Have ILITs Lost Their Magic?

An Interview with Vincent M. D'Addona

Reprinted from The Estate Analyst, August, 2007

By Robert L. Moshman, Esq.

an the venerable ILIT retain its position as one of the preeminent estate-planning tools in the modern context after macro-economic analysis? Specifically, is a married couple best served by an irrevocable life insurance trust that is funded by a survivorship life policy?

Such a question! The redoubtable ILIT has been the building block of numerous trust designs. They are the premise of estate plans ranging from young executives using insurance to create an instant estate, to major tycoons designing their long-term dynasty trust.

But times have changed and the role of ILITs in estate planning may need to be reassessed. These ideas were recently touched upon in a recent speech to the American Association of Life Underwriters by a professional estate planner Vincent M. D'Addona, who was also kind enough to respond to several followup questions for this newsletter.

Tax Revolution, Technique Evolution

This publication has previously gone searching for the "perfect trust"…and the ILIT has figured prominently in the results.¹

But estate-planning techniques using life insurance haven't always existed. They arise in response to the tax system itself as normal taxpayers try to protect their assets. It is a process not unlike the evolutionary adaptation of living things to survive whatever conditions they meet.

The panda's anatomy is adapted to a diet of bamboo. The star-nosed mole lacks vision but has a fringed eye thing that finds food in the dark.²

Wealth, just like animals and life itself, adapts to its environment like a living thing but much more rapidly. When the flow of wealth is impeded by a system of rules, it finds various ways around, over, under, and through every obstacle.

For example, when the tax laws allowed for short-term trusts of at least 10 years to have income taxed to beneficiaries as an exception to grantor tax rules, Clifford trusts arose. The birth and death of Clifford trusts is bracketed by the Revenue Act of 1954 and the Tax Reform Act of 1986 that established the "kiddie tax."

Viva La Life Insurance

In a recent presentation, wealth strategist and CLU Vincent D'Addona took note of how the use of survivorship or second-to-die life insurance in an irrevocable life insurance trust was born in response to the unlimited marital deduction that arrived with the Economic Recovery Tax Act of 1981.

Since Canada had an unlimited marital deduction before the United States, Canadian companies took the lead in offering survivorship policies.

The advantages were immediately apparent; survivorship insurance was a custom-made fit to the unlimited marital deduction. Since a couple could avoid all tax at the death of the first spouse, the life insurance did not have to pay out until the second spouse died. By postponing the payout, lower premiums applied.

But could a grantor set up a trust and have it purchase the insurance like some alter ego making estate plans and not be taxed directly?

Modern estate planners know the answer is "yes" and may even take that for granted, but it took a series of cases over 10 years for the IRS to finally throw in the towel in 1991. It had been argued that the trust was a sham and that the purchase of the insurance by the trust was part of a "beamed transfer" of the insurance from the grantor to the trust beneficiaries.³

Magic With Life Insurance

With the coast clear, this publication covered ILITs in 1992 with specific focus on the trend of utilizing survivorship policies.⁴ The best interest defense would "generate serious harm to future beneficiaries."

The benefits were numerous and robust but whether they remain viable remains to be seen.

Life insurance is a natural complement to a Crummey trust because the annual funding of premiums could be qualified under the annual gift tax exclusion using hanging powers.

Where invested assets would yield taxable income, insurance could build equity without triggering current taxation.

Life insurance can make a substantial estate materialize where there is none.

Survivorship life insurance can produce liquid assets exactly when needed, at the death of the second spouse.

A well-planned life insurance trust can slip through the transfer tax system like Houdini escaping manacles.

Before long, the ILIT funded with survivorship life insurance was being used for estates of any size or liquidity and grantors of any status. And at a time of high interest rates, many policies were offering the prospect of "vanishing premiums" due to the rapid cash accumulations that were taking place in such policies. In theory, after a few years of paying premiums, the cash value would be high enough to produce dividends that would finance the future premiums.

And there are inspired variations. For example, what does one get when combining an IDIT (intentionally defective irrevocable trust) with an ILIT (irrevocable life insurance trust)? Why, an IDIOT Trust®, of course.

An "intentionally defective irrevocable outstanding trust," as coined by attorney Michael Weinberg of the Weinberg Group in Denver, Colorado, involves a grantor selling assets (such as a family business) to a trust using valuation discounts and taking back a promissory note. The trust (using seed money) purchases life insurance on the grantor equal to the principal amount of the note. This creates a grantor trust that limits income tax consequences.

Do ILITs Still Make Sense?

Not everyone accepted ILITs as the only solution or the best solution as an automatic for every set of circumstances. Nevada attorney and author Richard Oshins recalls Professor Ed Halbach and others observing, years ago, that making lifetime gifts of premiums for insurance might be transferring the wrong assets.

"If we were to gift discountable assets," said Oshins, "such as limited partnership interests, rather than money to pay life insurance premiums, and we live to our actuarial age, a much larger wealth shift would occur. That concept made sense before the popularity of income tax defective trusts. When combined with IDGTs, the disparity is magnified."

Keeping things simple, the asset is transferred at a discounted value, the future appreciation is not in the grantor's estate and income is taxed to the grantor, further reducing the grantor's estate, and therefore avoiding additional transfer taxation in the future.

There are also some practical considerations. Using an ILIT involves a fair amount of client education and maintenance, particularly if there are to be annual letters to document the availability of hanging powers for Crummey transfer purposes. Failure to comply leaves the ILIT with an Achilles heel of sorts.

Moreover, by focusing lifetime gifts on premiums for life insurance, the use of lifetime gifts for current purposes could be overlooked or limited.

A New Planning Paradigm

While the benefits of ILITs have overwhelmed such weaknesses in the past, there is a new context of planning today. In recent presentations, Vincent D'Addona of Strategies for Wealth Creation and Protection in New York City observes several critical changes. Large gains in the stock market during various bull markets of the 1980s and 1990s made high dividends and vanishing premiums a beautiful feature.

In recent years, however, lower interest rates and a less enthused stock market have diminished the gratifying "pay-for-itself" models. If the insurance is not self-sustaining, then the grantor must continue paying premiums. And with people living longer (and new life expectancy tables being utilized), more premiums are being paid for longer periods of time. The same deferral of payments that makes a second-to-die policy attractive as a just-in-time funding mechanism for liabilities payable upon the second spouse's death also extends the payment of premiums long into the future.

"With a second-to-die insurance policy," D'Addona noted, "the best case scenario is that both insureds die the year after the policy is written. So the purchase of the second-to-die gives you no incentive to live."

Meanwhile, the grantor is preoccupied with future tax events instead of the present family needs. "When a trust is used," said D'Addona, " *** it is as if we have the tax tail wagging the planning dog. The grantor does not get any enjoyment out of the money and the children are not getting a chance to enjoy the money. Long-term wealth creation may be stymied by this approach."

Macroeconomic Realities

Assume a married couple with both spouses at age 50 purchases a $1-million survivorship life insurance policy with annual premiums of $12,500 and that dividends offset premiums after 18 years.

The total cost of the $1 million appears to be $225,000. That's a return of $1 for every $.22 investment. But that overlooks opportunity costs, argues D'Addona. Assuming a 7% return, those premium payments would be worth $456,000 after 18 years. And the couple may not recover those funds after 18 years because both spouses must die before benefits are paid. Statistically, in this example, the joint life expectancy is 37 years. That $456,000 is not being invested for an additional 19 years.

The use of ILITs for estate planning will need to be examined in greater detail.

TECHNICAL REFERENCES

An Interview With Vincent D'Addona

Q: Is life insurance still appropriate for estate planning in general?

A: Of course. I believe that life insurance should be thought of as a good asset as opposed to an annoying expense.

Q: Is life insurance still appropriate for estate planning in general?

A: There is a perception about ILITs that has become embedded in the traditional thought processes of the legal, accounting and life insurance communities. But if you go back in time and look at the literature you would discover that there was actually a time period during which is was totally inappropriate to put life insurance in the title of a trust. After the IRS lost badly on the beam theory life insurance trusts became more commonplace. Now our industry has gotten to the point where life insurance is perceived as 'purchased incorrectly' (with malpractice implications) unless it is positioned inside of a trust.

The mathematics do not support and I do not agree with that contention. Irrevocable trusts, especially intentionally income tax defective trusts (IDGTs), are powerful wealth shifting tools. As Jeffrey Pennell says in his 1997 Trusts & Estates article series, The Economics Of Prepaying Wealth Transfer Tax, "...it always pays economically to incur wealth transfer tax as soon as the client can possibly tolerate and be done with the wealth transfer tax system."

With modern estate planning strategies such as fractional entity interests, note sales to IDGTs or Walton GRATs, gift tax need not be incurred to shift large amounts of wealth.

Q: Is there still a role for the ILIT?

A: Absolutely. Life insurance has a place in virtually all estate plans. That may involve irrevocable trusts that eventually own life insurance. Personally-owned life insurance does not have to be gifted to these trusts and probably should not be by dint of the three-year rule. As we recommend intentionally income tax defective trusts, the policies can be sold by the policyowner/grantor to the trust that is income-tax defective to the grantor at which time it is immediately out of the estate.

That being said, if the client is over 65 or has health issues or is single with highly illiquid assets then the idea of an ILIT becomes more acceptable. I am more concerned about the knee-jerk reaction to always using an ILIT. The evidence does not support this assertion.

Q: Is client maintenance of a trust a bad idea in general?

A: In 28 years of being in the estate planning business I know of only a handful of cases where Crummey letters have actually been filed. While I am not sure of the implications of this, my sense is that poor compliance cannot go in favor of the taxpayer. To the extent that a client can pack a trust with dollars for premium using Crummey, I would rather see a client pack a fully discretionary trust with investments or fractional interests in entities.

What is missed in the thought process of planning is that if the Grantor (G1) generation's life is long and gift limits are used up in the form of premium, then an attempt to help G2 or G3 with money or property may in fact produce a taxable gift. Even if an ILIT is drafted in such a way that the cash value can be used for distributions to any beneficiaries, that use of cash value can send the policy into an irrecoverable death spiral defeating the original estate plan.

Q: Can the average estate planning professional ignore the realities that you have identified about ILITs?

A: I think that there are currently very few practitioners who handle planning the way we do. However, the mathematics of estate planning supports the planning as we design it and does not support the traditional model. My sense is that clients like our solutions (as evidenced by their implementation of them) and that other advisors, if open minded, can see the evidence that supports our methodology. The evidence can be ignored but that doesn't make the evidence any less right.

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Vincent M. D'Addona, CLU, ChFC, MSFS, AEP, is a principal of Strategies for Wealth in New York City. He can be reached at vdaddona@strat4wealth.com or (917) 453-4008.