Fixing Damaged ILITs (Plus a Checklist to Avoid Problems)

Long-term irrevocable trusts, particularly irrevocable life insurance trusts (ILITs), may need to be restructured or "fixed" due to various reasons such as poor initial design, changes in tax laws, or shifts in the grantor’s financial situation. These trusts, which often have life insurance as their primary asset, face unique challenges like managing Crummey withdrawal rights, generation-skipping transfer tax (GSTT) issues, and adapting to new life insurance policy options. 

One major issue in ILITs is the proper handling of Crummey withdrawal rights, which allow beneficiaries to withdraw gifts made to the trust, thereby qualifying them for the annual gift tax exclusion. If Crummey notice requirements have been neglected, steps can be taken to rectify the situation, such as documenting oral notice or filing a late gift tax return. The courts have ruled that the mere possession of a withdrawal right, even without notice, may be sufficient to qualify as a present interest for tax purposes, which could be leveraged in estate tax audits to argue that notice is not necessary.

Another common problem arises when the life insurance policy within the ILIT is no longer suitable or too expensive. Options to address this include using a tax-deferred exchange under I.R.C. § 1035 to replace the policy without recognizing gain, or establishing a new ILIT with a more appropriate insurance policy if the grantor is still insurable. However, caution is advised when lapsing or canceling a policy with outstanding loans, as this could trigger significant income tax consequences.

Finally, the article presents a detailed checklist for attorneys advising on ILITs, emphasizing the importance of avoiding reciprocal trust issues, ensuring that life insurance policies are owned exclusively by the ILIT trustee, and preventing the three-year rule problem by setting up the trust with a new policy. These steps help ensure that the ILIT functions as intended, providing tax benefits while protecting the assets for the beneficiaries.

For more information see Robert Adler and Michael J Hausman "Fixing Damaged ILITs (Plus a Checklist to Avoid Problems)" ABA Probate & Property July/August 2024 Edition, July 1, 2024.