So you took our advice and decided to form an Irrevocable Life Insurance Trust--then your situation changed and you want to change the beneficiary.
As the name indicates, an irrevocable life insurance trust’s terms cannot be amended after it is created. In the State of New York, “irrevocable,” means that it is “less flexible,” since even irrevocable trusts can be modified or amended in accordance with the statutory law if, and only if, all of the interested parties (beneficiaries, the grantor, and the Trustees) agree in writing to the modification. If any of those interested parties will not agree to the proposed modification, or if any of them are not adults of majority age, amendment by agreement may not be possible.
What then are the options for adjusting this trust after a change in circumstances? What is a grantor to do if she is no longer happy with the terms of her trust?
A grantor can always stop making gifts to the trust, let the existing policy lapse, and start over with a new trust and a new policy. But, retaining the current policy may be preferable for health or economic reasons. The irrevocable life-insurance trust can sell the policy back to the grantor-insured, who then assigns it to a new irrevocable life-insurance trust, but that will start the running of a new three-year rule (under IRC Section 2035(a)). If the trust permits, the policy can be distributed to one or more of the beneficiaries. But, absent a trust, the policy beneficiaries would not be protected from creditors, ex-spouses, or estate taxes. Here are a few options:
1. Let the policy lapse
If the grantor can still obtain a new policy for essentially the same premium amount, an easy option may be to let the policy lapse and simply obtain a new policy. This will likely require a new application for life insurance, and a new medical exam, but assuming that a new policy can be placed at or about the same premium amount, this may be a feasible option. This option will likely work best with a term policy or a whole policy that has not accrued much cash value.
2. Convert or exchange the policy
If the trust instrument authorizes the Trustee to convert or exchange the policy for another policy of equal or lesser value, the Trustee can “swap out” the policy in the trust for one that is already outside of it. If the grantor already owns another policy outside the trust, he can exchange it, assuming that there is supportable documentation showing that the policies are of approximate value.
3. Purchase the policy
Assuming the grantor has the cash available, or other property of approximately the same value as the policy in the trust, the grantor can purchase the policy from the trust. Assume, for example, that the irrevocable life-insurance trust has a 30-year term policy for $2 million in the trust, and that is about two years into the policy. The grantor can get a valuation estimate of the cost of the policy and pay that amount into the trust in exchange for the policy. If the trust instrument contains the power to sell the policy, this can be an option.
Just as a bottle of wine decants into a separate receptacle, a trust can be decanted into another trust instrument containing the desired terms. Again, the trust instrument must permit the Trustee to decant into a new instrument under the law, which in New York permits such decanting with certain restrictions. (See EPTL 10-6.6(b)). The new trust may not reduce any fixed income rights; it must provide for one or more of the beneficiaries of the existing trust; and the interest of the remainder beneficiaries cannot be extended beyond a permissible time limitation.
Based on IRS Revenue Rulings (Rev. Rul. 2007–13), a grantor of an existing irrevocable life-insurance trust can create a new one with the new desired beneficiaries and provisions, and then gift or loan the new trust with sufficient assets to enable the new trust to buy the policy from the old one. However, there are various precautions that will need to be followed in order to engage in such a transaction properly and avoid scrutiny from the taxing authorities. It is also critical to avoid future claims by the affected beneficiaries against the grantor’s estate or the Trustees. There are many tax and non-tax issues specific to each person’s situation that must be examined carefully before embarking on a change to any trust, particularly an irrevocable life-insurance trust. Trustees and grantors should proceed with caution and with legal advice before engaging in this type of transaction.