When international estate tax rules are layered onto common errors in Irrevocable Life Insurance Trusts (“ILITs”), the consequences can be dire. PLR201941008 illustrates one common drafting mistake that can cause havoc for cross-border families.
ILITs have been a mainstay in U.S. estate planning for decades. The premise of the trust is that it can accomplish at least three things: (1) the settlor and other third parties can make contributions to the trust that qualify for the gift tax annual exclusion, (2) the trust assets can be excluded from the settlor’s gross estate for estate tax purposes, and (3) the trust assets can be excluded from the trust beneficiary’s gross estate for estate tax purposes. The trust does not need to hold life insurance, but since the trust is generally set up to receive relatively small annual exclusion gifts (up to $15,000 per donee per year in 2019) and the death benefits on life insurance can be much higher than the premiums, life insurance is a useful asset.
In order to make the contributions to the trust qualify for the gift tax annual exclusion, the beneficiary must have a present interest in the gifted amount. That rule, which is enshrined in Internal Revenue Code Section 2503(b)(1), generally prevents a gift into a trust from qualifying for the gift tax annual exclusion. If the beneficiary of the trust is granted the ability to withdraw the gift amount, then the beneficiary does have a present interest in the gift and therefore the gift to the trust can qualify for the annual exclusion. Typically, however, the trust beneficiary does not exercise the power to withdraw the gift amount and, by the terms of the trust, the power lapses.
It is the lapsing of the power to withdraw that can cause issues. In PLR201941008, an ILIT was created by a parent, both parents and two grandparents made annual exclusion gifts to the trust, but the trust contained a drafting error. Under Internal Revenue Code Section 2514(e) if a power of withdrawal, like the power a beneficiary has in an ILIT, lapses as to the greater of $5,000 or 5% of the trust assets that could be used to satisfy the withdrawal, then the excess is a gift from the beneficiary to the trust. Under other rules of the estate tax statutes, causing a beneficiary to make a gift to the ILIT would make the ILIT property includible in the beneficiary’s gross estate—defeating the third goal of most ILITs. In the PLR, the trust did not limit the lapse of the withdrawal powers to the greater of $5,000 or 5% of the asset values. The settlor of the trust asked a state court to reform the trust language to include that limitation and the IRS agreed to accept the court’s reformation, thus rescuing the trust from the error.
Without careful drafting, however, ILITs can violate these rules. In the international context, causing a beneficiary who is a non-resident of the United States to have made a gift to an ILIT can be disastrous. While citizens and residents of the United States currently each have an $11.4 million exemption from estate tax, a non-resident only has a $60,000 estate tax exemption. A non-resident is only subject to estate tax on their property located within the United States, but a special rule applies to trust assets when the non-resident makes a gift to the trust an retains a beneficial interest in the trust, such as in the ILIT context when a beneficiary’s withdrawal power lapses at a rate higher than the $5,000 or 5% limitation.
That rule, found in Internal Revenue Code Section 2104(b), subjects the trust property to estate tax at the non-resident beneficiary’s death regardless of where the trust property is located on the date of the beneficiary’s death. In effect, the trust is “tainted” forever, and the non-resident is subject to estate tax on the worldwide assets of the trust, to the extent those are worth more than $60,000 and no other exception applies. For example, if an ILIT with the same drafting error as in the PLR received one annual exclusion gift and the next year recovered life insurance proceeds from a term policy of $1,000,000, invested the proceeds in a house for the beneficiary in Spain, and the beneficiary was a non-resident, then at the beneficiary’s death 2/3 of the value of the trust’s interest in the Spanish house would be subject to estate tax of roughly 40% in the United States (i.e. the portion of annual exclusion the beneficiary was deemed to contribute to the trust, $10,000/$15,000). This is the result despite the fact that had the trust simply given the $1,000,000 to the beneficiary and the beneficiary had purchased the Spanish house, the house would not be subject to U.S. estate tax. Thus, the 2104(b) rule can have harsh consequences that compound issues like the drafting error in PLR201941008.
While ILITs need careful attention to ensure they avoid gifting issues generally, when a beneficiary is a non-resident of the United States the cost of errors raises substantially.