Take-Away:  A recent Michigan Court of Appeals panel declined to terminate an irrevocable life insurance trust (ILIT) notwithstanding arguments that the trust was invalid because the trustee did not comply with crummey withdrawal notices that were supposed to be given to the trust’s beneficiaries. The Court found that despite the risks of the death benefits being included in the insured’s taxable estate, the purposes of the ILIT were not frustrated by the failure to give crummey notices of gifts to the ILIT.

Law: The reported appeals decision spends a considerable amount of space describing the present interest requirement for an annual exclusion gift, the purpose of crummey withdrawal notices, and the estate inclusion of life insurance  death benefits when there is a retained incidents of ownership in the insurance policy. [IRC 2042 and 2035.] There is also an extended discussion with regard to two sections of the Michigan Trust Code that authorize a probate judge to terminate an irrevocable trust. Those two statutes are (abbreviated;)

  • MCL 700.7410 provides, in part: “A trust terminates to the extent..no  purpose of the trust remains to be achieved, or the purposes of the trust have become impossible to achieve.”
  • MCL 700.7412(2) provides, in part: “A court may terminate a trust if, because of circumstances not anticipated by the settlor…termination will further the settlor’s stated purpose, or if there is no stated purpose, the settlor’s probable intention.”

Issue: The settlor’s claim was that with the failure of the co-trustees to provide crummey withdrawal notices to the trust beneficiaries, the death benefit could/would be included in the settlor’s estate, thus frustrating the tax-avoidance purpose of the ILIT. Therefore, the trust should be terminated while the insureds were still alive, apparently (although not stated in the Court’s decision) returning the  insurance policy to the settlor.

Case: In re Peter and Lois O’Dovero Irrevocable Trust, Michigan of Appeals, No. 346896 (May 14, 2020) (Unpublished)

  • Facts: An unusual set of facts are the background for this decision, and they are only tersely described in the decision, leaving a lot of assumptions. The basics are that Pete executed an ILIT for the benefit of his wife, Lois, and their 9 children in 1996. The life insurance policy was placed through SunLife. The policy was the sole asset of the ILIT. The policy was a second-to-die policy that insured the life of Pete and Lois. The policy would pay $5.0 million on the last to die of the two insureds. Three of their 9 children were co-trustees. Pete made monthly premium payments directly to SunLife. While not explicitly stated in the decision, it appears that Pete purchased the policy and then transferred it to the ILIT. In addition, it would seem that a whole life policy was the subject of the transfer, otherwise why would Pete go to the lengths that he did to get his hands on the policy, but the Court’s decision does not identify it as a policy with a cash surrender value.
  • Crummey Notices: Pete and one of his children petitioned the probate court to terminate the ILIT on a variety of grounds. Most of Pete’s arguments centered on the failure of the co-trustees to provide crummey withdrawal notices to the trust beneficiaries in order for Pete’s monthly premium payments to qualify as present-interest gifts, thus qualifying for the federal gift tax annual exclusion.  Initially, crummey withdrawal notices were sent to the ILIT beneficiaries, but for a number of years no crummey withdrawal notices were ever prepared or delivered to the beneficiaries. For several years Pete filed annual federal gift tax returns in connection with his premium payments to SunLife, but he then stopped reporting the gifts on gift tax returns.

Pete claimed that the lack of crummey notices made in connection with his premium payments were ineffective, and on the deaths of Pete and Lois, the death benefit “will be included in the last-to-die’s taxable estate.”  Pete also claimed that the IRS would assert that no trust was effectively established because Pete did not really make a gift of the policy, and thus he had retained incidents of ownership over the insurance policy. However, it is difficult to discern how Pete reached this ‘no gift’ conclusion in reading the Court’s decision.

Arguments: Summarizing, Pete’s alternate arguments, either (i) the death benefit would be taxed in his, taxable estate, or (ii) the absence of the crummey notices caused the premium payments Pete made  to be subject to gift taxation.  Consequently, because the ILIT had as its purpose tax avoidance, that purpose had been thwarted by the absence of crummey notices, and the ILIT must therefore be terminated. The co-trustee children (respondents) disagreed that the ILIT had to be terminated because of possible transfer tax exposure to Pete or to Pete’s estate.

  • Trial Court: After a trial with expert testimony, the probate court refused to terminate the ILIT on the grounds that Pete’s concerns with respect to federal tax consequences were only hypothetical, and that he failed to meet the statutory requirements to terminate a trust. The probate judge also found that Pete lacked standing to file his Petition to terminate the trust. Finally, the probate judge noted the practical reality that Pete and Lois’ children will receive the net proceeds from the SunLife policy, regardless of Pete’s transfer tax concerns. This last statement was sort of like finding the the purpose of the ILIT was to benefit Pete and Lois’ children, not necessarily to save estate taxes.
  • Appellate Court: The appellate court affirmed the dismissal of Pete’s petition to terminate the trust,  but with an extensive discussion of crummey withdrawal rights, incidents of ownership exposure, and the potential estate tax consequences arising from the absence of crummey notices provided to the trust beneficiaries over several years.
  • Gift Tax Return: The Court referred in a footnote to an earlier Michigan Court of Appeals decision, In re Rudell Estate, 286 Mich App 391 (2009) which stated that the filing of a gift tax return is ‘somewhat probative to determine whether a gift has been given.’ The Court felt that this case dispensed with Pete’s arguments that his direct payment of the SunLife premiums monthly somehow meant that he never transferred the policy to the ILIT in the first place, i.e. he could not claim no gift was made when he filed several gift tax returns reporting his payment of the policy premiums.
  • Direct Payment of Policy Premiums: Pete argued that his direct payment of the insurance premiums somehow exposed the SunLife death benefit to taxation in his estate. In response, the Court referred to Estate of Headrick v. Commissioner, 918 F.2d 1263 (CA 6, 1990) where that Court had held that the decedent’s payment of premiums is irrelevant to the determination of whether he/she retained an incident of ownership in the life insurance policy.
  • Beamed Transfer Argument: Pete pointed to the incidents of ownership rules under the Tax Code, relying on the Bel ‘beamed transfer’ decision, which was covered in a missive last week. The Court found that Pete held no incidents of ownership and also that the SunLife policy proceeds are only paid at the last death of Pete and Lois. If Pete dies first, then “clearly he will retain no incidents of ownership over the policy.”
  • Demutualization of the Policy: Pete argued that there was no gift of the policy, and therefore he remained the owner of the life insurance policy. This argument was based on the demutualization of SunLife in 2000, where a check was sent  by SunLife to Pete (the owner?) after that demutualization, and not to the ILIT trustees. However, Pete later turned the SunLife money over to the ILIT co-trustees, and the ILIT paid income taxes on that money. The Court dispensed with this argument that somehow the demutualization of SunLife and initially sending Pete the check somehow caused Pete to be treated as the policy owner.  ”The Petitioner’s argument about a lack of gifting is not persuasive.”
  • Breach of Trust: Pete argued that the co-trustees failed to administer the trust properly. In response to this argument, the Court said “That the trustees could have been more proactive in managing the trust does not somehow establish that no funded, legal trust was ever created.”
  • Gift Tax Exposure: The Court noted that Pete had made a strong argument that the IRS may end up viewing many of his premiums payments as not subject to the annual gift tax exclusion. “But merely because more tax might be owed than Pete had hoped doesn’t mean that the trial court abused its discretion by failing to terminate the trust…This would leave approximately $3,800,000 for the children (the death benefit payout of approximately $5,000,000 minus taxes of approximately $1,200,000.) This is more than would be available if the policy were cashed out now, and a cash-out now would lead to speculative returns for a company [?SunLife] that is not currently viable and that is partially owned by only eight of the children. [?] Under the all the circumstances, it was not an abuse of discretion for the probate court to conclude that petitioners failed to establish that the trust must be terminated.” This quote is confusing with reference to the ‘company’ and it is the first time the Court refers to ‘owned by only 8 of the 9 children.’
  • Standing: Finally, there was considerable discussion about Pete’s lack of standing to file the petition to terminate the ILIT. Pete argued that he had standing to file the petition under MCL 700.7201 and MCL 700.1105(c).The Court noted that MCL 700.7410 permits only a trustee or beneficiary to commence proceedings to modify or terminate a trust. As for the Trust Code sections relied upon by Pete, the Court noted that they refer to “any other person that has a property right in or claim against a trust estate..” The ILIT clearly stated that Pete had “relinquishes all rights in life insurance contracts that the Grantor contributes to this trust.” “Clearly Pete did not have a property right in the trust estate.” Nor was Pete an ‘interested person’ under the other statute that he relied upon.

Conclusion: There is virtually no discussion in the Court’s decision about a ‘company’ and its reference to ‘8 of the 9 children’ is not explained. However, it may explain why one daughter joined in with Pete’s Petition to terminate the ILIT. There is also some vague, albeit passing, reference to a ‘defective’ trust, but no explanation how it fits into the Court’s analysis. There is no mention of whether the second-to-die policy was a term or whole life policy, but you have to assume it was a whole life policy, since Pete was desperately trying to have the Court find that he was its true owner. Finally, there is only a single reference to Pete transferring the policy to the ILIT; by inference, the co-trustees did not independently apply for the second-to-die policy insuring their parents’ lives.

With those caveats, the decision does provide a good summary of ILITs, crummey withdrawal rights, incidents of ownership of a life insurance rules, and why a trust may not be terminated just because the settlor is having second-thoughts about why he established the trust to begin with. The case is also a good reminder about the fact that a settlor does not have standing to seek a modification, or termination, of the irrevocable trust that he/she created.

What left me wondering was why the litigation in the first place? Pete wanted to terminate the ILIT and get his hands on a second-to-die policy. Why  did 1 out of his 9 children aligned herself with her father in filing the petition? A divorce between Pete and Lois, in which the kids ‘took sides?’ Pete disinherited 8 of his 9 children, but worried about the estate tax burden on the one child if the value of the  ILIT’s death benefit was included in his estate (but not the death benefit itself?) The decision never tells us what was motivated Pete’s petition. Still an interesting case.