ILITs and the proposed “For the 99.5 Percent Act”

Take-Away: If Senator Bernie Sander’s proposed For the 99.5 Percent Act is adopted, the amount of an individual’s gift tax exemption drops to $1. 0 million, and grantor trusts created or funded after the Bill becomes law will be included in the grantor’s taxable estate. These changes will dramatically impact existing irrevocable life insurance trusts (ILITs).

 

Background: Several changes in Senator Sander’s proposed Bill would dramatically impact the use of ILITs. An ILIT is often funded using annual exclusion gifts coupled with crummey withdrawal rights held by the ILIT beneficiaries.

 

Grantor  Trust:  An ILIT is classified as a grantor trust under the Tax Code. [IRC 677(a)(3).] That is because the ILIT trustee possesses the power, without the approval or consent of any adverse party, to apply income of the trust to the payment of premiums on policies of life insurance on the life of the settlor. Usually an ILIT will not hold many other assets other than the life insurance policy on the settlor-insured’s life.

 

With the current law, on the insured’s death the life insurance death benefit is paid to the ILIT. The death benefit is income tax-free. The death benefit is not included in the settlor-insured’s taxable estate since the insured retained no incidence of ownership in the trust-owned policy.

 

Impact of Changes on ILITs: The income and estate tax-free implications of an ILIT would all change under Senator Sander’s proposed Bill. With a new ILIT, since it would be a grantor trust, the entire death benefit would be included in the settlor-insured’s taxable estate at death.

 

• Gift Tax Exemption Drops: The federal gift tax exemption would drop from $11.7 million to $1.0 million. That $1.0 million exemption would not be adjusted annual by cost-of-living increases.

 

• Grantor Trusts Taxed: New grantor trusts, and transfers to existing grantor trusts would be included in the settlor-insured’s taxable estate.

 

• Crummey Withdrawl Rights Curtailed: Annual exclusion gifts would drop from $15,000 for each donee, to $10,000 per donee, and only two $10,000 gifts per year.

 

Example: Dr. Smith has three children. Dr. Smith just went through a divorce. Dr. Smith agrees to purchase as part of the divorce settlement a life insurance policy on his death with a face amount of $5.0 million. The purpose is to cover the contingency of Dr. Smith dying before his child support obligation ends, or should he live beyond his child support paying years, to pay for his children’s college education. A standard ILIT is created to own the life insurance policy on his life. After the first payment of $240,000 in insurance premiums, Dr. Smith dies in an auto accident. Assume that Dr. Smith died with an estate of $3,300,000 and no debt.

 

Existing Law:  Dr. Smith’s estate would not pay any federal estate tax, despite there now being $5.0 million to pay for his children’s care and education.

 

Proposed Law: If the Bill becomes law, it would appear to require Dr. Smith’s estate to include the value of $4,760,000 in his taxable estate [$5 million death benefit less the $240,000 premium paid.] Consequently, under the new tax regime, Dr. Smith’s estate would pay federal estate taxes of $2,052,000, if none of his $3.5 million applicable exemption amount is available. The Bill would require the ILIT to pay the estate tax attributable to the assets held in the ILIT (the insurance proceeds) included in Dr. Smith’s estate, rather than reduce the assets included in his taxable estate.

 

Possible Planning Steps to Consider: Most of the Bill’s changes would be effective after December 31, 2021, thus providing a short window of opportunity to ‘fix’ or restructure existing ILITs.

 

1. Prefund ILITs: With the limitation on the number of annual exclusion gifts to trusts, it might make sense to overfund an existing ILIT using the donor-insured’s unused federal gift and GST tax exemption amounts, to ensure that the ILIT will have enough funds on hand to pay annual premiums for years to come.

 

1. Loans to Replace Annual Exclusion Gifts: The settlor-insured could make direct gifts to the ILIT beneficiaries. Those beneficiaries could then loan the funds to the ILIT trustee. The loans could be structured as split-dollar insurance loans to avoid the need to make any current interest payment. [See Regulation 1.7872-15.] Or, the settlor-insured could enter into a split-dollar loan to the ILIT trustee.

 

1. Explore Intra-Trust Transactions: If the settlor-insured also has created a spousal lifetime access trust (SLAT), which is also classified as a grantor trust, or another type of irrevocable trust which holds substantial income producing assets, the life insurance policy could be shifted from the ILIT to the SLAT so that future insurance premiums will not have to be funded with annual exclusion gifts. The two grantor trusts might be merged, or the ILIT might have its asset (the policy) decanted to a new SLAT, or insurance the policy might be sold from the first grantor trust ILIT to the second grantor trust SLAT. However, caution needs to be exercised with any transaction with the ILIT, since the safety net of the ILIT being a grantor trust will no longer exist.

 

1. Use Non-Trust Entities: A family limited partnership or a limited liability company might own a life insurance policy on the parent’s life. The children would own the partnership or LLC interests. A trust which holds a 1% manager interest could control distributions and liquidation decisions. Gifts (annual exclusion or part of the $1.0 million exemption) made each year to the children would be used to recapitalize the entity. The children could transfer their partnership or LLC membership interest to a separate trust which they create using their own $1.0 million lifetime gift exemption under the Bill.

 

1. Exploit the Prospective Date: The Bill’s proposed effective date would be after December 31, 2021, which means that transferring the life insurance policy to a new grantor trust, or prefunding the existing ILIT with additional assets to pay future policy premiums, would be ‘grandfathered’ until after the Bill becomes law.

 

1. Durable Powers of Attorney Updated: Most existing durable powers of attorney for financial affairs  give to the agent the ability to make annual exclusion gifts. If the number of annual exclusion gifts is dramatically reduced by the Bill, then the agent may not possess sufficient authority to prefund an existing ILIT. [Recall in the recent, infamous, Powell Tax Court decision, the sons of the deceased just prior to her death transferred her entire limited partnership interest to a charitable lead annuity trust. That charitable gift was later voided by the Tax Court because the mother’s durable power of attorney only authorized her agents to make annual exclusion gifts, not a gift of $9,900,000 to a CLAT.] A durable power of attorney might expressly give to the insured’s agent the authority to continue to fund an existing life insurance plan, including contributions (or loans) to an entity to assure the entity will have sufficient financial resources to pay premiums.

 

Conclusion: With radical changes to the gift tax exemption, gift tax annual exclusion exemption, and effective elimination of grantor trusts, now is a good time to take a look at existing ILITs and determine if they need to be modified, decanted, or in some manner made more sustainable, especially if crummey withdrawal powers that were historically used to fund the insurance premium disappear. There does appear, at least from the Bill’s proposed effective date, to make changes now, and before the end of the year, in the event that Congress acts this fall to make portions of the Bill part of the Tax Code.

Take-Away: If Senator Bernie Sander’s proposed For the 99.5 Percent Act is adopted, the amount of an individual’s gift tax exemption drops to $1. 0 million, and grantor trusts created or funded after the Bill becomes law will be included in the grantor’s taxable estate. These changes will dramatically impact existing irrevocable life insurance trusts (ILITs).

 

Background: Several changes in Senator Sander’s proposed Bill would dramatically impact the use of ILITs. An ILIT is often funded using annual exclusion gifts coupled with crummey withdrawal rights held by the ILIT beneficiaries.

 

Grantor  Trust:  An ILIT is classified as a grantor trust under the Tax Code. [IRC 677(a)(3).] That is because the ILIT trustee possesses the power, without the approval or consent of any adverse party, to apply income of the trust to the payment of premiums on policies of life insurance on the life of the settlor. Usually an ILIT will not hold many other assets other than the life insurance policy on the settlor-insured’s life.

 

With the current law, on the insured’s death the life insurance death benefit is paid to the ILIT. The death benefit is income tax-free. The death benefit is not included in the settlor-insured’s taxable estate since the insured retained no incidence of ownership in the trust-owned policy.

 

Impact of Changes on ILITs: The income and estate tax-free implications of an ILIT would all change under Senator Sander’s proposed Bill. With a new ILIT, since it would be a grantor trust, the entire death benefit would be included in the settlor-insured’s taxable estate at death.

 

• Gift Tax Exemption Drops: The federal gift tax exemption would drop from $11.7 million to $1.0 million. That $1.0 million exemption would not be adjusted annual by cost-of-living increases.

 

• Grantor Trusts Taxed: New grantor trusts, and transfers to existing grantor trusts would be included in the settlor-insured’s taxable estate.

 

• Crummey Withdrawl Rights Curtailed: Annual exclusion gifts would drop from $15,000 for each donee, to $10,000 per donee, and only two $10,000 gifts per year.

 

Example: Dr. Smith has three children. Dr. Smith just went through a divorce. Dr. Smith agrees to purchase as part of the divorce settlement a life insurance policy on his death with a face amount of $5.0 million. The purpose is to cover the contingency of Dr. Smith dying before his child support obligation ends, or should he live beyond his child support paying years, to pay for his children’s college education. A standard ILIT is created to own the life insurance policy on his life. After the first payment of $240,000 in insurance premiums, Dr. Smith dies in an auto accident. Assume that Dr. Smith died with an estate of $3,300,000 and no debt.

 

Existing Law:  Dr. Smith’s estate would not pay any federal estate tax, despite there now being $5.0 million to pay for his children’s care and education.

 

Proposed Law: If the Bill becomes law, it would appear to require Dr. Smith’s estate to include the value of $4,760,000 in his taxable estate [$5 million death benefit less the $240,000 premium paid.] Consequently, under the new tax regime, Dr. Smith’s estate would pay federal estate taxes of $2,052,000, if none of his $3.5 million applicable exemption amount is available. The Bill would require the ILIT to pay the estate tax attributable to the assets held in the ILIT (the insurance proceeds) included in Dr. Smith’s estate, rather than reduce the assets included in his taxable estate.

 

Possible Planning Steps to Consider: Most of the Bill’s changes would be effective after December 31, 2021, thus providing a short window of opportunity to ‘fix’ or restructure existing ILITs.

 

1. Prefund ILITs: With the limitation on the number of annual exclusion gifts to trusts, it might make sense to overfund an existing ILIT using the donor-insured’s unused federal gift and GST tax exemption amounts, to ensure that the ILIT will have enough funds on hand to pay annual premiums for years to come.

 

1. Loans to Replace Annual Exclusion Gifts: The settlor-insured could make direct gifts to the ILIT beneficiaries. Those beneficiaries could then loan the funds to the ILIT trustee. The loans could be structured as split-dollar insurance loans to avoid the need to make any current interest payment. [See Regulation 1.7872-15.] Or, the settlor-insured could enter into a split-dollar loan to the ILIT trustee.

 

1. Explore Intra-Trust Transactions: If the settlor-insured also has created a spousal lifetime access trust (SLAT), which is also classified as a grantor trust, or another type of irrevocable trust which holds substantial income producing assets, the life insurance policy could be shifted from the ILIT to the SLAT so that future insurance premiums will not have to be funded with annual exclusion gifts. The two grantor trusts might be merged, or the ILIT might have its asset (the policy) decanted to a new SLAT, or insurance the policy might be sold from the first grantor trust ILIT to the second grantor trust SLAT. However, caution needs to be exercised with any transaction with the ILIT, since the safety net of the ILIT being a grantor trust will no longer exist.

 

1. Use Non-Trust Entities: A family limited partnership or a limited liability company might own a life insurance policy on the parent’s life. The children would own the partnership or LLC interests. A trust which holds a 1% manager interest could control distributions and liquidation decisions. Gifts (annual exclusion or part of the $1.0 million exemption) made each year to the children would be used to recapitalize the entity. The children could transfer their partnership or LLC membership interest to a separate trust which they create using their own $1.0 million lifetime gift exemption under the Bill.

 

1. Exploit the Prospective Date: The Bill’s proposed effective date would be after December 31, 2021, which means that transferring the life insurance policy to a new grantor trust, or prefunding the existing ILIT with additional assets to pay future policy premiums, would be ‘grandfathered’ until after the Bill becomes law.

 

1. Durable Powers of Attorney Updated: Most existing durable powers of attorney for financial affairs  give to the agent the ability to make annual exclusion gifts. If the number of annual exclusion gifts is dramatically reduced by the Bill, then the agent may not possess sufficient authority to prefund an existing ILIT. [Recall in the recent, infamous, Powell Tax Court decision, the sons of the deceased just prior to her death transferred her entire limited partnership interest to a charitable lead annuity trust. That charitable gift was later voided by the Tax Court because the mother’s durable power of attorney only authorized her agents to make annual exclusion gifts, not a gift of $9,900,000 to a CLAT.] A durable power of attorney might expressly give to the insured’s agent the authority to continue to fund an existing life insurance plan, including contributions (or loans) to an entity to assure the entity will have sufficient financial resources to pay premiums.

 

Conclusion: With radical changes to the gift tax exemption, gift tax annual exclusion exemption, and effective elimination of grantor trusts, now is a good time to take a look at existing ILITs and determine if they need to be modified, decanted, or in some manner made more sustainable, especially if crummey withdrawal powers that were historically used to fund the insurance premium disappear. There does appear, at least from the Bill’s proposed effective date, to make changes now, and before the end of the year, in the event that Congress acts this fall to make portions of the Bill part of the Tax Code.