 7. There is no way around the three year inclusion rule if the grantor wants to get an existing policy into an ILIT. The desired course of action is to have the ILIT be the initial applicant and owner of a policy. That is all well and good if a new policy is being purchased and the trust is signed. If the grantor is no longer insurable at a reasonable cost or doesn t want the trust to purchase a new policy, the grantor may want to give an existing policy to the ILIT. The downside of giving 2007 The Northwestern Mutual Life Insurance Company, Milwaukee, WI 4 of 8

5 the policy to the ILIT is being smack dab in the middle of the three year estate inclusion rule. 14 There is a way around this rule. The grantor can sell the policy to the ILIT, rather than giving it to the ILIT. First, the grantor gives money to the ILIT no three year rule for gifts of money. Next, the ILIT uses the money to buy the insurance policy from the grantor. 15 Be sure that the ILIT is a grantor trust to avoid taxing any gain in the policy upon a sale and to avoid taxing the death benefit because of a transfer for value. 16 As long as the sale is for adequate and full consideration, the three year rule does not apply The ILIT pays estate taxes. If an ILIT directs that its assets are to be used to pay the grantor s estate tax, then those assets are subject to estate tax. 18 One reason for using an ILIT is to keep the insurance proceeds out of the estate tax system. Actually, the statement that the ILIT pays the estate tax is simply a shortcut version of what can take place. But let s be exact. The estate needs cash to pay the estate tax and the ILIT has a lot of it. How does the money in the ILIT get to the estate? The ILIT can use its money to buy assets from the estate. Alternatively, the ILIT can lend its money to the estate, at an appropriate interest rate. 19 In either case, the estate ends up with cash to pay any estate tax but it s not the ILIT that pays the estate tax. 9. The grantor cannot benefit from the policy. Flexibility is the name of the game when it comes to irrevocable trusts. Here are a couple of options. Let s say George creates an ILIT for his wife, Linda, and their children. The ILIT owns a policy on George s life. Traditional wisdom tells us that George cannot be a beneficiary. Let s go along with that traditional wisdom for the moment. Linda is a beneficiary, and she can be a trustee. So, while George is living, Linda as trustee can access the cash in the policy. She can use the cash to make a distribution to herself, as the beneficiary, assuming the trust permits distributions to Linda while George is living; so include this type of provision to maintain flexibility. While George is not a trust beneficiary, his benefit is that his wife is benefiting from the policy. There should be no pre-arrangement that the trust will be used this way; otherwise, estate inclusion may result and To avoid any disguised gift argument, the amount of the gift and the purchase price should be different, and there should be some distance in time between the gift and the purchase. 16 Rev. Rul , I.R.B. (February 16, 2007). See also Big And Good News! Policy Transfer To Grantor Trust Is A Transfer To The Insured!, Advanced Planning Bulletin, March (d) If the estate beneficiaries and the ILIT beneficiaries are the same, they receive an ILIT asset (the receivable) and an estate liability (the payable); the result a wash The Northwestern Mutual Life Insurance Company, Milwaukee, WI 5 of 8

6 Another option is have George be a beneficiary of the trust. Are the red flags going up? The idea here is that George is a discretionary beneficiary. There are no ascertainable standards no standards by which George could force a distribution to himself. Believe it or not, this does not cause estate inclusion as long as there is no pre-arranged plan to make distributions to George 20 and as long as neither George nor George s creditors can force a distribution of the trust assets, which depends upon state law. 21 Keep in mind that this is not an option to provide periodic distributions to George. This is an option to allow distribution of trust assets back to George for some unforeseen event, such as repeal of the estate tax, financial setback, catastrophic medical situation, etc. It is designed to be a safety net for George and not to provide steady income to him. 10. The grantor cannot undo an ILIT. Yes, this statement is technically true because the trust is irrevocable; however, some built-in flexibility may allow a work-around on this. Consider this: Jim set up an ILIT several years ago, with his wife, Sue, and their three children as trust beneficiaries. The trust provides that, after both Sue and Jim die, the children are to receive the trust assets once they are 30 years old. Unfortunately, an unforeseen tragedy has struck the family, with the result that Katie, the youngest child, is permanently disabled. Sue and Jim decide that it would be best to keep Katie s share in trust for her life rather than to give her one-third of the trust assets at some point. If the trust gives Sue an appropriately-worded limited power of appointment, she could exercise the power to make these changes. What if Sue is not living or the trust doesn t give her this type of power? Although the ILIT cannot be changed to keep Katie s share in trust, Jim could create a new ILIT that does. Just one problem how do we get the policy from the old ILIT into the new ILIT? Here are a couple of suggestions: The old ILIT can distribute the policy to the new ILIT if the old ILIT contains language allowing this to be done. 22 Jim can give money to the new ILIT so it can buy the policy from the old ILIT. Both ILITs should be grantor trusts to avoid taxing the gain on the policy, and the new ILIT should be a grantor trust to avoid taxing the death benefit due to a transfer for value. 20 Grantor Trust Taxes: Something Old, Something New: Revenue Ruling , I.R.B. 7 (July 6, 2004), Advanced Planning Bulletin, August Rev. Rul , 1972-C.B. 347; Outwin v. Comm r, 76 T.C. 153 (1981), acq C.B. 1; Vander Weele v. Comm r, 27 T.C. 340 (1956), aff d, 254 F.2d 895 (6th Cir. 1958), acq., C.B. 5; Paxton v. Comm r, 23 T.C. 182 (1954), acq., C.B Sample language: The trustee may transfer all or a part of the trust property to one or more of the trust beneficiaries, or to a trust for the benefit of one or more of the trust beneficiaries. The trust receiving the distribution does not need to have the same terms as the distributing trust. Joseph Maier, The Irrevocable Trust (March 2007) The Northwestern Mutual Life Insurance Company, Milwaukee, WI 6 of 8

7 Including appropriate trust provisions to provide for a distribution to another trust and for the receiving ILIT to be a grantor trust increases the flexibility of this irrevocable trust. 11. Having second-to-die insurance in an ILIT means neither spouse can be a beneficiary of the ILIT. A second-to-die policy on husband and wife can be owned by an ILIT created by husband, and wife can be a beneficiary of the ILIT. Impossible, you say? There s estate inclusion for the wife, you say? Let s bust another myth. To avoid estate inclusion for the wife, husband s money, not wife s money, should be given to the trust. If wife gives her money to the trust and is a beneficiary of the trust, there is estate inclusion. 23 Even though the wife s money is not used, her annual exclusion can be used on the gift. In this case, husband and wife must file gift tax returns to elect giftsplitting, which allows both husband s and wife s annual exclusions to be used. Giftsplitting is simply a tax election; it does not convert any portion of husband s property into wife s property. 24 There is only one bump on this road but it can be smoothed out. If husband dies first and more premiums need to be paid, where will the money come from? 25 It must not come as a gift from wife, as mentioned above. Here are some options: Husband, through his estate plan, can leave enough money to the ILIT to pay future premiums. Note that this will use some of husband s estate tax exemption. The ILIT can also own a single-life policy on husband. When husband dies, the ILIT will use the death benefit to pay the premiums. If the second-to-die policy has a limited number of premium payments, this single-life policy could be a term policy. For example, if the second-to-die policy will be self-sustaining or paid-up within fifteen years, the ILIT can carry a term policy for those fifteen years. Wife can lend money to the ILIT to pay the premiums. Appropriate interest needs to be charged. Any balance of the loan at the time of wife s death is included in her estate. Second to die insurance is a popular method to provide funds to help pay the estate tax. Having this insurance in an ILIT where one spouse is a beneficiary maintains maximum flexibility In addition, even though many practitioners will not name wife as the trustee, it appears that there are circumstances where an insured can serve as trustee without the fear of estate inclusion. See Rev. Rul , C.B See also Spousal Control Over Second To Die Insurance Without Estate Inclusion: Private Letter Ruling (January 23, 2004), Advanced Planning Bulletin, May ; Priv. Ltr. Rul (Apr. 30, 2001). Also, the mere fact that wife is a trust beneficiary does not give her an incident of ownership over the policy. 25 Northwestern Mutual offers a rider on its second to die life insurance policies that waives premiums upon the first death The Northwestern Mutual Life Insurance Company, Milwaukee, WI 7 of 8

8 Conclusion: Many estate planning dreams and visions have succumbed meekly to ILIT myths and so unnecessarily. Be guided and heartened by an offshoot of that movie music: Who you gonna call? Mythbusters! That s us. Source: Advanced Planning Bulletin, December 2007 This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements. This information was complied by the Advanced Planning Division of The Northwestern Mutual Life Insurance Company. It is intended solely for the information and education and/or promotional purposes of Northwestern Mutual Financial Network. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Financial Representatives do not give legal or tax advice. Taxpayers should seek advice based on their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions. - To comply with Circular The Northwestern Mutual Life Insurance Company, Milwaukee, WI 8 of 8