Charitable Trusts

The wealthy have long utilized charitable trusts to meet their philanthropic goals. In 1969, Congress provided tax benefits in the form of income tax deductions and income and estate tax exclusions for the transfer of assets to charitable trusts. Since then, these trusts have steadily gained popularity.

You can use one of several types of charitable trusts depending upon your goals. These trusts can be formed during your lifetime or after death, but all trusts must be irrevocable. Assuming you want to take advantage of these tax benefits during your lifetime, once you are comfortable with not being able to take back the assets, you must decide which type of trust meets your goals.

All types of charitable trusts have two classes of beneficiaries, one class entitled to periodic payments from the trust and the second class receiving the principal. The Charitable Remainder Trust (CRT) is designed to provide you or your designated beneficiaries (for example your children) with income from the trust either for your lifetime or a fixed period of time after which your designated charity receives the remaining principal. A Charitable Lead Trust (CLT) operates in reverse of the CRT in that your beneficiaries receive the remaining principal at your death, while your designated charity receives periodic payments from the trust.

Charitable trusts are further defined by how the periodic payments are determined. You can require the trust to distribute a fixed amount each year (a Charitable Remainder Annuity Trust or a Charitable Lead Annuity Trust). You can also require that the Trust distribute each year a fixed percentage of the trust principal (a Charitable Remainder Unitrust or Charitable Lead Unitrust).

Since Charitable Remainder Trusts (CRT) provide income to the donor or the donor’s beneficiaries, they are much more popular than Charitable Lead Trusts. The following is an example of how a typical CRT might work. Assume you are age 65 and have assets such as marketable securities or real estate worth $500,000 with a tax basis of $200,000. Once you decide which charity to receive the remaining principal, you must decide how much income you or your beneficiaries would like to receive and for what period of time. The unitrust, which pays a percentage of trust assets each year, is usually preferred by relatively young (age 65) donors because of its flexibility.

Assume you decide to receive 5% of the trust’s assets each year. (5% is the minimum). At age 65, you would receive $25,000 (5% of the fair market value of the trust or $500,000). For the rest of your life, you will receive 5% of the value of the trust. Your charitable tax deduction is $225460. If you cannot use all of it in the year you contribute the asset to the trust, you can carry forward the unused deduction for 5 years. Remember, you do not have to pay tax on the $300,000 appreciation in the donated asset and the asset is not included in your taxable estate.

The amount of your charitable tax deduction is directly related to the income you choose to receive. For example, if you chose to receive 8% of the trust’s assets ($40000) in year one, the charitable deduction is only $150,490. The amount of your charitable deduction is also a function of your age. If you wait until age 70 to make the contribution, assuming the minimum 5% payout is selected, your deduction would be $262,565.

Charitable Trusts are by no means for everyone. If you are otherwise charitable minded though,this may be a way to meet your goals with the help of the IRS. As always an attorney familiar with Charitable Trusts should be consulted.

Saving Estate Tax with a Family Limited Partnership

In order to reduce your potential estate tax you must reduce your taxable estate. One customary way to reduce your estate is to make gifts to your ultimate beneficiaries such as your children and grandchildren. Removing an asset from your taxable estate by gift though, will generally require you to part with all dominion and control of the gifted asset. Gifting interests in a Family Limited Partnership which owns the assets that you wish to transfer to your beneficiaries when, properly structured, will remove the assets including appreciation (at a discounted value) from your taxable estate while allowing you to retain control of the assets.

A Family Limited Partnership (FLP) is nothing more than a traditional limited partnership with the donor and the donor’s family members as the general and limited partners. A Limited Liability Company (LLC) is synonymous with a partnership for this purpose since an LLC can be taxed as if it were a partnership. Limited partners by law have no say in the operation and management of any limited partnership which accounts for the discount in value of their partnership interest. General partners control the operation of a limited partnership regardless of their percentage of ownership.

A typical FLP might be organized and operated in the following manner. Donor transfers an asset worth $1,000,000 to a newly created FLP in exchange for a 1% general partnership interest and a 99% limited partnership interest. Donor immediately gifts the 99% limited partnership interest to his children, retaining the 1% general partnership interest. Donor dies 10 years later when the asset is worth $2,000,000. Had Donor gifted 99% of the asset directly to his children, the value of the gift would have been $999,000. Since the children have no control over the asset, the value of the gifted limited partnership interest can be discounted for gift tax purposes. Properly structured and operated it is reasonable to assume the IRS would accept a discount for lack of control and marketability of at least 35%. The value for gift tax purposes of the limited partnership interest assuming a 35% discount would be $643,500. Assuming Donor retains control of the asset until death by retaining the 1% general partnership interest, he or she has removed $1,980,000 from his or her estate at a gift tax cost of only $643,500.

The IRS and Congress have been increasingly concerned with this estate tax saving opportunity. IRS has repeatedly challenged what it believes to be the abusive use of Family Limited Partnerships. The kind of asset transferred to the FLP can be an issue. If marketable securities are the only asset, one can expect IRS scrutiny. At this point though, funding the FLP with something like a rental property appears to be safe.An IRS challenge can also be expected if the FLP fails to operate as such. For example, if the 1% general partner in our example receives distributions in excess of his or her ownership percentage, IRS can be expected to object.

The amount of minority or lack of marketability discounts continues to be an issue. A review of the case law and my personal experience leads me to feel comfortable with a combined discount of 35% when indicated by a sufficient appraisal. The courts have delineated the factors which constitute a sufficient appraisal. A potential donor would be well advised to engage an appraiser conversant with these factors.

Certain members of Congress are interested in legislating away this tax saving opportunity. The “Certain Estate Tax Relief Act of 2009” would eliminate discounts to Family Limited Partnerships as a matter of course. Nevertheless, unless this bill is passed and made retroactive, properly formed and operated, transfers to and gifts of FLP interests are an effective way to reduce estate tax while retaining control of the transferred assets. As always, an attorney well versed in these provisions should be consulted.

Roth Conversions

The advantages of a Roth IRA over a Traditional IRA or 401(k) plan have been well documented. Withdrawals from Roth IRAs (including untaxed earnings) are generally not taxable. Furthermore, unlike other tax deferred arrangements, mandatory distributions upon attaining age 70 ½ are not required from a Roth IRA.

Unfortunately, many people have not been able to take advantage of this tax saving opportunity. If your income exceeds certain levels ($176,000 for joint filers, $10,000 for married filing separately filers and $120,000 for all others) you cannot make a direct contribution to a Roth IRA. You cannot convert a Traditional IRA or 401(k) to a Roth IRA before 2010 if your income exceeds $100,000 or you are married but file separately.

Beginning in 2010 though, you will be able to convert a traditional IRA or in some circumstances your balance in a 401(k) plan to a Roth IRA regardless of your income or filing status. Income tax will be due on the conversion of pre tax contributions and earnings, but for 2010 conversions only, one half of tax will be due on your 2011 return and one half on your 2012 return. Taxable income will be accelerated though to the extent you make distributions from the Roth IRA before 2012.

There are several planning opportunities available in 2009 for those who plan to convert in 2010 or later. As previously mentioned, higher income taxpayers are not eligible to make direct contributions to a Roth IRA. Such taxpayers can make non deductible contributions to a traditional IRA before converting this account to a Roth effectively avoiding the Roth income limitation. Please be advised though that you cannot roll over just after tax contributions. A partial rollover is deemed to be a proportionate amount of pre tax and after tax dollars. All traditional IRAs are considered one for this purpose regardless of which IRA is to be converted.

Another planning opportunity exists for participants in a 401(k) plan. Since 2008, otherwise eligible participants can directly roll 401(k) balances into a Roth IRA if the plan so allows. This opportunity also effectively avoids the Roth income limitation.

If you are planning to convert in 2010, you may also want to consider accelerating 2010 income to 2009 and deferring 2009 tax deductions to 2010 where possible in order to even tax brackets as much as possible.

Whether a Roth conversion is beneficial depends upon a number of factors such as your post retirement income tax rate, your state income tax rules and the length of time your money will remain in the Roth IRA. While these considerations are complex, within certain time limits you may be able to reverse a Roth conversion. As always, you should consult your CPA, attorney or financial advisor to help you plan for this potential retirement savings opportunity.

Garnett Decision Rejects Treatment of Losses from LLC and LLP Interests as Presumptively Passive

The passive activity loss rules in general prevent individuals and certain other taxpayers from deducting passive activity losses against non-passive income. In most cases whether an activity is passive depends on whether the taxpayer materially participates in it. In the case of limited partnerships, Code Section 469(h)(2) treats a taxpayer with a limited partner interest as not materially participating in the partnership’s activity except as provided in regulations (the “per se rule”). Those regulations in turn allow a limited partner to establish material participation, but only by using one of three tests—the 500 hours-per-year test, the test that requires material participation during five of the preceding ten years, or the test that requires three prior years of material participation in the case of a personal service activity. Temp.Reg.Sec. 1.469-5T(e). Were it not for the per se rule, the taxpayer could establish material participation under any of those tests or any of four additional tests—one of which allows aggregation of “significant participation activities” to achieve 500 hours of participation. Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009) holds, based on an analysis of state law governing the limited liability companies (“LLCs”) and limited liability partnerships (“LLPs”) at issue in the case, that interests in those entities are not subject to the per se rule. As a result, the taxpayers in the case are allowed to use any of the seven regulatory tests for material participation. The court reached the same conclusion with respect to certain interests of the taxpayers as tenants-in-common in rental properties.

The taxpayers in Garnett owned direct or indirect interests in seven LLPs and two LLCs engaged in various agricultural businesses. Under applicable state law, they had no personal liability for obligations of the entities. The IRS argued that such limited liability made the taxpayers’ interests limited partner interests for purposes of the per se rule. The Tax Court, however, pointed to the “general partner exception” of Section 1.469-5T(e)(3)(ii) under which an individual’s partnership interest is not treated as a limited partner interest if the individual is a general partner at all times during the relevant tax year. While that provision is aimed primarily at situations where the individual is both a general and a limited partner in the same partnership, the court found that the exception by its own terms is not limited to such dual-status cases. Noting the lack of a statutory or regulatory definition of “general partner”, the court looked to the legislative history of Section 469, which justifies the per se rule on the basis of state law principles that preclude a limited partner from participating in a partnership’s business while retaining limited liability protection. The court therefore concluded that the state law prohibition against limited partner participation in the partnership’s business—rather than limited liability—is the defining characteristic of a limited partner interest for purposes of the per se rule. Turning to the law of the state of formation of the entities (Iowa), the court noted that—in contrast to restrictions on the activities of limited partners—members of LLCs and LLPs can participate in management. Accordingly, the court concluded that taxpayers held their interests in the LLPs and LLCs as general partners for purposes of the per se rule. While the court acknowledged that a factual inquiry into the authority of taxpayers to act on behalf of their LLCs and LLPs may be appropriate in the context of determining material participation, it found such an inquiry unnecessary to determine the application of Section 469(h)(2).

Less than a month after the Garnett decision, the U.S. Court of Federal Claims decided Thompson v. U.S., 2009 TNT 138-4 (July 20, 2009), which also holds that an interest in an LLC is not an interest as a limited partner for purposes of the per se rule. While the court acknowledged certain legislative history suggesting that Treasury may have regulatory authority to treat “substantially equivalent entities” as limited partnerships for purposes of the per se rule, it found that an LLC is not such an entity. Whereas the Thompson decision is a final judgment while the Garnett decision is for partial summary judgment, should the government decide to appeal both cases it is likely the Thompson case would be decided first on appeal.

The Garnett and Thompson decisions may also benefit a real estate professional who qualifies for the “real property business” exception to the general rule that treats rental activities as automatically passive (Code Section 469(c)(2) and (c)(7)). This is because a real estate professional who holds an interest as a limited partner must still apply the per se rule before determining material participation (subject to a narrow de minimis exception contained in Treas.Reg.Sec. 1.469-9(f)(2)).

It is unclear what effect, if any, Garnett and Thompson may have on application of the self-employment tax to members of LLCs and LLPs. In this regard Code Section 1402(a)(13) excludes from self-employment earnings the distributive share of income of a limited partner, subject to an exception for certain guaranteed payments. Complicating any inquiry into this area are longstanding proposed regulations that create a separate series of tests for determining whether a taxpayer is a limited partner for self-employment tax purposes—tests relied upon today by some practitioners despite their status as proposed regulations. See Prop.Treas.Reg.Sec. 1.1402(a)-2(h).

Contributed by Glenn Madere, Esq. Glenn Madere is the Editor of The Readable Code and Regs: Partnerships (Blue Bell, PA: Readable Press, 2009)   Readable Press Website

The Qualified Personal Residence Trust

Reducing the federal estate tax beyond basic estate planning (a Credit Shelter Trust) will require reducing the taxable estate. The easiest way to reduce the taxable estate is to gift assets to one’s ultimate beneficiaries. Gifting, though for this purpose, requires parting with dominion and control of the assets. Retaining almost any interest will cause the “gifted” assets to be included in the purported donor’s taxable estate. There are exceptions to this rule that one cannot retain access and control over gifted assets and not be taxed on such assets at death.

Properly structured, a “Qualified Personal Residence Trust” (QPRT) is one of these exceptions. To take advantage of this opportunity, the donor must irrevocably transfer a personal residence (primary or secondary) to a trustee for the benefit of named beneficiaries (for example, the donor’s children). The donor must select in the trust document a period of time for which the transferred property will be held in trust. While the property is held in trust, the donor has the exclusive right to occupy the property without paying any rent as well as the responsibility to pay (and deduct) real estate taxes and other operating expenses.

The selection of the period of time to retain access and control of the property is critical for a number of reasons. Once the selected period is up, the donor loses access and control and if the donor wishes to use the property, he or she can only do so with the consent of the beneficiaries and must pay the fair rental value of the property. Secondly, the tax benefits increase in proportion to the length of time selected, however the donor (or spouse in certain cases) must outlive the period selected or the value of the property will be includible in the donor’s estate.

A simple example can illustrate the above. Assume Mr. Donor aged 65 owns a vacation house with a current value of $1,000,000. He is certain that upon his demise, he would like his children to own this property. Assume further that he dies 9 years and 364 days from now when the property is worth $2,000,000. If he does nothing, of course the property and its $2, 000,000 value will be included in his taxable estate. Should he transfer the trust into a QPRT and select a 5 year term, the property will not be included in his taxable estate any value. The value of the gift (which would be taxed or would reduce his lifetime exemption) would be about $550,000(the value is discounted using the current section 7520, IRC rate for the selected period and also considering the donor’s life expectancy). For the first 5 years after the transfer, Mr. Donor has the exclusive right to use the property, but must pay the annual expenses of the property. After 5 years, he must pay his children fair market rent if he intends to continue to use the vacation home (and his children agree to rent it to him. Had he selected a 10 year term, the value of the gift would be discounted even further, but sine he did not outlive the selected period, the entire value of $2,000,000 is included in his taxable estate.

A potential downside to this technique is the loss of a stepped basis, but since the long term capital gain rate is considerably less than the federal estate and gift tax rate, this appears to be an acceptable trade-off. Also, while it is true that if the donor does not outlive the period selected to retain the property there is no estate tax savings, the “nothing ventured nothing gained” approach should apply. Finally, while the donor is required to pay rent after the selected retention period, some view thai as an opportunity to pass even more of one’s assets to his or her ultimate beneficiaries free of tax.

There are however many potential complications to such a transfer, especially concerning a sale of the property while it is held in trust. If this estate tax saving opportunity is of interest, you should contact an attorney conversant with these provisions to advise you and draft the appropriate document.

State of The Estate Tax

The federal estate tax exemption or the amount that is not subject to tax is $3,500,000 for an individual dying in 2009. The gift tax exemption is $1,000,000. The maximum federal estate and gift tax rate is 45%. Under current law there is no estate tax for individuals dying in 2010, but for 2011 and beyond the estate tax exemption will return to the pre 2000 amount of $1,000,000 per person. The gift tax exemption remains at $1,000,000 per person for 2010 and beyond. Beginning in 2011, the maximum federal estate and gift tax rate is 55%.

Most everyone believes that the current law will be changed before the year 2010 comes and there is no estate tax. The question is how the law will be changed and is there anything that can be done in 2009 to take advantage of certain provisions of the current law.

The “Certain Estate Tax Relief Act of 2009” (H.R.436) has already been introduced in the House. This bill would retain the current exemption of $3,500,000 indefinitely beginning in 2010. The rate of tax would remain at 45% (50% for large estates). This bill also contains other important provisions. On the positive side, the bill would repeal the carryover basis rules scheduled to become effective in 2010. One negative aspect of this legislation is the removal of the valuation discounts for transfers of non business assets to closely held entities such as Family Limited Partnerships.

Senate Democrats have recently offered their proposal which would set the exemption for both estate and gift tax purposes at $5,000,000 per person ($10,000,000 per couple) indexed for inflation. The estate and gift tax rate would be 35%. There are other proposed bills in Congress dealing with the estate tax. While the post 2009 estate tax law must be determined by our legislators, this may not happen this fall. It has been suggested that Congress may simply extend the law effective for 2009 to 2010 and deal with the broader issues later.

In the meantime, it may be wise to consider transferring non business assets to a Family Limited Partnership now. The discounts for lack of marketability and control are currently available, thus allowing a transferor to either pay less gift tax or transfer more property. While the final version of H.R. 436 could make the effective date retroactive, this seems unlikely since the current version has a prospective effective date.

Contesting A Will

It is not unusual to hear a disgruntled potential heir make a threat to challenge someone’s will. Such threats are easy to make, but usually unsuccessful. Feeling that one has not been treated fairly is not enough by itself to prevail in a will contest. A competent decedent has the right to leave their estate to anyone he or she chooses. A surviving spouse (and in some jurisdictions minor children) may under state law have the right to elect to take a higher percentage of the estate (usually 1/3) if greater than the percentage actually left to them, but this is not contesting the will.

Contesting a will is usually a lengthy and expensive endeavor and the contestant, assuming a sufficient connection or “standing”, also must have a valid legal basis to do so. The following reasons are generally accepted as the legal basis for challenging a will, although state law will vary as to the particulars.

The document offered for probate is not a legally enforceable will. Each state has its own formalities, but usually the will must either be in the decedent’s handwriting or witnessed by two adults and notarized. The document must also have been intended to be the decedent’s last will and not for example, a draft.

The decedent lacked the testamentary capacity to make a will. A person is deemed competent to make a will as long as they understand the composition of his or her estate and know the natural objects of their bounty regardless of any illness or other infirmity.

The decedent was unduly influenced by a person in a fiduciary relationship with the decedent who stands to gain from the will. If such a relationship is found to exist, the burden of proof often switches from the contestant to the proponent of the will (the executor).

Some or all of the will resulted from fraudulent representations or mistaken beliefs of the decedent. Fraud would result if the decedent were intentionally provided with false information. Innocent misrepresentations to or mistaken beliefs by the decedent though, would generally not invalidate a properly executed will.

It is usually advisable to consult an attorney when you think someone may challenge your will. The attorney can explain your state law to you in general and in particular the effect in your state of an “in terrorem” clause. Such a clause in your will attempts to limit challenges by providing that any challenger will be disinherited. Some states do not recognize such clauses as against public policy.

If you expect a will challenge you may also want to take such precautions as videotaping the signing of your will and where appropriate, obtaining documentation from a physician that in your doctor’s opinion, you are competent to make a last will and testament.

The Estate Plans of Michael Jackson and Steve McNair

All too often, celebrities and otherwise wealthy people create problems for their families by failing to take the opportunity to plan their estates. Anyone who fails to provide for their loved ones creates problems, but these problems become magnified for celebrities because of the publicity and wealth. Two recent very public deaths underscore the value of proper estate planning.

Although there will probably be litigation over Michael Jackson’s estate if for no reason other than its size, “The King of Pop” appears to have done all that he could to discourage such challenges. Michael’s will “pours” his assets into a trust. He probably did this to limit public access to his affairs since while one’s entire will is public information, the specific details of a trust are not. Michael’s will and trust specifically name his three children as his beneficiaries. His trust names certain of his siblings’ children as contingent beneficiaries. This is important for two reasons. First of all, there would be no incentive for someone else to claim they are a child of Michael Jackson. Secondly, it takes the intestacy laws of the State of California out of the picture.

Michael’s will attempts to limit the inevitable legal battle over his children by naming a guardian for the children (his Mother) and even a contingent guardian (Diana Ross). His will also contains language to the effect that he is intentionally omitting to provide for his former wife, Deborah Jean Rowe Jackson. These clauses can be important in any future litigation.

The heirs of former star quarterback Steve McNair will not be as fortunate as Michael Jackson’s heirs. McNair, killed in a recent murder-suicide apparently died without a will. NFL insiders are incredulous at this apparent oversight since pro football agents typically refer their clients to estate planning attorneys as a matter of course. If McNair died without a will, the state of his residence and not McNair will decide who gets his assets. The former All-Pro left a wife and their two minor sons. Reportedly, he had two other sons not with his wife One can expect a lengthy legal battle over the paternity of these children and the resulting disposition of the estate. If McNair left no will, he may also have failed to take advantage of some fairly simple estate tax saving opportunities, thus requiring his estate to pay the maximum amount of taxes.

No one should die without a will. The relative complexity of settling the estates of these two recently deceased celebrities will highlight the consequences of failing to do so

The Credit Shelter Trust

The Credit Shelter Trust, sometimes referred to as a “Bypass” or “AB” trust, is so important to any married person’s basic estate plan that it would be malpractice for any estate planner not to at least discuss this estate tax saving tool with his or her married clients. This trust, properly drafted and implemented, will insure that a spouse’s exemption from the federal estate tax will not be wasted.

By way of background, every U.S. citizen and most U.S. residents are granted a lifetime exemption from the federal estate tax. Although technically a credit, the amount of this credit exempts the first $3,500,000 of any one individual’s estate from taxation in 2009. Although future legislation is expected, the current law would exempt only $1,000,000 per person from taxation in 2011. In addition to one’s lifetime exemption,
gifts or inheritances to spouses are fully exempt from estate taxation.

A couple with a combined taxable estate of less than two times the applicable exemption ($7million in 2009, but $2million in 2011) would expect that their ultimate beneficiaries (usually their children) would pay no federal estate tax. Under current law though, this is not always the case. Assume Husband and Wife each have a taxable estate of $1million or a total of $2million. Husband dies in 2011 when the exemption is $1million. Husband leaves his entire estate to Wife and because of the unlimited marital deduction, no estate tax is due. Wife dies then with an estate of $2million. Since her estate has an exemption of only $1million, her beneficiaries are subject to a federal estate tax of approximately $500,000 ($1,000,000 taxable estate times 50% federal estate tax rate).

This happened because her husband wasted his exemption by leaving his entire estate to his wife. This could have been avoided by leaving an amount of his estate equal to the exemption to the couples’ ultimate beneficiaries, but for a lot of reasons this is not usually practical. The solution then is for the first spouse to die to leave the amount of the exemption to a credit shelter trust. The taxable estate of the second to die spouse then would not include this amount.

The language contained in a properly drafted Credit Shelter Trust is by necessity voluminous and complex. However, the trust is fairly simple to administer. In order to accomplish the goal of not wasting the first-to-die spouse’s exemption, the principal (generally up to the amount of the exemption) is left to the couple’s ultimate beneficiaries, for example the children. Typically they are not entitled to any of the principal until the second spouse passes away. The surviving spouse receives all of the income from the assets placed in this trust during his or her lifetime. The surviving spouse may also receive the greater of 5% of the assets or $5,000 each year. In addition, the trustee is usually granted the authority to make discretionary distributions of principal to the surviving spouse for his or her health, maintenance, support or education. The surviving spouse is almost always a co-trustee and under certain circumstances, the only trustee.

Practically, the spouse has almost complete access to the assets of the trust. Considering that it comes with a substantial tax benefit to the ultimate heirs, it does seem foolish not to employ this tax saving tool where appropriate.

The Irrevocable Life Insurance Trust

To most estate planners, basic estate planning would include a will, living trust (where applicable), credit shelter trust (if married), property power of attorney, medical power of attorney and living will. Reducing the federal estate tax beyond the credit shelter trust usually requires an irrevocable transfer of the ownership and use of assets to your loved ones .This strategy is generally appropriate only for the wealthy. The Irrevocable Life Insurance Trust (“ILIT”) though, has the potential to escape estate tax while retaining the ability to control the disposition of assets in the form of life insurance proceeds

Proceeds of life insurance policies owned or deemed owned by a deceased insured or payable to his or her estate can be subject to the federal estate tax depending on the size of the estate. You can avoid having the life insurance proceeds included in your taxable estate by naming someone else such as your spouse or children as the owner of the policy. For many people, this is not a practical solution. For example, this may not be in the best interests of your children if they are minors or otherwise not in a position to manage a large sum of money. Furthermore, the proceeds would be included in the beneficiary’s estate.

The ILIT may be an opportunity to have your cake and eat it too, in that you can provide who and under what circumstances receives the proceeds while escaping the federal estate tax on these proceeds. The trust and not the insured, spouse or heirs must own the policy, The insured must not have any of the powers of ownership such as the right to change the policy in any way. For new policies, the trustee is the original applicant and subsequent sole owner of the policy. The ownership of an existing policy can be transferred to the trust by completing an irrevocable assignment form provided by the insurance company designating the trust as the new owner and beneficiary of the policy. However, if the transferor insured dies within three years of the transfer of an existing policy (but not the purchase of a new policy), the proceeds will be taxable for estate tax purposes.

Like wills and other estate planning documents, sample ILITs can be obtained on the internet. It is highly recommended though to engage an attorney to draft an ILIT because certain legal issues may have to be addressed. For example, if an existing policy is transferred to an ILIT, the cash surrender value could be a taxable gift. A taxable gift can also occur to the extent the insured pays the premium for the insurance policy unless a “Crummey Power” is utilized.

In addition to these pitfalls, a well drafted trust can provide opportunities for the insured and his or her beneficiaries. For example, a “fail-safe” clause could provide protection from the estate tax should the insured die within three years of the transfer of an insurance policy to an ILIT. Also, it is customary to add a clause to the trust authorizing the trustee to either purchase assets from or lend money to the insured’s estate. This option provides the estate with liquidity while shielding the insurance proceeds from tax.

Any competent estate planning attorney can help you avoid the pitfalls and take advantage of the opportunities of an Irrevocable Life Insurance Trust.