Irrevocable life insurance trusts (ILITs) are useful and powerful tools, and have been a staple of estate and asset protection planning for quite some time; however, as laws and personal circumstances continue to change with each passing decade, those once cutting-edge ILITs drafted in years past may not be serving the objectives that inspired their creation, and clients may want to essentially revoke the irrevocable.
Fortunately, there are viable options to do this without triggering adverse tax results.
Reviewing ILIT objectives, purpose.
Ascertain how the ILIT is no longer serving the client's needs, as updated planning may determine the best course of action to effect a modification. The most common reasons for modifying an existing arrangement include:
- Financial wherewithal to maintain policy premiums or long term viability of the policy.
- Diminished perceived benefits due to changes in the transfer tax laws.
- Identity of desired trust beneficiaries due to marital status changes or family strife.
- Concerns over early distributions/termination to trust beneficiaries.
Potential options to modify.
- Policy sale. Because the trustee of the ILIT owes a fiduciary duty to the beneficiaries, a trustee may not generally effect a distribution of a policy directly to the non-beneficiary insured. For a trust that no longer meets the insured’s planning objectives, the trustee may generally sell the policy to the insured for the fair market value of the policy.
- Trustee's discretion to terminate/distribute. Often, provisions exist that permit the trustee to terminate a trust based upon its size or the inherent administrative burdens relative to the benefits remaining. Also, depending on the express terms of the document, the trustee may employ liberal discretion to distribute principal or income outright.
- Powers of appointment. Conversely, provisions may permit a trustee or beneficiary to employ a limited power of appointment of trust assets, offering a way to direct assets to specific beneficiaries or a trust with more current distribution, tax, and asset protection provisions.
- Trust protectors. More recent ILITs may have provisions that permit modification of the trust language based on changed circumstances, tax laws, or a beneficiary's specific situation. For example, a trust protector using his or her appointed power may modify the trust language to include a special needs trust provision in anticipation of distributions for disabled beneficiaries.
- Trust decanting. Some states have recently provided a helping hand to modify a trust arrangement in the form of decanting statutes that provide a structure to move assets from older ILITs with insufficient or imperfect language to new trusts with language specifically addressing new tax laws or changed circumstances. Decanting may be especially helpful to address beneficiary distribution issues, such as when an overly strict or liberal ILIT distribution provisions are not appropriate or too restrictive for a given beneficiary.
- Judicial reformation. Of course, as a last resort, the ability to petition a court of law to modify or terminate an ILIT may be available under state law; however, depending on the jurisdiction and the sophistication level of the local judges regarding trust matters, the cost and probability of success of doing so vary somewhat. Typically, if all parties to the termination or modification agree, a court may acquiesce to a termination or modification, but a single dissenting voice can increase costs and unpredictability as to the outcome. Additionally, a judicial reformation of a trust can give rise to unintended tax consequences, as the IRS has stated that it will generally not be bound by a reformation for tax purposes.
As in all situations involving a potential modification to an otherwise irrevocable trust, a visit with an experienced estate planning attorney in the applicable jurisdiction to discuss the reasons for seeking to alter an arrangement and review potential planning options is always of paramount importance.
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