Changing Trustees: Irrevocable Life Insurance Trust Guide

Irrevocable Life Insurance Trusts (ILITs) are a popular estate planning tool used to avoid estate tax on the death benefits paid out under life insurance policies. However, the irrevocable nature of these trusts means that once they are set up, they usually cannot be modified or cancelled. Nevertheless, there are a few options for changing the trustee of an ILIT. One way is to decant the trust, which is similar to upgrading to a new phone without erasing the content of the old one. Decanting allows for the upgrading of unhelpful provisions of a trust while keeping the interests of the beneficiaries intact. Another option is to use a non-judicial settlement agreement, which allows for the modification of a trust without having to go to court. This option is available in certain states such as South Dakota. Finally, it is possible to transfer an ILIT to a new trust, although this requires a special legal document.

Non-judicial settlement agreement

A non-judicial settlement agreement (NJSA) is a contract between the beneficiaries of a trust that can modify the terms of the trust and provide an effective and cost-efficient manner to resolve disputes regarding the terms of the trust while avoiding the need for litigation.

A non-judicial settlement agreement is a useful tool when an irrevocable trust is not functioning as intended and needs to be modified. In the past, efforts to modify an irrevocable trust would require lengthy and expensive court proceedings. However, with a non-judicial settlement agreement, modifications can be made without court involvement.

To be valid, all persons whose interests in the trust would be affected by the provisions of the agreement must be parties to the agreement. This means that all beneficiaries and interested parties must agree to the terms of the non-judicial settlement agreement.

A non-judicial settlement agreement can address various matters, including the interpretation of the terms of the trust, direction to a trustee to refrain from performing an act or granting a trustee power, determination of a trustee's compensation, distribution of the trust corpus, transferring a trust's principal place of administration, and liability of a trustee for an action related to the trust.

It is important to note that a non-judicial settlement agreement cannot violate a material purpose of the trust or any laws. A material purpose could include trusts created to benefit charities, trusts meant to treat beneficiaries equally, or a trust created to preserve a family compound or the ongoing operation of a business.

If the grantor is still alive, it is helpful to have them sign as a party to the non-judicial settlement agreement to support the assertion that the agreement does not violate their material purpose. In some states, the non-judicial settlement agreement may even be inconsistent with the trust's material purpose if all the beneficiaries and the grantor agree.

A non-judicial settlement agreement can be a useful tool to settle disputes, clarify terms, address ambiguities, correct mistakes, and change administrative provisions. It allows for flexibility when circumstances arise in the settlement of an estate and encourages the resolution of disputes by non-judicial means, giving them the same effect as if approved by the courts.

Transferring an ILIT

Understanding the ILIT Structure

The first step is to understand the structure of the ILIT. An ILIT typically involves three main parties: the grantor, the trustee, and the beneficiaries. The grantor creates and funds the trust, the trustee manages it, and the beneficiaries receive distributions. It is important to note that once the ILIT is established, the grantor gives up control and cannot make any changes.

Reasons for Transferring an ILIT

There are several reasons why someone may want to transfer an ILIT. One common reason is to reduce the taxable estate. By transferring life insurance to an ILIT, individuals can reduce the size of their taxable estate, as assets placed into trusts are not treated as individual taxable assets. Additionally, ILITs can provide asset protection and help minimise estate taxes, avoid gift taxes, and protect government benefits.

Options for Transferring an ILIT

There are a few options for transferring an ILIT, and the best approach will depend on the specific circumstances and the terms of the trust:

• Decanting the ILIT: Decanting involves transferring the assets of the original ILIT to a new trust with more favourable terms. This option is typically used when the original ILIT is irrevocable and difficult to amend or revoke. It allows for the upgrade of unhelpful provisions without changing the interests of the beneficiaries. However, not all states allow decanting, so it is important to check the state laws.
• Non-Judicial Settlement Agreement: In some states, a non-judicial settlement agreement can be used to modify or address issues in the trust. This option may be available if the state statutes permit interested parties to use this type of agreement to make changes to the trust.
• Merging the ILIT into a new trust: It is possible to merge an old ILIT into a new life insurance trust, but it requires a special legal document and is generally limited.
• Creating a new ILIT: Another option is to create a new ILIT that addresses any issues and have it purchase the policy from the old ILIT. The policy can be sold at its fair market value, and certain exceptions must be met to keep the proceeds free from income tax.

Important Considerations

When transferring an ILIT, it is important to consider the tax implications and ensure that the transfer meets certain exceptions to avoid paying income tax on the proceeds. Additionally, it is crucial to work with professionals such as a CPA and estate attorney to properly document and value the transaction. Obtaining professional help can ensure that the transfer is done correctly and in compliance with the relevant laws and regulations.

Decanting a life insurance trust

The process of decanting allows for the modification of problematic trust provisions without requiring court approval or beneficiary consent. It is important to note that the trustee must have the discretion to make distributions from the original trust for decanting to be a viable option.

While the specific rules vary by state, the basic premise is that the trustee's distribution discretion includes the lesser power to move trust assets to a second trust. Some states require the trustee to have full discretion, while others allow decanting based on a reasonably definitive standard. It is crucial to review the applicable state laws and consult with legal and tax professionals before initiating the decanting process.

• Review the original trust: Understand the terms and purposes of the original trust, including the grantor's intentions, beneficiary interests, and any restrictions on distributions or trust modifications.
• Identify the need for change: Determine if there are problematic provisions in the original trust due to changed circumstances, such as outdated language, tax implications, or administrative burdens.
• Create the new trust: Work with legal professionals to draft the new trust document, ensuring it aligns with the grantor's intentions and addresses the issues identified in the original trust.
• Provide notice to beneficiaries: Develop a written instrument that memorializes the decanting, explaining the changes and their impact on all beneficiaries. This notice should be signed by the trustee and provided to all beneficiaries.
• Obtain necessary approvals: Depending on the state, you may need court approval or beneficiary consent for the decanting. Even if not required, it is advisable to obtain beneficiary consent to avoid potential disputes.
• Transfer trust assets: Working with a financial advisor, transfer the assets from the original trust to the new trust, ensuring compliance with applicable tax laws and regulations.
• Terminate the original trust: File a final tax return for the original trust and obtain a new tax identification number for the new trust, treating it as a separate taxpayer entity.
• Monitor and maintain the new trust: Ensure ongoing compliance with legal and tax requirements, and make any necessary adjustments to maintain the effectiveness of the new trust over time.

By following these steps, you can successfully decant a life insurance trust, providing updated provisions while preserving the interests of the beneficiaries. Decanting offers a flexible approach to trust management, allowing for necessary changes without the need for costly and time-consuming legal proceedings.

Trustee's power to terminate

Trustees' Power to Terminate

While an irrevocable life insurance trust (ILIT) is designed to be impossible to revoke or change once it has been created, there are still ways to terminate or adjust the trust. The options available depend on the terms of the trust and the laws of the state in which the trust is based.

Some ILITs grant trustees the flexibility to make distributions of some or all of the trust's assets. Others may grant the trustee the discretion to terminate the trust altogether. The ability to terminate an ILIT is uncommon and may be subject to additional restrictions, such as requiring the approval of a special independent trustee. However, it is a possibility that merits examining the trust document to determine if it is an option.

Another option for termination is if the trust includes a provision that allows the trustee to terminate if it is no longer "economical" to maintain the trust because it is too small. This is common in most trust documents due to ongoing accounting and tax filing costs, as well as trustee fees. In the case of an ILIT with a cash value life insurance policy, this option may not be feasible. However, for an ILIT owning a term insurance policy with no cash value, this may be a viable path to termination.

If termination under the trustee's powers is not feasible, the next option is to obtain a court order to terminate the trust. This typically requires the consent of all beneficiaries and the grantor, unless the court determines that other factors substantially outweigh the original purpose of the trust.

Consent termination by grantor and beneficiaries

Consent termination by the grantor and beneficiaries is one of the four common pathways to terminating an Irrevocable Life Insurance Trust (ILIT). Although the exact rules vary by state, most states allow trusts to be terminated by the mutual consent of the trust beneficiaries and the trust's original grantor.

However, consent termination requires the affirmation of all (current and even distant remainder) beneficiaries, which may be difficult or impossible if some beneficiaries are uncooperative, hard to reach, or minors. The grantor must also give consent, which makes a consent termination impossible if the grantor won't cooperate or has already passed away.

In addition, the beneficiaries must still receive whatever their respective shares would have been at the time, which can be messy with a large number of current and remainder beneficiaries.

Therefore, while consent termination by the grantor and beneficiaries is a viable option for terminating an ILIT, it is important to carefully consider the context and potential tax implications before making any decisions.

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