Take-Away: There is a lot of angst these days with regard to the possible reduction in an individual’s lifetime federal transfer tax credit. It is also possible that the utility of an irrevocable life insurance trust, or ILIT, may also be in jeopardy if many of the advantages of a grantor trust are eliminated.

Background: Remember when Bernie Sanders proposed his ‘For the 99.8 Percent Act?’ One of its proposals was to add a new section to the Tax Code,  IRC 2901. That proposed Tax Code section would impact how grantor trusts would be taxed, and indirectly irrevocable life insurance trusts ( ILITs.) The proposed IRC 2901 would make the following changes from existing tax laws:

  • Estate Inclusion: It would include all assets held in a grantor trust in the grantor’s gross estate at the time of his or her death, despite the trust being irrevocable’ [IRC 2901(a)(1)];
  • Distributions as Taxable Gifts: It would treat any distribution of assets from a grantor trust to a beneficiary during the grantor’s lifetime as a taxable gift from the grantor to the trust’s beneficiaries. [IRC 2901(a)(2);
  • ‘Toggling’ Grantor Trust Status Would be Deemed a Taxable Gift: It would treat an event that toggles a grantor trust’s status, from grantor to non-grantor, as a deemed gift from the grantor to the trust’s beneficiaries. [IRC 2901(a)(3)]; and
  • Estate Inclusion for BDITs: A note sale to a beneficiary defective grantor trust [BDIT] would no longer remove any asset appreciation from the ‘grantor’ beneficiary’s gross estate. [IRC 2901(b)(2).]

Irrevocable Life Insurance Trusts: Generally, an ILIT is a grantor trust since the trust instrument usually provides that income may be applied towards the payment of premiums of insurance policies that insure the life of the grantor, or the grantor’s spouse. [IRC 677(a)(3).] If the trust instrument gives the trustee the discretion to use the income for such purposes, that does not constitute a retained ‘incident of ownership’ in the life insurance policy by the insured. Consequently, an ILIT that gives the trustee the discretion to apply trust income in the payment of premiums for life insurance on the life of the insured will not cause the death benefit to be included in the insured’s taxable estate. The trust instrument must expressly allow the application of trust income for this purpose. If the trust instrument is silent, or it allows only the use of trust principal to pay life insurance premiums, is not a grantor trust. Otherwise, an ILIT that uses trust income to pay insurance premiums on the life of the grantor is a grantor trust.

Grantor Trusts: Two common provisions used to create an ‘intentionally defective’ grantor trust are: (i) the settlor-grantor is given the power to substitute trust assets by substituting assets of equivalent value [IRC 675(4)(C)]; and (ii) authorizing the settlor-grantor to borrow from the trust without adequate interest or without adequate security [IRC 675(2).] If proposed IRC 2901 were to become law, most traditional ILITs, as grantor trusts would not function as intended and the death benefit paid to the ILIT would be included in the insured-grantor’s taxable estate.

Going Forward: Of course it is only speculation that proposed IRC 2901 will ever become the law. Then again, if President Biden is looking for some ‘compromise’ proposal that would accommodate the progressive wing of the Democrat Party, he might be willing to offer up the grantor trust as a sacrifice in exchange for more moderate tax law changes. Only time will tell. In the interim, if there is a possible threat to the use of ILITs in the future, what might be done in the event that the advantages of a grantor trust cease to exist?

  • Make the ILIT a Non-Grantor Trust: An ILIT can be intentionally designed as a non-grantor For example, the trust instrument could be drafted to avoid any of the provisions that are normally included to cause grantor trust status, e.g. IRC 675(4)(C) or IRC 675(2) or IRC 677(a)(3) which results in grantor trust status if trust “income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, or both, may be applied to the payment of premiums on policies of insurance of the life of the grantor or the grantor’s spouse.” Yet, if the ILIT is not a grantor trust, then it will be subject to the highly compressed income tax brackets for income that is earned and accumulated in the trust, e.g. a federal income tax rate of 37% imposed on income above $13,050.
  • Use an Insurance-Only LLC: More and more LLCs are used as an alternative to an ILIT. A transfer to an LLC is generally treated as a capital contribution and not a taxable gift under the partnership tax rules, in contrast to a transfer to an irrevocable trust. Contributions of property to a partnership (or LLC taxed as a partnership) in exchange for partnership interests are tax-free exchanges [IRC 721.] This might enable the gift of LLC units to family members, possibly using some valuation discounts if estate taxes are a concern.

No Incidence of Ownership: A Private Letter Ruling [PLR 200747002] exists that concluded that the insured-member of an LLC-owned life insurance policy did not possess any incidence of ownership over the life insurance policy, so long as there was an independent manager of the LLC and the insured member could not exercise any control over the insurance policy owned by the LLC. Consequently, it is possible for an LLC to own life insurance on member’s life and avoid estate tax inclusion under IRC 2042. If proposed IRC 2901 was ever adopted, it would not apply to an LLC-owned life insurance policy, as IRC 2901 only would pertain to grantor trusts. While PLRs are not precedents, they can provide a helpful roadmap to follow when structuring an LLC.

Lawful Purpose: A word of caution. If an insurance-only LLC is pursued, it should be set up in a jurisdiction that has adopted the Revised Uniform Limited Liability Company Act. That is because that Act does not have a required that the LLC be established with a profit motive; it only requires that the LLC have a lawful purpose. In contrast, the Revised Uniform Partnership Act requires that a partnership have a profit motive

Example: An LLC is set up where the parent-insured owns only a small percentage (e.g. 2%) of the LLC, with the balance of the LLC owned by the parent’s family members. The parent’s friend retains managerial control over the LLC until the parent-insured’s death. Commercial real estate is transferred to the LLC. The LLC purchases a life insurance policy on the parent’s life, and it uses the rental income that it receives to pay the policy premiums. 98% of the death benefit paid to the LLC on the insured parent’s death is removed from the parent’s gross estate. In short, the LLC functions much like the ILIT, with only minor (2%) ‘leakage’ of the death benefit to be included in the deceased parent’s taxable estate.

  • Insured’s Children Own the Policy: This is the simple approach but it may not be practical for the reason that the insured may not be comfortable with the fact that a policy with a large death benefit payable is owned and controlled solely by their child. The child would be the named beneficiary of the policy, so that the death benefit would be completely removed from the insured-parent’s taxable estate, i.e. there is no incidence of ownership in the policy. But that also leaves the child in complete control of the death benefit, and if one of the purposes of obtaining the life insurance was to provide estate liquidity on the insured’s death, there is no assurance the child-owner will go along with making that liquidity available to their deceased parent’s taxable estate.

Conclusions: ILITs are a staple of many sophisticated estate plans. It is possible that in a climate of ‘tax-reform’ ILITs may be substantially impacts, if not completely eliminated. As such, if life insurance is being considered, e.g. in anticipation of a dramatic reduction in the federal transfer tax exemption amount, making more estates vulnerable to federal estate taxes, it might be wise to give some thought to an alternative to the conventional ILIT. I am not suggesting that ILIT status grantor trusts are on the way out, but there are some in Washington who apparently think that it is a good idea.