Are You Sure You Want to be an ILIT Trustee?

Take-Away: Many unsuspecting individuals serve as trustees of an irrevocable life insurance trust (ILIT.) Most of those individuals are clueless as to the fiduciary responsibilities associated with that role and their corresponding exposure to personal liability.

ILIT Trustees: If an individual agrees, often as an accommodation to a family member or friend, to serve as a trustee of an ILIT, that person seldom reads the trust instrument. Even if they read the ILIT instrument, they may take comfort when they read a common-place boiler-plate provision that exonerates the ILIT trustee from liability for holding life insurance policies in the trust. However, release or exoneration clause in the trust instrument can be very misleading.

Exoneration of a Trustee: The Michigan Trust Code (MTC) provides that the term of a trust that relieves a trustee of liability for breach of trust is unenforceable to the extent that either of the following applies: (i) the term 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 trust beneficiaries; or (ii) the term was inserted as a result of abuse by the trustee of a fiduciary or confidential relationship to the settlor. Reckless indifference is a close cousin of negligence. The terms of a trust that relieves the trustee of liability for breach of trust for the acquisition or retention of a particular asset or asset class or failure to diversify investments are, however, enforceable. [MCL 700.7908.]

• MTC Prevails: While the settlor (and the trustee) might think that the trust can be drafted to avoid this limit on the exculpation of the trustee, this is one of the few sections of the MTC that cannot be altered. Accordingly, such a provision that prohibits the exculpation of the trustee from certain actions (or inaction) will prevail over the express terms of the trust. [MCL 700.7105(2)(k).]

ILITs: An ILIT is intended to hold life insurance, usually on the life of the ILIT settlor, to provide a death benefit on the settlor’s death. That death benefit is not included in the settlor’s taxable estate since the policy, and its death benefit, is owned by the ILIT. Estate taxation of the death benefit is avoided, but only so long as the insured-settlor held no in incidence of ownership in the life insurance policy. [IRC 2042.]

Life Insurance: However, life insurance policies seldom perform as presented in the initial policy illustration that is given to the policy owner. That is particularly so these days with the low interest rates, where presumed dividends accruing under the policy, as represented in the initial policy illustration, are seldom achieved. This means fewer dividends are accumulated under the policy, and thus less value that can accumulate under the policy, as more value must be allocated to pay the increasing mortality costs associated with the life insurance policy as the insured ages.

• Uncomfortable Questions:  Consider the following, especially if the ILIT trustee serves as an accommodation to a family member or friend, or client:
• How many ILIT trustees ask for an annual updated policy illustration to monitor the performance of the policy compared to the initial policy illustration?
• How many ILIT trustees explore engaging in a like-kind exchange of the policy held by the ILIT in search of a better performing life insurance policy to maintain the anticipated death benefit?
• How many ILIT trustees periodically review the cost of various life insurance policy riders that cause additional premiums to be incurred, when those premiums might be shifted to purchase additional death benefits?
• How many ILIT trustees explore converting a term policy to a whole life policy or a universal life policy, or an index-life policy?
• How many ILIT trustees confirm how long the policy dividends can be used to defray the premium costs, before the life insurance policy can no longer be sustained?

Prudent Investor Rule: Sadly, most individual ILIT trustees simply sit on the insurance policy that was initially purchased when the ILIT was set up. More often than not, the policy that they ‘inherited’ held in the ILIT was selected by the ILIT settlor-insured. Life insurance is treated as a separate asset class under the Prudent Investor Rule that applies to all Michigan trusts unless the trustee is expressly relieved from complying with that fiduciary investment law. [MCL 700.1502; MCL 700. 1505.] That Rule required that the trustee make investment decisions with regard to trust assets, i.e. life insurance, with inflation in mind vis-à-vis the purposes of the trust. A flat death benefit paid on the death of the settlor-insured 20 or 30 years from now does not, on its face, address the trustee’s duty to take future inflation into account if the purpose of the ILIT was for an express purpose, such as providing sufficient liquidity to loan to the insured’s estate to pay estate taxes. [MCL 700.1503(2)(b).]

ILIT Trustee Liability Exposure: It is possible that an ILIT trustee, merely serving as an accommodation to the ILIT’s settlor, may find himself or herself facing claims of negligence even if the trust instrument includes some form of exoneration. A recent case from New York is a stark reminder of the liability that an ILIT trustee can face.

In the Matter of Dorothy D. Wilkinson, 179 A.D. 3d 817 (2d Dept. 2020)

• Facts: Dorothy died in 1981. Her Will created two testamentary trusts, one for each of her children, a son and a daughter. The corporate trustee of the testamentary trusts was directed to invest the principal and pay the income to Dorothy’s child. On the child’s death, the testamentary trust was to be distributed to the deceased child’s issue. In 1992 Dorothy’s son and daughter, along with the daughter’s issue, entered into an agreement to substitute trust assets, transferring them out of the trusts to be replaced by life insurance. The daughter agreed to withdraw $170,000 of the principal of her trust and the son withdrew a parcel of real estate in his trust. They, along with the daughter’s issue, agreed to substitute those assets with a $250,000 insurance policy that insured the daughter’s life and a $370,000 policy that insured the son’s life. In short, the ‘substitution agreement’ converted the testamentary trusts to ILIT equivalents. The policies that were purchased were one year renewable term policies which the corporate trustee formally purchased as the policy owner. The same ‘substitution agreement’ required the son to make the premium payments on both of the term insurance policies into an escrow account that was administered by the corporate trustee. The ‘substitution agreement’ also provided that if the son failed to deposit the funds used to pay the policy premiums, the son was required to convey the real property directly to his sister for $1.00 (not the trust for her benefit.) [Squirrely, yes, but I don’t make the facts, I just report them.]

The ’substitution agreement’ also contained a liability release clause which stated that the corporate trustee was released and discharged under the trusts from all actions, causes of action, suits, debts, sums of money, accounts, bonds, contracts, controversies, damages, judgments and demands in law or equity which “may arise as a result of the substitution of property.”

[For those oldies like me, now comes Paul Harvey’s “The Rest of the Story.”] In 1994 the son sold the real property to a third party. In 2004 the two life insurance policies lapsed for the son’s nonpayment of the policy premiums. The son died in 2012. The daughter died in 2014. In come the daughter’s issue with a lawsuit.

• Lawsuit: The deceased daughter’s issue sued the corporate trustee. They argued that the exoneration and release language that relieved the trustee from liability for failure to exercise care, diligence and prudence was contrary to New York’s public policy. The failure of the trustee to monitor the status of the two life insurance policies constitute a failure to properly manage the trust’s portfolio. However, their claims did not assert that the trustee’s investment in the life insurance policies pursuant to the ‘substitution agreement’ was improper. Rather, the ‘substitution agreement’ stated that the son was required to pay the insurance premiums for the life of the insurance policies into an escrow account administered by the trustee, and that as the owner of the two life insurance policies the trustee would receive notice that the premiums were due and that the policies were going to lapse for nonpayment of premiums. Apparently the corporate trustee did nothing in reliance upon the exoneration clause in the ‘substitution agreement.’
• Trial Judge: The judge found that the duty of the trustee was governed by statute, which provides that the exoneration of the trustee from liability for the failure to exercise reasonable care, diligence and prudence is contrary to New York’s public policy. While the ‘substitution agreement’s exoneration provision relieved the trustee from liability with regard to the substitution of property, i.e. the life insurance policies, the ‘substitution agreement’ did not absolve the trustee from liability in the management of the substituted property, i.e. the insurance policies that were substituted for other trust assets. Specifically, the trustee had assumed the obligation to monitor the status of the premium payments for the insurance policies in light of the escrow account. Accordingly, by allowing the insurance policies to lapse without any action on its part, the trustee’s failure to act constituted ordinary negligence. In computing the beneficiaries’ damage award against the trustee, the judge held that  the death benefit that would have been paid had the two policies been preserved was the initial damage award, less the premiums that would have been paid that would have been required to sustain the two life insurance policies held in the trusts.

Conclusion: Many trusts, and especially ILITs where the trustee has agreed to serve as an accommodation to the ILIT’s settlor, contain exoneration clauses that release trustees from liability and from only investing in life insurance policies. Trustees need to carefully review those exoneration clauses to ensure that they fully understand their liability exposure, as well as the scope of the exoneration. In Wilkinson, the trustee’s failure to monitor the life insurance policies held in trust amounted to ordinary negligence for which it was held liable. While the ‘substitution agreement’ prevented the trustee’s liability for investing in the  life insurance policies, the failure to monitor the life insurance policies was still negligence which could not be excused under the applicable anti-exoneration statute. This is something to think about if you are asked to serve as trustee of an ILIT, particularly if the measure of damages is the death benefit that would have been paid, less any policy premiums that would have been paid.