Irrevocable Life Insurance Trust - Termination Question

[PPJCPA]

I have a client who is insured (The Grantor) under an Irrevocable Life Insurance Trust (ILIT). My client wants to terminate the trust and the two children who are named beneficiaries in the trust are fine with the termination. However my client is now asking me what the tax consequences are. I have tried to research but I have not been successful.

I have learned that the trustee can sell the policy back to the insured for its market value. However if the policy is sold back to my client - is it correct to say that what she pays to the trustee will be her new basis? Are the beneficiaries the recipients of the cash paid to the trustee for the policy?

The trust does include a clause that allows the trustee the power to distribute the principal of the trust for the health and support of the beneficiary without regard to other resources available to the Beneficiary. The trust also allows the trust income attributable to periods after the date on which the beneficiary attains the age of twenty-one to be distributed to the beneficiary not less often the semi-annually. Both beneficiaries are over the age of 30.

The trust later states that the principal and income shall be distributed in equal shares to the each primary beneficiary during the term of the Trust and after the death of Grantor as follows: (The Grantor is my client and and is still alive.)

- the remaining Trust properties shall be held IN TRUST until Beneficiary attains the age of Thirty, at which time the Trust shall terminate as to that child, and the remainder of that Beneficiary's one-half share of the principal and any accumulated income in the Trust shall be distributed to the Beneficiary fee of any Trust as soon as possible.

Should the trustee terminate the policy and distribute the principal and income to the beneficiaries? If yes, what are the tax consequences to them.

I apologize for such a long question but I have spent a considerable amount of time trying to research this and still have not come up with an answer I am confident with presenting to my client.

Any feedback or direction on where to further research this would be greatly appreciated.

[Burke]

Should the trustee terminate the policy and distribute the principal and income to the beneficiaries? If yes, what are the tax consequences to them.
Any feedback or direction on where to further research this would be greatly appreciated.

If the trustee terminates the policy by surrendering it for its cash value, then the Trust (which is the owner) will receive the proceeds and those will be subject to the terms of the trust document. If that amount is more than the premiums which were paid in, then there is a taxable gain. If, instead, the trustee sells the contract back to the insured for its cash value, then it still would have those funds to administer under the terms of the trust document and the same tax consequences would apply. The insured would then own the contract, however, and that amount paid would be his basis. He could continue to pay the premiums. This is assuming the insurance company would go along with this option. An ILIT cannot normally be cancelled by the grantor under the IRS rules. If the beneficiaries receive distributions of any amounts under these circumstances, IMO, it will be fully taxable as ordinary income since they have no basis in the contract and it is not as a result of a death payout. The trustee could also terminate the policy by simply letting it lapse, i.e, stop paying premiums. This will cause the contract (if it is a whole life contract with a non-forfeiture value) to remain in effect for a limited term based on the contract provisions in the policy. The face amount would still be payable to the trust if death occurs during this period. Once that period has expired, there is no benefit remaining.

This was done for estate tax purposes and these values may be large amounts. There must have been a reason to want the contract out of the insured's estate. Have the insured consult with the attorney who drew up this trust for all the possible ramifications and don't get yourself involved in giving opinions.

[PPJCPA]

Thank You

Thank you very much. I appreciate the time you took to explain your answer in great detail.

My client's tax circumstances have changed since the ILIT was set up in 2002.

I have a some follow up questions.

(1) If in the first scenario that you explained, (trustee terminates the policy by surrendering it for it's cash value - Trust receiving the proceeds), proceeds will have be distributed to the beneficiaries per the trust document. Is this correct? Does the Trust report the gain? or will the beneficiaries receive a Schedule K-1 showing the distribution and the gain?

(2) If the trustee sells the contract back to the insured for it's cash value, does the trust report the gain and pay taxes? Assuming the proceeds remain in the trust and the trustee administers the funds.

You wrote, "If the beneficiaries receive distributions of any amounts under these circumstances, IMO, it will be fully taxable as ordinary income since they have no basis in the contract and it is not as a result of a death payout." Does this relate to (1) or (2) or both?

Sorry for the multiple questions. I have not dealt with this type of transaction before because as you said, an ILIT normally cannot be cancelled by the grantor under the IRS rules.

Your assistance with this tax matter is greatly appreciated.

[Burke]

I am not an expert on ILIT's nor an attorney. However -- in my opinion -- the answers to your questions are:

1. The trust is required to distribute the income (based on the wording in the trust document that you provided in your OP), since apparently both bene's are over 30? But I don't have that document to review to say absolutely. The trust document controls when distributions are to be made, and whether they are discretionary or mandatory by its terms. The trust will report the gain (if any) but if it distributes the income to the bene's, then the gain will pass through via the K-1 to them.

2. If the trust retains the proceeds of the monies received, then it would pay the tax. But then, what would be the purpose of that? It's rate is going to be much higher than their individual income tax rate in most cases and will simply deplete the monies unnecessarily. The trust was designed to administer a life insurance policy for the benefit of the beneficiaries of the trust, and they might have to petition the court to terminate it. Normally, if a trust has no funds, nor any future interest in funds for which it is designated a beneficiary, it would terminate automatically, IMO.

3. And it is my belief it would be taxable to the bene's if they receive the proceeds under the scenarios you propose. However, I am qualifying this answer with the admonition that the interested parties run this through the attorney who drew up the trust, or another one of their choosing who is qualified to do such transactions.

[PPJCPA]

Thank You

Burke,

Thank you once again. You have been a tremendous help. I seriously can't thank you enough.

I completely understand that you are not an expert on ILITs and you are not an attorney. However your responses have provided me better insight and understanding on how to handle this transaction.

Hope you have a wonderful weekend.

Paula