An irrevocable trust is one in which the grantor completely gives up all rights in the property transferred to the trust, and retains no rights to revoke, terminate or modify the trust in any material way. When such a trust holds a life insurance policy, usually on the grantor's life, it is an irrevocable life insurance trust. If Crummy powers are granted to the beneficiaries, it may also be referred to as a "Crummy trust" after a famous court case of the same name [Crummy v. Commar, 397 F.2d 82 (9th Cir. 1968)].

 Typically, these trusts are used in estate planning to accomplish four primary objectives:

 

  to help meet the liquidity needs of the grantor's estate,

  to avoid the estate taxation of the death proceeds,

  to help provide for the income needs of survivors after liquidity costs have been satisfied, and

  to shelter property from creditors at death.

 

Funding Alternatives

 

An irrevocable life insurance trust may be either "funded" or "unfunded."

In a funded life insurance trust, the grantor not only transfers the life insurance policy to the trust, but also transfers other property to the trust from which the premium payments may be made. The property may be in the form of cash, securities or some other asset. The major drawback of the funded life insurance trust is that the trust income may be taxed to the grantor if it can be used to pay premiums on a policy on the life of the grantor or the grantors spouse.

 

In an unfunded life insurance trust, the trustee has no other property in the trust with which to pay premiums, and is dependent on annual cash gifts from the grantor. The "unfunded" trust is more commonly used, and we will focus upon it in the remainder of this section.

 

Features of the Irrevocable Life Insurance Trust

 

The irrevocable life insurance trust is created during the grantor's life. The beneficiaries of the trust are often family members of the grantor€�spouse, children, grandchildren, spouses of children and grandchildren.

The trust is funded with a life insurance policy on the grantor. This may be an existing policy which the grantor gifts to the trust, or it may be a new policy that the trustee acquires with cash transferred to the trust from the grantor.

The trustee is usually given the discretion to pay premiums. If premiums may be paid from trust income, then the trust generally is considered to be a grantor trust. A grantor trust is ignored for income tax purposes, which, in some estate planning circumstances, is a way to ensure that growth to future generations is not diminished by income taxes.

 

Usually, the grantor makes annual transfers of cash to the trust so that the trustee can pay the premiums. Of course, these annual transfers are gifts. Where the trust beneficiaries cannot begin to "enjoy" the policy until the grantor-insured dies, the gifts would ordinarily be future interests. That means no gift tax annual exclusion is available to shelter the annual cash transfers from the federal gift tax.

The IRS concluded in one ruling that an employer's payment of monthly premiums for group term life insurance held in an employee's irrevocable trust qualified for the gift tax annual exclusion [Rev. Rul. 76-490, 1976-2 C.B. 300; see also G.C.M. 37451]. The premiums were considered a present interest because, under the terms of both the group insurance policy and the trust, death proceeds were payable to the trust beneficiary immediately upon the death of the insured.

 

When the trust and policy terms provide that the death proceeds are to be held in trust upon the insured's death rather than be paid immediately to the beneficiary, the annual premium transfers would be gifts of future interests unless one or more Crummy powers are used to convert them to present interests.

Click here for more information on the gift tax annual exclusion.

 

The Crummy Power

 

The Crummy power is meant to secure the gift tax annual exclusion for annual gifts to the trust that enable the trustee to pay premiums. The trust beneficiaries are given the power, exercisable annually for a limited period of time, to withdraw the annual cash transfers to the trust. The beneficiaries are notified when a transfer is made to the trust that is subject to their Crummey powers.

Naturally, one hopes they won't exercise their powers. But the mere fact that they could is sufficient to convert what might otherwise be future-interest gifts into present interests that qualify for the gift tax annual exclusion. So, if there are four beneficiaries with Crummy powers, up to $44,000 of cash transfers could be sheltered in 2004 from the gift tax, or up to $88,000 with gift-splitting. These withdrawal powers may or may not accumulate if unexercised; they generally lapse after the specified period expires.

 

Notwithstanding the gift tax annual exclusion amount, the Crummy power for each holder is often limited to the greater of

 

  $5,000, or

  5% of principal, if that turns out to be less than $11,000.

 

This is the maximum amount that will not be considered a taxable gift to the other trust beneficiaries if the holder of the power allows it to lapse unexercised each year.

Click here for an example of a 5-and-5 Crummy power.

If the beneficiary's annual right of withdrawal does not exceed the five-and-five limits, the amounts the beneficiary could have withdrawn but did not are excludable from the beneficiary's gross estate except for the amount which could have been withdrawn in the year of death, which generally must be included. However, if a withdrawal right is limited to a certain period during the year of the beneficiary's death, and it had lapsed before death, the amount that could have been withdrawn in that year need not be included in the beneficiary's gross estate. If the beneficiary's right of withdrawal exceeds the five-and-five limits, the aggregate excess amounts which could have been withdrawn will be includable in the beneficiary's gross estate up to a maximum of the full amount of the proceeds.

 

However, the lapse of the withdrawal power is considered a gift to other trust beneficiaries under IRC Sec. 2514, to the extent that the lapsing right exceeds the greater of $5,000 or 5% of the trust assets subject to the power. If the Crummy power extends over the entire trust, and is not limited to the annual addition to the trust, there is a greater likelihood that the 5% criterion will shelter the lapse from the gift tax. For example:

 

Where trust corpus is:        Greater of

$5,000 or 5% is:

$  50,000 $   5,000

75,000     5,000

100,000   5,000

300,000   15,000

500,000   25,000

If lapses exceed the $5,000/5% safe harbor, the Crummey power holders will have to draw upon their applicable credit amounts to shelter the resulting taxable gifts from the gift tax.

To avoid this result, Crummey trusts are sometimes drafted to limit the withdrawal right to the lesser of:

 

  the Crummey beneficiary's proportionate share of additions to the trust, or

  the amount of the gift tax annual exclusion (with gift-splitting, if available), or

  the lesser of $5,000 or 5% of the trust corpus.

 

If the $5,000/5% criterion turns out to be the lowest of these amounts, the grantor will not get the full benefit of the gift tax annual exclusion. That unfortunate result led to four alternative strategies: the "hanging power," the power of appointment trust, the separate trust, and a large initial gift to "seed" the trust.

 

Hanging Power

 

The Crummey beneficiary's withdrawal rights could be limited to the lesser of:

 

  the beneficiary's proportionate share of the addition, or

  the amount of the gift tax annual exclusion.

 

Then, to prevent any lapse in excess of $5,000/5% from becoming a taxable gift, the trust would provide that the excess portion of the annual withdrawal right does not lapse. Rather, it is "suspended" or "hangs" until such time as the lapse can occur within the "5-and-5" rule limitations. Then, the theory goes, since the $5,000/5% safe harbor is not being used to offset taxable gifts to other beneficiaries, it is available to reduce the accumulated excesses. The result expected is that the accumulated excesses will lapse each year, within the $5,000/5% limit, without gift tax consequences.

 

When the insurance death proceeds are paid into the trust, the hanging power may be exercised by distributing the accumulated excesses. Alternatively, the trust could remain in effect until the accumulated excesses lapse without resulting in taxable gifts.

The IRS, however, has ruled one hanging power invalid [TAM 8901004]. Where the withdrawal right would not lapse if a taxable gift would be the result, the IRS said, the power to withdraw beyond the $5,000/5% limit would not be respected.

 

Power of Appointment

 

Another alternative is to give the trust beneficiaries a testamentary power of appointment over the accumulated excesses. In their wills, the beneficiaries designate who will receive the excess amounts not withdrawn under Crummey powers. Since there is no lapse of the accumulated excesses, the beneficiaries do not make any taxable gifts.

But under IRC Sec. 2041(a)(2), the estate of a beneficiary who died before trust termination would include any portion of the trust over which he or she held a general power of appointment. Thus, the amount that could have been withdrawn in the year of death will be included in the gross estate.

 

Further, for every prior year in which the beneficiary had rights in excess of the $5,000/5% limit, a portion of the trust principal may come into the beneficiary's gross estate. IRC Sec. 2041(a)(2) treats each lapse as a transfer subject to the estate tax's lifetime transfer rules [IRC Secs. 2035-2038].

 

Separate Trust

 

A separate trust for each beneficiary is the third option. The beneficiary of each trust would be entitled to receive distributions from the trust, and the beneficiary's estate entitled to receive any remaining trust property upon the beneficiary's death. The lapse of the withdrawal right in this case does not result in a taxable gift because all the property subject to the power goes either to the beneficiary or to his or her estate, and not to other trust beneficiaries. The value of each trust at the beneficiary's death (or the alternate valuation date) is includible in his or her gross estate.

 

Large Initial Gift

 

The final option is to "seed" the trust with a large initial gift. Here, no taxable gifts should arise with respect to lapses of Crummey powers exercisable over subsequent gifts because the 5% safe harbor will apply to a sufficiently high trust corpus to shelter the lapses. Of course, a taxable gift may very well occur upon the initial gift.

 

IRS Vigilance

 

When the premium payment is substantial, there may not be enough beneficiaries to shelter the annual cash transfers to the trust under the gift tax annual exclusion. Grantors have tried to get around this by "creating beneficiaries" who have no rights in the trust except Crummey powers. The IRS has attacked this practice in letter rulings.

But the IRS received something of a setback in the Cristofani case in 1991 (97 T.C. 74). The Tax Court ruled that the unexercised rights of withdrawal by several beneficiaries allowed additions to the trust to qualify for the gift tax annual exclusion. The IRS later acquiesced in the result in Cristofani (Action on Decision 1992-09, 1992-1 C.B. 1 and Action on Decision 1996-10, 1996-2 C.B. 1), but has indicated that it will continue to press the issue outside the Ninth Circuit. Two 1996 IRS releases, Technical Advice Memorandum 9628004 and Action on Decision 1996-10 (on Cristofani), indicate that the IRS will seek to deny exclusions for Crummey powers when the power holders have no other interests in the trust, when there is a prearranged understanding that the powers will not be exercised, or when the withdrawal rights are not in substance what they purport to be in form. At a minimum, the beneficiaries should have some other interest in the trust besides Crummey powers.

 

The trust should give the beneficiaries a reasonable period of time in which to exercise their powers, say, 30 days. If the trust says they have until December 31 to exercise their powers, and the grantor makes the cash transfer on December 30, the IRS would almost certainly view this as a sham. The gift tax annual exclusion (multiplied by the number of beneficiaries with present interests) would be lost.

Also, the trustee must give the beneficiaries formal notice that the trust has received a cash transfer subject to their Crummey withdrawal powers.

 

The IRS has ruled that where a beneficiary of an irrevocable life insurance trust could withdraw up to 10% of the principal each year (i.e., more than the five-and-five limit), the lapse of the power unexercised would be a gift to the other trust beneficiaries to the extent of the excess over the greater of 5%/$5,000. This result applied even though the other trust beneficiaries had only a remainder interest and the trustee could theoretically exhaust the entire principal by making distributions during the income beneficiary's life [Ltr. Rul. 9804047].

 

Click here for a recent IRS ruling in which charities were given Crummey powers.

 

"Intentionally Defective" ILIT

 

A so-called intentionally defective ILIT is an irrevocable life insurance trust in which:

 

  The grantor has not retained any power or interest that would result in the trust being included in his/her gross estate for federal estate tax purposes;

  The grantor's transfers to the ILIT have been completed gifts for federal gift tax purposes; and

  The grantor has retained a power or interest in the trust that causes him/her to be treated as the owner of the trust for federal income tax purposes, and thus taxable on trust income.

 

The grantor's payment of any income tax on trust income arguably confers an economic benefit on the trust beneficiaries, since they are relieved of any income tax burden during the grantor's life. Does the grantor, then, make a gift to the beneficiaries?

An IRS revenue ruling has concluded that the grantor of a defective ILIT does not make a gift to the beneficiaries by virtue of paying the income tax on trust income [Rev. Rul. 2004-64, 2004-27 I.R.B. 7]. If the trustee is required by the trust instrument or state law to reimburse the grantor for any income taxes paid, the trust is includable in the grantor's gross estate as a retained interest under IRC §2036. However, the trust will not be includable merely because the trustee has discretion to reimburse the grantor under the terms of the trust or under state law, unless there is evidence of a prior understanding between the grantor and trustee or other extrinsic facts that would fetter the trustee's discretion.

 

Liquidity Planning

 

Suppose the grantor-insured dies and the policy proceeds are paid into the trust. How can the proceeds be made available to the executor for liquidity?

The trust document must authorize the trustee to make the proceeds available to the executor. This is usually done in one of two ways:

 

  by authorizing the purchase of illiquid assets from the estate, or

  by authorizing loans to the estate.

 

Either way, cash flows into the estate at the time it is needed to pay funeral costs, expenses of the decedent's last illness, death taxes, probate expenses, and the claims of creditors.

However, it is critical that the trust document merely authorizes the trustee to do this. If the trustee is required to do so, the policy proceeds would likely be includible in the grantor-insured's gross estate [Ltr. Rul. 200147039]. This would undo a chief advantage of using the irrevocable life insurance trust.

 

So long as the trustee has discretionary power only, and the estate is not a direct or indirect beneficiary of the proceeds, the proceeds will not be includible in the gross estate unless and to the extent actually used to pay estate obligations (i.e., without any bona fide loan or asset purchase taking place).

The danger doesn't end there. If the trustee purchases an asset from the estate, it should be for a fair price. If the trustee "overpays" to pump additional cash into the estate, this could be deemed a taxable distribution of trust income.

 

Similarly, if the trustee makes a loan to the estate on terms much more favorable than prevailing commercial credit conditions, that could be deemed an income distribution by the trust. So, any loan should

 

  bear a reasonable rate of interest,

  provide a repayment schedule, and

  be secured by estate assets as collateral.

 

A "sweetheart deal" on the purchase or loan could be considered a use of the life insurance proceeds to benefit the estate and thereby jeopardize the estate tax exclusion for the proceeds.

 

Tax Aspects of Irrevocable Life Insurance Trusts

 

The trust corpus, including the life insurance, generally avoids being included in the grantor-insured's gross estate for estate tax purposes if:

 

  the trust is irrevocable;

  the grantor is not the trustee;

  the grantor has no incidents of ownership over the insurance policy;

  the insurance proceeds are only used to purchase estate assets or to make loans to the estate in reasonable, arm's-length transactions, not to pay estate costs in a direct manner; and

  the insured lives for at least three years after transferring the policy to the trust.

 

Click here for more information on the three-year rule.

The IRS has ruled that a grantor's power to remove a trustee and appoint an individual or corporate successor trustee that is not related to or subordinate to the grantor is not a reservation of the trustee's power by the grantor. Thus, such a reserved power will not cause the trust property to be included in the grantor's gross estate [Rev. Rul. 95-58, 1995-1 C.B. 191].

If the trust produces any income, the income will be taxed to the grantor if the trust is a grantor trust as defined in tax law. The trustee's ability to use trust income to pay premiums on a policy on the life of the grantor or the grantor's spouse is one of the factors that would make the ILIT a grantor trust.

 

The gift tax can be avoided on annual cash transfers to the trust if the beneficiaries have properly drafted Crummey powers.

After estate settlement costs have been provided for, the remaining trust assets can be held for the benefit of trust beneficiaries.

When several generations are covered by the trust, the generation-skipping tax becomes a planning consideration. There is an exemption from this tax, so it will only be a factor in rather large trusts.

 

Nontax Advantages of Irrevocable Life Insurance Trusts

 

Besides tax avoidance, irrevocable life insurance trusts offer the following practical advantages:

 

  Cash can be made available to help pay estate settlement costs.

  It can help to provide financial security for the grantor's survivors.

  Probate costs can be avoided on the life insurance proceeds and any other assets passing via the trust.

  The trust provisions are private and confidential, not a matter of public record as in the case of a will.

  Assets in the trust at the grantor's death can avoid the claims of creditors.