I have written this article for information purposes, and I hope you learn something from it. Though I would like to state it is current and up to date, in all candor, I can't. In most cases, the concepts are relatively accurate (except for obviously old and dated materials, primarily related to taxes). You should confer with your own lawyer about issues that affect you and your family.
SOME APPLICATIONS FOR IRREVOCABLE TRUSTS
To the uninitiated, estate planning may be likened to Alice’s trip into Wonderland: though there are people in this strange place, they sometimes make no sense when they speak. Principles of physics are not necessarily in operation, as Alice grows when she drinks and shrinks when she eats; animals talk but abandon logic when they speak; and there is a twist in general semantics.
Pretend for a moment that you are in a Wonderland. As you gaze across the landscape, you are approached by a rabbit who begins to talk. He tells you he is a lawyer who will serve as your guide to the Wonderland of Irrevocable Trusts; his job is to help you understand why and how things work as they do. So be prepared for surprises.
First, the rabbit makes a disclaimer: there are lots of things that will not be covered in his short guide to irrevocable trusts. Says he, "Consider this as a small tray of hors-d’oeures. What is said here is not the entire meal."
He hops along the trail and you follow him. Around the hedge, you see a blackboard nailed to a tree. The rabbit picks up a piece of chalk, and begins telling you a few concepts about trusts, as he scribbles on the board. And this is what he relates.
A trust is simply an agreement made by a person, which deals with how property will be held and what happens to the property when that person dies. There are three “parties” to every trust: The person who creates it (the grantor, trustor, settlor), the trustee, and the beneficiaries of the trust. Most of the time, when a person establishes a trust, he or she reserves the right to change its terms. This type of trust is known as a “revocable” trust. When the trust is properly funded, an estate can pass to the beneficiaries, without probate, and depending upon the how the trust is written, some estate taxes can be saved. See the article “Tips in Estate Planning” and "Tax Sheltered Trusts" for a more lengthy explanation of revocable trusts.
There is another species of trust, where the creator of the trust does not permit any changes in the trust terms – this variety is known as an “irrevocable trust”. The primary purpose of an irrevocable trust is to permit property to be transferred to beneficiaries, without any probate and without any estate taxes. As with revocable trusts, there are three parties to the irrevocable trust, but the creator of the trust will not be the trustee. If the grantor wants to serve as trustee of the trust, the assets of the trust will be included in the grantor’s taxable estate, for estate tax purposes.
The rabbit reminds you that when Alice toured Wonderland, she met the Mad Hatter. He then says, "In the Wonderland of Trusts, there is a Mad Hatter, of sorts, but this one isn’t a person, it is a book of laws: the Internal Revenue Code of 1986 (the IRC). At this bend in the road, we must now deal with the tax laws. When an irrevocable trust is created, under the Internal Revenue Code, a new taxpayer entity is being created, much like a new corporation is formed. The irrevocable trust will be assigned a tax payer identification number by the Internal Revenue Service, and the trustee of the trust will file an income tax return each year (a Form 1041)".
The rabbit twitches his nose and you hear a soft whistle as he sighs through his teeth. "But remember, we are in the Wonderland of Trusts, and under the Internal Revenue Code, the trust will not pay income tax, even though there is taxable income." Under the IRC, the grantor will pay the income tax (because the grantor has retained certain rights under the trust terms, such as substituting trust property, or naming his or her spouse as a discretionary beneficiary; see IRC §§671-679). Stated differently, the Internal Revenue Code has a section devoted to “grantor trusts”. These provisions of the Code simply attribute trust income to the grantor, who then reports the income on his 1040 tax return.
With these concepts in mind, the rabbit hops away from the blackboard and runs up a hill. You follow him to a vista, and from this vantage, can see several beautiful destinations. The rabbit points to the island in the West. He tells you this is the Island of Life Insurance Perks. You ask, what benefits are found on this island? The rabbit explains, "Under the IRC, insurance policies may earn income and grow in value, but the owner of the policy does not have to report the increase in value or earnings on his or her income tax return. Thus, if an irrevocable trust owns life insurance, which grows in value, the grantor will not have to pay income tax on the growth in value, and when he or she dies, the policy will be paid to the beneficiaries without any income or estate taxes."
Traditionally, the irrevocable trusts own life insurance on the life of the grantor. Under the Internal Revenue Code, earnings and growth under life insurance policies are not taxed, for income tax purposes, to the grantor. Thus, if the trust grows in value, due to an increase in value of the life insurance policy, this growth in value will not be attributed to the grantor.
There are certain precautions that must be taken in establishing an irrevocable life insurance trust (fondly known as an “ILIT”). Under the IRC, if the grantor retains some incident of ownership over the life insurance policy, the policy (even though owned by the ILIT) will be included in the grantor’s taxable estate (for estate tax purposes). The primary safeguard to avoid falling into this trap is to name an independent trustee (someone other than the grantor), who will simply hold the insurance policy until the grantor dies, then collect the insurance proceeds and distribute them to the beneficiaries without being obligated to pay gift or estate taxes.
Now let us consider an obvious fact: insurance must be purchased, and the insurance company will want its premium, as a condition to issuing the policy and keeping it in force. The grantor (who is the insured) usually pays the premium, but the grantor is not permitted to write checks to the insurance company directly (remember, there is an IRC rule which prohibits this from being done). So, the grantor will give the premium to the beneficiaries. However, the beneficiaries (say a 23 year old son) might keep the money and not pay the premium. So, says the rabbit, " What do we do, what do we do?"
He then answers his own question. The grantor will give the premium to the independent trustee of the ILIT, who will, in turn, write the beneficiaries a letter, along these terms:
Your dad has given me $14,000, which is a gift to you. You have thirty days to pick up the money. If you don’t pick it up in 30 days, I will use the money to pay the next year’s premium on the life insurance policy I own (as Trustee) on your dad’s life.”
The Bank Trust Department
Hopefully, the premium will be less than $14,000 dollars per year for each donee (beneficiary), so there will be no federal gift taxes to pay (one is permitted to gift $14,000 a year to a donee, without being required to pay gift taxes). Gifts above that amount are taxable, for gift tax purposes (the $14,000 per year, per donee, is an annual exclusion).
Let’s examine this a bit closer. In order to constitute a gift, there must be three elements: Donative intent, delivery of the gift, and acceptance of the gift. The Internal Revenue Service has taken the position that if the donee has a right to pick up the money from the trustee of the ILIT, and keep it, but declines to do so, a completed gift is nonetheless made. This position had its origin in the famous case of Crummey vs. Commissioner, (397 F2d 82, 9 Cir., 1968) after that case was decided, the right to withdraw a gift from an ILIT was labeled as the “Crummey Power of Withdrawal”, or simply put, the “Crummey Power”.
Thus, in the traditional setting, when the grantor dies, the insurance proceeds will be collected by the trustee who will then distribute the same to the children. The children are expected to use the proceeds to pay for estate taxes, or if there are no estate taxes, then to keep the proceeds.
The rabbit then draws your attention to a forest, which seems to be full of briars, but also has a very pretty lake in its center. He says, "Let’s consider some other uses of irrevocable trusts", and begins talking like a lawyer. You remember him mentioning one interesting application discussed in the Journal of the American Society of CLU & ChFC, September, 1997, entitled The WRAP Trust. The article (by James G. Blase) is extremely interesting, and should be referenced for further details. However, the gist of a WRAP trust is this: As cash value in an insurance policy (owned by the ILIT) increases, the trustee borrows from the policy, and loans the cash to the Grantor, in exchange for the Grantor’s note and pledge of assets (this is a secured loan). The grantor will presumably spend the cash. When the grantor dies, the ILIT owns a note from the Grantor’s estate, but also holds the securities the Grantor has pledged, as collateral for the loan. The trustee of the ILIT will collect the debt by using the pledged assets (thereby reducing the size of the grantor’s federal taxable estate).
The rabbit then points to a deep gorge, with a beautiful river cutting its way into fiords in the distance. He explains that another avant-garde application for irrevocable trusts involves the concept of arbitrage. Here’s how it might work: the grantor loans large sums of money to the irrevocable trust, which in turn, agrees to repay the grantor principal and interest. Since the Internal Revenue Service will regard this as a wash transaction for income tax purposes, the Grantor will not realize taxable income (one does not report income payable to oneself). For purposes of the transaction, however, an interest rate will be used on the note (which will be the Applicable Federal Rate, or AFR).
Let’s use an example. Suppose the AFR is 2%, and the grantor loans the irrevocable trust $1,000,000. Each year the trust will pay him $20,000 in “interest”; the Grantor will not report the interest on his income tax return, because one does not report income paid by oneself to oneself. Let’s also assume that the trust assets increase in value 15% during the year. If part of the growth is attributed to capital gains distributions (e.g., from mutual funds), the grantor will, of course, report the capital gains on his tax personal income tax return (remember, this is a grantor trust).
When the grantor dies, the irrevocable trust owns assets which have increased in value (remember, the assets grew at 15%, but the ILIT paid interest to the Grantor at 2%; thus, the arbitrage difference in rates is 13% – and this increase in value is then distributed to the heirs without any gift or estate taxes). The ILIT assets will then be distributed to the beneficiaries, without any gift or estate taxes.
However, there is one other issue which must be dealt with, and that is, the ILIT owes the Grantor’s estate the principal balance of the loan, plus any accrued interest which has not been paid. This loan increases the value of the Grantor’s estate, for estate tax purposes – but the note might be designed as a self-canceling note. If that is the design of the instrument, then nothing is reported in the Grantor’s estate.
By this time, the sun is setting and it is becoming dark. The rabbit extends his paw, to shake your hand as he prepares to depart. He closes by saying that ordinary rules and common logic do not apply when irrevocable trusts are created. There are complex tax issues which must be dealt with in designing any irrevocable trust, but hopefully, the topics in this article will be of interest, and after you consult with your financial advisor, insurance representative, accountant and attorney, some of the ideas mentioned might be applicable to your overall estate plan.