Using a Long-Term Care Rider in an ILIT
Introduction. For years, life insurance policies have become more and more flexible with capabilities far beyond simply guaranteeing a death benefit. A trend that has been developing for quite some time (and shows no sign of slowing down) is the long-term care rider attached to a life insurance policy. Essentially, this rider allows an acceleration of the death benefit to be used as a de facto long-term care policy. Such a structure seems pretty straight-forward and attractive for someone seeking that benefit. However, it also makes sense for some life insurance policies to be inside an Irrevocable Life Insurance Trust (ILIT). The primary benefit of owning a life insurance policy inside an ILIT is that a guaranteed death benefit can be secured on the death of the insured without such death benefit being included in the insured's gross estate (and thus potentially subject to tax).
The fundamental structure of an ILIT is to distance the insured from the trust so as to qualify for, and capture the tax savings. As so, at first glance it would seem that a life insurance policy inside of an ILIT is not congruent with attaching a LTC rider to that policy: On the one hand we want to distance ourselves from the policy, but on the other hand we want to enhance the policy to access additional benefit. Although both objectives appear to be incompatible, creating an structure where one can, in fact, benefit from both is entirely possible.
Consideration #1 - Type of Rider. There are two types of long-term care benefits in any LTC policy or rider: "Reimbursement" and "Indemnity." Reimbursement benefits are paid out to reimburse the policy owner for specific covered expenses. Receipts need to be turned in and approved, and such approved expenses are then reimbursed to the client up to the benefit amount. Indemnity benefits have a specific dollar amount of benefit and when the insured goes on claim (after the elimination period), the benefit pays out regardless of actual expenses incurred. For example, a LTC policy with a $5,000 monthly reimbursement benefit would reimburse the policy owner for covered expenses up to $5,000 per month. That same policy with a $5,000 indemnity benefit would simply write a check for $5,000 to the policy owner each month. When it comes to purchasing a long-term care rider on a life insurance policy inside of an ILIT, the benefit has to be an indemnity benefit. With the ILIT owning the policy the ILIT will be the recipient of the monthly benefit check. This is a right the owner has and is not related to the actual needs of the insured. If the rider is the reimbursement type, then then receiving benefit requires too intimate of an interaction between the insured and the trust to be able to later claim exclusion from his gross estate. So first and foremost, the rider benefit must be an indemnity benefit.
Consideration #2 - Access to Benefits. When the insured goes on claim (and after the elimination period), indemnity benefits will begin to pay out to the owner of the policy (the trust). Accessing that benefit needs to be handled with caution. Any sort of entitlement to benefit puts the the estate tax benefit of the ILIT at risk. Like everything in estate planning, there is a spectrum of options. On the one side of the spectrum is the most arm's length (but arguably more administratively burdensome) structure of borrowing the benefit money from the trust. On the more informal, but convenient, end of the spectrum is simply authorizing the trustee to make distributions to the insured. This can also be problematic if not handled properly. A brief evaluation of both options is appropriate here:
Accessing the Benefit via a Loan. With the indemnity benefit being paid to the trust, the insured has no inherent right to those benefits (this right belongs to the policy owner). The insured borrows those funds from the ILIT per a fully collateralized loan with interest charged and an agreement to fully pay back the debt. The borrowed funds can be used to pay LTC bills or used for a variety of other purposes. The interest is not paid immediately, but rather allowed to accrue to purposely increase the debt. By satisfying the debt prior to death, the cumulative payments act as an additional tax-free transfer out of the estate. (Note that any interest repaid after the death is income taxable to the trust).
Discretionary Trustee Distributions. There is no reason the trustee can't simply make a discretionary distribution to the insured. However, it is essential that the insured not have a right to distributions, as such would pull the trust assets back into the gross estate of the insured. But a friendly trustee can certainly make a distribution without any problem...but it depends on whether the trustee is an "adverse party" or a "non-adverse party." A trustee is an adverse party if an action as trustee has an negative (or positive) affect on him/herself. A trustee is a non-adverse party if they are personally disinterested in their decisions as trustee. If the trustee is a non-adverse party, then the only consideration is that the insured (grantor) not retain the power to replace the trustee with him/herself. Other than that single issue, discretionary distributions to the insured (grantor) are fine. If the trustee is an adverse party, then the ability for that trustee to make discretionary distributions to the insured (grantor) need be replicated to other beneficiaries as well. In other words, if an adverse party trustee wants to make a discretionary distribution, they cannot be railroaded into only one option which benefits the insured (grantor) at the expense of the trustee.
These are just explanations on the two ends of the spectrum of accessing accumulating indemnity benefits inside the trust. There can be different strategies along this spectrum, or combinations of different strategies. The one thing to consider, however, is any opportunity available to further reduce the value of the estate. For example, if we look at the loan strategy, accrued interest and a high interest rate give the insured the opportunity to transfer additional assets outside of the trust tax-free.
Conclusion. With a high estate tax exclusion amount and an uncertain legislative future, flexibility needs to be built into financial and estate plans. The origin of the long-term care rider on a life insurance policy was born out of a desire for flexibility, and enjoying the such a benefit alongside the estate tax benefit of an ILIT merits serious consideration.