September 1998 Issue

Removing the ties that bind

Irrevocable Life Insurance Trusts

By Lawrence M. Lipoff

In Brief

Planning Ideas Relating to Income, Gift, Estate, and Generation-Skipping Taxes

Life insurance proceeds are included in the insured's gross estate if the insured owns the policy or his or her estate is the policy's beneficiary. Properly structured, an irrevocable life insurance trust will keep the proceeds out of the estate.

The author discusses a number of scenarios and planning tools relating to the incidents of ownership of life insurance policies. He also covers the gift, generation-skipping transfer, and income tax ramifications of such trust arrangements.

ife insurance proceeds are included in an insured's gross estate (and subject to estate taxation) if the insured owns the policy or if the insured's estate is the policy's beneficiary. Even if an estate does not receive or benefit from the proceeds of a life insurance policy, any incidents of ownership held within three years of death (the three-year rule) will cause policy proceeds to be included in the decedent's gross estate. A retained right only exercisable in conjunction with another person will also have estate tax consequences.

If includable in the estate, failure of the executor to pay transfer taxes, or the lack of a will provision so mandating, can lead to the imposition of personal liability upon the beneficiaries of the insurance policies and the executor. Slightly mitigating the effect is the IRS's conclusion that the three-year rule does not alter the character of the initial transfer as a taxable gift. Accordingly, a credit will be available for gift taxes paid.

The Benefits of an Irrevocable Life Insurance Trust

In order for the irrevocable life insurance trust to work, the insured should not have a beneficial interest in the policy nor any incidents of ownership. Should the trust's beneficiaries die, the next line of beneficiaries (often their children) will become beneficiaries of the trust and therefore the policy.

To partially mitigate the effect of the three-year rule inclusion when an irrevocable life insurance trust is established, some suggest the use of a clause to qualify the trust for the estate tax marital deduction. The grantor of the trust contributes enough cash to pay the first year's policy premium. Should the grantor die within three years, the trust's beneficiary would be the insured's spouse. Alternatively, a qualified terminal interest property (QTIP) trust can be used for the insurance, which will qualify for the estate tax marital deduction. A trust provision authorizing the insured's personal representative to recover any incremental estate taxes because of the three-year rule may be an equitable solution.

Incidents of Ownership

Unfortunately, the IRC does not define incidents of ownership. Treasury regulations and case history provide a litany of examples, including a reversionary interest greater than five percent, the right to borrow against the policy, and the power to determine who will receive policy proceeds.

Trustee Pays Estate Taxes. The trust agreement should allow the trustees to protect the economic interests of the beneficiaries. If an irrevocable life insurance trust's governing instrument instructs the trustee to pay the insured's estate taxes, the policy proceeds are deemed receivable for the benefit of the estate and includable in the decedent's gross estate.

Insured Pays Premium. After considerable litigation, it is now established that an insured can pay directly for insurance without automatically triggering its inclusion in the gross estate. Initiation of a life insurance policy and payment of the premiums by the insured will not be enough to consider a trust as the insured's agent and an imputed incident of ownership. Nevertheless, to obtain assurance there will not be estate inclusion, a conservative estate planner would still have the insured transfer funds to the trust and have the trustee make the payments.

Insured Applies for Policy. What happens when the insured rather than the trustee of an irrevocable life insurance trust applies for the life insurance policy? Will this cause the potential for taxation in the estate? Resolution of this question depends upon when the insurance contract becomes effective under state law. Should applicable state law provide that the contract becomes effective before the trust becomes the applicant, the three-year rule would apply.

Split-Dollar Arrangements. A split-dollar arrangement exists where one party pays for the insurance element in a policy and another pays for the increase in cash surrender value as a means of financing a nonterm life insurance contract. Recently, the IRS has taken the position that a corporation's properly created split-dollar interest in a life insurance policy will not be imputed to the corporation's majority shareholder. Specifically, a controlled corporation's interest can be viewed as either a secured creditor with limited policy rights collaterally assigned or, more conservatively, as an unsecured creditor. Therefore, life insurance ownership and the related taxability in the estate of the majority owner do not occur.

Second-to-Die Policies. Many individuals attempt to decrease the amount of life insurance premiums they pay annually with after-tax dollars by buying second-to-die (survivorship) policies. A concept advocated is a survivor life stand-by trust, which can be revocably established by the spouse with the longer life expectancy. This provides access to the policy's cash surrender value while both spouses are alive. Upon the death of the first spouse, the trust becomes irrevocable. The question that arises is whether a spouse is a beneficiary of a trust that holds a survivorship policy on his or her life. Is he or she considered a beneficial owner of the insurance policy and therefore holding an incident of ownership that would cause inclusion of the insurance proceeds in his or her estate? It appears likely the three-year inclusion period commences on the date the trust becomes irrevocable.

Gift Taxes

As noted earlier, to avoid these issues of estate taxability, an irrevocable life insurance trust should be established before applying for the policy. If an existing life insurance policy is transferred, regardless of type of entity, a gift occurs which must be valued as it would be for estate tax purposes. Unless the insured's health has been impaired to significantly shorten life expectancy, the value is the policy's interpolated terminal reserve value, not its cash surrender value. The necessary calculation is done by the insurance company and reported on Form 712 (Life Insurance Statement), which should be requested well in advance of the due date of the gift tax return.

Consideration of the income tax consequences should be given prior to transfer of a policy to an irrevocable life insurance trust if policy loans exceed basis.

Whether an existing policy is transferred or annual contributions are made to the trust to pay insurance premiums, a taxable gift of a future interest has occurred. Use of Crummey powers, which are unconditional rights to withdraw certain assets given to a trust, has been developed to convert a portion of these future interests into present interests that can qualify for the IRC section 2503(b) $10,000 annual gift exclusion. For a present interest to be deemed to exist, these unrestricted demand powers need only last for a short period of time, typically 30 to 60 days. A realistic possibility of exercise must be afforded the powerholder. The IRS has considered a 30-day demand period acceptable but has rejected a three-day demand period. Should a demand period overlap two years, a present interest is deemed to exist for the year when the transfer was made.

Notice of the withdrawal right must be provided to the power holder. For a minor beneficiary, notice should be given to the minor's parent or guardian. Otherwise, a minor's legal inability to withdraw funds will make the power ineffective. If there are multiple Crummey power holders, the governing (i.e., trust) instrument should require apportionment. In all events, proof that notice was given should be preserved until after the insured's eventual estate is finalized with the taxing authorities. Increasingly, IRS agents have been requesting proof of notice during estate audits.

Recent court cases have also blessed naked Crummey powers held by contingent beneficiaries. A naked Crummey power is one for which family members more remote than children are given withdrawal rights. Based upon the original court case, these are often referred to as Cristofani powers. Some commentators advise practitioners to perform due diligence audits of existing Crummey trusts and suggest occasional exercise of withdrawal rights. Others feel this is unnecessary.

In determining the amount for which a Crummey power is needed in the year of transfer, the value of an in-force life insurance policy transferred in the year must be added to other contributions to the trust. Should a Crummey power be exercised, the trustee must have access to sufficient assets.

The IRS has sanctioned use of Crummey powers even in situations in which policies did not have cash value. If a private ruling will not be sought and liquidity from other sources is not available, consideration should be given to having the trustee hold off payment of premiums until after the demand period, or drafting a provision to allow payment of a fractional interest in a policy.

The lapse of a withdrawal power is considered a release of such power. Such a power, however, must lapse rather than be given up. For example, the beneficiary must not say that he or she is waiving a withdrawal right; this would obviate the efficacy of the present interest exclusion. To the extent that the property that could have been withdrawn by exercise of such lapsed power exceeds the greater of $5,000, or five percent of the then value of the trust (five-and-five power), the beneficiary makes a taxable gift not subject to annual exclusion. Should a beneficiary die holding a demand power, the Crummey amount is includable in the beneficiary's gross estate. If there is only one beneficiary (without offspring), no gift is made upon the lapse of a Crummey power.

To mitigate the adverse estate tax effect, some planners suggest a year of death provision that would require the beneficiary to be alive on December 31. Should a spouse allow a lapse in excess of the five-and-five rule, the unlimited marital deduction should be available. However, it is possible the trust corpus may be included in the beneficiary's estate.

As an irrevocable life insurance trust's existence continues over a number of years, yearly transfers in excess of the five-and-five amount can erode both the grantor's and, to a lesser extent, the Crummey power holder's lifetime unified credit.

The rationale for the Crummey power holder is that when the Crummey power lapses there is a future gift to other beneficiaries of the trust. A technique known as a hanging power provides for the Crummey power to lapse only to the extent of the greater of $5,000 or five percent of the then value of the trust each year. Any excess remains subject to an ongoing demand power. Upon cessation of contributions to the trust (for example, after a five-year guaranteed premium period ends), or upon the trust fund (presumably trust corpus) exceeding $100,000 (when the five percent provision would apply), the hanging power amount will begin to decrease.

Other techniques developed to deal with diminution of lifetime unified credit include single beneficiary trusts with either a limited power of appointment (where the holder's estate receives the trust property upon death), or a grant of a withdrawal power to a grandchild (to the extent of the excess above the five-and-five amount).

Generation-Skipping Transfer Planning

While it may appear that lapses of Crummey powers create potential estate planning difficulties for children of the insured (beneficiaries of the trust) because of erosion of their unified credit, certain intergenerational planning opportunities arise. To the extent a beneficiary makes a gift by allowing a Crummey power to lapse, certain concerns regarding the generation-skipping transfer tax may be alleviated. This is because the child, not the grandparent, becomes the transferor.

A key to understanding the impact of the generation-skipping transfer tax is the concept that a transfer to a trust subject to a beneficiary's right of withdrawal is treated as a transfer to the trust rather than to the beneficiary (contrary to the IRS's former position that the transfer is to the individual). Since the generation-skipping transfer tax annual exclusion is much more limited than the gift tax annual exclusion, the mechanics of allocating the $1 million lifetime generation-skipping transfer tax exclusion become extremely important.

Since pure life insurance (separate from any investment portion in a whole, variable, or universal policy) expires on an annual basis, the choice of when to allocate the generation-skipping transfer tax becomes important. Should the insured survive the year, a late allocation of exemption (at fair market value at time of exemption) may be preferable. The high administrative costs in the early years of a non-term policy will keep the fair market value of the policy (assuming no adverse health situation) close to zero.

A wait-and-see position can delay decisions regarding allocation until the gift tax return is filed by April 15 of the year following the transfer. Furthermore, the filing of the gift tax return can be extended until October 15. Still, should the allocation not be made on a timely filed return, death or faltering health of the insured may dramatically and adversely affect the leveraging of the exemption. Instead of being totally exempt at a relatively small exemption cost, the trust may become partially subject to the generation-skipping transfer tax.

A potential problem exists where a child of the insured predeceases the parent during the trust period and the grandchildren become trust beneficiaries. The predeceased child exception is not available. It may be desirable to have the trust agreement provide for a deceased child's interest to pass to his or her estate or to a separate trust.

A fully funded irrevocable inter vivos insurance trust that has received neither additions nor constructive additions after September 25, 1985, is not subject to the generation-skipping transfer tax. However, any additional premium payment will taint this exception and may cause the trust to be subject to the generation-skipping tax.

Split-dollar funding of an insurance policy can provide a low-cost generation-skipping transfer tax planning opportunity. Keeping in mind that a trust will be generation-skipping tax exempt if its applicable fraction is one, a "late" annual allocation of an insurance policy's P.S. 58 cost (the applicable fraction's numerator) will lead to this optimal result. The reason is that the applicable fraction's denominator will be the same amount. The denominator is calculated by adding the value of the current gift (the same P.S. 58 cost) to the value of all property in the trust. Since at the end of the year the value of the pure (term) insurance has expired and pure insurance is what is owned by the trust in a traditional split-dollar arrangement, the value of all property in the trust is necessarily zero.

Income Taxes

The gift and generation-skipping transfer tax intricacies of Crummey withdrawal powers lead into the income tax complexities of grantor trust rules. Except for funded trusts (a trust with assets other than insurance) the grantor trust rules only become effective after the insured's death.

Generally, the grantor trust rules mandate that the grantor (or sometimes a third party) be considered the owner of a portion or all of the income and/or principal of a trust for income tax purposes. The intent of Congress was to halt tax abuse resulting from the shifting of income from high-bracket grantors to low-bracket beneficiaries.

Rev. Rul. 67-241 holds that Crummey withdrawal rights make the beneficiaries taxable as owners of both their income and a portion of the principal of the trust. Some commentators (known in professional literature as cumulativists) believe that IRC section 678 requires an accumulative method to determine how much of a trust is subject to grantor trust treatment. For $10,000 annual draw-down powers, they believe the calculation is made by dividing the aggregate draw-down opportunity (number of years times $10,000) by the fair market value of the trust at the end of the draw-down period. They admit there is no specific ruling to this effect from the IRS. Others (the noncumulativists) have opined that allocation under IRC section 678 should be based on both the percentage of the trust the beneficiary could withdraw and the length of the demand right. Furthermore, they note that the release referred to in IRC section 678(a)(2) must be an affirmative act and not merely a lapse.

The grantor trust rules appear to be contradictory regarding who is considered the grantor. Fortunately, IRC section 678(b) says that if a grantor holds a power under IRC sections 673 through 677 and a beneficiary holds a IRC section 678 power over the income of the same trust, the beneficiary's power is disregarded and the grantor is taxed as the owner of the trust income. IRC section 678(b), however, refers only to conflicting ownership of the trust's income; it is silent with respect to conflicting ownership of the trust's principal. If the grantor and beneficiary both hold powers that apparently create conflicting ownership (for income tax purposes) over the trust's principal, the most logical action would be to treat them as co-owners of the trust, with each taxable on a proportionate share of the items of income, deduction, gain, and loss allocated to trust principal. Still, there are those who believe that IRC section 678 is inapplicable to the lapse of a noncumulative, amount-limited power, such as the five-and-five power.

To the extent that the trust is not classified as a grantor trust, it will be considered a complex trust, which must annually report its accounting income to the IRS. If the trustee is not required to distribute the proceeds from an insurance policy, this will become extremely important. Furthermore, the amount that must be reported will follow fiduciary, not tax, accounting rules.

Access to Cash

While the establishment of an irrevocable life insurance trust should be done without the preconceived notion that the insured will borrow money, at times access to cash becomes a necessity. While a private reverse split-dollar arrangement (in which the trust owns the insurance and the insured's spouse owns the cash surrender value of the policy) may allow a couple access to the policy's cash surrender value without inclusion of the insurance itself in the insured's estate, there are times (especially when considering a second-to-die policy) that this option is not available. Should borrowing from the trust be required, a note with proper collateral (and interest) should be drafted and executed. Such a loan should only be entered into if the trustee determines that making the loan is acceptable within the confines of the fiduciary responsibility to the trust's beneficiaries.

There are also income tax implications if a direct or indirect loan of income or corpus has not been completely repaid by the beginning of the next taxable year. Loans without a genuine debtor-creditor relationship will be seen as lacking economic substance.

Trust Flexibility

To create flexibility with irrevocable life insurance trusts, some practitioners advocate the use of a trust protector (commonly seen in offshore trusts). The trust protector can have specified powers, such as replacing a trustee. The new trustee should not be anyone deemed subservient to any interested party under IRC section 672(c).

Additional drafting considerations for trust flexibility include eliminating the insured's spouse as a trustee and trust beneficiary upon divorce, and allowing the trustee to both reduce the amount subject to a Crummey power and terminate the trust. For some inflexible trusts, having the insured purchase the insurance policy from the trust and then sell it to a new grantor trust may offset the inflexibility. *

Lawrence M. Lipoff, CPA/CEBS, is a manager of taxes and estates with Rogoff & Company.

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