DESIGNING AND DRAFTING A MORE FLEXIBLE IRREVOCABLE LIFE INSURANCE TRUST

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1 DESIGNING AND DRAFTING A MORE FLEXIBLE IRREVOCABLE LIFE INSURANCE TRUST By Julius H. Giarmarco, J.D., LL.M. Giarmarco, Mullins & Horton, P.C. 101 W. Big Beaver Road, 10th Floor Troy, MI Phone: (248) Fax: (248) Julius H. Giarmarco, Esq.

2 I. MAINTAINING ACCESS TO THE CASH VALUE OF THE POLICY. A. Potential Problem. 1. To avoid estate tax at the death of the insured, the irrevocable life insurance trust (ILIT) must be irrevocable, and must prohibit any distributions of trust income or principal to the insured. 2. Therefore, the insured may be reluctant to give up access to policies projecting a significant buildup of cash value because of unexpected future financial needs. 3. Also, changes in the tax law or the insured s family situation might make getting the policy out of the ILIT desirable. B. Solution: Friendly Power Holder Technique. 1. The ILIT can give the grantor-insured s spouse (unless the trust owns a survivorship policy), the insured s child or another trusted individual a limited power of appointment, during the grantor-insured s lifetime, to appoint trust income and principal to anyone other than the powerholder, the powerholder s estate, or the creditors of either. 2. With such a provision, the powerholder could appoint the policy back to the grantor-insured or directly to a new ILIT with revised terms. C. Tax Consequences. 1. If the policy is returned to the grantor-insured, the death proceeds will be included in his/her estate if still owned at death. 2. However, the mere existence of such a power in the ILIT, whether or not exercised, will not cause the property still in the trust to be included in the grantor-insured s estate. a. Since the right is exercisable only in the absolute discretion of the powerholder, then the value of the reversionary interest is less than 5 percent. IRC Sec. 2042(2). b. Since the right is not exercisable by the grantor-insured, it is not a general power of appointment. IRC Sec. 2041(a)(2). c. Since the right is not exercisable by the grantor-insured, the insured does not have the power to alter, amend, revoke or terminate the transfer. IRC Sec. 2038(a)(1). 1

3 d. If there was no understanding, express or implied, between the grantor-insured and the powerholder that the powerholder would later distribute trust income or principal to the grantor-insured, then the grantor-insured will not be treated as having retained the right to possess or enjoy the trust property. IRC Sec. 2036(a)(1). 3. What are the gift tax consequences upon exercise of the power? D. Sample Provision. a. If the powerholder is a vested beneficiary of the trust, there would be a gift equal to the present value of the powerholder s interest in the trust. However, the gift tax annual exclusion will be available. Moreover, if the grantor-insured s spouse is the powerholder, there will be no gift tax because of the unlimited marital deduction b. If the powerholder is not a beneficiary of the trust (i.e. parent, sibling, friend, advisor, etc.), or is only a discretionary income beneficiary, the exercise of the power will not constitute a gift. The Settlor s spouse, if living, otherwise the Settlor s oldest living child shall have the power (exercisable in a non-fiduciary capacity, either personally or by an attorney-in-fact under a power of attorney, without the consent or approval of any person or entity in a fiduciary capacity), at any time and from time to time during the Settlor s lifetime, to make gifts of the principal of this Trust in whole or in part and in any manner and in such proportions as he or she sees fit to any one or more of Settlor and Settlor s descendants, whether living at the time of exercise or thereafter born, but excluding himself or herself, his or her estate, his or her creditors, and the creditors of his or her estate, provided that no such gift may be applied or distributed for the health, education, support or maintenance of any issue of the Settlor whom either the Settlor or the Settlor s spouse is legally obligated to support or maintain, and provided further that this power shall not be exercised by any child of the Settlor who has not yet attained his or her majority. Notwithstanding the above, the holder of this power shall not exercise it during any period in which a beneficiary has a right to demand distribution of trust property in accordance with the provisions of Article 4. 2

4 II. WHAT TYPE OF CRUMMEY NOTICE MUST BE GIVEN? A. Potential Problems. 1. No written notice was given to the beneficiaries after the initial gift to the trust. 2. ILIT owns a group term policy where premiums are paid directly by insured s employer (typically monthly and in varying amounts). B. Solution. 1. Do not require written notice, but rather reasonable notice. 2. Do not require notice where beneficiary has actual notice. 3. Allow trustee to use a one-time notice, particularly when ILIT owns a group term policy. 4. Use a one-time notice in conjunction with annual notices. C. IRS s Position. 1. In PLR the IRS determined that a father s contributions to two trusts qualified for the gift tax annual exclusion where the beneficiary had reasonable notice of the contribution and the right to withdraw the contribution within 30 days. Unfortunately, PLR does not specify what reasonable notice consists of. 2. No Revenue Rulings or PLRs have required that the trust agreement have a provision requiring the trustee to give written notice. In fact, no notice was given to the beneficiaries in the Crummey case. However, since the taxpayer has the burden of proof, written notice provides permanent evidence. 3. If the donee has actual notice (i.e. donee is a trustee or minor donee s guardian is the trustee), no other notice is necessary. See Estate of Carolyn W. Holland v Comm r, T.C. Memo , and PLRs and A one-time notice has been upheld which identified when future contributions were expected to be made. PLRs , , and In TAM the IRS ruled that it will recognize Crummey withdrawal rights only in those situations in which the donees receive actual current notice of any gifts to the trust. 3

5 D. Sample Provision. a. In TAM the trust beneficiaries signed a statement waiving their right of withdrawal to the initial contribution, and revocably waiving their right to future notices. b. Query? Is a single notice containing a schedule of when additions will be made to the trust in the future still current even though many years have passed? The Trustee shall make reasonable efforts to notify each designated beneficiary of his/her demand power and the amount of any contributions made to the trust that are subject to the power. Such efforts may include annually apprising each designated beneficiary of his/her rights to withdraw, providing the designated beneficiary with a single notice sufficient to apprise him/her of his/her current and expected future rights to withdraw, or any other means determined by the Trustee to provide each designated beneficiary with reasonable notice. After receiving such notice from the Trustee at least once, any such person, or the legal guardian of any such person, by a written instrument mailed or delivered to the Trustee, may permit the Trustee to provide such written notices annually (during the first month of each calendar year) in anticipation of gifts to be made during such year or may altogether waive the Trustee s obligation to provide further such written notices. Further, no notice shall be required to be given to any designated beneficiary who has actual notice of his/her withdrawal rights. 4

6 III. ABILITY TO CHANGE CRUMMEY POWERHOLDERS. A. Potential Problems. 1. A Crummey powerholder becomes uncooperative and begins exercising his/her withdrawal rights. 2. The grantor wishes to delete a withdrawal right to a Crummey powerholder so as to make other annual exclusion gifts to such powerholder. B. Solution. 1. In the trust instrument, permit the donor to determine (each time a gift is made to the trust) whether the withdrawal right may be exercised. 2. Donor should also be given the right to determine the amount of exercise and by whom it may be exercised. C. Tax Consequences. 1. In PLR the IRS approved a provision in an irrevocable life insurance trust which gave the trust s grantor the ability to cancel a beneficiary s withdrawal right, to modify the amount subject to withdrawal, and/or change the period during which the beneficiary s withdrawal power could be exercised. 2. The IRS ruled that those provisions would not cause any adverse gift or estate tax consequences. D. Sample Provision. Notwithstanding anything contained herein to the contrary, any individual making an addition to the trust shall have the right, by an instrument filed with the Trustee at the time of the addition, with respect to any power of withdrawal that would otherwise be created (i) to exclude any individual from exercising the power, (ii) to increase or decrease the amount subject to the power, except that the amount subject to all powers shall not exceed the amount of the addition, or (iii) to change the period during which the power may be exercised. 5

7 IV. PROTECTING THE TRUSTEE FROM THE INSURANCE SELECTION PROCESS. A. Potential Problem. 1. Existing policies are assigned to the ILIT, or the grantor selects a new policy for the ILIT to acquire. In either case, the trustee was not significantly involved in the selection process. 2. What is the trustee s liability should the policy underperform or, even worse, non-perform? Arguably, the trustee did not exercise the degree of care and diligence required under the circumstances. 3. Oftentimes the trustee during the grantor s lifetime is a family member, friend, attorney or accountant. At death, a corporate fiduciary replaces the initial trustee. Therefore, this issue could be a trap for the unwary. B. Solution. 1. Add a provision in the trust instrument limiting the trustee s liability with respect to those life insurance policies gifted to the ILIT by the grantor. 2. Indemnify the trustee from any liability resulting from the grantor s selection of the policies. C. Sample Provision. It is the Settlor s desire that the Trustee shall retain the insurance policies selected by the Settlor, and the Settlor expressly agrees to indemnify and save the Trustee harmless from any and all liability for retaining these policies as trust assets. The Trustee may rely, without inquiry or independent investigation, on the representations of any person selling, or in any way associated with the marketing, promotion or sale of, a given life insurance policy regarding the relative quality of such policy (as compared to other available policies) or regarding the absolute quality of such policy (without regard to other available policies). Specifically (but not by way of limitation), the Trustee shall have no duty: (i) To verify that any particular life insurance policy satisfies the requirements for a life insurance contract under Section 7702 of the Code; (ii) To compare the performance or pricing or the projected performance or pricing of a particular life insurance policy with the performance or pricing or the projected performance or pricing of any other life insurance policy that then may be available from any source; (iii) To assess the appropriateness of purchasing or retaining any life insurance policy as an investment for the trust as compared to other then available investment vehicles that are not life insurance policies; and (iv) To investigate the strength or solvency of the company that issued or is offering a given life insurance policy. 6

8 The Settlor acknowledges that the Trustee is not a guarantor of any life insurance policy held in the trust, whether purchased by, or transferred to, such Trustee. The Trustee shall not be liable to the Settlor or to any present or future beneficiary of the trust for any loss or damage suffered in connection with the performance, or failure to perform, of any life insurance policy or the insolvency of any life insurance company. 7

9 V. REMOVAL AND REPLACEMENT OF TRUSTEES. A. Potential Problems. 1. Beneficiaries wish to remove a trustee who is unresponsive or ineffective. 2. Beneficiaries wish to remove a trustee to reduce administration costs. B. Solution. 1. Allow beneficiaries in the trust instrument, usually by a majority vote, to remove and replace trustees. 2. Provide guidelines as to qualifications of any successor trustee. C. Tax Consequences. 1. Rev. Rul , reversed Rev. Rul , and held that a grantor s reservation of an unqualified power to remove and replace a trustee is not a reservation of the trustee s discretionary powers of distribution that might cause trust corpus to be included in the grantor s estate under IRC Sec In PLR , the IRS extended its holding in Rev. Rul to beneficiaries who were given the power to remove and replace trustees. 3. However, Rev. Rul also stated that any successor trustee must not be related or subordinate to the grantor (within the meaning of IRC Sec. 672(c)). Thus, a family member or an employee could not serve as a successor trustee. 4. Is the use of IRC Sec. 672(c) appropriate? a. IRC Sec. 672(c) is an income tax standard used in the grantor trust rules. Prior to Rev. Rul , IRC Sec. 672(c) had no estate tax significance. b. The requirement to replace the trustee with someone who is not related or subordinate is inconsistent with the Tax Court s holding in Estate of Wall, 101 TC 300 (1993). c. The implication in Rev. Rul that a power to remove a trustee and appoint a related or subordinate party as successor trustee is a reservation of the trustee s powers, has no support in IRC Sec. 2036(a)(2) or IRC Sec. 2038(a)(1) or the Regulations promulgated thereunder. 8

10 D. Sample Provision. At any time the Settlor s spouse, if living, and if not, then a majority in number of the beneficiaries to whom the current trust income may or must then be distributed, with any person under a legal disability voting through his/her lawful guardian, may remove, in writing, an incumbent Trustee or a Co-Trustee, with or without cause. In addition, any beneficiary who has attained the age of twenty-one (21) years may so act with respect to any trust named for such beneficiary, or with respect to which such beneficiary alone is the present income beneficiary. As a condition precedent to removing a Trustee or Co-Trustee hereunder, the person or persons who are removing the Trustee shall first appoint a successor Independent Trustee; provided, however, no person, acting alone, may remove or name a Trustee of a trust hereunder that would be included in the Settlor s or that person s estate solely by reason of this right of removal or appointment. 9

11 VI. SWITCHING TRUSTS DEFECTIVE IS MORE EFFECTIVE. A. Potential Problems. 1. Grantor wishes to change the ILIT s beneficiaries. 2. Grantor wishes to change the terms of the ILIT (i.e., add generation skipping provisions). B. Solution. 1. Create a new ILIT with the desired terms and beneficiaries. 2. Fund the new ILIT (using the grantor s gift tax exemption) with an amount equal to the fair market value of the policy owned by the old ILIT. C. Tax Consequences. a. Generally, a policy s fair market value is its interpolated terminal reserve plus the unearned premium. Treas. Reg. Sec (a). Example 4. b. For an insured on his/her deathbed, the IRS will argue that the value of the policy approaches its face amount. Estate of Pritchard v. Comm., 4 TC 204 (1944); Treas. Reg. Sec c. Must the trustee look to the life settlement market to determine fair market value? 1. Generally, life insurance proceeds are income tax free. IRC Sec. 101(a)(1). 2. However, if the policy is transferred for valuable consideration, the income tax free amount is limited to the consideration paid for the policy plus the subsequent premiums paid on the policy. This is referred to as the transferfor-value rule. IRC Sec. 101(a)(2). 3. One of the exceptions to the transfer-for-value rule is a transfer to the insured himself/herself. IRC Sec. 101(a)(2)(B). 4. A grantor trust is a trust where the grantor will be treated for federal income tax purposes as the owner of the trust assets. IRC Secs In PLR the IRS ruled that where both ILITs were grantor trusts, transfers between the trusts would be disregarded for federal income tax purposes. Therefore, the transfer-for-value rule would not be triggered. It s as if the grantor shifted ownership of the policy to himself/herself. 10

12 6. The three year rule of IRC. Sec will not apply because that Code Section is limited to gratuitous transfers not sales. D. Sample Provision. SECTION 10. GRANTOR TRUST STATUS a. Grantor s Intent I intend that this trust be a grantor trust deemed owned by me for federal income tax purposes. Accordingly, notwithstanding anything contained in this Trust Agreement to the contrary, the provisions of this Section shall apply to this trust during my lifetime. Notwithstanding any applicable provision of law to the contrary, I shall not be permitted to participate in any decision regarding the revocation of any trust created hereunder with or without the consent of the beneficiary(ies). In addition, I shall not be permitted to exercise, either alone or in conjunction with any other person, any power described in Section 2036(a)(2) or 2038 of the Code. It is my intent that no portion of any trust created hereunder be includable in my gross estate for estate tax purposes at my death; and, notwithstanding any provision herein contained to the contrary, this Agreement shall be construed and any trust created hereunder administered in accordance with and to achieve that intent. b. Special Grantor Powers During my lifetime, I shall have: 1. The power to substitute any trust assets (other than any stock of a controlled corporation, as defined in IRC Section 2036(b), or any property that would cause me to have an incident of ownership, as defined in IRC Section 2042, with respect to insurance policies on my life held as part of the trust property) in exchange for assets of equivalent value; and 2. The power to borrow any of the trust income and principal (other than any stock of a controlled corporation, as defined in IRC Section 2036(b), or any property that would cause me to have an incident of ownership, as defined in IRC Section 2042, with respect to insurance policies on my life held as part of the trust property), in exchange for my promissory note, which note shall be equal in value to the amount loaned, shall bear an adequate rate of interest, but shall not require any security. c. Non-Fiduciary Capacity The powers granted to me under this Section shall be exercisable solely in a non-fiduciary capacity, and without the consent or approval of any other person. d. Restrictions The special powers given to me under this Section shall not be exercisable to the extent that their 11

13 exercise would reasonably be expected to cause any of the trust assets to be included in my gross estate for federal estate tax purposes. e. Release I may at any time in my sole, absolute and uncontrolled discretion, temporarily or permanently waive/release any or all of the powers granted under this Section with respect to any or all trusts created hereunder, without any liability to any trust beneficiaries (current or future). Any such waiver/release shall be in writing, delivered to the Trustee, and such waiver/release shall bind me, the Trustee, and all other persons. f. No Power to Pay Income Taxes The Trustee shall not pay to me, my spouse, my Personal Representative, or my spouse s Personal Representative any income or principal of any trust estate hereunder on account of or in discharge of my or my spouse s income tax liability (whether Federal, State or otherwise), if any, with respect to property held in any trust hereunder and taxable to me or my spouse including, but without limitation, tax on realized capital gains. 12

14 VII. PROTECTING HEIRS FROM POTENTIAL CREDITORS. A. Potential Problems. 1. Trust requires mandatory distributions to beneficiaries at stated ages (e.g., 1/3 at ages 25, 30 and 35). 2. Trust provides beneficiary with a power of withdrawal at stated ages (i.e., a general power of appointment). 3. At time of distribution or withdrawal, beneficiary has creditor or personal problems (e.g., malpractice claims, pending divorce, addiction to drugs or alcohol, serious mental or physical disability, etc.) B. State Law Generally. 1. A creditor can reach property subject to a general power of appointment if the power is presently exercisable. 2. Exercise of the power is not necessary to expose the assets to the creditor s claim. C. Solution. 1. Make sure trust has a spendthrift provision. 2. Add a provision to the trust instrument allowing the trustee the discretion to postpone distributions under specified circumstances (i.e., pending divorce, serious disability, etc.) D. Sample Provision. To the fullest extent permitted by law, the interests of all of the beneficiaries in the various trusts and trust property subject to this agreement, except for my interest therein while I am living, shall not be alienated, pledged, anticipated, assigned, or encumbered unless specifically authorized by the terms of this agreement. Such interests, while they remain trust property, shall not be subject to legal process or to the claims of any creditors. Notwithstanding any of the foregoing provisions, the Trustee of each trust hereunder shall have the power to postpone any distributions of principal otherwise required to its then primary beneficiary upon or after the beneficiary s attainment of a specified age or the death of a third person, and to postpone the termination of such trust which might otherwise be required, all as if such age had not been attained or such death had not occurred, if the Trustee, in its sole discretion, determines that such postponement is consistent with the Settlor s overall intent. In exercising such 13

15 discretion, Settlor authorizes and approves the Trustee s use of such information as may be available and pertinent, such as the beneficiary s serious physical or mental disability, the beneficiary s addiction to drugs or alcohol, the beneficiary s incarceration, a pending divorce, a gambling problem, present or imminent financial difficulty, a serious tax disadvantage in making a distribution, or similar substantial cause. Any such postponement may be continued by the Trustee from time to time, up to and including the entire lifetime of the beneficiary. The Trustee s exercise of discretion in such postponements shall be final and binding upon all parties in interest. No Trustee shall at any time be held liable for any action taken or not taken pursuant to this Paragraph, nor shall any Trustee be required to take any affirmative action pursuant hereto, and no Trustee shall be required to inquire into or investigate any beneficiary s status as it may relate to this Paragraph. 14

16 VIII. TESTAMENTARY LIMITED POWERS OF APPOINTMENT. A. Potential Problems. 1. Changes in tax laws make the trust s dispositive provisions undesirable. 2. Changes in economic, social and individual circumstances make the trust s dispositive provisions undesirable. B. Solution. 1. Provide the beneficiaries with a testamentary limited power of appointment (LPA) to change the asset allocation that would otherwise apply at the beneficiary s death. 2. A LPA can be drafted broadly or narrowly. a. Class of potential recipients can be as broad as anyone other than the powerholder, his estate, or the creditors of either. b. Class of potential recipients can be as narrow as the grantor s descendants (other than the powerholder). 3. The LPA can permit property to be appointed outright or in trust. C. Tax Consequences. 1. The broadest class for a nongeneral power of appointment is anyone or more persons or organizations other than the powerholder, his/her estate, or the creditors of either. IRC Sec The existence (or exercise) of a LPA does not have any tax consequence to the powerholder. D. Sample Provision. If any of the Settlor s children die before the complete distribution of his or her separate trust, such trust shall terminate and the Trustee shall distribute the remaining trust property to, or in trust for the benefit of the class of persons comprised of the Settlor s then living descendants or the spouse of a descendant, or a charitable organization, upon such conditions and estates, with the powers, in the manner and at the time or times as the deceased child appoints by will which specifically refers to this power; provided, however, that any property allocated to the spouse of the child shall be held in trust and the trust must provide that (i) only income, but not principal, may be distributed to the spouse, (ii) the spouse shall not be a trustee, (iii) the trust will terminate no later than the spouse s death (and the 15

17 trust may terminate earlier on events such as the spouse s remarriage or cohabitation with an unrelated person), and (iv) upon termination, the trust property shall be allocated or distributed (in a manner designated by the child) among the Settlor s then living descendants. To the extent this power of appointment is not exercised effectively, the Trustee shall distribute the remaining trust property to the deceased beneficiary s descendants, per stirpes. In the absence of such descendants, the property shall be delivered over in equal shares to the Settlor s then living children and the then living child or children of any deceased child, per stirpes; provided, however, that if there is in existence hereunder a trust for the benefit of such distributee, distribution of such property shall be made by adding the same to such trust, to be held, administered, and distributed as if it had originally formed a part thereof. 16

18 IX. CHANGING TRUST SITUS: FORUM SHOPPING. A. Potential Problems. 1. Beneficiaries move away from jurisdiction where grantor established the ILIT and, therefore, it is more convenient to deal with a local trustee. 2. Another state may have laws which may be more congenial to the purposes and needs of the ILIT than those of the state where the trust was originally established (e.g., South Dakota and Alaska have neither a rule against perpetuities nor a state income tax). B. Solution. 1. Whether or not a trust may be removed from its original jurisdiction is a matter of the Settlor s intent. If the Settlor s intent is not clear, then the matter becomes one for judicial interpretation. 2. Therefore, provide in the document that the trustee can change the trust s situs. C. Controlling Law. 1. The U.S. Supreme Court has held that a state may not assert its taxing jurisdiction if it does not maintain certain minimal contacts with the matter which is subject of the tax. Safe Deposit & Trust Co. v Virginia, 280 U.S. 83 (1929). 2. Therefore, if the trust assets and the trustee are outside the state, the mere fact that the grantor was a state resident when the trust was established is not enough to justify continued taxation. D. Sample Provision. The Trustee shall have the power to maintain the situs of the property of any trust created under this Agreement in any jurisdiction, in the Trustee s absolute discretion, and thereafter transfer the situs at any time or times to any jurisdiction selected by the Trustee. Upon any such transfer of situs, the Trust Estate may thereafter, at the election of the Trustee, be administered exclusively under the laws of (and subject, as required, to the exclusive supervision of the courts of) the jurisdiction to which it has been transferred. If the Trustee of any trust created hereunder elects to change the situs of any such trust, the trustee is hereby relieved of any requirement of having to qualify in any other jurisdiction and of any requirement of having to account in any court of such other jurisdiction. 17

19 X. POWERS TO AMEND OR MODIFY. A. Potential Problems. 1. Tax or other legal changes require an amendment to the ILIT. 2. There is a desire to change the dispositive provisions of the ILIT (e.g., the purposes for which distributions may be made, the termination date of the trust, etc.) B. Solution. 1. Provide in the trust instrument that an independent trustee can amend or modify the ILIT subject to specific limitations. 2. Alternatively, the grantor can give this power of amendment to a separately appointed trust protector. C. Tax Consequences. 1. The grantor cannot be the trust protector. IRC Sec. 2036(a)(2) and IRC Sec. 2038(a)(1). 2. The trust protector should be independent (i.e. not a related or subordinate party) to avoid any IRS argument that there was an implied agreement between the grantor and the trust protector as to how the trust protector will carry out his/her duties. 3. The trust protector should not be a beneficiary, unless the powers are narrowly defined to exclude an exercise for the benefit of said beneficiary that would constitute a general power of appointment. IRC Sec The grantor should not have the power to remove the trust protector. 5. If the trust protector can exercise a power to add new beneficiaries, then grantor trust status is triggered under IRC Sec. 674(c). 6. Do not permit any power that would impair an existing Crummey right. D. Sample Provision. (L) Trust Protector. Notwithstanding any other provision of this Agreement: (1) At any time and from time to time, the Trustee(s) may appoint a Trust Protector hereunder. If any person selected as a Trust Protector fails or ceases to act as Trust Protector, he/she may (but is not required 18

20 to) appoint any one or more successor Trust Protector as provided in subparagraph (3) below. Any person selected as a Trust Protector must not be related and/or subordinate to the Settlor or to any beneficiary hereunder. For this purpose related and subordinate have the same meaning that they have under Section 672(c) of the Internal Revenue Code of 1986, as amended. No trust created under this instrument is required to have a Trust Protector acting with respect to that trust. (2) The Trust Protector may, with respect to any trust as to which the Trust Protector is acting, modify or amend: (a) (b) (c) (d) The trust administrative provisions relating to the identity, qualifications, succession, removal, and appointment of the trustee; The financial powers of the trustee; The withdrawal rights granted under this instrument (except a withdrawal right that has already matured at the time the Trust Protector seeks to exercise the power conferred under this subparagraph); and The terms of any trust created under this instrument with respect to (i) the purposes for which the trustee may distribute trust income and principal, and the circumstances and factors the trustee may take into account in making such distributions; and (ii) the termination date of the trust, either by extending or shortening the termination date (but not beyond any applicable perpetuities period). Notwithstanding the foregoing, the Trust Protector shall not have the power to amend this Agreement (i) to add one or more persons to the group of beneficiaries hereunder, (ii) to delete one or more persons from the group of beneficiaries hereunder, or (iii) to affect the amount of property which may be distributed to or for the benefit of any person. (3) The Trust Protector acting from time to time, if any, may appoint any one or more individuals (who are not related and/or subordinate to the Settlor or to any beneficiary hereunder) as successor Trust Protector. Any appointment of a successor Trust Protector hereunder shall be in writing, may be made to become effective at any time or upon any event, and may be single or successive, all as specified in the instrument of appointment. The Trust Protector may revoke any such appointment before it is accepted by the appointee, 19

21 and may specify in the instrument of appointment whether it may be revoked by a subsequent Trust Protector. In the event that two or more instruments of appointment or revocation by the same Trust Protector exist and are inconsistent, the latest by date shall control. (4) Any Trust Protector may resign by giving prior written notice to the Trustee. All trusts created under this instrument need not have or continue to have the same Trust Protector. The provisions of this instrument that relate to the Trust Protector shall be separately applicable to each trust held hereunder. (5) Notwithstanding any other provision of this instrument, the Trust Protector shall not participate in the exercise of a power or discretion conferred under this instrument for the direct or indirect benefit of the Trust Protector, the Trust Protector s estate, or the creditors of either, or that would cause the Trust Protector to possess a general power of appointment within the meaning of Sections 2041 and 2514 of the Internal Revenue Code of 1986, as amended. (6) The Trust Protector acting from time to time, if any, on his or her own behalf and on behalf of all successor Trust Protectors, may at any time irrevocably release, renounce, suspend, cut down, or modify to a lesser extent any or all powers and discretions conferred under this instrument by a written instrument delivered to the Trustee. (7) The Trust Protector shall have no duty to monitor any trust created hereunder in order to determine whether any of the powers and discretions conferred under this instrument should be exercised. Further, the Trust Protector shall have no duty to keep informed as to the acts or omissions of others or to take any action to prevent or minimize loss. Any exercise or nonexercise of the powers and discretions granted to the Trust Protector shall be in the sole and absolute discretion of the Trust Protector, and shall be binding and conclusive on all persons. The Trust Protector is not required to exercise any power or discretion granted under this instrument. Absent bad faith on the part of the Trust Protector, the Trust Protector is exonerated from any and all liability for the acts or omissions of any other fiduciary or any beneficiary hereunder or arising from any exercise or nonexercise of the powers and discretions conferred under this instrument. (8) Notwithstanding anything contained in this Paragraph to the contrary, a power to distribute to a new trust or to amend this Trust shall not be exercised in a manner that would impair a beneficiary s existing withdrawal rights or cut off a beneficiary s powers over such withdrawal rights. 20

22 XI. DEFINITION OF SPOUSE. A. Potential Problems. 1. In a single life ILIT, a life estate is established for the surviving spouse. Subsequently, the parties divorce. 2. Same facts as above, except that the grantor s spouse also is named as a trustee or successor trustee, and also has a lifetime special power of appointment to appoint assets back to the grantor or the grantor s descendants. B. Solution. 1. Add a provision to the trust instrument that in the event of a divorce, the grantor s spouse shall be deemed to have predeceased the grantor for all purposes of interpreting the trust agreement. 2. Alternatively, the grantor s spouse can be defined to mean that person grantor is married to from time to time. C. Sample Provision. The term Settlor s spouse shall mean that person specifically hereinabove identified as such; provided, however, if, at any time during the Settlor s lifetime the Settlor and the Settlor s said spouse shall become divorced or if at the time of the Settlor s death, there shall be pending any court proceedings for divorce, annulment, separation, separate maintenance or the like, then (i) the Settlor s said spouse shall be conclusively deemed not to be the Settlor s spouse, regardless of the legal relationship of the Settlor and such person at that time; (ii) all of said person s right, title and interest as a beneficiary hereunder shall absolutely cease; (iii) any special powers of appointment held by such person shall lapse, cease and determine with respect to such person; (iv) said person shall cease to serve or be eligible to serve as a Trustee hereunder, and shall have no power to remove or replace a Trustee hereunder; and (v) said person shall be treated for all purposes of interpreting this Agreement as having predeceased the Settlor at such time. 21

23 XII. DO YOU HAVE TO WAIT UNTIL THE CRUMMEY WITHDRAWAL PERIOD ENDS BEFORE PAYING THE PREMIUM? A. Potential Problems. 1. Once the decision has been made to purchase a new policy, oftentimes the client does not want to wait until the withdrawal period ends (usually 30 days) before paying the first premium. 2. In subsequent years, the gift to the trust is made too late to stay safely within the policy s grace period. 3. Under the above situations can the beneficiary waive his/her withdrawal right? B. Tax Consequences. 1. The lapse of a Crummey power is a release of a general power of appointment to the extent the lapse exceeds the greater of $5,000 or 5 percent of trust principal. IRC Sec. 2514(e). 2. The lapse of the Crummey power (in excess of $5,000/5%) will usually result in a gift back to the other beneficiaries of the trust. Moreover, this gift back is not a present interest gift which qualifies for the $11,000/$22,000 annual exclusion. 3. The $5,000/5% safe harbor only applies to a lapse of a general power of appointment. It does not apply to a release of the power. 4. If the IRS decides to treat a beneficiary s waiver of his/her withdrawal power as a release, a taxable gift back would occur. Thus, the Crummey powerholder will have to file a gift tax return and use up a portion of his/her $1,000,000 exemption. C. Solution. 1. Provide the Crummey powerholders with notice and, in lieu of waiving same, have them authorize the trustee to use the contributed property to pay premiums during the withdrawal period. 2. If a powerholder were later to decide to exercise his/her withdrawal right, the trustee could do so out of the policy itself, or from other trust property, if any. 22

24 D. Sample Provision. Check One: I wish to exercise my withdrawal right. I hereby acknowledge receipt of notification of my power of withdrawal under the above-named Trust and the addition made to the Trust. I consent to use of the addition to pay premiums on any life insurance policy in the Trust prior to the end of the period for the exercise of my power of withdrawal. Further, I understand that additions will be made to the Trust in future years, and I may be given a power of withdrawal with respect to such additions. Unless I notify you to the contrary, you do not need to notify me regarding future additions when I am given a power of withdrawal. Signature of Beneficiary or his/her Guardian if Beneficiary is a Minor 23

25 XIII. ABILITY TO CHANGE IRREVOCABLE TRUSTS WITH SURVIVORSHIP LIFE INSURANCE. A. Potential Problems. 1. Clients purchase a survivorship policy to pay federal estate taxes, but cannot decide upon beneficiaries and/or terms of ILIT. 2. Clients purchase a variable survivorship policy as a private pension and are reluctant to transfer same to an ILIT until the first spouse dies. B. Solution. 1. Spouse with shortest life expectancy (lets assume it s the husband) creates an ILIT containing the couple s present dispositive wishes. 2. Husband applies for the survivorship policy as the owner, and the ILIT as the contingent owner. 3. As owner, the husband has access to the policy s entire cash surrender value. 4. If the couple change their dispositive wishes at a later date, husband can create another ILIT and name it as the new contingent owner. 5. Alternatively, the policy can be assigned to an ILIT whenever the clients are ready to do so, and start the running of the three year rule of IRC Sec They could also have the ILIT purchase a term policy on the healthier/younger spouse to cover the estate taxes if both were to die within three years of the transfer. C. Tax Consequences if Husband Dies First. 1. The most recent ILIT becomes the new policyowner. 2. The policy s interpolated terminal reserve (approximately the cash value) is included in husband s gross estate. The policy does not mature as a death claim because the wife is still living. 3. When the wife subsequently dies, the ILIT receives the death benefit free of income and estate taxes. 4. If the couple dies simultaneously, the insurer would assume that the owner (i.e. husband) died first. This same presumption should be contained in the husband s will. 24

26 D. Tax Consequences if Wife Dies First. 1. Husband should immediately gift the policy to the ILIT. The policy s interpolated terminal reserve at such time will be the measure of the gift to the ILIT. 2. If husband dies within three years of the transfer, the entire policy proceeds would be included in his estate. IRC Sec If husband is still insurable when his wife dies, he can have the ILIT purchase a term policy on his life to cover the federal estate tax should he die within three years. 4. After three years, the term policy can be cancelled or, if husband s health has declined, the policy can be converted to permanent insurance. 5. Finally, if the husband is not terminally ill, he can avoid the three year rule by selling the policy to a grantor trust. See PLR The three year rule of IRC Sec only applies to gifts not sales. 25

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