Trust Planning with Life Insurance and Long Term Care Riders

Clients are increasingly concerned with having enough funds accessible should long-term care needs arise later in life. The life insurance industry has responded to this by broadening the reach of traditional products. A new type of “hybrid” life insurance, which merges death benefit protection and a flexible, guaranteed premium schedule, along with a long-term care (LTC) rider[1], can help Clients manage potential long-term care costs while protecting families from financial hardship. Additionally, if benefits aren’t completely utilized, the remaining dollars can help fund a financial legacy. Because Clients may also be concerned about Federal and/or state estate taxes, or wish to set parameters around the inheritance of a death benefit, they may want an Irrevocable Life Insurance Trust (ILIT) as owner of the policy.

It has generally been established that a life insurance policy with an indemnity LTC rider can be appropriately owned inside of an ILIT, vs. a reimbursement LTC rider. The difference being that an indemnity plan pays the benefit directly to the owner of the policy. Thus, if the insured qualifies for a $5,000 monthly benefit and an ILIT owns the policy, the $5,000 is sent to the Trustee. In contrast, with a reimbursement plan, the benefit is paid directly to the nursing home or agency providing the care, with the Insured submitting bills or receipts each month to the carrier. A reimbursement rider will generally not work for a policy owned by an ILIT because the reimbursement benefits the Insured and therefore brings the death benefit back into the Insured’s estate. An indemnity rider can work because the LTC benefit is paid to the Trust.[2]

However, due to IRC § 2042 and the incidents of ownership issues inherent in this planning scenario, we submit that the appropriate considerations do not end here. Just as one does not simply “walk into Mordor,” one cannot simply place a life insurance policy inside a traditional ILIT and intend to benefit the Grantor. The following is an overview of three ways LTC rider benefits can actually (and appropriately) get into the hands of the Insured under the life insurance policy owned by an ILIT.

  1. For the right client situation, a potentially “simple” approach is to have the policy owned by the ILIT, but have the insured pay for any long term care expenses “out-of-pocket” (rather than borrowing money from the trust). The insured’s direct payment for long term care reduces the insured’s estate. Any long term care benefit paid to the ILIT is retained an invested by the ILIT which effectively results in a lifetime shifting of wealth from the insured (by the amount paid for long term care coverage) to the ILIT (the amount received as a long-term care benefit under the life policy) on a gift tax free basis.
  2. When undertaking the ILIT drafting process (always in conjunction with a qualified estate planning attorney), there is some flexibility. One version of such a Trust gives the Grantor/Insured the right to borrow from the Trust, provided that he/she executes a demand note secured by other property owned by the Grantor/Insured and pays interest (usually accrued) at a fair market rate at least equal to any interest charged by the insurance company on loans the Trustee takes from policies owned by the Trust. A more conservative version would not permit the Grantor/Insured to make such loans, but the power would be given to the Grantor/Insured’s spouse. An even more conservative version would permit such loans only in the discretion of the Trustee. In any event, the Grantor/Insured or spouse’s right to borrow from the Trust would be subject to the Trustee’s power to prohibit any loan that would cause the underlying life insurance policy to lapse or not extend to maturity.
  3. One final option is to allow the Trustee to make discretionary distributions (without reference to the LTC rider) to Trust beneficiaries (spouse, children, etc.), while the insured is alive. The beneficiaries could then make loans or gifts to the insured to help cover his or her LTC expenses. The risk with this latter approach is that the IRS could view such payments to the insured as pre-arranged/obligatory on the part of the beneficiaries. And to date this strategy has not been endorsed by the IRS. There is also the “moral hazard” to be concerned about – that the beneficiaries, being under no real obligation to gift or loan the funds, won’t.

Ultimately, it is most important that Clients work closely with their Financial, Legal, and Tax Advisors to arrive at the appropriate solution based on their individual facts and circumstances. Nevertheless, when working in conjunction with Advisors who might not be as familiar with the particular design of these products, it is important to highlight these considerations.

[1] Many carriers now offer this type of innovative policy design. However, so-called “chronic illness riders” are sometimes marketed as “true long term care riders” – it is important to distinguish between the two. For instance, to qualify for benefits under a “chronic illness rider,” a Dr. must certify the Client’s condition is “expected to be permanent.”

[2] It is most important when considering any estate planning strategies that qualified legal advice be obtained.

THIS IS NOT TAX OR LEGAL ADVICE. Neither the company nor its agents or representatives give tax or legal advice. You should consult your attorney or tax advisor for specific answers to your legal or taxation questions.