Irrevocable Life Insurance Trusts

An irrevocable life insurance trust (ILIT) is created to purchase life insurance or to receive a policy that is already in effect so that the insurance proceeds will not be included in the estate of the insured. To exclude the insurance proceeds, federal tax laws require that the insured does not have any incidences of ownership in the policy, meaning that the grantor of the trust, who is usually the insured, must relinquish all control of the trust, including the ability to revoke the trust. Thus, the grantor cannot serve as trustee nor can he change the beneficiaries of the trust. The trust owns the insurance policy and continues to pay the premiums.

IRS rules require that the trust be set up at least 3 years before the death of the grantor; otherwise it is includable in his estate. Likewise, if the grantor transfers a policy to the trust and dies within 3 years of the transfer, then the policy will be included in the estate. However, if the grantor pays cash to a trust that has existed for at least 3 years, which the trustee uses to buy the insurance policy, then the 3-year rule will not apply to the life insurance policy.

As an alternative to the trust, the life insurance policy could be given to the beneficiaries, but they may not continue to make the payments or they may cash the policy, if it has cash value, before the death of the insured.

A major drawback of the irrevocable life insurance trust is that the beneficiaries cannot be changed by the grantor, so he will not be able to add new beneficiaries who may not have been alive when the trust was created nor exclude a divorced spouse. However, if the trust document gives the trustee discretion, then the trustee can change beneficiaries, but the grantor cannot have any control over the discretion. As a separate taxable entity, the irrevocable trust must receive a taxpayer identification number and may have to file tax returns annually, depending on income. Professional fees for setting up the trust may range from several hundred to several thousand dollars.

Crummey Trusts and Crummey Powers

A special type of irrevocable life insurance trust, called a Crummey trust (aka irrevocable gift trust), allows a wealthy grantor to fund the trust in such a way that payments are treated as gifts of present interest to the trust's beneficiaries, thereby qualifying for the annual gift exclusion, then using the payments to pay the premiums for the life insurance policy. Since the beneficiaries do not have to pay any income taxes when they receive the proceeds of the life insurance policy, the Crummey trust allows the transfer of considerable wealth tax-free.

Property or income that comes from a trust is considered a present interest when the beneficiary has the right to withdraw the money, thereby making it eligible for the annual gift exclusion. The Crummey trust — named after the 1968 court case, Crummey v. Commissioner, 25 TCM (CCH) 772 - Tax Court 1966 — is designed to pass property to beneficiaries free of both gift and estate taxes. The grantor makes a gift to the trust, usually equal to the annual exclusion, for each beneficiary. The beneficiaries are given some time, usually 30 days or less, but it can be no more than 60 days, to withdraw the gift. If they fail to do so, then the gift remains in the trust, where it is often used to purchase life insurance, with the proceeds going to the beneficiaries when the donor dies. Beneficiaries are notified of their gift by a letter, which is generally called a Crummey withdrawal right or Crummey notice. A Crummey withdrawal right can be given to a minor by giving the withdrawal right to the guardian, so that gifts may be made even to infants. The Crummey withdrawal notice must be given annually, since the IRS does not consider a "once only" notice to be adequate, which is a notice that the beneficiaries will have the same withdrawal rights every year.

However, if the parties have an agreement that the current Crummey power — as it is called — will not be exercised, then the IRS considers the power to be a sham and it will not be considered a gift of a present interest, and, therefore, not eligible for the annual gift exclusion.

Crummey powers were expanded in 1991 by Estate of Cristofani v. Commissioner, 97 TC 74 - Tax Court 1991, which allowed contingent remainder beneficiaries, such as grandchildren, to also be considered as having a present interest.

5 × 5 Rule for Lapsed Powers of Appointment

To qualify for the gift tax annual exclusion, the beneficiary must be given a present interest in the gift. Ordinarily, a gift to a trust is not a present interest unless the beneficiary has an unconditional right to the income or principal. With the Crummey trust, the present interest requirement is satisfied by the Crummey withdrawal right. The Crummey withdrawal right is a general power of appointment over the gifted property, because the beneficiary has an unconditional right to withdraw that amount. However, under IRC §2514(e), any general power of appointment over property held by a trust that lapses is considered a gift to the other trust beneficiaries by the amount of the value of the appointive property exceeding the greater of $5000 or 5% of the trust corpus, often called the 5 x 5 limit. However, the other trust beneficiaries do not have a present interest in the lapsed gift, so the annual exclusion cannot be applied to that portion of the transfer. So, for instance, if you set up a Crummey trust for your 2 children, and the trust currently has a value of $100,000, and you transfer $14,000 for each beneficiary to the trust, then the $9000 of each gift exceeding the $5000 or 5% of the trust corpus is treated as a gift to the other child, but one with a future interest, which is ineligible for the annual exclusion. Therefore, you would be liable for gift tax on the $18,000 of the 2 gifts exceeding the 5 x 5 limitation.

Hanging Powers of Appointment

To treat the entire gift to each child as a present interest, a power of appointment can be extended for a longer time over the property or amount that exceeds the 5 x 5 limit, called a hanging power of appointment. The problem with this is that the child has an extended time to withdraw the property subject to the hanging power, the property is includable in the child’s estate, and creditors of the child may legally compel the child to exercise the general power of appointment to satisfy the child’s debt. Hence, it is desirable to reduce or eliminate the amount subject to the power of appointment. As the value of the trust increases, the 5% of the trust corpus also increases, reducing the amount of property that needs to be subject to a hanging power. Eventually, all hanging powers can be allowed to lapse without being subject to gift tax and the full annual gift tax exclusion can be applied to all transfers to the trust without creating additional hanging powers of appointment.

The Crummey Trust and the Generation-Skipping Transfer Tax

A gift made to a Crummey trust that has beneficiaries in several generations will usually not qualify under the generation-skipping transfer tax (GSTT) annual exclusion since deemed allocation rules will not automatically apply to the gift unless the trust is a skip person because the IRS treats the transfer as a gift to the trust rather than to the beneficiary. Consequently, if any of the beneficiaries are non-skip persons, then the GSTT annual exclusion will not be automatically applied to the gift. In such a case, the grantor will either have to allocate his GST exemption to the transferred property by filing Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return or the skip beneficiaries must pay a GST tax on any property distributed to them at the time of the transfer. This GST tax can be avoided if the trustee directly pays providers of educational or medical services for the skip beneficiaries.

If a trust is designated as a skip person, then the deemed allocation rules will automatically apply the donor's GST annual exclusion to all gifts made to the trust. However, a trust can only qualify as a skip person if:

  1. trust principal or income benefits only 1 skip person during her life;
  2. trust assets become part of the beneficiary's gross estate if she dies before the trust terminates.

If a grantor wants to provide for more than 1 skip person and take advantage of the automatic GST exclusion, then a trust can be set up for each skip person.

Is a Crummey Trust Legally Valid?

A Crummey trust is legal because the courts have said so, the IRS has acquiesced to it, and the Crummey trust has, since 1968, been successfully used to reduce estate and GST taxes. This is usually accomplished is by using the gifts to the trust, in the name of the beneficiaries, to buy life insurance payable to the beneficiaries upon the donor's death. Because the trust owns the life insurance policy, the proceeds are not included in the donor's estate, and, thus, pass to the beneficiaries free of both estate and GST taxes.

However, the Crummey trust does not comport with other provisions of the law, including the legal requirements for a gift:

  1. The donor must have the intent of giving a gift of present interest, since a gift of a future interest does not qualify for the gift tax annual exclusion. Although the courts have ruled that giving the beneficiary a Crummey withdrawal right is a gift of present interest, this ruling seems to ignore the purpose of the Crummey trust, since the donor expects the beneficiaries to leave their gift in the trust so that the life insurance premiums can be paid. Therefore, the donor does not intend it to be a gift of present interest. Indeed, if the donor just wanted to give the beneficiaries a gift, he would just give it to them. Putting it into a trust only to have them withdraw it is needlessly more complicated if its true purpose was just to give a gift of present interest.
  2. The donee must take actual delivery of the gift; if the donee does not take delivery, then the property remains the donor's. In a Crummey trust, the beneficiaries never actually take delivery of the gift, so the gift fails.
  3. To be valid, the IRS says that the Crummey withdrawal right must be a real right and not a sham. Well, it is a sham. The whole purpose of a Crummey trust is to avoid estate and GST taxes and it can't work if the beneficiaries actually withdraw the money from the trust. Indeed, because the sum of all gifts is usually used to purchase the maximum amount of life insurance, there would not be enough to maintain the payment of premiums year after year if one or more beneficiaries actually exercised their Crummey withdrawal rights.