Chapter 35: Revocable life insurance trusts.
"As an estate planning tool, life insurance has no peer. It can create an estate where none otherwise exists or it can provide liquid funds to safeguard existing wealth. The benefits of life insurance as an estate planning tool can be increased through careful planning for the disposition of the life insurance itself. The personal life insurance trust is the premiere vehicle for achieving maximum flexibility in utilizing the death proceeds of life insurance to accomplish the decedent's personal and tax goals." (1)
This chapter should be read together with Chapter 30 on irrevocable life insurance trusts. Together, they will provide an excellent overview of how life insurance as a pivotal estate planning tool can be leveraged through another key tool, the trust.
WHAT IS A TRUST?
Picture in your mind a box. (2) Let's call that fictional box a "trust." Into that box you can put cash, stocks, bonds, mutual funds, the deed to your home, or even life insurance. You can put almost any asset into the box. When you do put property into the box, you are "funding" the trust (although some authorities restrict the definition of the term "funding" to the transfer of income producing assets into the trust). Funding (in the sense of adding income producing assets to a life insurance trust) is usually for the purpose of providing a source for premium payments where the trust will actually own and hold one or more policies.
State law determines the existence or nonexistence of a trust. In fact, a trust does not technically come into existence until the trust is at least nominally funded (often with little more than a small U.S. Savings Bond).
Some states allow a trust to be considered funded merely by naming it the beneficiary of life insurance proceeds. Almost any type of asset can be placed into the trust. Assets typically found in trusts include cash, stocks, bonds, mutual funds, the deed to real estate, and life insurance. Additional assets can be placed into a trust even after it is initially "funded." For example, a small government bond may form the initial funding of a trust but then later the same trust can be named as beneficiary of a life insurance policy, a pension plan, an IRA, or HR-10.
A trust is therefore a legal relationship that enables one party (called a trustee) to hold money or other property (the trust principal or "res" or "corpus") transferred to the trust by a second party (called the "grantor," "settlor," or "trustor") for the benefit of one or more third parties (the "beneficiaries") according to the terms and conditions of a legal document (called the "trust agreement"). In other words, a trust is a means by which a property owner may separate the burdens of property ownership from the benefits of property ownership to whatever degree, upon whatever terms, for whatever period (within reasonable limits imposed by law), and for the benefit of whomever he pleases. (3)
Again, the key to understanding a trust is that for investment, management, and administration purposes the trustee holds full legal title to the property in the trust. But that trustee (or trustees, since there can be more than one) must use or distribute the property and the income it produces solely for and to the beneficiaries (or class of beneficiaries) selected by the grantor and named in the trust.
Should the trust fail (perhaps because the trust is declared invalid for technical reasons), the beneficiary holds the proceeds under what is called a "resulting trust." This is a fictitious trust created by law to prevent unjust enrichment. Usually, the proceeds held in such a resulting trust are eventually paid to or for the benefit of the would-be grantor's estate. However, if the trust is poorly drafted and there is not sufficient evidence to show that the presumptive grantor intended to create a trust, the beneficiary takes total and absolute title to the proceeds. (4)
LIVING TRUST DEFINED
A trust set up during the lifetime of the client is called an "intervivos" (living) trust. That trust can hold assets (including life insurance contracts) placed into the trust by its creator during his lifetime. It could also provide for the acceptance of additional assets at its creator's death. His will could "pour over" assets from the estate into the previously established trust. This is the "LITPOW" (Life Insurance Trust--Pour Over Will) combination that has been used as an effective estate planning tool for generations.
WHAT IS A REVOCABLE LIFE INSURANCE TRUST?
A revocable trust, as its name implies, is a trust established during a client's lifetime that can be revoked by the client. The client who sets up a revocable trust specifically reserves the right, at any time (until specifically making the trust irrevocable or until death, at which time it becomes irrevocable), to alter or amend its terms or terminate the trust and recover its assets. In most states, a trust is irrevocable unless the trust document specifically provides otherwise. Also, a revocable trust is generally irrevocable while the grantor is incompetent.
If the revocable trust, through its trustee, is designated as the beneficiary (or as both the owner and beneficiary) of one or more insurance policies on the life of the trust's grantor, the trust is a revocable life insurance trust. The policy owner names the trust as beneficiary of the policy proceeds and the trustee is directed in the trust agreement to hold those proceeds for the beneficiaries of the trust to be distributed in the time and manner specified in the trust document.
When a revocable life insurance trust is created, the policy owner typically reserves all of the ownership rights in the policies and, unless the trust is funded with income producing assets, the policyowner will continue to be responsible to pay all premiums. If the trust is funded with income producing property, the trustee usually will be required to use the income from those assets to keep the insurance in force.
Actually, life insurance policies are seldom transferred to a revocable trust. Although the mere designation of a trust as the beneficiary of life insurance is sufficient in most states to create the trust, most cautious authorities suggest some other cash or other asset be placed into the trust as well to thwart an argument in a jurisdiction that may not clearly accept such a designation as adequate.
Note that a formal trust document should always be created since the mere designation of "trustee" as policy beneficiary will not, per se, establish a trust. Absent sufficient evidence to prove that a trust was intended, the policy proceeds will be paid outright (probably to the insured's estate if no other beneficiary was named). But if it can be shown that a trust was intended, even if the trust should fail for technical reasons, a "resulting trust" (a fictitious trust created by law to uphold the creator's wishes) occurs and the proceeds are held for the beneficiary. (5)
A revocable trust can be named as a contingent beneficiary of policy proceeds so that if the primary or even backup beneficiary died before the insured, there would be a receptacle for the money. For instance, a parent might name the other parent as primary beneficiary but provide in the insurance application that "If my spouse predeceases me, proceeds are to be paid to Thomas Trustworthy, trustee of the living trust I have established."
There is one good reason to transfer ownership of life insurance policies to a revocable trust and have the trustee name the trust as beneficiary: if the grantor becomes incapacitated, the trustee can, if necessary, borrow the cash value of the policies to keep them in force.
WHY SHOULD A CLIENT SET UP A TRUST?
There are many reasons why a client may want to make a gift in trust as opposed to outright. There are, of course, tax savings goals but, typically, these cannot be accomplished through revocable life insurance trusts.6 Generally speaking, revocable life insurance trusts save neither income nor estate taxes. So it is the people oriented objectives of revocable trusts that provide the greatest incentive for their creation.
These can be categorized into the following broad terms of income and wealth:
2. conservation; and
More specifically, clients set up revocable trusts during their lifetime ("inter vivos" revocable trusts) to accomplish the following objectives:
1. Postpone ownership during incapacity or inability of the beneficiary--Quite often a client will feel that the beneficiary is unwilling or unable to invest, manage, or handle the responsibility of an outright gift. Gifts to minors, for example, would fall into this category. But a trust should also be considered for persons who are legally adults but who lack the emotional or intellectual training, experience, physical capacity, or willingness to handle either large sums of money or assets which require constant and high level decision making ability. So a trust is often used to postpone full ownership until the donees are in a position to handle the income and the property itself properly.
2. Maintain control over a beneficiary--Some clients are reluctant to place all the ownership rights in the hands of a donee. They utilize trusts as the solution to the ambivalent position of wanting to institute a gift program but fear the possible results of an outright no strings attached transfer that lessens the donee's dependence on them.
3. Avoidfragmentation of property--A further impetus for the use of a trust is where the proposed gift property does not lend itself to fragmentation, but the client wants to spread beneficial ownership among a number of people. For example, a large life insurance policy and the proceeds generated by it at the insured's death are often better held by a single trustee than jointly by several individuals.
4. Retention of control over assets--A revocable life insurance trust, which the client can alter, amend, revoke, or terminate at will, should be considered where conservation of assets and particular dispositive plans are important. In other words, if retention of lifetime control is essential to the client, such as where the client wants to limit the class of beneficiaries (e.g., no in-laws) or where the client wants to prevent the beneficiary from disposing of the property to persons outside the family, a trust provides a vehicle for a client to make a gift with minimal loss of lifetime control. At the same time, the client builds in flexibility to meet future contingencies and attain personal objectives.
5. Unifying receptaclefor other assets--Because a trust can be named as recipient of almost any type of asset and because such property can be placed into trust at any time (and because parties other than the party who originally established the trust can make contributions of cash or property), a revocable trust makes an ideal vehicle for later contributions to "pour-over" into it. This unification of assets is particularly important if the client owns many different types of assets or owns property in more than one state. Bringing the assets together may save administrative costs and avoid multiple probates where property is owned in more than one state.
6. Avoidance of publicity--The terms of a trust are not public knowledge. Therefore, the amount placed into trust, the terms of the transfers, and the identity of the income and ultimate recipients does not become public knowledge. Privacy is particularly important where there are (or there is the potential for) intra family conflicts. Since there are no requirements that nonbeneficiary family members must be notified of the nature or extent of trust assets or the details of the dispositive plan of a revocable trust, the potential for family disputes is low. This is particularly important where the client wants to disinherit a particular family member or name a friend who is not a family member as a beneficiary.
7. Opportunity for a trial run--Setting up a trust during the client's lifetime affords an opportunity of seeing how well the trustee manages the property placed into the trust and how well the beneficiaries handle the income or other rights given to them. It also familiarizes the trustee with the client's assets, family, plans, and relationship of each to the others. If the client doesn't like what he sees, changes can be made.
8. Selection of a favorable forum--A revocable trust allows the client to select a state where the laws are most favorable to accomplishing his dispositive and administrative objectives. It is not necessary to use the laws of the client's domicile when creating a revocable living trust. To accomplish this objective, the trust should specify the state law that is to govern it. In some cases, it may be necessary to have trust proceeds paid to a trustee in the selected state. Planners must, however, take care not to set up a multiple domicile issue when setting up a trust outside of the state of the grantor's domicile.
Cases where it may pay to shop for more favorable state law include (as well as where it may pay to use a trust rather than dispose of property by will) where the other (nondomiciliary) state has a more favorable (from the client's viewpoint) law regarding:
* The rule against perpetuities--This would allow the trust to continue longer than might be permitted otherwise.
* Elective share (surviving spouse's rights to a statutory share of a deceased spouse's estate)
--For instance, in Florida, if property is placed into a revocable living trust, the surviving spouse has no right to it, since the elective share is defined as a percentage of the probate estate.
* Will contests--If the client anticipates an attack on the will, a revocable trust should be considered. One reason is that the trustees of the trust can use trust assets to defend the trust against a challenger. On the other hand, in a will contest, until the validity of the will is determined, neither side has access to estate funds and each must personally bear the costs of litigation. Furthermore, the criterion for proper execution of a trust may be more lenient and, therefore, more easily defended than the requirements for a valid will.
* Creditor's rights--However, if the transfer is made to the trust in avoidance of existing or anticipated claims of creditors, it may be voidable.
* Charitable bequests--Some states contain charitable rules, called "mortmain" statutes, that nullify or otherwise limit gifts to charities if made within a specified period prior to death. The use of a revocable living trust may avoid this rule in some states.
* Restrictions on qualification to serve as executor
--Careful selection of applicable state law may allow a party to serve who might not be qualified under the law in the client's state of domicile.
9. Equalize risk and potential--A living trust can be a great equalizer for both downside risk and upside potential. For instance, if a parent owned several parcels of land of equal value or used life insurance proceeds to purchase several parcels of land, he could make outright gifts of Parcel A to his daughter and Parcel B to his son. However, the children may be treated unequally since one property could drop in value while the other could rise. Alternatively, both properties could rise or fall at different rates. Placing both properties in trust could equalize the risks and potential rewards between the children. Investment results of life insurance proceeds invested in a pool by the trustee could be shared equally by the beneficiaries.
10. Provide for ownership flexibility during beneficiaries' minority--Major decisions and actions cannot be taken if property is placed directly in a minor's hands, but can be taken if the same property is placed in trust for the minor. This generally makes it possible to sell, exchange, or mortgage a minor's property without the expensive, inflexible, and troublesome process of appointment of a guardian.
11. Assure dispositive objectives--An outright gift to a beneficiary will often return to the child's parents or go to the child's spouse or someone other than to whom the client would want it to go. This may defeat many of the client's non-tax objectives. A revocable trust would provide an assurance that the client's dispositive objectives could not be easily defeated.
12. Provide for the helpless--Physically, mentally, emotionally, and legally incompetent beneficiaries can be financially provided for though a revocable trust.
13. Relieve the overburdened--Even beneficiaries who are competent adults can be both protected against their own indiscretions and relieved of the burdens of investment, management, and record keeping.
14. Back-up for the healthy--A funded revocable trust can provide for the grantor in the event he is incapacitated and avoids the expensive, complex, aggravating, and embarrassing court process necessary to declare a person legally incompetent. A revocable trust, coupled with a durable power of attorney, can provide the basis for a contingency plan to deal with a client's inability to handle his own financial affairs.
15. Multi-state administration can be avoided through the use of a revocable trust--For instance, many clients will own property in more than one state. Ancillary administration (i.e., estate administration by a state other than the client's domicile state) is both expensive and aggravating. The client can unify the process and, in many cases, significantly cut down administration costs by placing title to out of state assets in a single revocable trust.
16. Reduce the risk of a successful challenge--Once an inter vivos (during lifetime) trust is created, its ability to perform the task for which it was designed is more certain than a will. This is at least one reason to establish an inter vivos trust, rather than a testamentary trust (one established under the grantor's will). Particularly, when one or more provisions of the client's will are controversial or likely to stir up a family dispute, a will is likely to be challenged or a surviving spouse may elect against (i.e., exercise a statutory right to take a share of the estate regardless of the terms of) the will. A trust is much less likely to be broken than a will based on the lack of capacity of the grantor or upon a claim of fraud or distress. Furthermore, the trustee can use trust assets to defend against a party who disagrees with the terms of the will.
ADVANTAGES OF A REVOCABLE LIFE INSURANCE TRUST
Among the advantages of a revocable life insurance trust, in addition to or as a consequence of making a revocable trust beneficiary of life insurance proceeds, are the following:
1. If a revocable trust is named as the beneficiary of all of a client's life insurance, a simple amendment to the trust can instantly achieve a redistribution of the proceeds of dozens of policies. This should save the client considerable time and aggravation, compared to filling out a multiplicity of forms from numerous insurance companies.
2. Life insurance proceeds payable to a revocable trust are immediately available for the trustee's disposition. Conversely, insurance proceeds payable to a testamentary trust will not be available to the beneficiaries until the will has been admitted to probate and the trustee has accepted the trust. In some cases, there may be a delay of several years between admission of the will to probate and acceptance and final funding of the trust.
3. The transfer of a life insurance policy to the trust, the designation of the trustee as the beneficiary, and even the distribution of the proceeds to the trustee can generally be structured as tax-free transactions.
4. Use of a trust makes the disposition of a policy easier where the beneficiary predeceases the insured. Compare this with an outright gift of the policy to a beneficiary who then dies before the insured. If a trust is used, it can continue to hold the policy after the predeceasing beneficiary's death and eventually transfer it to another party and in the way the insured client intended.
5. Probate is avoided with respect to a policy held by or payable to a revocable trust that continues after the beneficiary's death. Compare this with an outright gift of a policy to a beneficiary who then dies. If the intended individual beneficiary dies either prior to or after the insured, the policy or its proceeds are likely to be subjected to the costs, delays, and uncertainties of probate. Under the revocable trust document, interim distributions to the client's surviving spouse and/or children can be made without waiting for court approval.
Use of a revocable life insurance trust assures continuation of the privacy of life insurance since there is no publicity and the amount of proceeds and other assets in the trust, as well as the terms of the trust, are not open to public scrutiny as are the reports and accounts filed with the probate court. Use of a revocable living trust as the receptacle for life insurance continues the exemption of proceeds from some states' death tax.
6. To some limited extent (varying widely from state to state),7 life insurance proceeds payable to a revocable trust may be insulated from the claims of the grantor's creditors and the claims of the grantor's surviving spouse through an attack on the will or election against the will.
7. Using a trust continues the privacy afforded through life insurance. Confidentiality of who receives the proceeds and how much they receive is generally maintained for a longer period of time than if the proceeds were paid outright.
8. All the client's assets (such as life insurance, pension plan, IRA, and personal property) can be "poured over" into a revocable living trust. The trust serves as a unifying receptacle for the collection of assets from a variety of sources and makes it easier to coordinate life insurance with other sources of financial security.
9. Compared to the use of settlement options, a trust provides significantly greater flexibility in terms of the trustee's ability to sprinkle income or spray capital when and as needed by the beneficiaries.
10. Compared to the use of settlement options, a trust makes it possible for the beneficiary to receive greater income and appreciation of capital. (Of course, both advantages entail greater risk.)
DISADVANTAGES OF A REVOCABLE TRUST
There is no tool or technique that is without cost and totally risk free. Trusts, even revocable trusts, are no exception. There are costs, paperwork, and other potential problems. These include:
* Legal and accounting fees--Legal fees to draft a trust may range from $500 to $5,000 or more depending on the degree of complexity in the trust, the expertise and reputation of the attorney, the prevailing legal fees in the area, and issues collateral to the creation of the trust that must be resolved. Compare these costs to buying an insurance policy and selecting a settlement option. In cases where the amount of insurance concerned is modest, a policy settlement option to provide for the management of insurance proceeds for the insured-grantor's family may prove to be a more cost efficient and objective effective mechanism than a revocable life insurance trust.
Once a revocable trust is funded, filing of income tax returns may be required even though the trust may be treated as a grantor trust. IRS Form 1041, the Fiduciary Income Tax Return, is used to show the trust's income, deductions, and credits which must be reported by the grantor for taxable years beginning before the grantor's death. If the same person is both the grantor and the trustee (or co-trustee) or if one or both spouses are grantors and one or both spouses are trustees or co-trustees, Form 1041 is not required. If the trust has no income (as it typically would not, as long as its only significant asset was the potential receipt of life insurance proceeds), no income tax returns need be filed. At the insured's death, as long as the trust continues in existence, income earned from insurance proceeds payable to the trust must be reported on returns filed by the trust.
* Trustee's commissions--Although typically nominal when a trust is still unfunded, trustees' fees may run as high each year as 1.5 to 2% of trust assets and therefore must be considered. The younger the client is, the longer the trust will run and the higher the overall fees.
* Hidden obstacles--There are also hidden obstacles, such as the problem where a bank that holds a mortgage on property refuses to allow the mortgage to be carried over to the trust because a lender might have difficulty selling the mortgage on the secondary market. Will the client's property and casualty company insure cars and homes owned by a trust? (Consider the question of who has the right to drive trust owned cars?)
Perhaps the biggest hidden obstacle is the time and trouble it takes to continually assign assets to the trust. Special forms must be completed at banks and brokerage houses and new deeds must be prepared (entailing conveyancing costs) and recorded (and in some cases transfer taxes must be paid) to transfer real estate to a revocable trust. Even if the client takes the time to transfer title to all his assets to the trust at its creation, after a number of years the client will often forget or not go to the trouble of titling new assets such as a car or personal effects in the name of the trust. Yet if such items are not transferred to the trust, the benefits of probate avoidance and property management and dispositive control for which the revocable trust is formed are unobtainable.
* Estate taxes--Since by definition, the trust is revocable, insurance proceeds paid to the trust will be includable in the insured-grantor's gross estate for federal estate, and generation-skipping transfer tax purposes. Of course, this may not be a disadvantage if the estate is less than the unified credit equivalent.
* Panacea syndrome--Many promoters of the revocable trust imply that somehow this tool is--by itself--a "magic pill" that can be purchased genetically and once swallowed will solve all problems. "Buy my book, rip out the form, sign your name, and all your problems are solved." Not only is this incorrect; it is dangerous. Why? Because it deprives the estate owner of the advice of true estate planning professionals. It blocks questions about other problems the client may not know he has and eliminates the potential to use other tools and techniques, either as alternatives or complementary devices to the revocable trust.
ROLE OF THE TRUST DOCUMENT
Sometimes called a "Trust Indenture" or "Trust Agreement," this document sets forth the agreement between the parties (and serves as evidence for the "other parties in interest" in every trust agreement, the federal and state taxing authorities) and spells out:
1. how assets are to be managed;
2. who will receive income and capital from the trust;
3. how the trust income and capital is to be paid out; and
4. when (date or beneficiary's age) or under what circumstances (birth, death, marriage, etc.) the income and capital is to be paid to each beneficiary.
Where a trust is to be the beneficiary of life insurance or is to hold one or more policies, specific wording should be provided in the trust document to enable the trustee to accept the proceeds and hold the policies. Even more important, if the trustee is to purchase life insurance on the grantor's life or the lives of others, or is to pay premiums on one or more such policies, it is necessary that the terms of the trust specifically authorize such action. Many states do not permit the investment of trust assets in life insurance unless authorized by the terms of the trust or under provisions of the state's trust laws. (8)
WHAT IS THE JOB OF THE TRUSTEE?
The trustee is responsible for safeguarding and investing the assets in the trust and making payment as directed (or if given discretion, as appropriate under the guidance provided in the trust) to the named beneficiaries. This responsibility may run for as short as a few years or for generations.
Any natural person with the legal capacity to take and hold title to property and deal with it or any corporation which is authorized by its charter or articles of incorporation to act as trustee and which meets relevant state law requirements can be named as trustee. Unincorporated associations or partnerships cannot be trustees since they are not separate legal entities.
Although legally, there is no limit to the number of trustees, most clients select one, two (often a corporate trustee and an individual), or three (to avoid a voting tie). In some states, individuals and nonbank corporations serve as professional trustees. When more than one party is named, each is a co-trustee and all make decisions (and bear responsibility for mistakes) jointly. The authors recommend that at least two backup trustees be named in every trust in case the one named for some reason can't continue to act or refuses to serve.
A trustee's job can be a dangerous one depending on the funding of the trust. Life insurance is a relatively clean and safe asset to make payable to or have owned by the trust. But consider real estate, perhaps an apartment house, manufacturing business, or gas station placed into the trust to provide income and avoid probate. Consider the liability of the trustee for fines, cleanup costs, and damage to the environment if hazardous waste is found on the property, even if the hazard was created long before the trust and without the knowledge of the trustee.
WHO CAN BE THE BENEFICIARIES OF A TRUST?
Beneficiaries of a trust receive income from trust assets and/or principal at the ages and under the terms specified in the trust document. They can (and often do) include the person who established the trust. The first people to receive distributions are called "primary beneficiaries." The class of beneficiaries who receives what remains when a trust terminates are called "remainderpersons."
Although beneficiaries do not have to be identified by name, or even all be in existence at the date the trust is created, they must be an identifiable and definite class or group and must be in existence within the period measured by the appropriate state's rule against perpetuities. This makes it possible for a trust to be created for the "children of the grantor" even though all the members of that class of beneficiaries (the grantor's children) may not be in existence at the moment the trust is created, since the grantor is presumed capable of having more children. As long as the class is limited and definite and all its members must be in existence within the period of the rule against perpetuities, the trust will be valid.
The rule against perpetuities is a state law restriction designed to limit the period during which a trust can withhold property or its income from outright ownership. The operation of the rule will vary from state to state, but typically provides that a restriction will fail if it ties up property longer than a length of time equal to "lives in being" plus 21 years. In other words, the right to outright ownership of property must "vest" (can't be indefinitely restricted) within a given time frame. (9)
The Uniform Statutory Rule Against Perpetuities, which has now been adopted by a number of states, takes a slightly different approach. Rather than invalidating property interests at inception, this law adopts a flat period of 90 years from the creation of the interest (rather than a period measured by lives in being at the creation of the interest) and waits to see if the rule is violated before invalidating the interest.
SELECTION OF A TRUSTEE
When selecting a trustee, the major attributes to consider are the trustee's willingness to serve and at what cost; the trustee's experience with trust, financial, business, accounting, and tax matters; the trustee's temperament and relationship with the beneficiaries; and the tax effects of serving as trustee.
There are important tax considerations that go into the selection of a trustee. The grantor must consider whether a particular family member or related person can serve as trustee without creating unanticipated and adverse income, gift, or estate tax consequences.
During the grantor's lifetime, the trustee of an unfunded revocable life insurance trust has a relatively simple task. If the trust is merely the policy beneficiary, the trustee has virtually no responsibilities, not even to ascertain if premiums are paid or the policy is in danger of lapsing. If the trust is the policy owner and beneficiary, the trustee will have to use the trust funds and contributions by the grantor or others to pay the policy premiums. At the insured's death, the trustee must file the death claim, assuming the insured's executor hasn't already done so.
It is permissible, and often the case, that the person who establishes the trust names himself as the trustee while the only asset in the trust is the right to receive policy proceeds. But in such cases, there must be at least one other individual named as beneficiary of the trust. The reason is an ancient trust rule known as the "doctrine of merger." In a nutshell, this rule requires that the trustee and the beneficiary of the trust not be identical. Otherwise, the same party would hold both legal and equitable title, an event that nullifies the existence of the trust. If the sole trustee is the sole beneficiary, the trust is dissolved.
It is sometimes suggested that a trust should never have the following: (10)
1. one of two or more beneficiaries as sole trustee; or
2. one of two or more trustees as sole beneficiary; or
3. beneficiaries who are the same persons as the trustees.
Many expert planners suggest that someone other than the grantor be named as trustee because of the difficulty of accomplishing a smooth succession if the grantor becomes incapacitated. If the trustee is a corporate trustee, on the other hand, management of trust assets can continue without interruption even if the grantor becomes physically or mentally incapacitated. A potential compromise is for the grantor to be co-trustee. In any event, provision should be made for at least two or three successor trustees to take over administration of the trust in the event the current trustee, for whatever reason, cannot or will not continue to serve.
ESTATE TAX IMPLICATIONS
There are a number of estate tax related issues that must be considered with respect to revocable life insurance trusts. One concerns inclusion of trust assets. A second relates to the taxation of proceeds from policies owned by a third party but payable to the revocable trust. A third concerns the mechanism through which policy proceeds payable to a revocable trust can be used to provide estate liquidity.
1. General estate tax inclusion issues--Picture the box that represents a trust. Now imagine that the client retains a string on that box that enables him to pull back the assets in the box at any time or use the income from the assets in the box for any purpose. Precisely because the client retains until death that right to alter, amend, revoke, and terminate the revocable trust, all the assets in such a trust will be included in the client's estate. The provision that encompasses such transfers is IRC Section 2038 which deals with lifetime gratuitous transfers in which the transferor retains the right to alter, amend, revoke, or terminate the gift. So revocable trusts, contrary to what is sometimes conveyed to the public, provide absolutely no shelter from the federal estate tax. Policy proceeds and any other assets in the trust at the client-grantor's death are estate tax includable.
2. Third party owner issues--Can the IRS include a life insurance policy in an insured-decedent's estate merely because the policy names a revocable trust established by the decedent as beneficiary? The IRS has (unsuccessfully) argued that by virtue of his power to "appoint" (i.e., direct the disposition of) trust property, the grantor of a revocable trust had to include in his estate a policy on his life purchased and owned by his spouse. In other words, through the ability to change the trust and its beneficiaries, the husband had the indirect ability to change the beneficiary of the life insurance. But the court held that unless the property over which one holds a power was in existence prior to the decedent's death, there is nothing to tax. In this case, the insured-decedent had a mere expectancy. (11)
But there are other traps for the unwary. For instance, the IRS will argue that even though the proceeds may not be estate tax includable under these facts, when the insured's death occurs, the surviving spouse (who was the policy owner) is deemed to have made a gift to the other beneficiaries. For instance, if the trust set up by the deceased insured provided income to the surviving spouse for life with the remainder passing at her death to her children, the IRS would claim that, at the moment the insured died, a gift equal to the present value of the children's remainder interest was made by the wife. Worse yet, since the surviving spouse is deemed to have made a gift (the remainder interest) but retained a lifetime income from the gift, the IRS would claim that the entire amount in the trust at the time of her death should be included in her estate. (12)
3. Providing estate liquidity--The trust document should provide that assets in the trust at the decedent-insured's death can (or even must) be used to (a) pay the expenses, administrative costs, and taxes of the estate, and (b) of the surviving spouse's estate if other funds are not available. But planners should note that if the surviving spouse is the trustee or has the power to appoint the trustee, the IRS could argue that the proceeds should be included in the surviving spouse's estate to the extent those proceeds could be used if the trustee is required (or even authorized) to pay the surviving spouse's debts, administrative expenses, or taxes.
Of course, the revocable life insurance trust, although not technically an estate tax planning vehicle, can save estate taxes and thereby enhance relative liquidity through use as a nonmarital trust and/or marital trust. In other words, there is no reason why a revocable life insurance trust established during a client's lifetime can't be used as part of an overall tax planning arrangement to lower estate taxes in the estates of a married couple. The trust can form either the marital or nonmarital share or even provide for both shares. This would allocate a portion of the estate into a CEBT (Credit Equivalent Bypass Trust), so that an amount equal to the credit equivalent (equal to $2,000,000 in 2007) would pass to it without tax, and the balance of the assets passing into the trust would pass to the surviving spouse in a manner qualifying for the marital deduction.
GIFT TAX IMPLICATIONS
There are only a few gift tax considerations with respect to revocable trusts. But they can be significant:
* No gift until the client gives up power to revoke--A direct gift of an asset from a client to a revocable trust will not cause any gift tax, because the client has never parted with dominion and control of the assets placed into the trust. This rule applies up until the moment when the client gives up the right to alter, amend, revoke, or terminate the trust. But if the trust becomes irrevocable for any reason during the client's lifetime, at that moment, since the client can no longer control the use, possession, or enjoyment of the property transferred into the trust, the client has made a gift.
Note that gift tax implications are based on the value of trust assets as of the date the grantor parts with dominion and control. For example, assume a client creates a revocable life insurance trust and retains the power to revoke the trust anytime until the youngest beneficiary reaches age 21. At that date, the client loses all dominion and control over the trust's assets and the gift becomes complete. Gift taxes will be based on the value of the assets in the trust at that time.
* Third party payment of premiums is a gift--If someone other than the grantor of the trust pays premiums while the trust is revocable, the IRS will treat such payments as gifts directly to the grantor even if the payor is a possible beneficiary of the trust or heir to the grantor.
* Gift when policy owned by other than insured is paid to third party--Whenever an insurance policy is owned by one party on the life of a second party and is payable to a third party, there is almost always a potentially serious and adverse tax consequence. For instance, suppose a revocable trust is set up by a client's wife for the benefit of her children. Suppose she contributed to that revocable trust a $1,000,000 policy on the life of her husband. The IRS will argue that, at the husband's death, the wife (who as owner, both before and after the transfer to the revocable trust) could have been the beneficiary of the proceeds. When instead, policy proceeds are paid to the trust (i.e., to her children), the wife is making a $1,000,000 (indirect but nevertheless taxable) gift to her children. Since she could have revoked the gift at any time, the gift from the mother to the children did not become complete at the moment of the husband's death. However, the gift does become complete when the trust becomes irrevocable (or the trust is included in her estate if the power to revoke is retained until death). Furthermore, the value of the gift includes proceeds, which are generally worth substantially more than the value of the policy or premiums when transferred to the trust.
INCOME TAX IMPLICATIONS
For most income tax purposes, there is no significant impact when assets are transferred to a revocable living trust. The client must report trust income, losses, deductions, and credits as though they were personally incurred. No fiduciary income tax return need be filed if the client who establishes the trust is also the trustee. (This suggests that the grantor of a revocable trust should be the trustee or co-trustee). This tax theory that the revocable trust is the income tax alter ego of the grantor is known collectively as the grantor trust rules. But if the grantor is not the sole or co-trustee, the trust must obtain a separate ID number and file information form 1041.
Usually, the holding period of the client is tacked on to the holding period of the trust for purposes of determining capital gain and loss when an asset transferred to a revocable trust is sold. But if, for any reason (such as the death or permanent incapacity of the grantor), the trust becomes irrevocable, a new holding period begins. That period starts on the day the trust becomes irrevocable. Planners should also note that if the trust becomes irrevocable during the grantor's lifetime, and then the grantor dies, the basis of the assets in the trust may not receive a step up. (13)
The ability to treat the grantor and the trust synonymously for most income tax purposes means that it is generally safe to transfer installment obligations, (14) a principal residence, (15) a partnership interest, (16) or a U.S. savings bond (17) to a revocable living trust.
There are, however, some important exceptions to the rule that generally transfers of assets to or from a revocable trust have no adverse income tax implications. There are several assets that, if transferred to a revocable trust, will not have the expected tax neutral effect and instead result in adverse consequences. (18) These assets include: (1) S corporation stock; (2) professional corporation stock; (3) Section 1244 stock; (4) Incentive Stock Options; and (5) IRAs, retirement plans, and annuities.
1. S corporation stock problem--The problem here is particularly dangerous since it occurs, not during the client's lifetime, but rather, after his death. If the revocable trust does not meet S corporation requirements under IRC Section 1361 (essentially requiring all income to be distributed currently to one beneficiary or that the trust be taxed at the highest income tax rate), the S election may be inadvertently terminated. S corporation stock can be owned by a revocable trust until the trust becomes (for whatever reason) irrevocable. So if the trust becomes irrevocable (for instance at the grantor's death), S corporation stock must generally be transferred out of the trust within two years.
2. Professional corporation stock problem--Most states allow only professionals to hold the stock of a professional corporation. This may not include a revocable trust.
3. Section 1244 stock problem--Ordinary, rather than capital loss, is allowed when stock in a small business corporation (defined in IRC Section 1244) is sold at less than its basis. But this favorable treatment does not apply if the seller is either an estate or trust. For favorable tax treatment, the seller must be an individual. So the loss on a sale by a revocable living trust of closely held stock would be a capital rather than an ordinary loss.
4. Incentive stock option problem--An incentive stock option (ISO) is a right to purchase stock issued to corporate employees and contain certain statutory tax advantages. (19) The ISO must be granted to a specific employee and must be expressly nontransferable as long as the employee lives. But if the options are held by a revocable trust, the tax advantages will be denied. The transfer to a revocable trust may be considered a taxable disposition.
5. IRAs--Although revocable trusts are often the beneficiary or contingent beneficiaries of IRAs and qualified retirement plans, some authorities caution that it may not be possible to roll benefits over tax free (as would be the case if the client's spouse were the recipient).
There may also be problems when trust assets are distributed to beneficiaries. One such potential problem concerns the loss disallowance rules. Losses may be disallowed when assets are distributed to beneficiaries after the grantor's death to fund a pecuniary (specific dollar amount) bequest. (20) Furthermore, the rental loss deduction allowed for losses incurred of up to $25,000 a year can be used to offset other income of an estate (provided the decedent actively participated in the property's management), but no such deduction is permitted to a trust.
It is a delusion to think that a client protects himself or his beneficiaries from creditors by placing assets in a revocable trust. The avoidance of probate does not equate to the avoidance of creditors. Creditors clearly have access to the assets in a revocable life insurance trust until and unless the client dies or for some other reason the trust becomes irrevocable. All states currently allow creditors access to any assets the client can revoke or liberally amend. Furthermore, where creditors of an estate generally have a very short period of time to press their claims (4 to 6 months in many jurisdictions), creditors of a trust have no such abbreviated deadline and can file suits even years after the grantor's death as long as the time is within the statute of limitations (as long as 6 or 7 years in some states).
COORDINATING THE REVOCABLE TRUST WITH THE OVERALL ESTATE PLAN
No tool or technique, no matter how useful, should be employed in a vacuum. For this reason, the revocable life insurance trust must be meshed with the overall estate plan. Therefore, the planner must consider the following when suggesting the use of a revocable trust (no matter how it is to be funded). (21)
Importance of a will. A will is necessary in almost every estate plan for many reasons:
* Few clients will take the time or trouble to place all their assets into a revocable trust no matter what real or even perceived advantages there are.
* No matter how careful and diligent a client may have been about assigning assets to a revocable trust, there will almost always be some asset, such as a car, household items, or jewelry, that will unintentionally be missed and that will pass through intestacy absent a valid will. There may be some assets, such as the proceeds from a lawsuit arising out of the wrongful death of the client, that would be impossible for the client himself to assign to the trust. But if the will is coupled with a revocable trust, such assets can be poured over from the probate estate to the trust and unified with other estate assets. (Note that the trust should be in existence before the execution of the will since, in some states, a provision in a will referring to a trust created after the signing of the will is not recognized).
* There are certain objectives that can only be accomplished by will. For instance, a client can't appoint guardians of the person for his children in a trust, but a will can provide for both guardians and backups.
Importance of a Durable Power of Attorney. A power of attorney is a relatively simple and inexpensive legal document by which a client gives a spouse, child, other relative, or trusted friend (technically called the attorney-in-fact) the legal right to act on behalf of the client and in his place with respect to specified financial matters. The power of attorney can be drawn as broadly or as narrowly as desired.
The power of attorney should generally be "durable." This means the power given to the agent is not affected by the client's subsequent disability or incapacity. (Each state has slightly different magic words that make a power durable).
A well drafted power may negate the need to petition a court to have a guardian or conservator appointed to handle assets during the client's lifetime that have not already been placed into the revocable trust. In the case of a revocable life insurance trust where the trust has been formed but the only asset in the trust is the trust's right to receive life insurance proceeds, the coordination of the durable power with the trust is essential to protect the client. This planning is essential, not only if the client is suffering from a physical disability or illness that could lead to permanent or long term incapacity, but also by healthy clients who would like to assure continuity of management of assets if for any reason they can't handle their own affairs for a period of time. If the power is broad enough, the attorney-in-fact could transfer assets into the previously established revocable trust. (22)
(1.) Simmons, 210-2nd T.M., Personal Life Insurance Trusts.
(2.) From Leimberg, "Trust Me: A Nutshell Primer on Trusts," (Financial Data Center).
(3.) Advanced Sales Reference Service, Sec. 48, 110 (The National Underwriter Company).
(4.) Advanced Sales Reference Service, Sec. 48, 120 (The National Underwriter Company).
(5.) Advanced Sales Reference Service, Sec. 48, 120 (The National Underwriter Company).
(6.) Tax savings goals can often be accomplished with irrevocable life insurance trusts. See Chapter 30 on Irrevocable Trusts.
(7.) See the Advanced Sales Reference Service (The National Underwriter Company) for a summary of state laws in this area.
(8.) A list of statutes of the various states that permit fiduciaries to invest in life insurance canbe found in the Advanced Sales Reference Service, Sec. 12, 110 (The National Underwriter Company).
(9.) For a discussion of the rule against perpetuities, see the Advanced Sales Reference Service, Sec. 51, 1270.2 (The National Underwriter Company).
(10.) Advanced Sales Reference Service, Sec. 48, 120 (The National Underwriter Company).
(11.) Est. of Margrave v. Comm., 45 AFTR 2d 1148,393 (8th Cir. 1980); Rev. Rul. 81-166, 1981-1 CB 477.
(12.) IRC Sec. 2036(a).
(13.) See IRC Secs. 1014(b), 2511.
(14.) Were the trust considered a separate income tax entity, the transfer of a client's right to receive installment sales payments to the trust would be considered a taxable disposition of the obligation. That would trigger an immediate acceleration of the entire deferred gain.
(15.) Here, the client will not want to jeopardize the ability to exclude up to $250,000 ($500,000 in the case of certain married couples) of gain from the sale of a personal residence. Since the revocable trust and the grantor are considered for income tax purposes as the same entity, the holding period for the personal residence by the trust and the grantor can be added together making it more likely that the client can qualify for the exclusion for gain from a principal residence. But if the client is not considered the owner of the entire trust, the IRS may deny the exclusion for gain. Planners should also note that some states (such as Florida) will not honor a homestead exemption if the deed is registered in the name of a revocable trust.
(16.) One of the most important estate planning post death elections is the one that allows a step-up in basis of the underlying assets of a partnership upon the death of the partner. This IRC Section 754 election will not be lost though a transfer of a partnership interest to a revocable trust.
(17.) The holder of a Series E, EE, H, or HH bond need not worry that a transfer to a revocable trust will trigger an acceleration of income. All interest income will be reportable by the client when the trust cashes in the bonds or they mature.
(18.) See Gassman, Robinson, and Conetta, "Living Trust Checklist," The Practical Lawyer, Fall 1991, Pg. 89. Planners should also note that there are tax problems when the assets used to fund a living trust are generating passive activity losses.
(19.) For additional information on ISOs, see The Tools & Techniques of Employee Benefit and Retirement Planning.
(20.) IRC Sec. 267.
(21.) See Hira, "Revocable Trusts: Appealing But Beware," Journal of Accountancy, October 1991, Pg. 91.
(22.) For more on powers of attorney, see The Tools & Techniques of Estate Planning.
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|Title Annotation:||PART II TECHNIQUES|
|Publication:||Tools & Techniques of Life Insurance Planning, 4th ed.|
|Date:||Jan 1, 2007|
|Previous Article:||Chapter 34: Pension maximization.|
|Next Article:||Chapter 36: Section 162 plans.|