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ALI-ABA Video Law Review

ILITs: Drafting and Administering Irrevocable Life Insurance Trusts

December 10, 2007

Live Program/Video Webcast

Designing and Drafting a More Flexible

Irrevocable Life insurance Trust

(with Drafting Examples)

By

Julius H. Giarmarco

Giarmarco, Mullins & Horton PC

Troy, Michigan

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TABLE OF CONTENTS ARTICLE PAGE I. MAINTAINING ACCESS TO CASH VALUES. 1 II. TYPES OF CRUMMEY NOTICES. 5 III. PAYING PREMIUMS DURING THE CRUMMEY

WITHDRAWAL PERIOD. 7

IV. CHANGING CRUMMEY POWERHOLDERS. 9 V. REMOVING AND REPLACING TRUSTEES. 10 VI. POSTPONEMENT CLAUSES. 13 VII. EXCULPATING TRUSTEES. 14 VIII. POWERS OF APPOINTMENT. 16 IX. “FIVE AND FIVE POWERS.” 19 X. CHANGING TRUST SITUS. 20 XI. BENEFICIARY CONTROLLED TRUSTS. 22 XII. DEFINITION OF “SPOUSE”. 25 XIII. TRUST PROTECTORS. 26 XIV. DEFECTIVE IS MORE EFFECTIVE. 30 XV. HOW TO “CHANGE” ILITS WITH SURVIVORSHIP

LIFE INSURANCE. 35

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DESIGNING AND DRAFTING A MORE FLEXIBLE IRREVOCABLE LIFE INSURANCE TRUST1

© 2007 by Julius H. Giarmarco, J.D., LLM

I. MAINTAINING ACCESS TO CASH VALUES.

A. Potential Problem.

1. To avoid estate tax at the death of the grantor-insured, the irrevocable life insurance trust (ILIT) must be irrevocable by the grantor, and must prohibit any distributions of trust income or principal to or for the benefit of the grantor. IRC Sections 2036(a)(2), 2038(a)(2), 2041(a)(2) and 2042(2); Treas. Reg. Sections 20.2041-1(b)(1) and 20.2042-1(c)(3).

2. Because of unexpected future financial needs, changes in the estate tax laws,

and/or changes in the grantor’s family situation, the grantor may be reluctant to give up complete access to his/her policies (by assigning them to an ILIT).

B. Solution: Friendly Power Holder Technique.

1. The ILIT can give the grantor-insured’s spouse (unless the trust owns a

survivorship policy), the grantor’s child or another trusted individual a limited power of appointment (LPA), during the grantor’s lifetime, to appoint trust income and principal to anyone other than the powerholder, the powerholder’s estate, or the creditors of either. IRC Sections 2041(a) and (b)(1).

2. Alternatively, the class of potential appointees can be limited to the grantor,

the grantor’s spouse and the grantor’s descendants in such manner (in trust or otherwise), but not to the powerholder, the powerholder’s estate, or the creditors of either.

3. With such a LPA, the powerholder could appoint the policy back to the

grantor-insured or directly to a new ILIT with revised terms.

4. Caution: do not allow any power that would impair an existing Crummey right.

1 See, Chapter 11 of Sebastian V. Grassi, Jr., A Practical Guide to Drafting Irrevocable Life Insurance

Trusts (With Sample Forms and Checklists) - Second Edition, ALI/ABA, Philadelphia, PA (2007), (800) 253-6397 (http://www.ali-aba.org/aliaba/BK45.asp) for additional techniques to provide flexibility to an irrevocable life insurance trust.

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C. Avoiding Estate Tax Inclusion.

1. If the policy is returned to the grantor-insured, the death proceeds will be included in the grantor’s estate. IRC Section 2042.

2. However, the mere existence of the LPA in the ILIT – whether or not

exercised – should not cause the trust property to be included in the grantor’s estate.

3. IRC Section 2042(2) includes as an incident of ownership a reversionary

interest whose value exceeds 5% of the value of the policy, immediately before the insured’s death.

a. The possible exercise of the LPA is a reversionary interest held by

the insured.

b. However, since the LPA is exercisable solely in the powerholder’s discretion (rather than a mandatory right or based on an ascertainable standard) the value of the reversionary interest is less than 5%. Treas. Reg. Section 20.2042-1(c)(3).

4. IRC Section 2041(a)(2) includes in a decedent’s estate property over which

the decedent has a general power of appointment at the time of death. But since the LPA is not exercisable by the grantor, Section 2041(a)(2) does not apply.

5. IRC Section 2038(a)(1) requires inclusion of property transferred by a

decedent prior to death to the extent that, at the decedent’s death, the decedent, alone or in conjunction with any other person, has the power to alter, amend, revoke or terminate the enjoyment of the property. But since the LPA is not exercisable by the grantor, Section 2038(a)(1) does not apply.

6. IRC Section 2036(a)(1) requires inclusion of property transferred by the

decedent wherein the decedent retained the “possession or enjoyment of” or the “right to the income from” the trust property. a. If the exercise of the LPA is purely discretionary, then IRC Section

2036(a)(1) will not apply. Estate of Wells v. Commissioner, 42 T.C.M. 1981-5T4.

b. But if the grantor and the powerholder had an understanding, express

or implied, that the powerholder would later distribute the trust property to the grantor, then the grantor will have “retained” an interest in the trust property under IRC Section 2036(a)(1). Treas. Reg. Section 20.2036-1(a).

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i. Since the burden to prove no such understanding existed is on

the estate, IRC Section 2036(a)(1) presents the greatest estate tax risk to using the LPA technique.

ii. However, the LPA technique offers no risk for the grantor-

insured who would not otherwise transfer the policy to an ILIT but for the possibility of retaining access to cash values.

c. In addition, if the existence of the LPA in the ILIT allows the

grantor’s creditors to attach the trust property under state law, the grantor will be treated as having retained an interest under IRC Section 2036(a)(1). Treas. Reg. Section 20-2036-1(b)(2)

i. The reason is that the grantor could incur indebtedness and

then relegate his/her creditors to the trust for payment. ii. Therefore, if the grantor lives in such a state, the ILIT should

be established in a state with less favorable creditor laws. 7. Revenue Ruling 2004-64, 2004-27 I.R.B. 7, held that if a grantor trust

mandates that the trustee reimburse the grantor for income taxes, the trust assets will be included in the grantor’s estate under IRC Section 2036.

a. However, a discretionary reimbursement clause will not, by itself,

cause the trust assets to be included in the grantor’s estate under IRC Section 2036.

b. But the ruling cautions that estate tax may be triggered if, under state

law, the discretionary reimbursement clause subjects the trust assets to the claims of the grantor’s creditors.

c. Therefore, to be safe, it may be advisable to not give the trustee

discretionary reimbursement powers (except in “self-settled” asset protection trust states).

D. Gift Tax Consequences Upon Exercise of LPA.

1. If the powerholder is a discretionary income beneficiary of the ILIT, the exercise of the LPA is not a gift to the grantor because the power cannot be valued. Estate of Regester v. Comm’r, 83 TC 1(1984). But see PLR 8535020 (ruling that a holder made a gift when the holder was a potential beneficiary of a discretionary trust).

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2. If the powerholder is not a beneficiary of the ILIT, the exercise of the LPA is not a gift to the grantor. Treas. Reg. Section 25.2511-1(g)(1).

3. If the powerholder is a mandatory income beneficiary of the ILIT, upon

exercise of the LPA the powerholder is making a gift to the grantor equal to the present value of the powerholder’s life income interest in the trust. IRC Section 2511(a); Treas. Reg. Section 25.2514-3(e) Ex.(3).

4. If the powerholder has the right to receive trust income under an

ascertainable standard, the regulations indicate that the holder’s failure to distribute income to himself is not a taxable gift under IRC Section 2514. Treas. Reg. Section 25.2514-3(e) Ex.2. But the IRS could argue that the holder has made a gift of his/her ascertainable right to receive distributions in the future under IRC Section 2511. See PLR 9451049.

5. If the powerholder has the right to receive trust principal as needed under an

ascertainable standard, the value of the gift is the present value of all possible distributions on a year-to-year basis. PLR 9451049.

6. If the grantor’s spouse is the powerholder, there will be no gift tax because of

the unlimited marital deduction. Other powerholders will be able to use the gift tax annual exclusion.

7. Planning Technique: To avoid gift taxes altogether, name a non-beneficiary

as the powerholder. E. Sample Provision.

SECTION ___. LIMITED POWER OF APPOINTMENT

During the Grantor’s life, the Trustee shall have the limited 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) to appoint the principal of the trust to any one or more of the Grantor and the Grantor’s descendants (or to a trust for their benefit), whether living at the time of exercise or thereafter born, in whole or in part, or in equal or unequal proportions, subject to the following provisions. The Trustee may, at any time and from time to time during his/her life, by written instrument delivered to the beneficiaries, release such limited power of appointment with respect to any or all of the property subject to such power and/or may further limit the persons or entities in whose favor this power may be exercised or the extent to which this power may be exercised.

a. Successor Trustees

If the Trustee resigns, is terminated, or cannot serve for any other reason, then the

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Trustee’s successors in trust shall have the right to exercise this limited power of appointment.

b. Qualifications on the Limited Power of Appointment

The power shall only be exercisable by the holder of the power, and shall not be exercised in favor of the holder, the holder’s estate, the holder’s creditors, or the creditors of the holder’s estate.

The power shall not be exercised by the holder in any manner that would result in an economic benefit to the holder or that would in any manner discharge or reduce any legal obligation of the holder, or any legal obligation of the Grantor or the Grantor’s spouse.

The power shall not apply to any “incidents of ownership” with respect to life insurance policies insuring the life of the Trustee which are owned by the trust. The power shall not be effective to the extent it could be considered a general power of appointment because it could be a reciprocal power with someone else holding another power of appointment or power of distribution in this trust or any other trust. The power shall not be exercised by the holder if the value of the principal of the Trust after the exercise would be less than the aggregate amount subject to an unlapsed or outstanding right of withdrawal under this Article after the exercise of the power.

II. TYPES OF CRUMMEY NOTICES.

A. Potential Problems.

1. No written notice was given to the beneficiaries after the initial gift to the ILIT.

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 the 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 as a failsafe.

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C. IRS’s Position.

1. In PLR 199912016 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 199912016 does not specify what constitutes “reasonable” notice.

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. Annual exclusion allowed where beneficiaries were given verbal notice. See

Estate of Carolyn W. Holland v Comm’r, T.C. Memo 1997-302. 4. Annual exclusion allowed for minor beneficiaries (where their parent was a

trustee, beneficiary and their guardian) even though the trustee did not give herself written notice. PLR 9030005. This is an example of constructive notice.

5. Annual exclusion allowed where grantor’s spouse was trustee and had actual

notice. PLR 8008040.

6. A “one-time” notice has been upheld which identified when future contributions were expected to be made. PLRs 8143045, 8133070, 8138102 and 8121069.

7. In TAM 9532001 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.

a. In TAM 9532001 the trust beneficiaries signed a statement waiving

their right of withdrawal to the initial contribution, and revocably waived their right to future notices.

b. Arguably, a single notice that informs the beneficiary of his or her

rights over specific gifts to the trust, and of their dates and amounts is “current” even though many years have passed. If the gift is made on other dates, however, another notice must be given to create an annual exclusion.

E. Sample Provision.

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SECTION ___. NOTICE OF WITHDRAWAL RIGHTS

Each Powerholder shall be kept reasonably informed by the donor, the donor’s agent or the Trustee of all withdrawable transfers hereto which are made or expected to be made. Such efforts may include annually apprising each Powerholder of his/her rights to withdraw, providing the Powerholder 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 donor, the donor’s agent or the Trustee to provide each Powerholder with reasonable notice. After receiving such notice from the donor, the donor’s agent or the Trustee at least once, any Powerholder, or the legal guardian of any Powerholder, by a written instrument mailed or delivered to the donor, the donor’s agent or the Trustee, may permit the donor, the donor’s agent or the Trustee to provide such written notices annually (during the first month of each calendar year) in anticipation of transfers to be made during such year or may altogether waive the donor’s or the Trustee’s obligation to further provide such written notices. In addition, no notice shall be required to be given to any Powerholder who has actual or verbal notice of his/her withdrawal rights. In no event shall the donor, the donor’s agent or the Trustee be held liable for failing to give any notice required hereunder, nor shall the failure of any Powerholder to receive such notice be deemed to abrogate his/her withdrawal rights in accordance with the provisions of this Article. A Powerholder’s right of withdrawal is not contingent upon such notice. Upon request by any Powerholder, the Trustee shall furnish full, detailed information with respect to any such transfers subject to withdrawal hereunder.

III. PAYING PREMIUMS DURING THE CRUMMEY WITHDRAWAL PERIOD.


1. Once the decision has been made to purchase a new policy, the insured does not want to wait until the Crummey 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. A Crummey power is a general power of appointment. 2. A “release” of a general power of appointment (created after October 21,

1942) is treated as a gift by the person possessing the power. IRC Section 2514(b).

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3. However, IRC Section 2514(e) provides an exemption for gift tax purposes for “lapses” of powers that do not exceed $5,000 or 5% of the aggregate value (at the time of lapse) of the trust assets subject to the power.

4. The lapse of the Crummey power (in excess of the $5,000/5% exemption)

will usually result in a “gift over” to the other beneficiaries of the trust (unless “hanging powers” are used or the beneficiary has a limited power of appointment over his/her portion of the trust so as to create an incomplete gift). Moreover, this gift over is not a present interest gift which qualifies for the gift tax annual exclusion.

5. 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.

6. If the IRS decides to treat a beneficiary’s waiver of his/her withdrawal power as a release, a taxable gift over 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 gift tax exemption. It will also change the identity of the transferor for GST tax purposes.

C. Solution.

1. Provide the Crummey powerholder with notice and, in lieu of waiving the

notice, have him/her 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 assets.

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.

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________________________________________ Signature of Beneficiary or his/her Guardian if Beneficiary is a Minor IV. CHANGING CRUMMEY POWERHOLDERS.


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 that powerholder.

B. Solution.

1. In the trust instrument permit the donor to determine (each time a gift is made to the trust) whether the Crummey withdrawal right may be exercised.

2. The donor should also be given the right to determine the amount of exercise

and by whom it may be exercised.

C. Tax Consequences.

1. PLR 9834004 involved a Crummey trust that contained a provision which gave the donor of any transfer to the trust 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 because the power is exercised at the time the gift is

made, it is not a retained power subject to IRC Sections 2036 and 2038.

D. Sample Provision.

SECTION ___. POWER TO CHANGE WITHDRAWAL RIGHTS

Notwithstanding the limitations provided in this Article with respect to withdrawal rights of the Powerholders, the donor making a transfer shall have the right, by acknowledged instrument delivered to the Trustee on or before the date of the specific transfer: (i) to prohibit any or all of the Powerholders from exercising a withdrawal right with respect to such transfer; (ii) to increase or decrease the amount subject to the withdrawal right of any or all of the Powerholders with respect to such transfer, except that the amounts subject to the withdrawal right shall not exceed the value of the property transferred at the time of

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transfer; or (iii) to change the period during which any or all of the Powerholders may exercise the withdrawal right, including provisions relating to the lapse of such right, with respect to such transfer.

V. REMOVING AND REPLACING TRUSTEES.


1. The grantor and, after the grantor’s death or incapacity, the beneficiaries desire to remove a trustee who is unresponsive or ineffective.

2. The grantor and, after the grantor’s death or incapacity, the beneficiaries

desire to remove a trustee to reduce administration costs.

B. Solution.

1. Provide the grantor and the beneficiaries (after the grantor’s death or incapacity) in the trust instrument the right to remove and replace trustees.

2. Consider whether or not the grantor’s ex-spouse (or the ex-spouse of a

descendant of the Grantor) should have the right to remove and replace trustees on behalf of minor children.

3. Provide guidelines as to qualifications of any successor trustee.


1. Rev. Rul. 95-58, 1995-2 C.B. 191, reversed Rev. Rul. 79-353, 1979-2 C.B.

325, 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 Sections 2036 and 2038.

2. In PLR 9607008, the IRS extended its holding in Rev. Rul. 95-58 to

beneficiaries who were given the power to remove and replace trustees.

3. However, Rev. Rul. 95-58 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 should not be appointed 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

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rules. Prior to Rev. Rul. 95-58, 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 also inconsistent with the Tax Court’s holding in Estate of Wall, 101 TC 300 (1993).

c. The implication in Rev. Rul. 95-58 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.

d. Nevertheless, the prudent course of action is to follow the

requirements of Rev. Rul. 95-58.


SECTION ___. THE REMOVAL OF A TRUSTEE

The Grantor reserves the right to remove any incumbent Trustee or Co-Trustee and any successor Trustee designated to act in the future and appoint a successor individual or Independent Trustee or a series of successor individual or Independent Trustees or Co-Trustees. As a condition precedent to removing a Trustee or Co-Trustee hereunder, the Grantor must first appoint an Independent Trustee (if no successor Trustee has already been named herein), as such term is defined in subparagraph (c) of this Section.

After Grantor’s death, or during any period that Grantor is disabled, Grantor’s spouse may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a series of successor Independent Trustees or Co-Trustees. As a condition precedent to removing a Trustee or Co-Trustee hereunder, Grantor’s spouse shall first appoint an Independent Trustee (if no successor Trustee has already been named herein) or a series of successor Independent Trustees, as such term is defined under subparagraph (c) of this Section.

After the death or disability of Grantor’s spouse, a majority of the beneficiaries (with any beneficiary under a legal disability acting through his/her Agent) then eligible to receive mandatory or discretionary distributions of net income under this agreement may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a series of successor Independent Trustees or Co-Trustees. In addition, each beneficiary (with any beneficiary under a legal disability acting through his/her Agent) for whom a separate trust is named or established hereunder may remove any incumbent Trustee or Co-Trustee and a successor Trustee designated to act in the future and appoint a successor Independent Trustee or a

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series of successor Independent Trustees or Co-Trustees with respect to his/her separate trust. As a condition precedent to removing a Trustee or Co-Trustee hereunder, Grantor’s beneficiaries (or their Agent as the case may be) shall first appoint a successor Independent Trustee (if no successor Trustee has already been named herein) or a series of successor Independent Trustees, as such term is defined under subparagraph (c) of this Section. Notwithstanding the foregoing, for all purposes of the trust, a surviving parent of a minor beneficiary who is also the Grantor's ex-spouse by divorce or an ex-spouse of a descendant of the Grantor by divorce shall not, in his/her capacity as guardian of such beneficiary, or in any other capacity in which he/she may be acting on behalf of such beneficiary, have the power to remove a Trustee, name any successor Trustee or otherwise act on behalf of such beneficiary with respect to any trust created under this Trust Agreement. In no event shall Grantor serve as a Trustee hereunder.

a. No Cause for Removal Needed

The beneficiaries need not give any Trustee being removed any reason, cause, or ground for such removal.

b. Notice of Removal

Notice of removal shall be effective when made in writing by either:

Personally delivering notice to the Trustee and securing a written receipt, or

Mailing notice in the United States mail to the last known address of the Trustee by certified mail, return receipt requested.

c. Definition of Independent Trustee As used in this instrument, the term “Independent Trustee” means a person: (i) who is not related or subordinate (within the meaning of IRC Section 672(c)) to any donor or beneficiary with respect to the trust in question; (ii) who cannot be benefited by the exercise or non-exercise of any power given the Trustee by this Trust Agreement or by law; (iii) who is neither a beneficiary nor a donor of the trust in question; and (iv) who is a Bank or Trust Company or an individual experienced in business, finance or investments or is an attorney or accountant experienced in the areas of trusts or taxes. In the event that any Independent Trustee should for any reason cease to meet such qualifications, he or she shall immediately cease to be a Trustee as though he or she had resigned immediately prior to the occurrence of such disqualification.

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VI. POSTPONEMENT CLAUSES.


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 (a

general power of appointment).

3. At time of distribution or withdrawal, the beneficiary has creditor or personal problems (e.g., malpractice claims, pending divorce, addiction to drugs or alcohol, serious mental or physical disability, etc.)

B. Applicable State Law.

1. Generally, 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.)

3. Use a Dynasty Trust.

4. Don’t allow the beneficiary to be the sole trustee, but allow the beneficiary to

remove and replace the co-trustee with someone who is neither related nor subordinate.


SECTION ___. RETENTION OF DISTRIBUTIONS IN TRUST

Notwithstanding anything contained herein to the contrary, but subject to the provisions creating a Qualified Subchapter S Trust herein, the following provisions shall apply to all trusts created by this Trust Agreement:

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a. Distributions to Existing Beneficiaries. Property otherwise distributable under any trust created under this Trust Agreement to a beneficiary for whom a trust is then held hereunder shall be added to that trust to be held, administered and distributed in accordance with the terms thereof. b. Postponement of Distributions in Trustee’s Discretion. The Trustee shall have the power to refuse a withdrawal request (other that a Crummey withdrawal right that has been granted to the beneficiary concerning intervivos gifts made to the trust by a donor) or to postpone any distributions of principal otherwise required to a beneficiary upon or after the beneficiary’s attainment of a specified age or the death of a third person (if such withdrawal right exists or distribution direction is provided for with respect to that Trust share), and to postpone the termination of such trust which might otherwise be required, all as if such withdrawal right had not been available, or such age had not been attained, or such death had not occurred, if the Trustee, in its sole discretion, determines that such refusal or postponement is consistent with the Grantor's overall intent. In exercising such discretion, the Grantor authorizes and approve 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, the beneficiary’s involvement in a "cult" type organization, the involvement of the beneficiary as a defendant in a civil or criminal lawsuit or in any bankruptcy proceeding, present or imminent financial difficulty, a serious tax disadvantage in making a distribution, or similar substantial cause. Any such refusal or 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 refusal or postponement 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 Section, 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 Section. Notwithstanding anything contained in this Article to the contrary, during any period of time that a beneficiary’s distributions are being postponed pursuant to the foregoing provisions, the Trustee may also distribute the income and/or principal of such beneficiary’s trust to or for the benefit of the beneficiary’s spouse and descendants (if any) for said spouse’s and descendants’ health, education, maintenance and support. The Trustee may make unequal distributions to said spouse and descendants or may at any time make a distribution to fewer than all of them, and shall have no duty to equalize those distributions.

VII. EXCULPATING TRUSTEES.

A. Potential Problem.

1. Existing policies are assigned to the ILIT, or the grantor applies for a new

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policy for the ILIT to acquire. In either case, the trustee was not significantly involved in the selection and/or “due diligence” 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 (and/or the life insurance agent’s) selection of the policies.

C. Applicable State Law.

1. The extent to which a trustee’s liability for breach of trust can be exculpated under the terms of the trust instrument is a matter of state law.

2. For example, under Section 1008 of the Uniform Trust Code an exculpation

clause is unenforceable to the extent that it relieves the trustee of liability for breach of trust committed in bad faith or with reckless indifference to the purposes of the trust or the interests of the beneficiaries. Thus, accordingly to the UTC, a trustee must always comply with a certain minimum standard.


SECTION ____. LIMIT ON TRUSTEE’S DUTIES AND RESPONSIBILITIES The Trustee, conclusively and without inquiry or independent investigation, may rely upon 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 at no time shall have any duty whatsoever (i) to verify that any particular life insurance policy satisfies the requirements for a life insurance contract under IRC Section 7702; (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 projected performance or pricing of any other life insurance policy which may then be available from any

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source; (iii) to assess the appropriateness of purchasing or retaining any life insurance policy as an asset of the trust as compared to other then-available vehicles that are not life insurance policies; or (iv) to investigate the strength or solvency of the company which issued or is offering a given life insurance company policy. The Trustee may retain any life insurance policy purchased by the Trustee or transferred to the Trustee by the Grantor, a predecessor Trustee, or any other person, and the Trustee shall have no duty at any time to make any inquiry or investigation into the advisability of such retention (including, but not limited to, inquiry or investigation into the same or similar matters set forth above). With respect to any such policies retained by the Trustee, the Trustee shall have no liability to the Grantor or to any present or future beneficiary of the Trust for non-productivity, decline in value or lack of diversification of the trust assets. The fact that the Trustee may have made inquiry regarding any such matter prior to the acquisition of a policy or after the acquisition of such policy shall place no duty upon the Trustee to make any further inquiry, but shall be considered activity beyond the scope of the Trustee’s duties. The Trustee shall not be liable to the Grantor nor to any present or future beneficiary of the Trust for any loss or damage suffered in connection with performance or lack of performance of any life insurance policy owned by the Trust or by the insolvency of any life insurance company issuing any such policy. The Trustee’s duties and responsibilities with respect to any life insurance policy owned by the Trust, until such policy matures or is surrendered or otherwise disposed of, are to provide safekeeping services with respect to the policy, and to pay premiums as and when they come due or, under the terms of the policy, may be paid, if, but only if, the Trustee has sufficient available funds to do so. Grantor specifically acknowledges that the Trustee would not accept the position of Trustee unless the Trustee’s duties, responsibilities, and liabilities were limited as set out herein.

VIII. POWERS OF APPOINTMENT.


1. Changes in tax laws make the ILIT’s dispositive provisions undesirable.

2. Changes in economic, social and individual circumstances make the trust’s dispositive provisions undesirable.

3. Primary beneficiary’s descendants become “vested”.

B. Solution.

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1. To allow beneficiaries more flexibility to address future circumstances,

provide them (in the trust agreement) with a testamentary and/or inter vivos 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/her estate, or the creditors of either”.

b. Class of potential recipients can be as narrow as “the grantor’s descendants (other than the powerholder)”.

c. Class of appointees can include charities and allow income and/or

principal to be paid to a beneficiary’s spouse (in trust).

3. The LPA can permit property to be appointed outright or in trust. 4. Where the trust property is subject to GST taxes, the beneficiary may be

given a general power of appointment (GPA) thereby triggering an estate tax rather than a GST tax. IRC Section 2041(a)(2).

a. However, the lapse of a GPA up to the greater of 5% of the trust

assets (subject to the power) or $5,000 does not trigger an estate tax. IRC Section 2041(b)(2).

b. Because of the flattening of the federal estate tax rates, paying an

estate tax may not be more favorable than paying a GST tax. c. Caution: with a GPA, the powerholder’s creditors have an

opportunity to attach the assets subject to the power.


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. 2041.

2. The existence (or exercise) of a testamentary LPA generally does not have

any estate tax consequence to the powerholder. IRC Section 2041(a)(2). 3. However, if a LPA, created after October 21, 1942 (the first power) is

exercised to create a second LPA, which can be exercised to postpone the vesting period, the exercise of the first power to create the second power will

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result in the trust property being included in the frist powerholder’s estate. IRC Section 2041(a)(3) and IRC Section 2514(d). This is the so-called “Delaware Tax Trap.”

4. If an inter vivos LPA is exercised whereby property is redirected away from

a powerholder who is entitled to mandatory distributions of income, a gift has occurred. Treas. Reg. Section 25.2514-1(b)(2) and Estate of Regester v. Comm’r, 83 T.C. (1984).


SECTION ___. POWER OF APPOINTMENT UPON THE DEATH OF A PRIMARY BENEFICIARY Upon the death of the primary beneficiary, the Trustee shall transfer, convey and pay over the trust estate, as it is then constituted, to or for the benefit of such one or more of the descendants of the Grantor (other than the primary beneficiary, his or her estate or creditors or the creditors of his or her estate) or such religious, scientific, charitable or educational organizations described in IRC Section 501(c)(3), in such proportions and upon such terms and conditions and estates, with the powers, in the manner and at the times as the beneficiary appoints by a valid last will or by a valid living trust agreement which specifically refers to this power, including, without limitation, the granting of a presently exercisable general or limited power of appointment. Provided, however, that the primary beneficiary is prohibited, without the prior written consent of the Trustee, from exercising such power of appointment over any trust created hereunder that has an inclusion ratio of less than one (1) for generation-skipping transfer tax purposes in a manner that would cause Code Section 2041(a)(3) or Code Section 2514(d) to apply by reason of such exercise, and any such exercise shall be void. In addition, the primary beneficiary may appoint an income interest for life (or a term of years) in favor of a spouse of a descendant of the Grantor, the remainder of which shall be payable to or for the benefit of one or more descendants of the Grantor or charity, other than the primary beneficiary, the primary beneficiary’s estate and creditors, and the creditors of the primary beneficiary’s estate. The primary beneficiary may, at any time and from time to time during his or her life, by a written, acknowledged instrument delivered to the Trustee, release such power of appointment with respect to any or all of the property subject to such power, or may further limit the persons or entities in whose favor or the extent to which this power may be exercised. If the primary beneficiary does not effectively exercise this power of appointment for any reason, in whole or in part, the trust estate, to the extent not effectively appointed by the primary beneficiary, shall, upon his or her death, be disposed of in accordance with the terms and conditions provided herein.

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IX. “FIVE AND FIVE POWERS.”

A. Problem.

1. The grantor desires that the beneficiary be the sole trustee of a GST ILIT. Thus, if the beneficiary-trustee is not limited to an ascertainable standard (health, education, support and maintenance), the trust property will be included in the beneficiary’s estate as a general power of appointment. IRC Sections 2041 (a)(2) and 2041 (b)(1)(A).

2. The grantor desires that an independent trustee manage the ILIT but would

like the beneficiaries to have some degree of unfettered access to trust property.

B. Solution.

1. Give the beneficiary the power each year to withdraw the greater of $5,000 or 5% of the aggregate value of the trust property.

2. For estate tax purposes (see Paragraph C(3) below), provide that the $5,000

or 5% power can only be exercised on a particular date or during a particular month.

3. If the trust assets are substantial, consider limiting the power to some lesser

amount or to a smaller percentage.

4. The terms of the $5,000 or 5% power should be available only upon the beneficiary attaining a specific age (i.e., 25 or 30 years).

5. Query: Can the grantor protect a beneficiary from creditors by providing that

the $5,000 or 5% power may not be exercised involuntarily? In any event, don’t permit an involuntary exercise of the $5,000 or 5% power. One way to prevent the involuntary exercise is to require the prior written consent or joinder of an “independent” Trustee. See, IRC sections 2041(b)(1)(C) and 2514(c)(3).

C. Tax consequences (IRC Section 2041).

1. A general power of appointment will not cause federal estate tax inclusion of

the entire trust assets if it is limited to the greater of $5,000 or 5% of the aggregate value of the trust property.

2. If the power is not cumulative and lapsed in prior years, the lapsed amounts

will not be includible in the beneficiary’s estate.

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3. The beneficiary’s estate will, however, include the property value that the

beneficiary could appoint to himself/herself at the time of his/her death (i.e., $5,000 or 5%). But see Paragraph B(2) above for a possible solution to this problem.

4. In PLR 9034004 the IRS ruled that a $5,000/5% powerholder (who was

entitled to all of the trust income quarterly) owned that portion of the trust that was subject to the power during its pendency, and upon the power holder’s failure to exercise the power, he/she would be treated as the owner of the trust under IRC Section 677 (income for benefit of grantor) and 678 (person other than grantor treated as owner), because the income of that portion would be ultimately paid to him/her.

D. Sample Provision. SECTION ___. RIGHT TO WITHDRAW PRINCIPAL. After attaining age 30, each Primary Beneficiary of a trust created hereunder shall have the non-cumulative right to withdraw from the principal of his or her trust in any calendar year amounts not to exceed Five Thousand ($5,000) Dollars in the aggregate. In addition, on the last day of any calendar year, if the Primary Beneficiary is then living and has attained age 30, the Primary Beneficiary may withdraw an amount by which five percent (5%) of the then market value of the principal of his or her trust exceeds the principal amounts, if any, previously withdrawn in that year under this Section. All requests for principal distributions pursuant to this Section shall be in writing delivered to the Trustee. The Primary Beneficiary’s right of withdrawal hereunder may not be exercised involuntarily.

X. CHANGING TRUST SITUS.


1. Beneficiaries move away from jurisdiction where grantor established the ILIT and, therefore, it is more convenient for them to deal with a local trustee (who prefers to apply local law).

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., jurisdictions with no state income tax).

B. Solution.

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1. Under the laws of many states, whether or not a trust may be removed from

its original jurisdiction is a matter of the grantor’s intent. If the grantor’s intent is not clear, then the matter becomes one for judicial interpretation.

2. Therefore, provide in the trust agreement that the trustee can change the

trust’s situs. C. State Income Taxes.

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.


SECTION ____. TRUST SITUS/APPLICABLE STATE LAW Except as otherwise provided in this sub-paragraph, the validity, construction, administration, meaning and effect, and all rights of beneficiaries under this Agreement (and any other instrument related thereto) shall be governed by the laws of the State of ____________ without regard to its conflicts of law principles; provided, however, that all matters pertaining to the Trustee’s administration of real property shall be governed by the laws of the situs of such real property, including such jurisdiction’s conflict of law principles. The administration, construction, meaning and effect, and rights of beneficiaries under a trust established by the exercise of a power of appointment granted hereunder shall be governed by the laws of whatever jurisdiction may be designated either in such instrument of appointment or in the resulting trust (or, absent such designation, by the laws of the State of ___________). This Section shall apply regardless of any change of residence of any Trustee or any beneficiary, or the appointment or substitution of a Trustee residing in another jurisdiction. The Trustee may, with the written consent of a majority of the trust’s current income beneficiaries who are not incapacitated, change the situs of such trust and elect to have the validity, construction, administration, meaning and effect or rights of beneficiaries of such trust be governed by the laws of another jurisdiction, in or outside the United States (including that jurisdiction’s law concerning the maximum duration of trusts). The Trustee may not change the situs of a trust or the trust’s governing law in order to limit its existing liability to the beneficiaries. The jurisdiction whose laws govern the validity, construction, administration, meaning and effect, and rights of beneficiaries of any trust may, but

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need not, be the same as the situs of the administration of such trust. This Agreement shall be exempt from mandatory registration (although the Trustee may, in its discretion register any trust).

XI. BENEFICIARY CONTROLLED TRUSTS

A. Potential Problems. 1. Assets left to beneficiaries outright (or at stated ages) are subject to estate

taxes (when the beneficiary dies), creditors, divorced spouses and mismanagement.

2. Assets left to beneficiaries outright (or at stated ages) may end up in the

hands of in-laws when the grantor preferred they pass to descendants only. B. Solution. 1. Hold assets in trust for beneficiary for the maximum perpetuities period

permitted under state law. 2. Make distributions of income and principal totally discretionary rather than

mandatory or subject to an enforceable ascertainable standard. 3. Give the beneficiary a testamentary limited power of appointment to

“rewrite” the trust for future generations, and a 5%/$5,000 power (after attaining a stated age).

4. Allow the trustee to acquire assets (including a vacation home or business) as

an investment of the trust rather than making distributions to the beneficiary who then acquires the assets. The beneficiary would be allowed “rent free” use of those assets.

5. Leverage the grantor’s GST exemption by allocating the exemption to all

gifts of premiums to the ILIT. 6. At a stated age (i.e., 25 to 30) allow the primary beneficiary to become a co-

trustee over his/her separate trust share, and to remove and replace his/her co-trustee with someone who is neither related nor subordinate.

C. Sample Provision. SECTION ___. DISTRIBUTION OF TRUSTS FOR THE GRANTOR'S CHILDREN

The trust for each child who survives the Grantor shall be distributed as follows:

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a. Distribution of Trust for [Name of Beneficiary].

The Trustee, in its sole and absolute discretion, shall apply to, or for the benefit of [Name of Beneficiary], (the "Primary Beneficiary") and the Primary Beneficiary’s descendants (hereinafter collectively referred to as the "beneficiaries") as much of the net income and principal from this trust as the Trustee deems advisable for their health, education, maintenance, support, and best interests. Any excess income shall be added to principal. The reference to “health, education, support and maintenance” is a limitation (ceiling) on such discretionary distributions, and is not an enforceable standard (floor) mandating discretionary distributions. 1. Guidelines for Discretionary Distributions.

To the extent that the Grantor has given the Trustee any discretionary authority over the distribution of income or principal to the beneficiaries, (including discretionary distributions limited to a beneficiary’s health, education, support and maintenance), the Trustee shall be mindful of, and take into consideration to the extent it deems necessary, any additional sources of income and principal available to the beneficiaries which arise outside of this trust and are known to the Trustee. It is the Grantor's desire that the preservation of principal be a priority for purposes of this trust and that genuine need must be shown by the beneficiaries before the Trustee shall make a discretionary distribution. The Trustee shall, therefore, lend income and principal of this trust to the beneficiaries or buy assets for their use, rather than distributing income or principal outright to beneficiaries, unless the Trustee determines that outright distributions are more appropriate. The Trustee may permit the use of any trust property by any beneficiary without the necessity of any compensation of any kind from the beneficiary to this trust for such use. In this regard, the Trustee may acquire any property, whether real or personal and whether income producing or not, which the Trustee believes desirable for the beneficiary’s health, education, maintenance, support and best interests. Such property may include, but shall not be limited to, residential real estate, household furnishings and appliances, artwork and jewelry. In addition, the Trustee can invest trust property in a business in which the Trustee believes the beneficiary has reasonable prospects for success.

Without in any way limiting the nature of the discretion conferred upon the Trustee and without imposing any fiduciary duty to do so, it is the Grantor's intention that the Trustee should consider the interests of the Primary Beneficiary as paramount to the interests of the other beneficiaries. A distribution to or for the benefit of a beneficiary shall be charged to this trust rather than against the beneficiary’s ultimate share upon the termination of this trust. 2. Right to Withdraw Principal. [See Sample Language in Article IX, above]

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3. Limited Power of Appointment Upon Death of a Primary Beneficiary.

[See Sample Language in Article VIII, above] 4. Disposition of Unappointed Property For Descendants of the Primary Beneficiary.

Upon the death of the Primary Beneficiary, if any descendant of the Primary Beneficiary is then living, the unappointed principal and accrued income, if any, of the trust shall be divided into shares to be set apart, on a per stirpital basis with respect to the then living descendants of the Primary Beneficiary. Any share so set apart with respect to a descendant of the Primary Beneficiary shall be held in a separate trust to be administered as provided in this paragraph (a), with such descendant with respect to which such share was created referred to as the “Primary Beneficiary”, and with such Primary Beneficiary and his or her descendants collectively referred to as the “beneficiaries”. If no descendant of the Primary Beneficiary is then living, the remaining trust property shall be distributed to the then living descendants, per stirpes, of the Primary Beneficiary’s nearest ancestor who is a descendant of the Grantor and of whom one or more descendants then are living, or, if no such descendant is then living, to the Grantor's then living descendants, per stirpes, provided, any share thus inuring to a descendant of the Grantor shall be held in a separate trust (then or previously created with respect to the descendant under this paragraph (a)) to be administered as provided in this paragraph (a). If a trust for a descendant has already been established in accordance with other provisions of this Article, and if the provisions of such other trust differ from the provisions of the trust for such descendant under this subparagraph (a), then the share created for such descendant pursuant to this subparagraph shall, notwithstanding this subparagraph, be added to such other trust and be administered in accordance with the provisions of such other trust.

5. General Dispositive Intention of the Grantor.

It is the Grantor general intention of that, upon the death of any Primary Beneficiary of any trust under this paragraph (a), regardless of his or her generation from the Grantor (except to the extent that the Primary Beneficiary effectively exercises his or her limited power of appointment) the property in that trust be divided, as provided above, on a per stirpital basis, into trusts for the Primary Beneficiary’s surviving descendants with each of those descendants becoming a Primary Beneficiary of his or her own trust, to be similarly disposed of through all succeeding generations in perpetuity to the maximum extent permitted by the governing law.

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XII. DEFINITION OF “SPOUSE”.


1. In a single life ILIT, a life estate is usually provided for the grantor-insured’s surviving spouse. Subsequently, the couple divorces.

2. Same facts as above, except that the grantor’s spouse is also named as a

trustee or successor trustee, and also has a lifetime special power of appointment to appoint assets back to the grantor and/or the grantor’s descendants.

3. Same facts as above, except that other members of the spouse’s family are

named as beneficiaries, trustees and/or powerholders.

B. Solution.

1. Add a provision to the trust instrument that in the event of a divorce, the grantor’s spouse (and all members of the spouse’s family that are not also members of the grantor’s family) shall be deemed to have predeceased the grantor for all purposes of interpreting the trust agreement.

2. Add a provision to the trust instrument that in the event of a divorce

involving a grantor’s descendent, the divorced spouse of grantor’s descendant spouse (and all members of the spouse’s family that are not also blood relatives of the grantor’s family) shall be deemed to have predeceased the grantor for all purposes of interpreting the trust agreement.

3. Alternatively, the grantor’s “spouse” can be defined to mean that person

grantor is married to at the time of his/her death.

C. Sample Provision.

SECTION ___. DIVORCE

In the event Grantor’s spouse and Grantor become divorced or legally separated, Grantor’s spouse and Grantor’s spouse’s relatives (who are not also Grantor’s blood relatives) shall be deemed to have predeceased Grantor for all purposes of interpreting this Agreement (other than for purposes of the “rule against perpetuities” provisions under this Agreement). In the event a descendant of Grantor and Grantor’s spouse become divorced or legally separated, such spouse and said spouse’s relatives (who are not also Grantor’s blood relatives), shall be deemed to have predeceased Grantor for all purposes of this Agreement (other than for purposes of the “rule against perpetuities” provisions under this Agreement).

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XIII. TRUST PROTECTORS.


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.)

3. While Rev. Rul. 95-58, 1995-2 C.B. 191, allows the grantor to remove and

replace trustees without running afoul of IRC Sections 2036 and 2042, the replacement trustee cannot be related or subordinate to the grantor. This prohibits the naming of family members.

B. Solution.

1. Provide in the trust instrument that an independent trust protector can amend

or modify the ILIT subject to specific limitations.

2. The trust protector’s powers may include the power to change the trust’s situs, to remove and replace trustees, to add beneficiaries, to alter the trust’s dispositive provisions, and to terminate the trust.

3. To protect the trust protector from beneficiary claims of breach of fiduciary

duty, the trust protector’s powers should be exercisable in a non-fiduciary capacity and the trust protector should not be liable for either acting or failing to act.

4. Note: the statues of seven states (i.e. Delaware, Utah, Alaska, Idaho, New

Hampshire, South Dakota and Wyoming) specifically address the role of a trust protector and, therefore, ILITs governed by those state laws must be drafted in light of those laws. For example, in Idaho, New Hampshire and South Dakota, a trust protector is considered to be acting in a fiduciary capacity, but not so in Alaska.


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 related or subordinate to the grantor) 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 and, therefore, subject the trust assets to estate tax

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inclusion under IRC Sections 2036 and 2038. 3. As long as the trust protector’s powers do not constitute a general power of

appointment, and there is no pre-planned collusion, there is no law or regulation that could cause giving a trust protector powers akin to a limited power of appointment to cause estate tax inclusion in the grantor or the trust protector. Since there is no retained control or incident of ownership, such a power does not come under IRC Sections 2041 or 2514.

4. 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. 2041.

5. The grantor should not have the power to remove the trust protector. Instead,

the ILIT should name a “remover” who possesses the power to remove a trust protector (in which case the successor trust protector takes over).

6. If the trust protector can exercise a power to add new beneficiaries, then

grantor trust status is triggered under IRC Sec. 674(c).

7. Do not allow any power that would impair an existing unlapsed Crummey right.

D. Sample Provision.2

SECTION _____. TRUST PROTECTOR

Notwithstanding any other provision of this Trust: 3.5.1. Appointment. Grantor nominates and appoints _____________, as the Trust

Protector of this Trust. If _________________, fails to act, or is unable to continue to act as Trust Protector, that person may (but is not required to) appoint any one or more successor Trust Protector as provided in Section 3.5.4 below. Any person selected as a Trust Protector must not be related and/or subordinate to Grantor, or to any vested beneficiary under this Trust. For this purpose related and subordinate have the same meaning as they have under IRC §672(c). No trust share created under this Trust is required to have a separate Trust Protector acting with respect to that trust share.

3.5.2. Scope of Authority. The Trust Protector may, with respect to any trust share

as to which the Trust Protector is then acting, modify or amend:

2 This sample language is provided courtesy of George F. Bearup, Esq. of Smith Haughey Rice & Roegge

of Traverse City, Michigan.

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A. This Trust’s administrative provisions relating to the identity, qualifications, succession, resignation, removal and appointment of the Trustee;

B. The financial powers of the Trustee, but only with the Trustee’s prior

written consent; C. The withdrawal rights granted under this Trust (except a withdrawal

right that has already matured at the time the Trust Protector seeks to exercise the power conferred under this Section) so as to preserve the annual exclusion gift tax treatment of transfer to this Trust; and

D. The terms of any trust share created under this Trust with respect to:

(i) the purposes for which the Trustee may distribute trust income and trust principal, and the circumstances; (ii) factors the Trustee may take into account in making such distributions; and (iii) the termination date of the trust share, either by extending or shortening the termination date (but not beyond the applicable perpetuities period).

3.5.3. Limitation on Trust Protector’s Authority. However, the Trust Protector

shall not possess the power to amend this Trust: (i) to add one or more persons to the group of beneficiaries under it; (ii) to delete one or more persons from the group of beneficiaries under it; or (iii) to affect the amount of income or principal that may be withdrawn by or distributed to or for the benefit of any named trust beneficiary.

3.5.4. Successors. The Trust Protector acting from time to time may appoint any

one or more persons (who are not related and/or subordinate to Grantor or to any vested beneficiary under this Trust) as successor Trust Protector. Any appointment of a successor Trust Protector 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, 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 and be binding upon the Trustee.

3.5.5. Resignation; Removal. Any Trust Protector may resign by giving prior

written notice to the Trustee. In addition, at any time and from time to time, the Trustee(s) may remove, with cause, a Trust Protector acting under this Trust.

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3.5.6. Several Protectors. All trusts created under this Trust need not have or continue to have the same Trust Protector. The provisions of this Trust that relate to the Trust Protector shall be separately applicable to each trust share or portion held or created under this Trust.

3.5.7. Limitation of Rights. Notwithstanding any other provision of this Trust, the

Trust Protector shall not participate in the exercise of a power or discretion conferred by this Trust 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 be considered as possessing a general power of appointment within the meaning of IRC §§2041 and 2514, as amended.

3.5.8. Renounce Rights. 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 on the Trust Protector under this Trust by a written instrument delivered to the Trustee.

3.5.9. Exoneration. The Trust Protector shall have no duty to monitor any trust

share or portion created under this Trust in order to determine whether any of the powers and discretions conferred under this Trust should be exercised. Further, the Trust Protector shall have no duty to keep trust beneficiaries 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 they shall be binding and conclusive on all persons. The Trust Protector is not required to exercise any power or discretion granted under this Trust. 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 under this Trust or arising from any exercise or nonexercise of the powers and discretions conferred under this Trust.

3.5.10. Beneficiary’s Withdrawal Rights; Subchapter S Requirements.

Notwithstanding anything contained in this Section to the contrary, a power granted under this Section shall not be exercised in a manner that would impair a trust beneficiary’s existing withdrawal rights or cut off a trust beneficiary’s powers over such withdrawal rights, or that would violate any of the Qualified Subchapter S Trust requirements for any trust created as a QSST.

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XIV. DEFECTIVE IS MORE EFFECTIVE.


1. Grantor wishes to change an ILIT’s beneficiaries.

2. Grantor wishes to change the terms of an ILIT (i.e., add generation skipping provisions).

B. Solution.

1. Create a new ILIT with the desired terms and beneficiaries, and make it a

grantor trust. a. The most common method of creating grantor trust status is the

inclusion of a power allowing the grantor or any other party to reacquire trust assets by substituting property of equivalent value. IRC Section 675(4).

i. The IRS has concluded that a retained power of substitution

held by a grantor in a fiduciary capacity will not cause estate tax inclusion under IRC Sections 2033, 2036, 2038 or 2039. PLR 200603040.

ii. But what about a power held in a non-fiduciary capacity? In

Jordahl v. Commissioner, 65 T.C. 92 (1975) the Tax Court declined to apply IRC Sections 2038 and 2042 to a power held in a fiduciary capacity.

iii. It is not clear whether a power of substitution causes

inclusion of trust assets under IRC Section 2036(a), or, with respect to voting stock (in closely held corporation) under IRC Section 2036(b), or will be deemed to be an incident of ownership over life insurance under IRC Section 2042. The IRS has now included the grantor’s power of substitution in a non-fiduciary capacity on its 2008 Guidance/Action List for further study.

iv. Perhaps the safest approach is to give the substitution power

to an independent third party acting in a non-fiduciary capacity thereby attaining grantor trust status under IRC Section 675, without the potential problems caused by IRC Sections 2036, 2038 and 2042. The IRS, in its recently released Charitable Lead Trust Forms permits the use of a third party power of substitution to create grantor trust

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status.3

b. Grantor trust status and Crummey powers.

i. The holder of a Crummey power is treated as the owner for income tax purposes of all or a portion of a trust since such person has a power of withdrawal over such property. IRC Section 678(a).

ii. However, IRC Section 678(b) provides that if the grantor is

deemed to be the owner of trust income under IRC Sections 671-677, then the grantor is deemed to be the owner of the entire trust notwithstanding that the trust may be taxable to the beneficiary under IRC Section 678(a).

iii. But the Crummey power is over trust principal – not income

(as provided in IRC Section 678(b)). iv. Many commentators agree that IRC Section 678(b) contains a

drafting error and was intended to refer to income and principal.

v. Fortunately, the IRS has ruled several times that IRC Sections

671-677 trump IRC Section 678. PLRs 200730011 and 200729005.

2. Have the grantor gift and/or lend the new ILIT (that is a grantor trust) cash in

an amount equal to the fair market value of the policy owned by the old ILIT.

a. Generally, a policy’s fair market value is its interpolated terminal reserve plus the unearned premium. Treas. Reg. Sec. 25.2512-6(a). Example 4.

b. Where the insured is uninsurable at the time of the sale, the IRS will

likely argue that the value of the policy is much greater than its

3 See, the IRS’ sample inter-vivos CLAT form in Rev. Proc. 2007-45, 2007-29 I.R.B. 1 (June 22, 2007) which contains the power of substitution held by a third party (but with the usual IRS disclaimer stating that whether the power to substitute assets is held in a non-fiduciary capacity is an issue of fact that the IRS can not determine in advance). Section 11 of the sample inter-vivos CLAT form provides “Retained Powers and Interests. During the Donor's life, [individual other than the donor, the trustee, or a disqualified person as defined in section 4946(a)(1)] shall have the right, exercisable only in a nonfiduciary capacity and without the consent or approval of any person acting in a fiduciary capacity, to acquire any property held in the trust by substituting other property of equivalent value.” See also, Priv. Letter Ruls. 199908002, 9247024 (power to substitute assets held by third party), and 200011012 (power to substitute assets held by the grantor).

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interpolated terminal reserve. Estate of Pritchard v. Comm., 4 TC 204 (1944); Treas. Reg. Sec. 25-2512-1.

c. Query: will the trustees look to the life settlement market to

determine the policy’s fair market value?

3. Have the trustee of the new ILIT (that is a grantor trust) purchase the policy from the old ILIT.

4. Caution: this transaction raises issues of fiduciary duty and trust law for the

trustees engaging in the transaction – particularly a trustee who is selling a policy to an ILIT with different beneficiaries.


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 “transfer-for-value” rule. IRC Sec. 101(a)(2).

3. One of the exceptions to the transfer-for-value rule is a transfer back to the

insured. 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 Sections 673-677.

5. In Rev. Rul. 2007-13, 2007-11 I.R.B. 684, the IRS held that, for purposes of

the transfer-for-value rule under IRC Section 101(a)(2), a grantor who is treated as the owner of a trust for income tax purposes is also treated as the owner of any life insurance policy on the grantor’s life owned by the trust.

a. Therefore, the transfer of a life insurance policy between two grantor

trusts (wholly owned by the same grantor) is not a transfer for valuable-consideration.

b. The IRS also ruled that a transfer of a life insurance policy from a

non-grantor trust to a grantor trust that is wholly owned by the grantor-insured is a transfer to the insured and, therefore, not a transfer for valuable consideration.

c. Unfortunately, Rev. Rul. 2007-13 did not expand its holding to cover

transfers of a survivorship policy to an ILIT where both insureds must be treated as grantors. Can an ILIT be wholly owned by two

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grantors?

6. The “three year rule” of IRC. Sec. 2035 will not apply because that Code Section is limited to gratuitous transfers – not sales. Thus, its important that the new ILIT pay fair market value for the policy to avoid a part sale/part gift situation.

D. Other Reasons for Creating Grantor Trust Status. 1. To make a tax-free gift of income taxes. Rev. Rul. 2004-64. 2. To permit income tax free sales between the trust and its grantor. Rev. Rul.

85-13. 3. To avoid the transfer-for-value rule. Rev. Rul. 2007-13. 4. To hold S Corporation stock. IRC Section 1361(c)(2)(A)(i). E. Sample Provision.

SECTION _____. 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 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 in exchange for assets of equivalent value; and

2. The power to borrow any of the trust income and principal 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.

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Notwithstanding the foregoing, the trustee shall not loan me or permit me to reacquire 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.

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 and without the requirement of any court approval.

d. Restrictions

The special powers given to me under this section shall not be exercisable to the extent that their 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, either permanently or for a specified period of time, 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.

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XV. HOW TO “CHANGE” ILITS WITH SURVIVORSHIP LIFE INSURANCE.


1. A married couple purchases a survivorship policy to provide liquidity to pay federal estate taxes, but cannot decide upon beneficiaries and/or terms of the ILIT.

2. A married couple purchases a variable survivorship policy as a “private

pension” and are reluctant to transfer same to an ILIT until the first spouse dies (when additional life insurance proceeds will be received).

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 and beneficiary.

3. As owner, the husband has access to the policy’s entire cash surrender value

income tax free (by surrendering to basis and borrowing the excess). 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 and beneficiary.

5. The policy can be assigned to an ILIT whenever the couple is ready to do so, and start the running of the three year rule of IRC Sec. 2035. In such event they can also have the ILIT purchase a term policy on the healthier/younger spouse to cover the estate taxes if both spouses 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 (plus the unearned premium) is

included in husband’s gross estate. Treas. Reg. Sec. 25.2512-6(a). 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 estate

tax free.

4. If the couple dies simultaneously, most policy contracts assume that the owner (i.e. husband) died first. This same presumption should be contained

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in the couple’s wills.

D. Tax Consequences if Wife Dies First.

1. Husband can immediately gift the policy to the ILIT. The policy’s interpolated terminal reserve (plus the unearned premium) at the time of wife’s death will be the measure of the gift to the ILIT.

2. If husband dies within three years of the transfer, the entire policy proceeds

will be included in his estate. IRC Sec. 2035.

3. 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. After three years, the term policy can be cancelled or, if husband’s health has declined, the policy can be retained or converted to permanent insurance.

4. The husband can avoid the three year rule by selling the policy to a grantor

trust. See PLR 200518061. The three year rule of IRC Sec. 2035 only applies to gifts – not sales.

a. If the husband is uninsurable at the time of his wife’s death, the IRS

will likely argue that the value of the policy is much greater than its interpolated terminal reserve value. Estate of Pritchard v. Commr., 4 TC 204 (1944); Treas. Reg. Sec. 25-2512-1.

b. Must the husband look to the life settlement market to determine the

policy’s fair market value?

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