Subtle Screwups: Twenty-six Ways to Sabotage an Irrevocable Life Insurance Trust

• Publication year: 1998
• Pages: 57
• Citation: Vol. 27 No. 1 Pg. 57

27 Colo.Law. 57 Colorado Lawyer 1998.

1998, January, Pg. 57. Subtle Screwups: Twenty-six Ways to Sabotage an Irrevocable Life Insurance Trust

---

57

Vol. 27, No. 1, Pg. 57

The Colorado Lawyer
January 1998
Vol. 27, No. 1 [Page 57]

Specialty Law Columns
Estate and Trust Forum
Subtle Screwups: Twenty-six Ways to Sabotage an Irrevocable Life Insurance Trust
by Mark D. Masters

Your long-standing client died about two years ago. You blink your eyes in disbelief at the latest round of discovery your defense attorney has just sent over for you to answer. This time it is Requests for Admission

Why have the client's adult children sued you for all that money? Because the life insurance trust failed and the IRS assessed the estate for a ton of taxes and penalties-but mostly because the decedent was your client

In this Kafka-esque setting, the plaintiffs' Requests for Admission below highlight some of the simple and not so simple ways a personal irrevocable life insurance trust can fail.1

Requests for Admission

1. Admit that more than one taxable lapse of a power of withdrawal occurred during one calendar year

If the grantor's contribution was made too late in the preceding year for the holders of powers of withdrawal to effectively exercise or waive their Crummy power, some portion of the grantor's contributions for the following year may not be covered by the gift tax annual exclusion.2 Furthermore, the lapse of a withdrawal right may be a gift by the beneficiary under Internal Revenue Code ("IRC") §§ 2041 and 2514.

2. Admit that the trust grantors retained incidents of ownership in the life insurance policy.

If the insured grantors actually or constructively retain any incidents of ownership in the life insurance policy, such as the power to change beneficiary or surrender the policy (even if the powers were never exercised), such retention violates IRC § 2042(2), and the full amount of the policy proceeds will be includible in the grantor's gross estate.3 Treas. Reg. § 20.2042-1(c)(2) gives guidance in identifying incidents of ownership. An insured (and his or her advisors who participate), in assigning a life insurance policy to an irrevocable life insurance trust ("ILIT"), must be careful not to retain any interest in the policy that might constitute an incident of ownership.

3. Admit that you helped create a life insurance trust in which the grantor, his spouse or other non-independent person served as trustee.

Depending on the provisions of the trust, allowing the insured grantor or his or her spouse to serve as trustee may violate IRC § 2042(2) because such position is an "incident of ownership." In all cases, an insured should not be trustee because it will constitute a general power of appointment.4

4. Admit that you allowed the grantor to retain string powers over his irrevocable life insurance trust.

Although in a grey area, allowing the grantor to retain powers under IRC §§ 2036 and 2038 to, for example, alter or revoke the trust may cause the life insurance proceeds to be includible in the grantor's gross estate.5 The risk of IRS scrutiny and family ire is probably too great. However, note that under Rev. Rul. 95-58, if the grantor retains a power only to substitute a trustee who is not related to or subordinate to the grantor within the meaning of IRC § 672(c), such power will not cause inclusion of the trust assets in the grantor's gross estate.

5. Admit that you helped create and fund a life insurance trust that was revocable by its grantor.

Allowing the grantor to retain powers under IRC § 2038 to alter, amend, revoke, or terminate the trust or any conveyance into the trust will cause the life insurance proceeds to be includible in the grantor's gross estate under IRC §§ 2036, 2038, or 2042, even if the deceased insured retained such rights in conjunction with another.6

6. Admit that holders of powers of withdrawal lacked actual notice of their Crummy withdrawal powers or a realistic opportunity to exercise such powers.

To qualify a grantor's contribution for the annual exclusion, Crummy beneficiaries must have timely notice of their withdrawal rights and a true opportunity to exercise their powers of withdrawal. The IRS maintains that thirty days between notice of the withdrawal right and its lapse constitutes a reasonable time period.7 For the annual contribution to be a present interest gift, the beneficiary must receive prompt and actual notice of his or her right of withdrawal,8 or the withdrawal right will be considered "illusory."

7. Admit that the window for withdrawal by holders of the power to withdraw was too short.

Crummy beneficiaries must have actual notice and a true opportunity to exercise their powers of withdrawal if grantor contributions are to be exempt from transfer taxes. The IRS maintains that thirty days between notice of the withdrawal right and its lapse constitutes a reasonable time period.9 Three or four days is too short.10

8. Admit that no trust assets existed from which the trustee could effectively satisfy any demand made by a holder of a power of withdrawal.

If assets are available to satisfy the demand of the holder of a power to withdraw, including the policy itself, the gift tax annual exclusion should be available.11 However, if no other assets exist to satisfy the withdrawal power-holder's demand and trust provisions prohibit withdrawal of the policy, the annual exclusion will not be...