When a client transfers a life insurance policy to an irrevocable trust, a gift is made subject to the gift tax. The tax, if any, payable on that transfer depends on the fair market value of the policy, the availability of the annual exclusion, and the availability of the lifetime exemption. If the annual exclusion is available, then up to $15,000 (in 2019, as indexed for inflation) of the value of the gift is shielded if the client is unmarried and up to $30,000 (in 2019) if the client is married and the spouse consents to split the gift so that each is treated as making a gift of one half of the policy. The value of the transfer in excess of that amount would be taxable to the extent not protected by the client’s remaining lifetime exemption. If the annual exclusion is not available, the entire value of the contract on the date of the gift would be a taxable transfer to the extent not protected by the lifetime exemption.
To minimize gift tax exposure upon the contribution of a policy to an irrevocable trust, a client may want to borrow a portion of the cash values out of the policy before making the gift. This reduces the initial gift tax value of the policy itself. However, caution should be used when utilizing this strategy as it may create an inadvertent violation of the transfer for value rule. Because the trust assumes the loan, it is treated as if it paid an amount equal to the transferred loan for the policy. This creates a part sale/part gift. If the loan amount exceeds the transferor’s basis in the policy, then the “transferee’s basis is determined by reference to the transferor’s basis” exception to the transfer for value rule will not apply, and another exception to the transfer for value rule will be needed. Therefore, as a general rule, avoid taking a policy loan in excess of the policy basis before making the gift.
When more than one large policy is to be transferred to the trust, they can be transferred over a period of years to fully utilize the annual exclusion and yet stay within the “five-or-five” maximum limitations. Alternatively, one large policy could be split into several smaller ones and staggered gifts could be made to the trust.
Payment of premiums by the client following a transfer of a policy to an irrevocable trust is an additional gift, regardless of whether the client makes the payment directly to the insurer or makes a cash contribution to the trustee who then pays the premium.
If someone other than the person who created the trust pays the premiums, there is a potential gift tax problem if that additional grantor is not a beneficiary of the trust. For instance, the aunt of a beneficiary makes contributions to a trust set up by her brother for her niece. Each premium the aunt pays is a gift to the niece.
If a beneficiary of the trust pays premiums to keep the insurance in force and protect his interest, the portion of the premium equal to the payor’s share of the trust would not be considered a gift but the portion of the premium that enriches the other beneficiaries would be treated as a gift from the payor to the others.
Example. Suppose the client cannot or will not make further contributions and the policy on his life held by the trust is about to lapse. To the extent the beneficiary’s contribution will be returned in the form of insurance coverage the beneficiary will receive, he has made a (nontaxable) gift to himself. But to the extent the money paid exceeds his share, the difference would be considered a gift to the other beneficiaries. So if three brothers were three equal beneficiaries of a trust and the oldest gave $12,000 to the trustee who in turn used it to pay a $12,000 premium, he would be deemed to have made a $9,000 (two-thirds of $12,000) gift to his siblings.
This gift tax liability is imposed even if there was no donative intent by the premium paying brother. Should the grantor not have the funds (or the will) to pay the premiums, one solution is for the trustee to have the insurer divide the policy up into separate policies for each beneficiary and ask each to contribute his share of the premiums. That way, in the event of a lapse, only the beneficiaries who did not pay premiums will suffer.
In general, since gift tax rates are identical to estate tax rates, in the long run a client would be trading dollars if he incurred gift tax in the attempt to save estate tax. Actually, because gift tax must be paid currently while estate tax can be put off until death, each dollar of gift tax, in essence, costs (time value of money wise) more than each dollar of estate tax. At the least, psychologically, each dollar of gift tax hurts more. Of course, there is no current gift tax cost to the extent gifts are covered by the annual exclusion or lifetime exemption.
The high financial and psychological cost of gift tax on taxable gifts is why planners must use every effort to accomplish the estate tax saving goals of an irrevocable life insurance trust at the least possible gift tax cost (and if possible without using up all or any of the client’s available estate and gift tax exemptions).
The major tool for getting the most estate tax savings at the least gift tax cost is the gift tax annual exclusion. As the following calculation shows, a long term systematic use of the annual exclusion, even without life insurance leveraging, can result in amazing federal estate tax savings.
If the beneficiaries, either inside or outside a trust, used the annual gifts (each of the five donees were given $30,000, a total of $150,000 a year of gifts in the above example) to purchase life insurance on the life of the client, the estate tax leverage in the illustration above could be multiplied many times over.
However, the annual exclusion is available only for gifts of a present interest. Present interest is defined for gifts of life insurance under the same rules as it is for other gratuitous transfers. Essentially, to be considered a present, as opposed to a future, interest, the donee must receive the immediate, unfettered, and ascertainable right to use, possess, or enjoy the transferred property. No annual exclusion will be allowed if the beneficiary’s right to take can possibly be threatened or delayed for even one minute. For instance, if the trustee has the discretion to invade trust corpus for the benefit of non-Crummey beneficiaries, even if that discretionary right is never actually used, the gift tax annual exclusion is not available for the transfer.
If a client gave his intended beneficiary an outright gift of a life insurance policy, the transfer would qualify for the gift tax annual exclusion (unless the gift of the policy was made to two or more people, in which case it would be a gift of a future interest since a joint owner could not withdraw his or her interest without the consent of the other joint owner(s)). The mere fact that the policy will not pay off until the death of the insured at some distant and uncertain date in the future does not cause the transfer to be considered a future interest since the recipient has the immediate, unfettered, and ascertainable right to use, possess, and enjoy all of the incidents of ownership in the contract.
But a gift of an insurance policy to a trust designed, almost by definition, to delay the timing and control the beneficiary’s use, possession, and enjoyment of its assets will be a gift of a future interest. Absent a special trust provision creating a present interest in one or more of the trust’s beneficiaries, each time a client made a contribution to a trust, enabling the trustee to pay life insurance premiums, the client would have to use up more of his unified credit to avoid gift taxes or actually pay gift taxes.
The solution to the problem of the beneficiary’s inability to immediately use, possess, and enjoy the client’s contribution is to create a window through which the beneficiary could reach to take all or a portion of that annual contribution or alternatively use the policy. This window is what practitioners call the Crummey power which is named after the successful taxpayer who was able to obtain a gift tax annual exclusion because of his beneficiaries’ rights to make a demand of the trustee even though:
- each beneficiary was a minor and obviously could not exercise the demand power without the appointment of a legal guardian;
- no guardian was ever, in fact appointed on behalf of the children;
- the demand power was never actually exercised by either the children or by a guardian on their behalf and none of the children had received any payment from the trust fund; and
- the power had a limited duration of only thirteen days (the demand was to be made by the end of the year in which the transfer was made from the gift the donor made that year but most transfers were made about the middle of December).
The key to recognition of this window as an effective gift tax exclusion device is therefore not the actual enjoyment of the right by holders of the Crummey power but rather the reasonable and realistic legal right to enjoy. The trust must therefore specify that each trust beneficiary to whom a Crummey power is to be granted is given an absolute but noncumulative right to withdraw a specified amount from the client’s annual contribution. The client may wish to limit this noncumulative right to the lowest of: (1) the amount of the annual exclusion per donor/donee per year; (2) the amount actually contributed; or (3) the greater of $5,000 or 5 percent of the value of the trust’s assets at the time of the withdrawal.
Although the IRS has accepted the Crummey power as a means of creating a present interest and has even privately approved the use of Crummey powers to satisfy the present interest requirement with respect to gifts of life insurance policies in trust, it continues to disallow the annual exclusion unless both the letter of the law and good intent are shown by the taxpayer.
When a grantor sets up the Crummey power window through which a beneficiary can reach in and make a withdrawal, the grantor is attempting to qualify each year’s transfer to the trust for the gift tax annual exclusion. But the grantor does not want to make the window opening so large and keep it open so long that the beneficiary will actually reach in and take the contribution. If the beneficiary does exercise the right to withdraw, the money will not be available to pay premiums on the life insurance that is meant to provide estate liquidity and provide financial security for the trust’s beneficiaries. (It would not be wise to provide for a shutting of the window in the event a holder does take a given year’s contribution, since that would be evidence that the power was a sham.)
But the client could maintain some control by providing in the trust agreement that each year’s contributions to the trust would be earmarked to specific donees. That way, if a powerholder actually took money in the prior year, the client could decide not to make a contribution subject to that beneficiary’s withdrawal right. In other words, the trust could provide that each powerholder had a right to withdraw funds from the trust only if specific contributions were designated as subject to that beneficiary’s right of withdrawal. The trust could also provide that if a beneficiary is subject to a bankruptcy proceeding, the right of withdrawal lapses. This would prevent the bankruptcy trustee from exercising the withdrawal right.
The open window (demand period) must be allowed to remain open long enough to give the beneficiary a meaningful interest in the property given to the trust. In other words, the beneficiary must know of his right to make a withdrawal and have a realistic and reasonable opportunity to actually exercise that right. So the trustee should keep sufficient funds in the trust during the open window period so that a demand can be realistically and immediately satisfied. If a client contributed money to the trust but the trustee paid the premiums for trust owned life insurance the very same day, the IRS could argue that, in reality, the Crummey powerholder never had a chance to make a withdrawal. So if the demand period is too short, the IRS will argue that the power was a sham and disallow the exclusion.
Trustees should notify all demand powerholders of the right to make withdrawals. In the case of minor beneficiaries, notification should be made to the person who can legally exercise the demand power on the minor’s behalf, typically the minor’s parent or legal guardian. This notice should take the form of a return receipt requested letter informing the beneficiaries that gifts to the trust can be expected on specified dates (coincident with premium payment dates). The letter should inform them of their demand rights, and promise supplementary information if gifts are not made according to this schedule or if additional gifts are made. An alternative is to request that the beneficiary acknowledge receipt of each year’s notice by initialing a copy and returning it to the client or trustee. The safer course would be to provide notice to the powerholder of each contribution with respect to which a withdrawal power is available.
What if no guardian has been appointed for a minor beneficiary? The IRS position is liberal:
“If there is no impediment under the trust or local law to the appointment of a guardian and the minor donee has a right to demand distribution, the transfer is a gift of a present interest that qualifies for the annual exclusion.”
There is no specific number of days during which a demand power can be exercised which assures that a demand power will create a present interest. The number of days within which the beneficiary can exercise the power is measured by both the terms of the trust and the date of the gift. The bottom line is that the trust agreement should give the beneficiary adequate time to realistically make a demand and exercise the right to enjoy the contribution the insured-client has made to the trust.
It is essential that the beneficiary or guardian for the beneficiary to whom the Crummey power is granted be given proper and timely written notice of the right to make a withdrawal. Regardless of the form of the gift, a withdrawal power will not be considered a present interest unless the beneficiary is aware of its existence. In the authors’ opinion, thirty days from the date of the notice seems to be the shortest reasonable period. So if the beneficiary’s power to make a withdrawal lapses at the end of the year, contributions should be made to the trust before December 1.
On the other hand, if the window is held open too long, there may be adverse tax implications to the Crummey powerholder. So if the beneficiary were to die while the window was open, the assets subject to that power to withdraw would be included in his estate. By limiting the duration of the opening to one month each year, if the beneficiary dies during any other month of the year (during which he had no power to make a withdrawal), there should be no estate tax inclusion.
If the window is opened too high, i.e., if the “five-or-five” power were not included in the withdrawal limitations, the value of any unexercised demand right existing at the beneficiary’s death would be included in his estate. This is because the absolute power to make a withdrawal is technically a general power of appointment, an unlimited right to direct the disposition of the property subject to the power to anyone, including the powerholder, his estate, his creditors, or the creditors of his estate. The mere possession of such a general power is enough to require estate tax inclusion. So if a beneficiary had the right to take an unlimited amount from the trust, the entire value of the trust’s principal would be included in his estate.
Furthermore, each year that the beneficiary allowed the right to make a withdrawal lapse, the IRS would claim that by not taking what could have been taken; the beneficiary is making a gift to the trust’s remainder person. Allowing a general power to lapse or expire is treated for gift and estate tax purposes as a release (i.e., as if the powerholder made an actual transfer of the property subject to the power). For instance, if the client’s wife is to receive income for life and then trust assets are to pass to the client’s children, to the extent the client’s wife does nothing and allows this year’s Crummey power to lapse, she is in essence making a gift to her son of what she could have withdrawn. That would trigger both gift taxes and gift tax filing requirements since the gift would not pass to the son immediately and would therefore be a future interest gift that by definition could not qualify for the annual exclusion. Worse yet, the wife retains for life the income from the gift she is deemed to have made. This is a classic gift with a retained life estate that requires inclusion in the wife’s estate of the date of death value of the entire property producing the income.
Here’s where the “five-or-five” provision comes in. Under a de minimis rule, the gift/estate tax problem of the powerholder who doesn’t exercise the power is avoided to the extent the lapse of the power each year does not exceed the greater of $5,000 or 5 percent of the value of the trust’s assets at the time of the lapse. In other words, the lapse of a Crummey power is considered a release (taxable gift) only to the extent that the value of the property in question exceeds the greater of $5,000 or 5 percent of the total value of the assets out of which the exercise of the lapsed power could have been satisfied. This is the reason why the familiar “five-or-five” limitation is built into the wording of most irrevocable life insurance trusts.
Planners should note, however, that it may pay—in certain cases—to use a higher withdrawal limit where it is expected the Crummey powerholder will never have a significant estate or gift tax problem and the major objective is to shield the client’s premium payments on a large policy from gift tax.
Many clients, who have discovered the irrevocable life insurance trust’s advantages, place sizable policies in such trusts. The large premiums that are generated by those policies quickly exceed the per donee annual exclusion limit. For this reason, clients want to multiply the annual exclusions available by giving many beneficiaries a Crummey withdrawal power.
A trust may grant demand powers to several individuals and therefore multiply the number of available gift tax annual exclusions, which in turn allows the grantor to make larger gifts in the form of policy assignments and/or premium payments without gift tax. It’s also good planning for the trust to provide for contingent powerholders, so that if a spouse or child who holds a power dies, another person would take over and the present interest exclusion could be maintained. But there are limitations on the grantor’s ability to use multiple Crummey demand powers in this fashion:
First, each beneficiary’s interest must be ascertainable at the moment the client’s annual contribution is made to the trust. Proper apportionment of demand rights is necessary. If the donee’s exact present interest can’t be immediately ascertained, no annual exclusion will be allowed since it would be impossible to determine whether the client should be credited with the full amount of the exclusion or some lesser amount. The trick is, therefore, to either: (a) make the number of eventual donees immediately ascertainable at the time of each gift to the trust, or (b) assure that the interest of each Crummey powerholder be immediately capable of valuation.
If a trust does not have sufficient principal to satisfy all of the Crummey demand powers given to its beneficiaries, the IRS could argue that none of the interests are capable of valuation and the gift was one of a future interest since no beneficiary’s right can be ascertained on the date of the gift. The solution is for the trust to provide that if any year’s contribution is insufficient to meet all the possible Crummey demands, then the contribution must be distributed on a pro rata basis among the powerholders. The trust should further require that if any donee receives an amount greater than his pro rata share of the trust corpus, that donee must immediately reimburse the trustee for the excess amount in the event there are insufficient assets satisfying the potential demands made by other powerholders.
Second, it remains the IRS’ position that a demand holder must have a significant, beneficial interest in the trust. The IRS believes that the critical test is whether the grantors ever expect that a particular demand power will be exercised. Because remote beneficiaries have little or no reason not to exercise their demand rights, the IRS views the failure of remote beneficiaries to exercise their demand rights as evidence that some understanding exists between them and the grantors. According to the IRS, this is fatal to the annual exclusion.
However, it has been the authors’ opinion that it should be immaterial that the donor does not want particular demand powers to be exercised. The statute requires only that the donees are appraised of their rights and legally can exercise those powers. The Tax Court agrees with the authors. It clearly stated in several cases that the sole criteria for allowing an annual exclusion is the existence in the donee’s hands of the immediate, unfettered, and ascertainable right to use, possess, and enjoy the subject of the gift on the date the power is issued. The Tax Court expressly rejected the IRS’s contention that “evil intent” —even when manifested by a family discussion about how funds transferred to the trust would be used by the trustee—taints the transfer and makes it a future interest. The only relevant test is: “Does the donee have the legal right to make a demand for payment?” and “Is the trustee legally obligated to comply with a demand from a Crummey power-holder?”
Having stated both the authors’ and the Tax Court’s opinion, the authors continue to suggest that notices in fact be made in writing on a timely basis. Further, family discussions as to what might or might not happen to the fortunes of a power-holder who made a withdrawal should be avoided. Counsel should insert wording into the agreement to the effect that “Trustee shall promptly comply with every demand for payment under the above withdrawal power.”
Another solution may be to give all demand powerholders at least a discretionary right to current distributions from a life insurance trust, despite the fact that no such distributions are likely.
Not all authorities agree on how gifts to the irrevocable life insurance trust should be structured or how best to word the trust so that an annual exclusion will be allowed, regardless of what type of gift is made to the trust or how large that gift is.
When a trust is unfunded, the client’s contribution may be in the form of: (a) direct payment of the insurance premiums to the insurance company by the insured-grantor; or (b) indirect payments by grantor to a trust, either by check or through his employer (for example, as payments toward group insurance or split dollar premiums). In such cases, the Crummey provisions of the trust should authorize beneficiaries to demand both direct and indirect gifts to the trust, ensuring that indirect gifts qualify for the annual exclusion.
Where the trust is unfunded, there are only two sources from which the demand right can be satisfied: (1) the cash contributions made by the grantor to the trustee in order to pay premiums (but if the premium payments go directly into the policy, due to surrender charges and other policy fees, the amount available to satisfy a demand may be considerably less than the full premium payment); and (2) the life insurance policy itself.
An annual exclusion should be allowed even if the trust holds only term insurance or permanent life insurance that has little to no cash value on the date contributed. However, the trust must give the trustee the authority to make payments in cash or in kind. This ability to satisfy the demand by distributing a fractional interest in individual life insurance policies or group term insurance should enable the grantor to obtain the annual exclusion in exactly the same way that an outright gift of a fractional interest in an insurance policy would qualify.
Conservative planners may protect the insured-grantor’s gift tax annual exclusion even further by funding the trust with some assets other than life insurance policies. If the trust has an amount of cash or other liquid assets equal to the annual premiums (the required amount of annual exclusion), the trustee could always distribute that cash to satisfy a beneficiary’s demand.
The recommended course of action in most cases is for the insured grantor to give the trustee a cash sum each year that the trustee could hold for the duration of the demand period. Only after the expiration of the demand period would the trustee use this contribution to pay the premiums. This requires that the client grantor make premium payments well ahead of their scheduled due date to avoid a policy lapse.
One conceptually simple alternative approach is for the client to make direct gifts of cash to the trust’s adult beneficiaries who then make contributions back to the trust. The amount given to each beneficiary should equal his proportionate share of the trust. Since the gifts are both direct and outright, the client should obtain an annual exclusion gift for each transfer. Then, when the children contribute the gifts back to the trust, they should not be deemed to be making gifts since each should be contributing only his share and that should be going only to his portion of the trust.
This technique may prove more difficult, however, in real life because of the administrative difficulties and the fact that beneficiaries may not co-operate. This technique should pose few problems during the life of the grantor or the grantor’s spouse, but may result in a portion of the trust being included in the beneficiary’s estate under Code section 2036(a). This may not be a major problem if the beneficiary does not have a very large estate or is young and likely to exhaust the trust funds.
There are two major reasons why a client may wish to give a spouse Crummey powers:
The client may be worried that children or other donees will exercise their demand powers and thus defeat the purpose of the trust by depriving the trustee of funds from which to pay premiums.
The client may want to increase the number of available annual exclusions.
In most cases, there is no good reason to deny the client’s spouse a demand power, but it should be limited to an annual amount not exceeding the greater of: (a) $5,000; or (b) 5 percent of the trust fund. To allow a greater right of withdrawal would invite IRS inclusion of the policy proceeds in the spouse’s estate. If the grantor’s spouse has the requisite beneficial interest in the trust, the IRS could argue that the lapse of the spouse’s demand power (i.e., the spouse’s failure to exercise the withdrawal right on her own behalf) is equivalent to the release of a general power of appointment.
Under Code section 2041(a)(2), a decedent’s gross estate includes the value of property subject to a general power of appointment that was released or exercised before the decedent’s death, if the result of the release or exercise is the creation of a retained interest described in Code sections 2035, 2036, 2037, or 2038. If the spouse is also an income beneficiary, therefore, this would create estate tax inclusion.
One technique that will not work is the use of reciprocal demand powers. For instance, suppose a client and his brother both want to shelter very large life insurance premiums from gift tax, so both simultaneously create irrevocable life insurance trusts in order to increase the number of available gift tax annual exclusions. Assume, further, that each brother gives his own children and his brother a Crummey power. The reciprocal powers the brothers gave each other will be ignored for purposes of the gift tax annual exclusion. Furthermore, the trusts will be included in each brother’s estate as a transfer with a retained life estate under section 2036.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM