The "Revocable-Irrevocable"Life Insurance Trust

By Maurice R. Kassimir and Melvin L. Maisel

Use of survivor life insurance in an irrevocable life-insurance trust is a viable estate planning tool. One disadvantage is the very fact that the terms and conditions surrounding the trust are irrevocable. One way to get around this is to fund the trust with life insurance carried in a profit sharing plan. Such funding provides the flexibility of a revocable trust.

A major problem for many estates is the lack of liquidity to pay estate taxes. This problem can arise when an individual owns real estate or the largest asset in the estate is a closely-held family business. Taxable estates that have the liquidity to pay the estate tax must use "choice" income producing assets resulting in a loss of income to the family. Quite often, the solution to solving the liquidity problem is the acquisition of survivorship life insurance, also known as second-to-die life insurance. Funds may not be available to pay large premiums, however. In addition, there may be significant adverse gift tax consequences in the event large premiums are required. This can have the effect of a much larger cash outlay that keeps increasing due to the creeping gift tax bracket. Over the years, we have been involved with an exciting estate planning technique that allows for the acquisition of large amounts of survivorship life insurance in profit sharing plans to assist in solving significant estate tax problems.

Many practitioners are unaware the funds in these plans can be used to solve substantial estate tax problems. Not only are the account balances of the business owners available but so are the account balances of the spouse and children in the business. Thus, multiple accounts, including rollover individual retirement accounts (IRAs) that have not been commingled with personal IRA funds, can be used as a source of funds for making premium payments.

Traditionally, an irrevocable life insurance trust (ILIT) is used to insulate the life insurance proceeds from inclusion in the taxable estate. It is possible to use the pre-tax dollars in the profit sharing plan in conjunction with an ILIT in a manner that avoids casting in stone the irrevocable provisions of the ILIT. Furthermore, the business owner or professional retains the ability to continue to make tax-free gifts to family members, can avoid using his or her unified credit, and can avoid the imposition of gift taxes if the unified credit has already been gifted away. In addition, the right to access the cash value at all times is retained. When the ILIT is created and funded, the dispositive provisions are irrevocable. Circumstances change and grantors change their minds and often regret the inability to alter the provisions of the ILIT. The planning technique envisioned here will permit the terms of the ILIT to be cast in sand, thus allowing changes at any time during the participant's life. The specifics of this exciting planning technique, the "revocable-irrevocable," trust are discussed in detail later. But first there needs to be an understanding of the implementation aspects of the survivorship ILIT.

Estate Planning Tool

One of the best, if not the best, techniques available to an estate plan is the ILIT. With the advent of survivorship life insurance, the ILIT has become the most popular and important estate planning legal document, next to the last will and testament, and is generally used to solve the problems of many individuals with taxable estates. The use of an ILIT enables an individual to provide their executors with the liquidity to pay estate taxes without the inclusion of those proceeds in their estate. This is accomplished by permitting the ILIT to purchase assets from the decedent's estate with the insurance proceeds.

Basis for Exclusion

IRC Sec. 2042 provides that life insurance on an insured's life is includable in the estate if the proceeds are payable to the executor of the insured's estate or if the insured retains any "incidents of ownership" with respect to the insurance policy. Under most circumstances, if the insured does not own the policy, does not retain the right to borrow against the cash surrender value, or does not retain the ability to change beneficiaries, the proceeds of insurance can escape estate taxation. To avoid falling within the parameters of IRC Sec. 2042, most estate planners suggest the creation of an ILIT that will remove all "incidents of ownership." Even though the children can be the owners of the policy without the proceeds being included in the parent's estate under IRC Sec. 2042, an ILIT is generally recommended to avoid any complications that may arise as a result of a divorce or death of a child. The ILIT prevents the spouse of the child from potentially becoming an owner or co-owner of the life insurance and permits the insurance proceeds to pass down the bloodlines.

Trust Provisions

For insurance proceeds to be excluded from the estate, a life insurance trust must be irrevocable. Under the typical scenario, the insured will gift to the ILIT an amount equal to, or exceeding, the annual insurance premium. A gift to the ILIT generally does not qualify for the $10,000 gift tax annual exclusion under IRC Sec. 2503(b) since it is a gift of a future interest rather than of a present interest. IRC Sec. 2503(b) provides that only a gift of a present interest will qualify for the annual gift tax exclusion. To qualify for the annual gift tax exclusion, the documents surrounding the ILIT require what has become known as a "Crummey" power. A Crummey power gives the trust beneficiary or beneficiaries, typically the children, the right to withdraw their pro rata share of the contributions to the ILIT. To ensure the transfer to the trust is a gift of a present interest, the trustee of the ILIT must give written notification to the trust beneficiary or beneficiaries of the existence of the withdrawal or Crummey power. It is preferable for the trustee to give annual notification. To avoid an oversight, however, two steps should be undertaken at the creation of the ILIT. The first is to have each beneficiary execute a waiver of future notices. The second is to send, with the initial notice, information regarding the amount of the projected insurance premium with due dates.

This will provide the beneficiaries with an estimate and timing of future contributions to the ILIT. This withdrawal privilege makes the transfer to the trust a gift of a present interest. While, generally, the withdrawal power is never intended to be exercised, the mere existence of the withdrawal power establishes the gift as one of a present interestÑthereby qualifying the contribution to the ILIT for the annual gift tax exclusion. As an example, if there are three beneficiaries under an ILIT and a gift of $18,000 is made to the ILIT, a Crummey power, with appropriate limitations, would allow each beneficiary to withdraw $6,000.

The Crummey power typically provides the withdrawal privilege will lapse at a particular time. Under IRC Sec. 2514(e), a lapse of power by a beneficiary is deemed a gift of a future interest to the other remaindermen of the ILIT to the extent the lapse of the power exceeds the greater of $5,000 or 5% of the trust principal. In the above example, a gift of $667 would be made by each beneficiary to the other two remaindermen on the lapse of the $6,000 withdrawal power. The gift is calculated as follows: $6,000 gift less $5,000 [the IRC Sec. 2514(e) threshold] = $1,000. Since a person cannot make a gift to him- or herself, two-thirds of the $1,000 amount, or $667, is a gift. Under certain circumstances, the ability to make the withdrawal may continue to another year to avoid these gift tax problems under a procedure known as a "hanging Crummey power." The provisions in the ILIT establishing the Crummey power and the hanging Crummey power are highly technical provisions and should be drafted by an experienced attorney. While Technical Advice Memorandum 8901004 provided that the hanging Crummey power, under a specific set of facts, was void as being against public policy, most experienced attorneys believe a properly drafted hanging Crummey power will still be effective.

Major Weaknesses of the ILIT

When an ILIT is drafted, the grantor is making an uninformed judgment regarding the future. A shortcoming of an ILIT is the fact the document cannot be modified: The terms of the ILIT are cast in stone and cannot be changed for any reason. If it is necessary to change any of the provisions of the ILIT, it will be necessary to start all over, at which time the insureds may be uninsurable. Even if they are insurable, there may be increased premiums resulting from health changes and an increase in age.

An attorney may be able to account for certain contingencies in the ILIT. However, even an experienced draftsman cannot foresee all possibilities. Planning for such contingencies generally requires that the trustee have significant discretion. On the other hand, giving the trustee too much discretion may be risky.

The typical ILIT, in addition to containing the Crummey power, provides for the distribution of principal to children and grandchildren (heirs) at specific ages. For example, the ILIT might require that the trustees pay one-third of the principal of the trust when the beneficiary reaches age 30, one-half of the balance upon attaining age 35, and the remainder at age 40. It is extremely important that the insured carefully consider which pay-out dates have been selected since, once again, the trust is irrevocable. Careful consideration is critical since the insureds would like a payout scheme that would contribute to the beneficiaries leading successful and productive lives. Paying out the principal too early may have an unwanted result.

The irrevocable feature of the ILIT may have the unintended consequences of paying out principal before the heirs are sufficiently mature and established to receive the funds. Mandatory pay-outs of principal may end up being ill timed and detrimental to the lives of the beneficiariesÑcertainly not intended when the trust agreement was drafted.

The foregoing are not the only concerns that make planning for insurance proceeds important. Under certain circumstances, the heirs may not be treated exactly the same. There are situations in which some of the heirs may be involved in a family business and others may not. In addition, even the heirs in the business may have varying percentages of ownership interests. There may be other reasons why a parent may wish to give a disproportionate interest in the estate to one heir over another. Under those circumstances, it is critical that the interests of the heirs under the ILIT mirror the interests of the heirs under the Will. Otherwise, the executor would not have the ability to pay estate taxes on behalf of the children in a manner that represents each heir's interest in the estate. If the grantor of the ILIT was given the option of minimizing or eliminating the possibility of error or regret with his family financial planning designed to benefit the heirs, what route would he or she choose?

The Solution to the Problem: The "Revocable-Irrevocable" Trust

An important estate planning technique that allows the grantors to maintain total flexibility, thereby allowing them to change the potential beneficiaries and the dispositive provisions of the ILIT is the acquisition of survivorship life insurance in a profit sharing plan.

Using a Profit Sharing Plan as An Estate-Planning Tool

The ability to change beneficiaries, modify dispositive provisions, use pretax dollars to pay insurance premiums, purchase survivorship life insurance with retirement funds, and avoid any gift tax consequences is the ideal position from which to do estate planning. An article addressing these subjects, "Using a Profit Sharing Plan as an Estate Planning Tool," by Andrew J. Fair, Esq., and Melvin L. Maisel was published in The CPA Journal in August, 1991. A number of important post-mortem planning suggestions involving survivorship life insurance in profit sharing plans were included, and the reader should refer to the article if the techniques discussed in this article are utilized.

The Benefits of Using the Profit Sharing Plan

A plan participant may always amend the beneficiary designation with reference to his or her profit sharing account. Under the planning technique involving survivorship life insurance, there will typically be wording designating an ILIT as the beneficiary of the survivorship life insurance policy on the death of the participant. It is not until the death of the participant that the survivorship policyÑwhich after the participant's death becomes a single life policy on the surviving spouse's lifeÑwill be owned by the ILIT. Until the death of the plan participant, the beneficiary designation can be changed. In fact, a new "Revocable-Irrevocable" trust can be created to be the beneficiary of the insurance policy. It is by maintaining the flexibility to change the beneficiary designation that the participant can "look back" to determine if the provisions in the ILIT should be changed. As long as the participant is alive, he or she can determine whether the heirs are mature enough and intelligent enough to handle the proceeds of insurance that will fund the ILIT upon the second death. Thus, if an heir turns to drugs or alcohol or has a physical or mental handicap, a new ILIT can be established to address those concerns.

Again, if the children are treated unequally, it is likely the provisions of the Will will be changed during the individual's life, and the percentage interest of each child will change at various points in time. Since it is critical that the percentages under the ILIT mirror those under the Will, having the insurance owned in the profit sharing plan maintains that flexibility. The typical ILIT arrangement does not take into account a change in circumstances.

What if the Nonparticipant Spouse Dies First?

If the non-participant spouse dies first, the profit sharing plan merely owns a single life policy on the life of the plan participant. To avoid estate tax inclusion in the participant's estate, the policy must be immediately removed from the profit sharing plan. In either event the participant will then make a gift equal to the cash value of the policy to the ILIT. Under IRC Sec. 2035, however, if death should occur within three years, the life insurance proceeds will be included in the plan participant's estate. Another choice is to have the children purchase the policy from the profit sharing plan for the policy cash value. However, the children will be in receipt of taxable income for death proceeds in excess of the premiums paid due to the transfer of value rules under IRC Sec. 101.

In order to avoid the transfer for value problems, a family partnership including the children and/or the ILIT should be created. The purchase by the children will not cause an income tax to be paid on the insurance proceeds when received due to an exception to the transfer for value rule which allows a partner of the insured to purchase the policy. Because a purchase is involved there is no gift. As a result, there is no three-year waiting period.

If ongoing premiums are required, the children can receive a gift from the insured parent, pay the premiums from personal funds or enter into a split-dollar agreement with the corporation. There are a number of alternatives and considerable flexibility to handle future unknown problems.

What if a Profit Sharing Plan Does Not Exist?

If a profit sharing plan does not exist, in many situations a plan can be created, and if the business owner or professional has an IRA rollover account with funds that were never commingled with a personal IRA, those funds, when needed, can be rolled into the profit sharing plan and used to pay premiums.

In addition to the flexibility described above, the acquisition of a survivorship life insurance policy through a profit sharing plan has other benefits that are described in the August 1991 article. These include the fact that pretax dollars are used to pay for the insurance and that neither the $10,000 annual exclusion nor the unified credit is used, thus allowing the parents to reduce their taxable estates through an aggressive gift-giving program.

Be a Monday Morning Quarterback

The planning technique suggested allows a participant to purchase survivorship life insurance that can be excluded from the estate, yet retain the ability to "look back" and make necessary adjustments in the estate plan. It also allows clients who might otherwise not consider purchasing insurance to make such a purchase. Since many participants will never need the funds in the profit sharing plan, the availability of money in those plans may provide the incentive to implement this extremely beneficial planning technique. By using a profit sharing plan as an estate planning tool, the grantor maintains the ability to be a Monday morning quarterback and can always look back to determine if the beneficiary designations and the dispositive provisions of the ILIT should be modified. The "revocable-irrevocable" trust coordinated with family financial planning should not be overlooked. *

Maurice R. Kassimir, JD, LLM is a partner in the New York law firm of Spielman & Kassimir. He is also a principal in estates and trust in the accounting firm, Mahoney & Cohen, P.C. Melvin L. Maisel, is chairman of Cornerstone Bank of Stamford, CT and president/CEO of Stabilization Plans for Business, Inc., White Plains, NY.

Copyright 1995 Maurice R. Kassimer and Melvin L. Maisel

SEPTEMBER 1995 / THE CPA JOURNAL