IRS Greenlights ILIT Replacement Policies

In both 2011-28 and 2008-22, the noninclusion rule is subject to two conditions:

1. The trustee must have a fiduciary obligation to determine that the property acquired by the grantor and the substituted property are actually equivalent in value.
2. The grantor's "substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries."

In other words, the trust agreement must not allow the trustee to turn a blind eye to a non-equivalent substitution. Without that requirement,
a trust could be drafted letting the grantor strip value out of the trust. By ensuring that the trustee has a "fiduciary obligation" to ensure equivalent value, the beneficiaries can hold the trustee to account if he or she allows the grantor to take action that will prejudice the beneficiaries' interests in the trust.

The substitution power cannot be "exercised in a manner that can shift benefits among the trust beneficiaries" if either:

1. The trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries, or
2. The nature of the trust's investments or the level of income produced by any or all of the trust's investments does not impact the respective interests of the beneficiaries–for instance, when distributions from the trust are limited to discretionary distributions of principal and income.

Conclusion

Often, grantor status isn't necessary (or desirable) in a life insurance trust. When the trust is funded with income producing assets that will be used to pay premiums on the policy, it may be appropriate to ensure that the trust is a grantor trust so that the grantor will pay income tax on trust income. Otherwise, the trust may be forced to pay under the trust rate table, which rises to the top 35% level much quicker than the individual rate tables.

But where there is some possibility that an obligation of the trust will be forgiven, generating cancellation of debt income for the trust, grantor status will be highly undesirable. For instance, if the trustee has the power to borrow from the policy and the policy is allowed to lapse while the loans are outstanding, the grantor will be on the hook for the tax bill.

Selling Opportunities

The ruling clears a path for replacing policies in an ILIT without disturbing your client's estate plan. Outdated, expensive policies no longer have to be an expensive irrevocable mistake. You have an opportunity to put the right policy in place for your client, even where their policy is locked up in an ILIT.

If your client's ILIT does not permit substitution of the policy by the grantor, there's hope. Depending on state law, an irrevocable trust can be amended in a couple of ways.

First, does the trustee or someone else have the power to amend the trust under the trust agreement? If the trust agreement doesn't include an amendment provision or the trustee is unwilling to sign off on an amendment, state law may grant amendment power to the grantor. Usually, state law allows a grantor to amend an irrevocable trust with the consent of everyone who has a beneficial interest in the trust.

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