Grantor-Trust ILIT Gives Ultimate Flexibility

Grantor-Trust ILIT Gives Ultimate Flexibility

By John S. Budihas

Though Irrevocable Life Insurance Trusts cannot be modified, they need not be inflexible. The creator of the ILIT can build flexibility into the trust instrument to accommodate future and unforeseen family needs, anticipate tax law changes and provide for unborn descendants.

The ILITs creator can provide flexibility in several ways: for instance, by giving the primary beneficiary of the ILIT a general or special power to distribute trust assets in accordance with the provisions of his or her last will and testament. This technique can be a safe harbor to avoid unforeseen generation-skipping transfer-tax consequences if, for example, the primary beneficiary is a child of the ILITs creator.

Flexibility also can be obtained by giving someone who has no beneficial interest in the ILIT (perhaps an independent trustee) the power to modify the existing provisions of the ILIT.

Often called a "protector provision," this power can include the ability to add and remove trust beneficiaries.

The ILIT's creator also can give an independent trustee the power to distribute the life insurance policy owned by the ILIT to the ILITs beneficiary. The trustee also can be given the power to borrow from the policy and lend the proceeds to anyone; terminate the ILIT and distribute the policy to another trust; shift the location of the ILIT to another state; sell the policy to anyone; or purchase assets from the creators estate for the use of the ILITs beneficiaries throughout their lifetime.

In addition to providing flexibility for the disposition of the ILITs assets, it may be beneficial, in some instances, for a client to create a defective, or grantor-trust, ILIT. A grantor-trust ILIT causes the creator or grantor of the ILIT to be taxed on the income earned by the ILIT.

Thus, although the ILIT is effective with respect to removing the trust assets from the grantors taxable estate, it is defective with respect to removing the trust income from the grantors taxable income. A grantor-trust ILIT can open the door to a multitude of planning opportunities.

A grantor-trust ILIT is created by violating (usually intentionally) one or more of the provisions of Internal Revenue Code Sections 673 through 677. For example, a grantor-trust ILIT results when the grantor reserves the power to re-acquire trust assets by substituting assets of equivalent value. Or, when the trustee is given the discretionary power to make a loan to the grantor without charging adequate interest. Another instance occurs when a party that does not have an interest in the trust (a non-adverse party) is empowered to add or remove a beneficiary. The trustee also could use trust income to pay a life insurance premium on the grantors or grantors spouses life without the consent of someone with a beneficial interest in the trust.

These are just some of the ways in which a grantor-trust ILIT may be created.

Here's one example of how the estate planning benefits of an ILIT can be enhanced through the use of a grantor-trust ILIT. Henry and Jane have a multimillion-dollar estate. They have several estate-planning objectives, including providing estate liquidity through the use of life insurance. They also want to preserve (to the extent possible) their unified credits during their life; avoid the use of those complex Crummey powers (especially the powers that hang from year to year); and reduce the size of their taxable estate with minimum or no federal income or transfer tax consequences.

The use of a grantor-trust ILIT in combination with a family limited partnership may achieve these objectives. How does this work?

Henry and Jane establish a FLP and transfer to it some of their assets, taking back general and limited partnership interests. Henry and/or Jane then create a grantor-trust ILIT and "gift" to it some of their assets. Henry and Jane gift $100,000 to the grantor trust ILIT.

Henry and/or Jane and the grantor-trust ILIT would then enter into a sales agreement in which limited partnership interests in the FLP are sold to the grantor-trust ILIT.

For example, lets assume that Henrys limited partnership interest worth approximately $1.8 million is up for sale. A professional appraisal has determined that this interest is actually worth approximately $1 million, after taking into account minority interest and limited marketability valuation discounts. Total discounts equal approximately 44 percent.

Henry and the independent trustee of the grantor-trust ILIT enter into a sales agreement for Johns limited partnership interest. The trustee agrees to purchase the discounted limited partnership interest with an interest-only promissory note that will balloon or become payable in 10 years. The interest to be paid is determined by reference to IRC Section 1274(d).

In this case, lets assume the annual interest equals 6 percent. Thus, a $60,000 interest payment would be payable by the grantor-trust ILIT to John over the 10-year period ($1 million x 6 percent).

Henrys and Janes initial gift of $100,000 to the grantor-trust ILIT represents "seed" money for the subsequent sales agreement between Henry and the grantor-trust ILIT.

The purpose of this seed money is, in part, an attempt to avoid the argument by the IRS that Henrys transfer of his limited partnership interest to the grantor-trust ILIT is a transfer with a retained interest.

A transfer to an ILIT with a retained interest would cause the fair market value of the transferred asset to be included in the transferors estate. The seed money attempts to avoid the argument that the interest payments from the grantor-trust ILIT to Henry represents an income interest in the ILIT.

A gift equal to 10 percent or more of the fair market value of the asset sold to the ILIT is generally thought to be advisable. In Henrys case, he and Jane have gifted 10 percent of the $1 million discounted limited partnership interest.

Finally, the grantor-trust ILIT purchases a multimillion dollar life insurance policy on Henry. Lets assume that the $1.9 million fair market value of the trust property (the $1.8 million asset plus $100,000 seed money) earns 10 percent or $190,000 per year. The $130,000 net income ($190,000 minus $60,000 interest payments) realized by the grantor-trust ILIT can be used to pay the premium for a single life insurance policy on Henry.

Should Henry die during the term of the promissory note, the unpaid principal of the installment note is included in his estate for federal estate-tax purposes.

Some commentators have recommended the use of a self-canceling installment note rather than a standard balloon note. In this way, any outstanding obligation would be canceled at death, thereby avoiding any estate-tax obligation. If, on the other hand, Henry survives the term of the note, the grantor-trust ILIT should have more than enough resources to repay the $1 million purchase price.

The benefits realized? Henrys income tax payments on the grantor-trust ILITs income of $190,000 are like additional tax-free gifts to the ILITs beneficiaries. He does not pay federal income tax on the interest payments he receives from the grantor-trust ILIT. He also can use these tax-free interest payments to pay the federal income taxes due on the grantor-trust ILITs income. His payment of the income tax on the income of the grantor-trust ILIT is determined based on his marginal rate of income tax and not by the potentially higher ILITs marginal rate.

The sale price of the limited partnership interest is discounted by the allowable limited marketability and minority interest valuation discounts. However, the grantor-trust ILIT would continue to earn income on the assets true market value, $1.9 million, rather than discounted market value, $1.1 million.

And Henry and Janes generation skipping transfer tax exemptions of $2.06 million (for 2000) are preserved, since only $100,000 of their combined exemption needs to be allocated to this, the only gift to the grantor-trust ILIT. No allocation of the exemption is required for the $1.8 million non-discounted limited partnership interest sold to the ILIT.

What are the potential estate tax savings that could be realized by Henry and Jane by adopting this strategy? In 10 years, with 10-percent compounded growth, the $1.9 million could grow to $4,928,110 within the grantor-trust ILIT. Without this strategy, Henry and Janes estates would have grown to this same $4.9 million, but any subsequent transfer to family members would trigger federal-gift and/or estate-tax consequences. This potential multimillion dollar asset transfer from the grantor trust ILIT to family members was leveraged with only an initial $100,000 gift.

Should both Henry and Jane die in the 10th year, the value of property transferred could be significantly enhanced by any life insurance owned by the grantor-trust ILIT on one or both of them.

Ultimately, the multimillion-dollar assets in the grantor-trust ILIT can be received by its beneficiaries free of federal estate, gift and generation skipping transfer taxes. Should the ILIT have a "protector provision" and be domiciled in a state without perpetuity limitations, i.e. states that have no rule against perpetuities, like South Dakota, then the ILIT can continue to provide similar tax benefits for future generations of lineal descendants.

You may have good reason to review the ILITs of your existing clients to see whether or not they are, in fact, grantor-trust ILITs. If they are, review the additional planning opportunities that may be available.

John Budihas,CLU,ChFC,CFP, is an independent business, estate and trust planning consultant for Hartford Life, in Corrales, N.M. He can be reached by email at john.budihas@hartfordlife.com.

John S. Budihas

Grantor-Trust ILITs

Reproduced from National Underwriter Life & Health/Financial Services Edition, June 12, 2000. Copyright 2000 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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