CRUMMEY POWER

In the discussion of various life insurance interests, it is noted that life insurance may be gifted to an irrevocable trust. If certain conditions are met, the proceeds paid to the trust upon the insured's demise are excluded from the grantor's estate. The key element is that the grantor must have released all control of ownership of the life insurance policy to the trustee of the irrevocable life insurance trust.

There can be no remaining incidents of ownership. The grantor cannot change the beneficiaries, indicate how the money will be spent, etc.

Additionally, the grantor must stay alive for at least three years after the transfer is made- otherwise the IRS assumes the gift is made in contemplation of death and the proceeds will be included in the grantor's estate. See Rules to Follow paragraph 5 below for further clarification.

Although the gift allows the assets to fall outside of the estate, does the transfer preclude the use of the assets to pay for estate taxes and other associated expenses? No, because the trustee of the irrevocable trust (not the grantor or spouse but an independent entity) will disburse the proceeds as determined by an "agreement" as arranged by the grantor prior to the change of ownership (see below for further comment).

PREMIUM PAYMENTS

Most insurance policies placed in the trust are rarely paid up policies- those no longer requiring any more payments to maintain the policy in force. And rarely are there any income producing assets placed in the irrevocable life insurance trust. The obvious solution to the payment for continuing premiums is that the grantor simply sends the money to the trustee. But the main problem to be considered for this paper is whether the premium payments gifted to the trust are designated as a PRESENT interest and are excluded from gift tax. The key is the term present interest since only those gifts capable of current enjoyment by the beneficiaries fall under the $10,000 per person per year exclusion from taxes. This therefore does not require the grantor to use any of his/her $675,000 lifetime exclusion.

As is probably obvious, if the gift is for a FUTURE interest- that is where enjoyment of the gift is deferred for some later time- the $675,000 lifetime exclusion must be utilized. And should this exclusion already be used up, or when it is, gift tax will need to be paid on any amount gifted to the trust to pay premiums. With very large estates, the tax can ultimately be as high as 55%. The problem arises that life insurance, by definition, is considered a gift of a FUTURE interest to the beneficiaries since the ultimate proceeds to the trust will only occur upon the death of the grantor some time in the future. Therefore absent any IRS rules to the contrary, the grantors gifts of ongoing premiums are subject to tax.

The courts have ruled however that there is a method of "payment" whereby the gift may be considered a present interest. This happens IF the beneficiaries have the right to withdraw certain amount of assets from the trust at least once per year. The courts have further elaborated that the beneficiaries do not actually have to comprehend the action- hence the beneficiaries can be minor children or those with mental incapacities- they merely must have the time available to do so. And the beneficiaries must also be notified- even if they be the guardians of the children. While the notification to minors may seem rather ludicrous since they would neither understand the actions nor would request the funds, the IRS has required such notice. So even if a child is only one year old, the grantor should provide said beneficiary with proper notification- in writing.

If properly structured therefore, the gift of premiums may be conceded as a present use and no tax would be assessed.

Of course, since the beneficiaries can call away their portion of the assets, it is possible that they may do so. In such cases, the trust would cease since there no more remaining funds available to continue making the life insurance premiums. In fact, grantors can actually destroy their own trust in the same manner if they desire- say that they no longer wish to enrich a particular beneficiary. No payments equals no insurance equals no trust.

RULES TO FOLLOW

The following should be adhered to very closely:

1. The insured must transfer all incidents of ownership to the trust

2. The trust must be irrevocable and unamendable

3. The insured should not be the trustee of the trust. If the insured is the trustee and also the grantor of the trust, all the proceeds of the insurance will be included in his or her estate even if he or she is not the beneficiary of the trust.

4. The insured should have no beneficial interest or retained power under IRC code 2036, 2037 and 2038

5. The insured must survive for at least three years from the date of the transfer to the trust. Otherwise, proceeds will be included in the grantor's estate. NOTE: This requirement exists only in the transfer of a life insurance policy. If the trust is established first, and then the policy is purchased by the trustee of the irrevocable trust- not the grantor- then the grantor never was the owner and the three year limitation is not compulsory.

6. The trust declaration itself should not require or encourage the trustee to use proceeds of life insurance to pay the insured's estate taxes or other estate expenses.

This last section requires additional comment primarily since the IRS is playing games with semantics. First, the gifts made to the trust should NOT be in the exact amount of the life insurance premiums due. Secondly, the grantor should not specifically earmark the gift actually to go to the pay premiums. The IRS apparently wants the trustee to have full discretion to do whatever he/she wants with the gift that is made. This apparently maintains the illusion of a present interest. Obviously, everyone knows what the money is to be used for and why, so it is merely a game of "words and definitions"- but one which should be closely adhered to . By the same token, when the grantor dies, everyone knows that the trustee will actually use the proceeds to pay estate taxes and other expenses. But the wording has to be excluded for the trust to remain a separate entity free from inclusion in the grantor's estate.

Another Crummey power requirement is that there should be adequate time for the beneficiary to withdraw the funds. The accepted time frame appears to be one month. If not exercised within that time, the beneficiary has no other opportunity that year to demand his/her portion of the assets or gifted "premium".

TAX CONSEQUENCES

When a gift is given to another- or to a trust- there may be tax consequences. If the amount is $10,000 and under and is considered a present interest, no tax implications ensue. If the amount is over $10,000, part of the lifetime exclusion must be used, and if over that amount, gift tax will need to be paid. While we have addressed the issue of premium payments, remember that the transfer of the insurance policy be gifted to an irrevocable trust has value and may be a taxable event.

The taxable value is NOT the amount of insurance but essentially the cash value within the policy. If the policy was a term policy, no cash was involved and no gift tax problem exists (though technically there is a value of the unamortized portion of any premium paid). If the policy was a whole life policy and not paid up, the value will be the interpolated terminal reserve value plus any unused portion of premiums paid prior to the date of actual gift. (This is essentially the cash value of the policy, but further analysis is required to insure that no tax is due.)

BENEFICIARY TAX CONSEQUENCES

While the irrevocable trust is an effort to remove assets from taxable estate and the Crummey power attempts to exclude the current taxation of the payments of the life insurance premium, there still exists another problem for the beneficiary who declines to take any portion of the gifted premiums. Basically, the beneficiary must have power to withdraw the greater of $5,000 or 5% of the trust principal. If the amount of the gift exceeds this aggregate, then the excess is construed a gift to the remaindermen. The possible solutions include:

1. Insure there are trust provisions restricting the right of the power of withdrawal to the limit of $5,000 or five percent of the trust corpus

2. Where the amount of the lapsed gift exceeds the safe harbor limits of the IRC, simply allow the beneficiary to use part of his/her lifetime exemption

3. Create multiple trusts and provide that each trust would have a limit of the power to withdraw to a maximum of $5,000 or five percent of the trust principal.

The issue of lapsed power is very technical and needs to be addressed by the attorney.

MULTIPLE TRUSTS

Though there are technical rules to the use of multiple trusts and they are unquestionably more cumbersome and costly, there are situations where they could solve some delicate problems. If there are several beneficiaries, the grantor may want assets to be distributed in many different manners. While one trust can accommodate this request, perhaps the grantor at some point might wish to disinherit a wayward beneficiary.

With one policy and no allowed changes to the irrevocable document, this would be effectively impossible. However a separate trust for each beneficiary would allow the grantor to simply stop making premium payments. The trust would be cease since it would have no reason for being. Yet none of the other trusts for the remaining beneficiaries would be effected. The collapsed trust could be reinstituted at a later time, if so desired, with a new policy. Admittedly, the use of several separate life insurance trusts is more expensive to have drawn up. The most costly problem is the issuance of many life insurance policies since one larger policy is invariably cheaper. But if the reasons are justified, price may not be the controlling factor.

TRUSTEE

Comments on who the trustee or trustees should be have been identified in a separate report. But as has been made apparent, the trustee must have wide latitude to use the funds at his/her disposal since, if the trust forces gifts to be used for insurance premiums, the net proceeds will be included in the grantor's estate. Obviously the individual must be trusted, but that is seldom sufficient background to run an irrevocable trust. The grantor should interview several highly knowledgeable entities capable of performing the function- then look to the issue of "trust".

The grantor should not universally use an attorney. While their technical skills may be satisfactory, their personal involvement may be suspect. Further, if their association with the grantor consists solely of the drafting of a few documents, their interest in maintaining continuity of the estate may be lacking. The selection will be time consuming and difficult. But where the lives of beneficiaries is dependent on the selection, it will be time well spent.