Trustee Duties and Best Practices for Life Insurance Policy Owned by an ILIT

By: Randall A. Denha, Esq.

Using life insurance inside of an irrevocable life insurance trust (“ILIT”) is a very common estate planning strategy to help create the liquidity to pay estate taxes upon a person’s death, or to replace the value of the assets that were lost due to taxes and estate administration expenses. The ILIT is a well-established estate and tax planning tool which can provide a source of funds for estate tax when due, especially for those estates with large, illiquid holdings such as a closely held business or real estate. Owning the life insurance in a properly designed ILIT will avoid having any of the proceeds taxed in the estate of the deceased-insured.  So, the ILIT not only shifts the insurance outside the estate for tax purposes but also allows for the estate to access funds to pay any estate taxes.

In any ILIT structure, a Trustee is selected. The trustee is the person or institution that is designated to manage and operate the trust. Often, the trustee is a family member or friend of the person creating the trust (the “Grantor”) with little or no experience in being a trustee. Once the ILIT has been created and funded with money, the trustee uses that money to buy a life insurance policy on the individual and/or the spouse. Is that the end of the process? What happens next?

First, lets begin by stating that a Trustee’s responsibilities are not simply placed on autopilot and then forgotten.  In recent years, there have been a number of new insurance products and increased scrutiny on trustee management of insurance policies which makes it hard for the trustee to forget about his/her duties. The management and operation of a trust does not end with the purchase of the life insurance, nor is the duty of the trustee simply to pay the premiums and to manage and disburse trust assets according to the terms of the trust. The trustee is a fiduciary and is held to a fairly high standard of care to properly manage and operate the trust. Let’s look at a common example.

Frank is the trustee of an irrevocable life insurance trust (ILIT) created by his best friend, Sammy. The trust holds a $7 million universal life insurance policy issued on the life of Sammy. The primary purpose of the insurance is to help pay estate taxes when Sammy dies. Sammy is currently 60 years old and in reasonably good health. Since policy inception, Sammy has been making gifts to the trust so that the trust would have the cash to pay the premiums. Frank, as the trustee, has been using the cash to pay the minimum premiums on the policy. Since the policy is a universal life contract, the policy owner can vary the premium payments and need not pay the recommended premium, known as the target premium. Frank finally agrees to meet with an insurance agent to review the policy in the trust. Frank is informed that if Sammy lives to life expectancy, the insurance policy will lapse or become too expensive to maintain. On the advice of the insurance agent, Frank decides to replace the existing policy with a $3 million permanent policy that Sammy could not outlive. Sammy agrees to the replacement and willingly signs the application as the insured. Frank goes one step further by discussing the situation with the trust beneficiaries who have no objection to the replacement. Two years later Sammy dies unexpectedly. Did Frank, as the trustee, breach his fiduciary responsibility to the trust beneficiaries? If Frank retained the original policy the trust would have been paid the original $7 million death benefit because the policy would have not lapsed in such a short period of time. A court case with a fact pattern similar to the one described above, was decided by the Court of Appeals in Indiana (In Re Stuart Cochran Irrevocable Trust.) Fortunately, in that case, the court decided that the trustee did not breach his fiduciary obligation to the trust beneficiaries.

However, as a result of this case, and common sense planning, trustees and their advisors should realize the following:

1. Trustees have a fiduciary responsibility to trust beneficiaries, not the grantor of the trust. Based upon state law, trustees have the obligation to manage and invest trust property in a prudent manner. Most states have adopted a law commonly known as the Uniform Prudent Investor Act that will provide guidelines to trustees regarding trust investments. Trustees should review their respective state law regarding fiduciary responsibility.
2. It is prudent for a trustee to retain an independent insurance consultant to review a trust owned policy in the context of the long term goals of the trust, the nature of the policy, the financial stability of the issuing company, the type of policy owned by the trust, and explore various options with respect to the policy.
3. Trustees should perform their due diligence before accepting the policy.
4. When an existing trust policy is replaced, effective communication with trust beneficiaries is important.
5. Based on this case, trustees should not be held liable for unforeseen events such as the premature death of the insured grantor. In other words, while hindsight may be a great virtue, the court looked at the actions of the trustee at the time of its actions based on the assumption that the existing policy would eventually lapse. However, many underfunded policies may provide coverage to or close to life expectancy, which makes a replacement decision that much harder.
6. An insured may want to consider naming a financial institution as a trustee to protect friends and family members from liability. Alternatively, a special trustee can be named to make all investment decisions regarding trust property.
7. Even in close families, relationships between parties may change after a parent dies.