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The design of trusts is as varied as the imagination of the grantors and their advisors who set them up, and life insurance trusts are no exception. Insurance trusts are almost always setup as ‘irrevocable trusts,’ which means once the trust is setup, you can’t change your mind. Now in New York there are procedures for amending irrevocable trusts, or for transferring the assets of one irrevocable trust to another irrevocable trust (called ‘decanting’, just like with wine!), but when setting up an irrevocable trust you should assume that “irrevocable” means what it says. That’s why, in part, clients and their advisers should be cautious and take their time designing a trust and an estate plan which will be effective decades, which generations into the future.
Irrevocable Life Insurance Trusts (ILIT) are also commonly designed to be “intentionally defective grantor trusts.” That sounds like an amazingly complex tax phrase, but it’s actually simple to understand if you know what all the pieces mean.
Let’s take the term “grantor trust.” What is that? Well, a little history and analogy. You’ve probably heard of the “kiddie tax” which applies to income taxes. What had been happening is that people with money, and taxed in the highest federal and state income tax brackets, were transferring assets to their children, who were in lower tax brackets. The parent still effective retained control of the property however. The IRS effectively put an end (to a large extent) to this strategy by enacting the “kiddie tax,” which requires interest and dividend income of a child under 16 (or 18?) to be reported on the parents’ income tax returns.
So the theory of shifting assets around within a family to take advantage of different aspects of the tax law is standard. The phrase Grantor Trust would typically refer to a trust, any trust, by whatever other name it might be called, where the person who establishes the trust is the same person who benefits from the trust. You might typically see this setup in a “living trust” or “revocable trust” or an “inter vivos trust,” the latin words ‘inter vivos’ meaning ‘while living.’ A “revocable living trust” is often setup as a means to avoid probate, for example. But a “revocable living trust” is also a “grantor trust,” because the person who is setting up the trust is also the beneficiary of the trust. For tax purposes, since the trust is revocable, meaning the person who setup the trust in the first place, called the “grantor” or “settlor” or on ocassion the “trustor,” can revoke the trust at any time (up until death), and take all of the property out of the trust, for tax purposes the trust is ignored: as if it didn’t exist.
Okay, that’s simple. Now, getting back to the tax angle, what people had been doing prior to 1986 was setting up trusts for the benefit of other persons, either their spouses or children or other relatives, for the most part. So these were not “grantor trusts,” because the settlor and beneficiaries were different people. However, the trusts were structured (meaning, the language of how the trust was managed and administered) was such that the settlor actually had some (or a great deal) of control over the trust. Because of this control, the IRS took the position that although the settlor and beneficiaries were different, the trust should be ignored for tax purposes, just like a grantor trust. Hence, Congress enacted the “grantor trust rules,” section 671 to 679 of the Internal Revue Code. Since the person setting up the trust, but retaining control or authority in some way over the trust property.