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George F. Bearup, J.D. Senior Legal Trust Advisor

22-Oct-19

Irrevocable Life Insurance Trusts: Trustees and Termination

Take-Away: A Bill has been floating around Lansing for a few years now that would provide liability relief to an individual who serves as the trustee of an irrevocable life insurance trust (ILIT). Unfortunately, this Bill has not received much traction, and it is debatable if it will ever become Michigan law. The fact that there is even a need for the Bill to be considered to provide liability relief to an ILIT trustee should prompt some concern by those who have been named, or who current act as, the trustee of an ILIT.

Background: For several decades, an ILIT was a popular tool to provide needed liquidity to pay federal estate taxes. The trust, not the insured, was the owner of the life insurance policy held in the trust, so that upon the insured’s death, the death benefit (usually distributed to the trustee income tax-free) was not included in the insured’s taxable estate, as the insured retained no incidents of ownership over the policy. [IRC 2042; IRC 101(a).] The ILIT would then be in a position to loan the income-tax-free death benefit to the decedent’s estate to pay any debts, expenses, and federal estate taxes that might become due on the deceased-insured’s death. In short, the ILIT was the source of that needed liquidity to pay administrative expenses, debts, and federal estate taxes.

Liquidity Needs: With the 2017 Tax Act and its $11.4 million federal estate and generation skipping transfer (GST) tax exemptions, many feel that there is no need for the continued use of an ILIT. As a result, many have considered ‘unwinding’ existing ILITs.  However, those currently high transfer tax exemption amounts are scheduled to drop back to $5.0 million (adjusted for inflation) in 2026. In addition, the need for continued liquidity to pay transfer taxes at death recently received renewed attention with Bernie Sanders’ “For the 99%” Bill now before Congress, which would reduce an individual’s federal estate and GST tax exemptions to $3.5 million. In sum, ‘not-so-fast’ might be the advice of the day with regard to  terminating an existing ILIT. It is in this uncertain period that a trustee must decide what to do with an ILIT and confront the fiduciary’s responsibilities to administer an ILIT and its policy prudently.

Trustee Duties of an ILIT: Despite the basic purpose of an ILIT, which is to simply hold a life insurance policy on the settlor’s life until his/her death, an ILIT is a far more complex trust to administer than its simplistic purpose would otherwise suggest. An ILIT trustee has multiple duties-

  • Administrative: Some of the administrative duties of an ILIT trustee include: Collect the trust’s assets; deposit trust funds in a reputable banking institution until they are otherwise invested in a prudent and reasonable manner, or distributed to ILIT beneficiaries; timely pay life insurance policy premiums; pay the trust’s debts and income tax liabilities; file tax returns; distribute trust assets to beneficiaries per the terms of the ILIT; execute documents required to take possession of trust assets; protect and preserve trust assets; retain accurate books and records of all transactions made on behalf of the ILIT; file claims for life insurance benefits for which the ILIT trustee is the named policy beneficiary.
  • Fiduciary: Added to these administrative duties are a couple of the ILIT trustee’s fiduciary duties, which include the duty to act:  loyally and impartially to all of the ILIT beneficiaries (current and remainder); and prudently manage and invest ILIT assets.
  • Liability: Like any trustee of any trust, the trustee of an ILIT can be held personally liable for: (i) breach of trust and fiduciary duty; (ii) failure to carry out the terms of the trust; (iii) losses that arise from the unauthorized delegation of trustee powers; (iv) losses that result from the failure to act with reasonable care; (v) losses that arise from speculative investments; (vi) losses that arise from commingling trust assets with personal or third-party assets; and (vii) negligent or willful failure to meet the required standard of care, diligence and skill in managing the trust’s assets, or in the case of an ILIT, making sure that the life insurance policy held in the trust will perform as anticipated.
  • Prudent Investor Act: The ILIT trustee is required to follow the Michigan Uniform Prudent Investor Act. [MCL 555.504.] A fiduciary is required to invest consistent with that Act’s principles. [MCL 700.1502; MCL 700.7803.] While the life insurance policy held in the ILIT is nothing more than a contract, usually a contract that was transferred into the trust by the settlor, or the trustee was directed by the settlor to acquire the life insurance contract shortly after the ILIT was formed, the Uniform Prudent Investor Act nonetheless requires the ILIT trustee to treat the existing policy like any other investment asset held in trust, which entails evaluating the insurance policy in the context of the purpose of the ILIT and to assure that the policy will perform consistent with its initial acquisition projections. The failure to  evaluate periodically the performance, and cost, of the existing life insurance policy held in the ILIT could constitute negligence by the trustee.
  • ILIT Trustee Responsibilities: This fiduciary responsibility of the ILIT trustee can be challenging. Life insurance is not a normal An ILIT trustee’s duties include the need to periodically determine if: (i) the existing ILIT policy is still performs as originally illustrated; (ii) the insurance carrier’s financial strength has changed in a significant way; (iii) there are current insurance products that have superior features and provisions better than the existing insurance policy; and (iv) if additional life insurance is required to meet the ILIT’s goals and purposes. While professional trustees have committees that annually review trust assets, including life insurance policies at investment committee meetings, seldom do individual ILIT trustees perform a formal periodic review of insurance policies, which in effect prompted the proposed Bill in Lansing. Looking at the annual policy statement mailed by the insurance company once, a year is definitely not performing a comprehensive policy review expected by the courts under the Uniform Prudent Investor Act. A trustee who fails to evaluate properly the quality and suitability of a particular life insurance policy could face liability from lawsuits filed by ILIT beneficiaries for breach of fiduciary duty.

Exoneration of Individual ILIT Trustee Bill: The Bill in Lansing, if adopted, would exonerate an individual trustee of an ILIT from liability with regard to monitoring its life insurance policy, if the ILIT held nothing more than the life insurance policy that is primarily intended to provide liquidity on the death of the settlor-insured. If the ILIT held other assets that had to be managed, in addition to the life insurance policy, then this Bill would not provide any liability relief to the individual ILIT trustee. The reason for this proposed legislation is that many individuals named as ILIT trustees are family members who have little, or no, experience as fiduciaries, who know little (or nothing) about their fiduciary responsibilities to manage trust assets in accordance with the Uniform Prudent Investor Rule. In some cases, an individual may not even know that they are named as the ILIT trustee if a single premium policy is held in the trust, where nothing is required to be done each year with regard to the ILIT’s administration.

Terminating an Existing ILIT: The trustees of existing ILITs may be encouraged to terminate the trusts, since there is no present need to keep the ILIT for estate liquidity purposes in light of the currently large federal estate and GST exemption amounts. As noted above, terminating an existing ILIT may be premature, either due to the 2026 sunset of the existing high federal estate and GST exemption amounts, or the possibility that the ‘For the 99%’ Bill in Congress becomes the law, with its much lower federal estate and GST tax exemption amounts. If the decision is made to terminate an existing ILIT, consider some of the following points:

  • An ILIT trustee must keep in mind that he or she cannot just transfer the life insurance policy back to the settlor-insured in order to terminate the ILIT. Their fiduciary duty is owned to the ILIT beneficiaries, not to the trust settlor, even though he/she is usually the source of the annual premium payments.
  • The ILIT’s terms may permit an in-kind distribution of trust assets to the ILIT beneficiaries, often the insured’s spouse and children. However, an in-kind distribution of the insurance policy may not be permitted by the terms of the ILIT instrument. Furthermore, even if an in-kind distribution is authorized under the terms of the ILIT, simply distributing the policy to the current ILIT beneficiaries may not fulfill the trustee’s fiduciary duty to act impartiality with respect to all trust beneficiaries, i.e. the remainder trust beneficiaries, vested and contingent. Example: The ILIT trustee distributes the life insurance policy, in-kind, to the insured’s spouse-beneficiary. The insured’s spouse surrenders the policy and spends the cash surrender value. The insured’s children may sue the trustee for breach of fiduciary duty since the trustee did not take their interests into account when the in-kind distribution of the insurance policy was made only to the insured’s spouse (excluding the children.) Even more remote trust beneficiaries, e.g. the children’s descendants, may ultimately have a claim against the trustee for distributing the policy from the trust or simply the decision to surrender the policy to stop the need to continue to pay insurance premiums.
  • If the ILIT trustee was also the drafting attorney, that attorney will likely be viewed (fairly or not) as holding himself out as an expert in fiduciary duties. That means the attorney will have more potential to be sued by unhappy ILIT beneficiaries. While the attorney-ILIT trustee might earn an additional fee for serving as trustee, he/she would have a conflict of interest by representing both the settlor and the ILIT beneficiaries in the formation of the ILIT. Matters become even more problematic if the attorney (or CPA) acting as ILIT trustee receives some form of remuneration or rebate of insurance commissions.

ILIT Provisions: Because of the ILIT trustee’s duties to abide by the Michigan Uniform Prudent Investor Act, there may come a time when the policy held in the ILIT needs to be changed, either due to poor policy performance, or the continued cost of premiums becomes prohibitive. Alternatively, some new policy ‘riders’ might become available that would improve the policy’s performance. As such, the terms of the ILIT should give to the ILIT trustee the following additional powers with regard to the existing insurance policy that is held in the ILIT:

  • (i) the ability to exchange one insurance policy for another under IRC 1035;
  • (ii) the right to surrender policies or modify their face values, premium schedules, or change other policy rider/benefits;
  • (iii) the right to take policy loans or distributions from policy cash surrender values;
  • (iv) the ability to purchase or modify an existing life insurance policy to become a modified endowment contract (MEC); and
  • (v) the ability to enter into split-dollar agreements to reduce the ILIT’s annual premium outlay each year.

If some of these powers are absent in the ILIT instrument, which could be the case if the ILIT is ‘old and stale,’ then the trustee should consider decanting the existing policy to a ‘new’ ILIT to provide this additional flexibility in order to efficiently manage the insurance policy held in the ILIT with the obligations of the Uniform Prudent Investor Act in mind.

Conclusion: There is currently a lot of talk about unwinding existing ILITs due to the prevailing high federal estate and GST exemption amounts.

  • Before the decision is made to terminate an ILIT the context for that decision, in particular the sunset of those large tax exemption amounts in 2026, needs to be fully considered by the ILIT trustee and trust beneficiaries.
  • If the insured-settlor is tired of making annual gifts to the ILIT to enable the ILIT trustee to continue to pay annual premiums, along with the crummey notices that must be sent to each ILIT beneficiary, the insured-settlor might consider using his/her temporarily large gift tax exemption to fully fund the ILIT at this time, so that no future annual exclusion gifts (and no further crummey notices!) will be required to sustain the life insurance policy in the ILIT.
  • If the ILIT trustee is asked to unwind the ILIT, the trustee must follow its duty of impartiality to all ILIT beneficiaries.
  • An in-kind distribution of the insurance policy held in the ILIT may not be an available solution if the trust instrument does not expressly permit in-kind distributions.

ILIT trustees cannot overlook their fiduciary duties to all trust beneficiaries, and their obligations to periodically monitor the policy’s performance, and the need to document all the steps that the ILIT trustee annually takes in that monitoring process consistent with the Prudent Investor Rule. While the Bill in Lansing would provide some protection to individual trustees of existing ILITs, apparently they will not receive that relief anytime soon.