October 03, 2018
Author: Thomas H. Bergh
Organization: Varnum LLP
I. Introduction
Life insurance is a basic component in the estate planning of many individuals. At the simplest level, life insurance can fulfill a basic risk reduction function by providing income replacement in the event of an untimely death of a supporting family member, and can provide liquidity to cover unanticipated post mortem costs and expenses. In addition, since life insurance owned by a decedent who has assets of a magnitude that cause potential exposure to the federal estate tax, removing life insurance proceeds from the gross estate of the deceased results in a savings of 40% of those proceeds. A time and practice tested technique for realizing those potentially significant savings is the Irrevocable Life Insurance Trust (the “ILIT”), which remains a bread and butter technique, not only because of the huge potential tax savings presented, but also the relatively low adoption and maintenance costs for a potential adopter. In addition, for purposes of this discussion, the ILIT provides a platform for integrating basic estate and gift tax planning concepts into a real world context.
II. Potential Tax Advantages of the ILIT Technique
A. Estate Tax Issues.
- IRC 2042(2): Incidents of Ownership: estate inclusion of the proceeds follows if the deceased possessed certain interests in the policy. An "incident of ownership" is any right of the insured or the estate of the insured to control the economic benefits of the policy either alone or in conjunction with another.
- Treas. Reg. §20.2042-1(c)(2) contains a list of incidents of ownership. Ranging from the obvious to the more subtle, they include the powers: to change the beneficiary; to surrender or cancel the policy; to assign or revoke an assignment; to pledge for a loan; or to borrow against the policy. Certain other factors cause inclusion under IRC §2042, including retention of a reversionary interest in excess of 5% of the policy value (Treas. Reg. §20.2042-1(c)(3)), and the power to change beneficial ownership of the policy or the time or manner of its enjoyment (Treas. Reg. §20.2042-1(c)(4)). Rev. Rul. 84-179 held that powers held by fiduciary/insured strictly in the fiduciary capacity do not cause inclusion in every case, but the exception is narrow enough to counsel against allowing the insured to act as a fiduciary. In PLR 9602010, it was held that a power held by a trust beneficiary (lifetime and testamentary limited power) will not cause insurance proceeds to be included in the beneficiary's estate. The beneficiary neither transferred the policy to the trust nor paid any premiums. The ruling turned on document provision which prevented power exercise in the event the trust owned a policy on the beneficiary. The Service's discussion indicates that the special power would otherwise have been treated as an incident of ownership, despite the fact the beneficiary neither created the trust nor transferred any property to it.
- Planning point. Incidents of ownership are key. As a "best practice", create the ILIT first and have the trustee apply for the policy so that its name is the only one in the records of the issuing company. The IRS is motivated to raise incidents of ownership if given an opening. In clean-up mode, an application naming the insured individually as owner is not fatal if the policy is never actually issued to the insured. PLR 9323002.
- IRC §2035(d)(2): Three-year "pullback" rule for gifts of life insurance. Death within three-year period following transfer of existing policy will cause estate inclusion of the proceeds of the policy. The purchase of a policy by a trustee is not subject to §2035(d) if the insured never possessed any incidents of ownership in the policy. Headrick v. Commissioner, 93 T.C. 171 (1989), Aff'd 918 F.2d 1263 (6th Cir. 1990); Action on Decision 1991-012 (1991) - (Acquiescence). This case and several others that were decided at about the same time dismissed the argument of the Service to the effect that the payment of premiums was a "beamed" transfer of the policy within the statutory period.
- If an existing policy is transferred, use of a contingent marital deduction at least defers tax until the death of the surviving spouse if death occurs within the three-year look-back period. Make sure inclusion of the contingent marital deduction coordinates with overall estate planning goals.
- Sale or other transfer of an existing policy to an ILIT (or a new ILIT where the original ILIT owner has beneficiaries or other features that are no longer consistent with client goals) may be available if made "for full and adequate consideration". Be mindful of transfer for value issues, which can render the proceeds subject to income taxation (IRC§101(a)(2))-use of grantor trust rules or creation of a tax "partnership" between the parties may be helpful in resolving this issue, as discussed further below
- Be careful of fair market value of policy-if the sale is not for "full and adequate consideration, the exception will not apply. Get expert evaluation of policy. Watch out for death bed transfers-the normal valuation rules may not apply.
- The miscellaneous "strings" under the estate tax law that most often cause problems with ILITs include IRC §2036 (retained life interest) and IRC §2038 (retained power to control beneficial enjoyment). Obvious interests to avoid include: a retained income right; a retained right to shift beneficiaries; and a retained right to revoke the trust regardless of circumstances.
- More subtle issues in this area include: trustee replacement power (Best to avoid unless sole right is to replace with independent or corporate trustee. Rev. Rul. 95-58, Wall v. Commissioner, 101 T.C. 300 (1993); also consider limitations on frequency of exercise); the requirement to use trust assets to discharge support obligations (causes inclusion pursuant to Reg. §20.2036-1(b)(2)). It is advisable to include general protective language in the trust document. Other powers may be vested in third parties designed to provide flexibility: for example, provide Grantor's spouse with a Limited Power of Appointment during Grantor's lifetime to dispose of trust property to descendants. If the Trustee is not an actual or contingent beneficiary, consider giving the Trustee (or another independent party) a termination right,. Avoid over-broad powers that appear to be provided to allow the Grantor to keep control through manipulation of a nominallyindependent trustee or other third party power holder.
- Reciprocal Trust Doctrine: Estate of Grace 395 U.S. 316 (1969): Avoid mirror image trusts between husband and wife-result is estate inclusion under IRC §2036. Avoid by providing a meaningful difference in the dispositive provisions of the trusts. (PLR 200426008)
B. Gift Tax Issues.
- Goal: Establish and fund ILIT while minimizing gift tax liability. This is particularly important in an environment which may lead to transfer tax repeal. Focus on: What does the trust document say? What is transferred to the ILIT? How will future premiums be funded?
- Utilization of an ILIT rather than direct ownership among beneficiaries such as children solves many potentially messy gift tax issues. For example, assume you have a do-it-yourself client with two children, one who is responsible and one who is not. The responsible child is the owner of the policy and both children are beneficiaries. If the premium is paid by the parent to the insurer, the entire gift is deemed made to the owner-child. Further, on the death of the insured, the owner-child has made a gift of the proceeds to his or her sibling. (Goodman v. Comm'r,156 F. 2d 218(1946).
- What is a Crummey power and why is it important? Maintenance of an irrevocable life insurance trust for the benefit of a party other than the grantor normally requires continuing premium payments or the transfer of property sufficient to meet future premium payment needs. A donor may make gifts of cash and property of up to $14,000 per donee in calendar year 2014 without the necessity of filing a gift tax return or paying a gift tax. This exclusion includes all the gifts made by the donor to the donee during a particular calendar year, whether for life insurance premiums or otherwise. The exclusion amount is indexed for cost of living adjustments in $1,000 increments and is reevaluated annually.
- In order to qualify for the exclusion, IRC §2503(b) requires the gifts to be of a "present interest." Most life insurance trusts provide for payments to beneficiaries after the death of the grantor/donor, and therefore would not without more qualify for the present interest exclusion. Instead, the limitation of use, compensation or enjoyment of the trust property to a future date or time would require the gift to be treated as that of a future interest, and therefore not subject to the present interest exclusion. Regulation §25.2503-3(a). In many planning contexts, such as where particular estate planning vehicles have been designated to be used in conjunction with gift programs, the present/future interest issue is not critical. For example, a donor may plan to use her annual exclusion to make fractional share gifts in a family limited liability company, in order to take advantage of discounts. Such gifts are unquestionably (in my view, although the Service may not agree-that raises other issues) of present interests, so in the event this donor decides to implement an irrevocable life insurance trust, she may decide to forego any attempt to attain present interest exclusion treatment for the premium payments, simply file gift tax returns and utilize a portion of her unified credit against the transfers to the trust.
• The Crummey power relates to the effort to qualify what would without more be a future interest gift for the present interest exclusion through the grant of carefully crafted withdrawal rights. Other factors may be important in determining proper planning for a particular irrevocable life insurance trust. For example, IRC §2513 allows husbands and wives to "split" their gifts for a particular calendar year if consent is provided on the appropriate gift tax return. Therefore, the unified credit of each spouse can be utilized with respect to premium payments, and, in the event that present interests are involved, the annual exclusion of each spouse can also be utilized. Valuation of the transfer is also important. In the event that cash gifts are made to the trust, valuation is straightforward. The transfer of an existing policy provides more complicated issues.
- The mechanics of acceptable withdrawal powers were laid out in the famous case of Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968). Granting beneficiaries the present right to make withdrawals of trust additions is the primary mechanism for saving the present interest exclusion in the ILIT context. Such powers are customarily referred to as "Crummey" powers, although they predate the decision of the Ninth Circuit in the Crummey case. For example, a good argument can be made that these withdrawal powers should be referred to as "Gilmore" powers, especially in the Sixth Circuit, since the prior case of Gilmore v. Commission, 213 F.2d 520 (6th Cir. 1954) sanctioned them. In accordance with tradition, however, the term "Crummey" power will be used throughout this outline to describe beneficiary withdrawal rights from an irrevocable trust. The Crummey case involved irrevocable trusts set up for the donor's children. Each beneficiary had the right to withdraw additions made during a calendar year, up to December 31 of that year, in an amount equal to the lesser of $4,000 or the amount of the gift.
Although the facts are not completely clear from the opinion, it appears that some of the additions to the trust were made in mid-December of each year, indicating that the time allowed to a beneficiary for withdrawal may have been quite limited. Some beneficiaries were minors, and the trusts provided that their guardians were authorized to make withdrawals on their behalf. In fact, no guardians had been appointed for any minor children. The trusts provided for future distributions of principal and interest to the beneficiaries.
The Tax Court allowed present interest exclusion for the transfers to trusts for the adult beneficiaries without much discussion, but found that since no guardians had, in fact, been appointed for the minors, no exclusions were allowable for transfers for their benefit. The Ninth Circuit, however, held that the likelihood that no actual demand for withdrawal (or guardian appointment) would ever be made was irrelevant, and that the demand rights, since they were legally sufficient, made the transfers present interests, despite the technical legal disability of the minor beneficiaries.
- Although not emphasized by the Court in Crummey, the IRS gives great weight to notice. For example, in TAM 9532001, transfers to trusts without any notice to beneficiaries in reliance on a prior year's blanket waiver of right to notice for all subsequent contributions was ineffective. The waiver of withdrawal right was held to be effective in the year given, but the waiver of the right to all future notices was not respected. Rev. Rul. 81-7 and numerous PLRs require actual notice and reasonable opportunity to exercise for a valid Crummey Power. How long should the withdrawal period be? In Crummey, some withdrawal periods were as short as 12 days, and the Court approved them without significant discussion of the issue. Thirty days has been approved in several PLRs, e.g. 9232013, 8813019, and 8103074. 30 days is suggested as a reasonable approach, although no hard and fast rule exists. Cristofani, cited below, authorized a 15 day period. A reasonable right to exercise (over a specified number of days) can extend into the following calendar year, while allowing the exclusion for the year of transfer. This technique may cause lapse problems, as discussed below. Rev. Rul. 83-108 also allows the notice to be given in the following year. In Holland v. Commissioner, 73 T.C.M. 3236 (1997), the lack of written notice from a parent-trustee to a child-powerholder was not fatal; the Tax Court held that notice to one's self is not a legal requirement. It is still advisable to generate these notices and the IRS focuses on them in the audit context.
- The number of eligible donees was the focus in Cristofani v. Commissioner, 97 T.C. 74 (1991). This case involved Crummey-type withdrawal powers granted to contingent beneficiary/grandchildren who would receive property only upon the death of their parents prior to trust termination. It was held that members of this class constituted eligible donees for which the Annual Exclusion was available, if proper withdrawal right notice was provided. In Estate of Kohlsaat v. Commissioner, 73 T.C.M. 2732 (1997), a contingent beneficiary withdrawal right was upheld, with notice, in the absence of evidence of a prearranged plan for non-exercise. The presence of a "prearranged plan" was held by the Tax Court not to be inferred from failure to exercise. The IRS looks unfavorably on "naked" Crummey powers and has issued numerous rulings disallowing them, e.g. TAM 9731004. In this context, the ordering of withdrawal rights must be addressed. In order to make sure the right is ascertainable, the various holders should be given proportional rights over a particular year's contributions.
- Lapse Issues: IRC §§2514(b) and (e). A Crummey Withdrawal Power is a general power of appointment held by the donee. Lapse of the power is considered a release and transfer of property subject to the power (a gift), to the extent the property exceeds the greater of $5,000 or 5% of the aggregate value of the assets out of which the lapsed power could have been satisfied
("5x5 Power"). If the power holder is the only beneficiary of the trust, the issue is avoided. This deemed transfer causes inclusion in the power holder's estate under IRC §§2036 or 2038. A Donee is allowed only one 5x5 Power during a calendar year no matter how many gifts are made to the subject trust (or multiple trusts for the donee's benefit) during that year, under the analysis provided by Rev. Rul. 85-88. The gift tax consequences of excess lapse: future interest gift by power holder to other beneficiaries of the trust. Major practical problem: Making sure beneficiaries receive proper notice and opportunity to withdraw.
- Potential Solutions to the lapse dilemma:
- Add beneficiaries so that lapse is totally covered by 5x5 Power. (Cristofani).
- Make power holder the sole beneficiary of the trust so that there is no "transfer" upon occurrence of the lapse. (This arrangement only rarely meets the insured's objectives in establishing the trust).
- Hanging Power: limit lapse to amount equal to 5x5 Power with excess carried forward into future years. This approach is especially useful in a "Vanishing Premium" situation where premiums can be projected to be unnecessary at a future date. A major disadvantage is the complexity of properly determining the amount of suspended powers from time to time, especially in the context of providing required notices. TAM 8901004 held that a hanging power framed in terms of "taxable gift" determination was deemed to be an invalid condition subsequent to defeat federal gift tax purposes, relying on Commissioner v. Proctor, 142 F.2d 824 (1944). Therefore the drafter should define the hanging power in terms of specified formula amount rather than "maximum amount not subject to Code" approach.
- Special Power of Appointment. Provide the power holder with a testamentary special power of appointment for the excess over the 5x5 Power. The theory is that there is therefore no "completed" lapse because of the continuing retained power. If the power holder dies during the term of the trust, the portion subject to the special power would be (presumably) included in the power holder's estate as a deemed transfer with a retained interest pursuant to IRC §2036.
- Indirect gifts. Non-contributory employer-provided arrangements present unique problems. The premium payment is made directly to the insurer; conversely, the economic benefit of the arrangement to the participant is treated as an indirect gift to the trust beneficiaries. The best solution is to have a "side fund" from which the beneficiary can withdraw after the notice is provided, so that the withdrawal right has substance.
C. GST Tax Issues.
- Presence of actual or potential beneficiaries who are assigned to more than one generation below the insured indicates review of GST Tax is required. This will include almost all ILITs. IRC §2642(c) exempts non-taxable gifts from GST Tax if a “direct skip” is involved. In the trust context, this will apply only if the trust has only one skip person beneficiary (and no others) and the beneficiary (or estate) will receive all distributions. Most ILITs will not meet these requirements.
- Allocation of GST Tax Exemption (IRC §2631). Each taxpayer is granted an exemption from the GST Tax, which can be allocated to trust additions through filing of Form 709 (Gift Tax Return). Decision to allocate requires integrated look at insured’s entire estate plan. Who are the ILIT beneficiaries? What interests are provided for skip persons in the other estate planning documents? It is not a good practice to make an allocation to a potential GST-subject trust if the creator is thinking about other techniques (such as a dynasty trust) for which the GST exemption will be critical.