What is an Irrevocable Life Insurance Trust?

A trust is an arrangement by which assets and property are placed into a trust, administered by a trustee. The concept behind a trust is that assets are protected during certain circumstances, most notably upon the principal’s death. There are several types of trusts. These are grouped largely by whether they are revocable or irrevocable.

The principal, or creator, of a revocable trust can modify or cancel the trust at any time. With an irrevocable trust, however, the principal forfeits all control of the trust’s assets. The advantages of an irrevocable trust is that its assets are protected from the estate tax upon the principal’s death.

Despite this notable tax advantage, irrevocable trusts are a tough sell. Most principal’s do not want to give up control of their assets, especially those assets that produce income. Once an income-producing asset is placed within an irrevocable trust, the principal may not benefit from its income.

With an ILIT, an existing life insurance policy is transferred to an irrevocable trust, or, preferably, a new policy is created with the trustee as owner.

How can an ILIT benefit an estate plan?

Once created, an ILIT represents funds that will be estate-tax free upon the principal’s death. If the principal has a large estate that is subject to estate taxes, then the proceeds of the life insurance policy can pay the estate tax without incurring a further tax burden and without necessitating the need for beneficiaries to liquidate any non-liquid assets.

The principal does not lose control or ownership of important assets during his lifetime, and the beneficiaries are not subjected to a massive estate tax bill. In addition to these important benefits, a properly drafted life insurance trust can include a spendthrift clause that protects beneficiaries from their own future creditors. An ILIT can even be drafted to encourage responsible behavior when the trustee is given discretion over the distribution of assets.

An ILIT can provide important benefits to people who have amassed enough wealth to be subjected to the estate tax, while protecting their control over their hard-earned assets. However, the wording of the trust document is binding. Therefore, an attorney competent in estate and probate law can best draft an ILIT that can suit your needs.

The donor receives tax benefits when a charitable remainder trust is established because a non-profit organization is designated as a beneficiary of the trust. Once property of the donor’s choosing is transferred to the trust, the donor can take a charitable tax deduction for the property. The amount of the deduction is based on the value of the property and rules established by the IRS.

The main way the donor saves money on taxes is by transferring ownership of a piece of property to the trust that has greatly appreciated in value over the original purchase price. Once the property belongs to the trust, it can be sold by the trust. The profits from the sale are not taxed because a charity benefits from the trust’s assets. The amount of money saved on capital gains tax by the donor can be substantial.

Similarly, properties that have greatly increased in value may have limited income producing potential, and the donor may need to generate additional income after retirement. These properties can be donated to the trust and sold without tax implications for the donor. The proceeds can then be reinvested within the trust to provide supplemental retirement income to the donor and his/her spouse. The IRS requires that at least five percent of the value of the trust’s assets is distributed as income. The income can be distributed over a fixed number of years or over the donor’s lifetime, depending on the terms of the trust agreement.

For estate planning, donors with a high net worth may want to transfer property into a charitable remainder trust. The property is considered a gift by the IRS, and would no longer be included in the donor’s estate. Any potential estate taxes would be reduced.

After the donor’s death, the charity that was designated as the beneficiary receives the remaining assets under the trust’s management. The trust may then be dissolved.

A Grantor Retained Annuity Trust (GRAT) is an estate planning tool used to transfer wealth to children, maintaining an income stream and minimizing estate tax liability.

In a GRAT, an individual transfers property to a trust. The individual will receive an annuity for a term of years, at a fixed term. The trust must be irrevocable, meaning the grantor cannot change or revoke the trust once created. At the end of the term, the remainder beneficiaries receive the amount left in the trust, and no estate or gift tax liability is owed. If the grantor dies during the term of the trust, the remaining assets of the trust will become a part of the grantor’s estate for tax purposes.

Taxation of a GRAT

When a GRAT is first created, it is considered a gift to the beneficiary. Because it is a gift of a future interest, it is not subject to the gift tax exclusion. On the other hand, the value of the gift is deeply discounted based on the actuarial value of the trust. This value is determined the terms of the GRAT and an interest rate set by the IRS under IRC section 7520 (currently 2.4%).

The grantor is paid an annual income based on the terms of the GRAT, whether fixed dollar amount or a fixed percentage of the income. If income derived from the GRAT is insufficient to pay the grantor, invasion of the trust principal is made to insure the fixed amount. When the GRAT expires by its terms, the remaining assets are transferred to the beneficiaries of the trust, without being subjected to estate or gift taxation. The value of the gift is the fair market value of the trust minus the actuarial value of the payments on the annuity. The actuarial value of the payments is based on the IRS interest rate, the term length, and the payout rate.

Example

Businessman A owns $5 million in stock in a company. Businessman A transfers the stock to a GRAT for a term of 20 years, with an income return of 2.4% per year, paying the grantor $310, 267.34. However, if the trust earns an annual return of 5%, there will be $2,671,787.95 at the end of the GRAT term. This amount would transfer to the remainder beneficiaries tax free. The gift tax value is the actuarial value is based on the initial sum, the 20 year term, and the percentage of payments in relation to the annuity amount.

In July the House of Representatives passed H.R. 5486, the Small Business Jobs Tax Relief Act of 2010. A provision in the bill requires a GRAT to have a term of more than 10 years to be effective, and prohibits zeroed-out GRATS. The president has indicated support for the bill. If interested in creating a GRAT, keep a close eye on this legislation.

In order to remaining on the up and up with the IRS, and to ensure that the estate will not be taxed a second time when the remaining spouse passes, there are a number of rules that must be followed.

1. The remaining spouse must have limited access to the trust for the remainder of his life. In short, the remaining spouse does not have unlimited access to the principal of the trust. He or she cannot withdraw as much as he or she wants whenever they want. Instead, the bypass trust is designed to provide funds for health, maintenance, education and support as well as the ability to withdraw $5,000 or 5% of the principle, whichever is greater, each year. Please note that because the remaining spouse can be named as trustee of the bypass trust, this law is actually somewhat flexible.

2. The remaining spouse has a limited ability to distribute the assets of the trust at the time of their death. The remaining spouse cannot simply leave the remaining assets of the trust to his own estate, his own creditors or his estates creditors. The bypass trust can be set-up to permit the remaining spouse to designate a person, or people, to succeed the trust upon their demise. For example, the bypass trust may state that the remaining spouse may divide the remaining assets among their children. Another option is to designate the final heir in the bypass document itself, leaving the remaining spouse no discretion in the matter.

If you are considering forming a bypass trust, it is critical that you work closely with a trust attorney. The language set forth by the IRS is very specific. Any deviation, no matter how slight, may result in a revocation of the rights granted by the bypass trust. In other words, if the bypass trust is not properly worded, the benefit, that the trust will not be taxable after the second spouse passes, will be revoked.

A bypass trust can be an excellent financial tool for estate planning purposes. It gives couples the ability to control their estate, even after they pass. It also prevents them from saddling future heirs with what can be very costly estate taxes. Proper planning of your estate may very well include a bypass trust. Consult your attorney to determine if this is the best tool for you, your spouse and your joint estate.

First, consider that it is possible to gift your children money. As long as the amount is $13,000.00 or less a year, the money is non-taxable. While this can serve as an adequate measure to distribute funds without worrying about estate taxes, and will work for estates of all sizes, many parents are concerned that the children in question are mature enough to handle the money.

If you would still like to gift the $13,000.00 each year, but wish to provide protection for that money, a good idea is to set up a trust. A formal trust will keep the money out of the child’s hands until they reach a pre-determined age. The money in question would be gifted directly to the trust, after which a trustee would invest and administer the funds. It is possible to name yourself as the trustee and thus save even more money.

There is a downfall to this concept. In order for the money to be considered a gift, the child must have a ‘present interest’ in the money. Simple put, they must have the right to take and spend the money at any given time. It is possible to put restrictions on the money and still be eligible for the gifting tax break. One such way to do this is a Crummey Trust.

The idea of the Crummey Trust comes from the Crummey family. They set some significant restrictions on the trusts of their children and when the IRS tried to deny them the tax exclusion, the Crummey family went to court and won.

What is different about the Crummey Trust is that the child does not have rights to any of the income. What they have is a right to make a withdrawal from the trust in the total amount of each gift as long as they do so within thirty days of the gift date. This clause means that the child has a ‘present interest’ in the trust. If the child does not make the withdrawal of the gift prior to thirty days, the gift reverts in full to the trust and the child loses the right to withdraw it until the pre-determined distribution date.

As you can see, a Crummey Trust offers a large degree of protection for the both the gifted money and the overall trust. For parents looking to gift part of their estate each year without worrying their children will spend it, the Crummey Trust is an excellent option.