This chapter discusses selected key gift tax issues concerning life insurance, including the gifting of an existing policy to an ILIT, and the payment of life insurance premiums.1 The starting point for gifts and life insurance is to determine the value of the policy that the insured wants to transfer either outright or in trust. Once a gift of a policy has been made (or if the grantor’s ILIT has acquired a policy), the grantor has to determine how to pay the life insurance premiums in a tax-efficient manner.
An ILIT can be funded or unfunded. A funded ILIT is where the trust owns a life insurance policy and the grantor transfers income producing assets (preferably rapidly appreciating income producing assets), such as a large amount of cash, marketable securities or a limited liability company that owns rental property, and the income from the transferred asset (such as the interest, dividends, or rental income from the limited liability company, etc.) is used by the trustee to pay some or all of life insurance premiums. See, Chapter 14, below, for additional ways to fund an ILIT. Also, if the ILIT is an intentionally defective grantor trust, the ILIT will not have to pay any income tax on the income earned by the income-producing assets; instead, the income tax will be paid by the grantor. Consequently, the ILIT trustee will have more “tax-free” income available for life insurance premium payments. See, section 2.7, above.
An unfunded ILIT is where the trust holds only a life insurance policy, the insured makes annual gifts (typically cash gifts) to the ILIT, and the trustee uses the annual gifts to pay the life insurance premiums. The most efficient way for most insuredgrantors to pay the ILIT life insurance premiums each year is to use their gift tax annual exclusion amount. Thus, a fundamental gift tax issue concerning the use of an ILIT is: When does a grantor’s gift to an ILIT constitute a gift of a present interest that is eligible for the gift tax annual exclusion? If the gift to the ILIT is not a gift of a present interest, then the gift is classified as a gift of a future interest and the grantor will have to apply some or all of his or her lifetime gift tax applicable exclusion amount (currently $1 million) to the future interest gifts. A closely related issue to qualifying a gift to an ILIT for the gift tax annual exclusion is how to structure the beneficiary’s right to the gift amount so that the ILIT trustee can use the gift amount to pay premiums and do so without the beneficiary creating an adverse gift, estate, or GST tax issue for him or herself. Granting the beneficiary a Crummey withdrawal right over the gift amount and allowing the gift amount to “lapse” within amounts specified by the Internal Revenue Code helps to solve this dilemma.
This chapter will also help practitioners draft an ILIT that avoids adverse gift tax consequences for both the grantor and the ILIT beneficiaries.
3A.1 VALUATION OF LIFE INSURANCE POLICIES
The gift tax value of a life insurance policy is the replacement cost of the policy at the time of the gift. Treas. Reg. §25.2512-6(a). The manner by which the replacement cost is determined, however, varies depending on the nature of the policy.2 Generally, the replacement cost is established through the sale of the particular policy by the insurance company or through the sale by the insurance company of comparable policies. Because valuation of an insurance policy through sale of comparable policies is not possible when the gift is of an existing policy that has been in force for some time and on which further premium payments are to be made, the value of an existing policy is its interpolated terminal reserve at the date of the gift plus the unused portion of the last-paid premium. A policy’s interpolated terminal reserve value is available from the life insurance company by requesting IRS Form 712. The policy’s interpolated terminal reserve value is generally greater than the policy’s cash surrender value.
For annual renewable term insurance or group term insurance, the gift tax value is the unused portion of the last-paid premium. The gift of a group term policy on the day before its premium due date has no ascertainable value. Rev. Rul. 76-490, 1976-2 C.B. 300. See also, Treas. Reg. §1.79-3(d)(2). Thus, the transfer of a group term policy (to the extent the transfer is not prohibited by the master policy or by state law) or an annual renewable term policy on the day before its premium due date should result in the policy being valued at zero for gift tax purposes. See, Rev. Rul. 84-147, 1984-2 C.B. 201 concerning the valuation of a group term policy.
For level premium term insurance (where the premium is level for a fixed term of years), the gift tax value may be the policy’s replacement cost. In the early years, the replacement cost for level term life insurance should be less than the annual premium. However, after approximately 40% to 50% of the policy’s term has expired, the replacement cost will probably be greater than the annual premium.
Near the end of the term, if the insured is no longer in good health, the replacement cost may be significantly higher. Because a level term policy has no cash value, a gift of as level premium term policy on the premium due date should result in the policy being valued at zero for gift tax purposes. However, if the insured is terminally ill, the gift tax value, even on its premium due date, may need to be determined by soliciting viatical or life settlement offers. These may be the best indication of the policy’s fair market value.
For permanent (or cash value) life insurance (other than a single premium policy or paid-up policy) the gift tax value is the policy’s interpolated terminal reserve at the date of the gift plus the unused portion of the last-paid premium, plus accumulated dividends, less any outstanding loans amounts against the policy. Treas. Reg. §25.2512-6(a), Example 4. (In many cases, however, the value of the policy can be reduced or even eliminated by loans against the policy, and by gifting the policy as close to the premium due date so as to reduce the amount of the unearned premium.)
Caution: If the loan amount exceeds the donor’s basis in the policy, the donee’s basis in the policy is not the donor’s basis, but rather the amount of the loan assumed by the donee, in which case the transfer for value rule under IRC section 101(a)(2) may be triggered. See, section 2.5, above.
For a universal or variable policy where the owner is no longer paying premiums and for a whole life policy where the premium are offset by policy dividends, the value of the policy is its interpolated terminal reserve at the date of the gift.
For a single premium policy or paid-up cash value policy, the policy’s gift tax value is the amount that the insurance company would charge for the same policy on the life of a person the same age as the insured at the date of the gift. Treas. Reg. §25.2512-6(a) Example 3. When the policy has been in existence for some time, it may not be possible to use the replacement cost method just described. Instead, the policy is usually valued at its interpolated terminal reserve. Rev. Rul. 78-137, 1978-1 C.B. 280. Generally, policies that have a large cash value are not good candidates for transfers to an ILIT because the death benefit may be not much greater than the gift tax value of the policy. Furthermore, the donor will be giving up direct access to the policy’s (significant) cash value.
For a newly purchased cash value policy (presumably less than one or two years old), the gift tax value is its cost, i.e., actual premiums paid. Treas. Reg. §25.2512-6(a), Example 1.
Split-dollar insurance arrangements entered into before September 18, 2003 (and not materially modified after September 17, 2003) are valued in the same manner as cash value life insurance policies (discussed immediately above) less the employer’s ownership interest in the policy at the date of transfer. Rev. Rul. 81-198, 1981-2 C.B. 188.
Practice Point: Rev. Proc. 2005-25, 2005-17 I.R.B. 962 provides guidance on how to determine the fair market value of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection for purposes of applying the rules of IRC sections 79 (employer provided group term life insurance), 83 (property transferred to a person in connection with the performance of services), and 402 (distributions from qualified retirement plans).3 Presumably, the IRS would allow this guidance to apply to other situations as well, although the purpose of this guidance was to prohibit the perceived abuses of purchasing life insurance policies with so-called “springing” cash values; and to put an end to so-called “pension rescue” plans,4 which use artificially depressed values of a life insurance policy to take assets out of a taxable account on a favorable basis. Thus, the guidance generally results in higher values for the policy.
3A.1(a) Insured Terminally Ill
If the insured has become uninsurable or is terminally ill at the time of the gift, the fair market value of the life insurance policy may be significantly higher than the amount computable under the Regulations. In some instances, the fair market value may be the discounted amount of the death proceeds. The valuation of the policy will depend on the facts and circumstances. Treas. Reg. §25.2512-1 indicates that “[a]ll relevant facts and elements of value as of the time of the gift [of the policy] shall be considered,” which may include the value of the policy in the secondary markets, such as viatical settlement companies. See, e.g., Estate of Pritchard v. Commissioner, 4 T.C. 204 (1944); United States v. Ryerson, 312 US 260 (1941); Priv. Letter Rul. 9413045; TAM 9127007.5 Arguably, the value of such a policy will be its value in the life settlement market.
Caution: When death is imminent, it may not be efficacious for the terminally ill insured to make a gift of the life insurance policy, because the proceeds will most likely be included in the insured’s gross estate because of the three-year inclusion rule of IRC section 2035(d).
Caution: An Estate Tax Inclusion Period (“ETIP”) (see, section 5.17, below) will prevent the effective allocation of a transferor’s GST tax exemption to an ILIT. The allocation will be deemed to have occurred at the close of the ETIP, and at that time, the transferor’s previously allocated GST tax exemption will be applied against the fair market value of the trust property (at the close of the ETIP). If the insured is terminally ill, uninsurable, or the policy has “matured,” the previously allocated GST tax emption may not be sufficient to cause the ILIT to be GST tax exempt.
Practice Point: When selling a life insurance policy for full and adequate consideration in money or money’s worth to avoid the three-year rule of IRC section 2035, consider soliciting quotes from viatical or life settlement companies regarding the value of the policy, and document the file. The secondary market’s value may be a good indication of the policy’s fair market value under the willing buyer/willing seller test of Treas. Reg. §25.2512-1.
3A.2 GIFT TAX CONSEQUENCES OF THIRD-PARTY PAYMENTS OF LIFE INSURANCE PREMIUMS
The payment (directly or indirectly) of life insurance premiums by someone other than the owner of the policy is a taxable gift. Treas. Reg. §25.2511-1(h)(8). Thus, direct payment of life insurance premiums by the insured (where the ILIT owns the life insurance policy) is a taxable gift to the beneficiaries of the ILIT. Treas. Reg. §25.2503-3(c), Example 6. Direct payment of premiums by the insured where the policy is owned outright (i.e., free of trust) by another person is a gift of a present interest. Id. Similarly, for split-dollar insurance arrangements entered into before September 18, 2003 (and not materially modified after September 17, 2003) employer premium payments (and employee premium payments under a contributory split-dollar arrangement) are an imputed gift by the employee to the ILIT.
3A.3 GIFT TAX CONSEQUENCES OF EMPLOYER-PAID GROUP TERM PREMIUMS
Payment of group term insurance premiums by an employer is an indirect gift from the employee to the transferee of the policy (such as an ILIT). Rev. Rul. 76-490, 1976-2 C.B. 300; Rev. Rul. 79-47, 1979-1 C.B. 312. The value of the gift is the lower of: (i) the actual cost of the group term coverage; or (ii) the Table I value without the $50,000 coverage exclusion (set out in Treas. Reg. §1.79- 3(d)(2)), provided the group term policy is nondiscriminatory and qualifies under section 79. If the plan discriminates, the value of the gift is the actual cost of coverage to the employer. Rev. Rul. 84-147, 1984-2 C.B. 201. See also, Rev. Rul. 78-420, 1978-2 C.B. 67, applying the same principles to split-dollar arrangements.
An employer’s payment of premiums (for a group term policy that the employee irrevocably assigned to an ILIT) constitutes a gift of a present interest by the employee-insured to the ILIT beneficiaries who hold Crummey withdrawal rights. Rev. Ruls. 79-47, 1979- 1 C.B. and 76-490, 1976-2 C.B. 300; Priv. Letter Ruls. 8138102, 8111123, 8103074, 8021058, and 8006109.
Practice Point: State law and the master group policy, which govern the ability of an employee to assign his or her group term coverage to an ILIT, should be consulted to determine if the group term coverage is assignable. Do not rely on the employee’s certificate of insurance coverage. If possible, try to obtain written confirmation from the life insurance carrier of the date that it irrevocably assigned the group term policy to the ILIT.
3A.4 TRANSFER OF LIFE INSURANCE POLICY TO CO-OWNERS IS NOT ELIGIBLE FOR THE GIFT TAX ANNUAL EXCLUSION
An outright transfer of a life insurance policy to an individual donee is a gift of a present interest in the policy, even if the policy has no cash value. Treas. Reg. §25.2503-3(a); Rev. Rul. 55-408, 1955-1 C.B. 113. However, the transfer of a single policy to two or more co-owners when no one co-owner can exercise rights of ownership without consent of the other co-owners constitutes a gift of a future interest.6 Ryerson v. United States, 312 U.S. 405 (1940). See also, Skouras v. Commissioner, 188 F.2d 831 (2d Cir. 1951).
Practice Point: If each co-owner has the immediate and individual power to sever the joint ownership of the policy and immediately obtain his or her share of policy cash values and other rights, the gift to each transfer should be considered a present interest. As a practical matter, it is far better planning to have the insurance company divide the policy into two (or more) parts, i.e. reissue as two policies, than to use joint ownership which can get very messy if one co-owner dies, divorces, goes bankrupt, etc. See, Priv. Letter Ruls. 200652043 (concerning the splitting of a parent corporation’s master life insurance policy into two separate (but otherwise identical) policies for the benefit of two of the parent corporation’s subsidiaries, where the IRS ruled there was no transfer for value because the subsidiary-transferees received the original parent-transferor’s basis in the policy, and there was no sale or exchange under the Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991)7 interpretation of IRC section 1001) and 9852041 concerning the splitting of a jointly owned policy into two separate policies where an ILIT terminated and distributed a life insurance policy jointly to the two trust beneficiaries and the beneficiaries sought to split the single policy into two separate policies, each separate policy to be equal to 50% of the jointly owned policy. The IRS ruled that there was no transfer for value under IRC section 101(a)(2) upon the splitting of the jointly owned policy.
3A.5 GIFT TAX ANNUAL EXCLUSION AND THE CRUMMEY WITHDRAWAL RIGHT
An outright transfer of a life insurance policy to an individual donee is a completed gift,8 and is a gift of a present interest in the policy, even if the policy has no cash value. Treas. Reg. §25.2503-3(a); Rev. Rul. 55-408, 1955-1 C.B. 113. However, a gift or transfer of money (or other property, such as cash or an existing life insurance policy) to an ILIT is a gift of a future interest and not a gift of a present interest. A gift of a future interest does not qualify for the gift tax annual exclusion under IRC section 2503(b)(1), and the gift is subject to gift tax under IRC section 2501. For a gift to qualify as a gift of a “present interest” that is eligible for the gift tax annual exclusion, the donee (i.e., the ILIT beneficiary) must have the unrestricted right to the immediate use, possession, or enjoyment of the gift property or the income9 from the gift property. IRC section 2503(b); Treas. Reg. §25.2503-3(b). An ILIT does not, in and of itself, give a donee the unrestricted right to the ILIT property or gifts made to the ILIT; in fact, the gifts to the ILIT are purposely designed to be “restricted” to ensure that the gifted property remains in the ILIT for use by the trustee for the benefit of the beneficiaries, including the payment of life insurance premiums. Therefore, if the grantor wants to have gifts to the ILIT qualify for the gift tax annual exclusion, the ILIT must be designed to provide the donee with a limited opportunity to withdraw the gifted amount. This is accomplished by giving the donee a Crummey withdrawal right over property that is gifted to the ILIT.
A Crummey withdrawal right over a gift to an ILIT constitutes an unrestricted right to the immediate use, possession, or enjoyment of the gifted property and converts what would otherwise be a gift of a future interest into a gift of a present interest that qualifies for the gift tax annual exclusion under IRC section 2503(b). A Crummey withdrawal right permits a beneficiary to make a one-time demand for the trustee to distribute to the beneficiary either the gifted property or other trust assets of equivalent value subject to the limitations of IRC sections 2503(b) (concerning the gift tax annual exclusion amount) and 2513 (concerning twice the gift tax annual exclusion amount if there is gift splitting).10 The beneficiary’s right to demand distribution of the gifted property (or other trust assets) is typically of limited duration, such as 30 or 60 days. If the beneficiary does not exercise his or her Crummey withdrawal right within the specified time period, the withdrawal right lapses, and the beneficiary cannot make another demand on the trustee as concerns the lapsed amount. The beneficiary’s one-time right of withdrawal with respect to the gift amount is known as a “non-cumulative right of withdrawal.” If the amount of the Crummey withdrawal right exceeds $5,000 or 5% of the value of the trust assets, the lapse of a Crummey withdrawal right may, if not handled correctly, create transfer tax problems for the beneficiary. D.C. Clifford Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968)15; Rev. Rul. 73-405, 1973-2 C.B. 321. See also, Gilmore v. Commissioner, 213 F.2d 520 (6th Cir. 1954); Kieckhefer v. Commissioner, 189 F.2d 118 (7th Cir. 1951). See, Paragraph 3.1 of Sample ILIT. See, sections 3.11, 3.12, 3.13, 3.14, 3.15, 3.17, 4.4, 4.5, 4.6, 5.19, 5.20, and 5.21, below, concerning the transfer tax issues regarding the lapse of a Crummey withdrawal right in excess of $5,000 or 5% of the value of the trust assets.
Practice Point: There are numerous other tax issues and technical requirements concerning Crummey withdraw- al rights, many of which are discussed in this Chapter and in Chapters 2, 4, 5, 10, 11, 12, and 15.
Since 1973, the IRS has recognized the validity of a Crummey withdrawal right to create a gift of a present interest that is eligible for the gift tax annual exclusion. Rev. Rul. 73-405, 1973-2 C.B. 321. However, over the years, the IRS has attempted to place limits on the expansion of the class of beneficiaries eligible to hold Crummey withdrawal rights. Fortunately, the courts have resisted many of those changes.
Generally, the IRS officially recognizes only Crummey withdrawal right beneficiaries who hold a current income interest or vested remainder interest in the trust, provided there is no preexisting understanding between the grantor and the beneficiaries concerning the nonexercise of their withdrawal rights. TAM 9731004;
Priv. Letter Rul. 9030005; Rev. Rul. 85-24, 1985-1 C.B. 329; Rev. Rul. 81-7, 1981-1 C.B. 474. But see, Estate of Maria Cristofani v. Commissioner, 97 T.C. 74 (1991), AOD 1996-010; Estate of Lieselotte Kohlsaat v. Commissioner, T.C. Memo 1997-212 (1997); Estate of Carolyn W. Holland v. Commissioner, T.C. Memo 1997-302 (1997) (where the Tax Court rejected the IRS’s “prearranged under- standing” test, and permitted Crummey withdrawal rights to qualify for the gift tax annual exclusion when the beneficiaries had dis- cussed in detail the purpose of the trust and their desire to not exercise their right of withdrawal). See, Chapter 15, below for a more comprehensive discussion of the Crummey case and its evolution. See, sections 10.1 through 10.10, 10.12, 11.2, 11.5, 12.2, and 12.6, below, concerning the administration of a Crummey withdrawal right.
The IRS generally will not issue advance rulings concerning the availability of the gift tax annual exclusion involving ILITs with Crummey withdrawal rights. See, Rev. Proc. 2007-3, 2007-1 I.R.B. 108, section 4.01(45).
Caution: A Crummey withdrawal right does not constitute a present interest gift if the trustee can defeat or impair the beneficiary’s right to withdraw the property. Rev. Rul. 83-108, 1983-2 CB 167; TAM 8107009; Priv. Letter Rul. 8121051. Therefore, all discretionary powers held by the trustee or a special powerholder should be expressly limited to prevent the trustee or special power holder from defeating or impairing a beneficiary’s unlapsed power of withdrawal. See, Paragraphs 3.2(F), 3.2(J), 4.1(B), 4.2, 7.1(D)(3), 7.2, 7.3, 7.6, 7.10, and 8.2(C) of Sample ILIT.
Practice Point: Unless the trust qualifies as a skip person under IRC section 2642(c)(2), a gift to a trust that has Crummey withdrawal rights is not considered a gift to the individual donees; rather, it is considered a transfer to the trust itself. Treas. Reg. §26.2642-1(b)(3). See also, Treas. Reg. §26.2612-1(d)(2) concerning trusts that are skip persons. This means that the Crummey withdrawal right is not automatically GST tax exempt, and GST tax exemption will have to be allocated to the annual gifts to the ILIT in order for the ILIT to be GST tax exempt. See, section 5.29, below.
Practice Point: IRC section 6039F requires a donee to report to the IRS gifts that the donee receives (other than the donor’s direct payment of medical expenses or tuition under IRC section 2503(e)(2)) from certain foreign persons if the aggregate value of the gifts received in a taxable year gift exceeds $10,000 (adjusted for inflation). The 2007 threshold amount is $13,258.
3A.6 GIFT TAX MARITAL DEDUCTION AND THE CRUMMEY WITHDRAWAL RIGHT
A Crummey withdrawal right granted to a spouse is a nondeductible terminable interest (because it lapses and other beneficiaries succeed to a right in the property) and therefore does not qualify for the gift tax marital deduction (although the withdrawal right may qualify for the gift tax annual exclusion under IRC section 2503(b)). IRC section 2523(b).
Practice Point: There is no gift tax marital deduction if the spouse is not a U.S. citizen. If the doneespouse is not a U.S. citizen the annual gift tax exclusion amount available to the donor-spouse concerning present interest gifts to a non-U.S. citizen doneespouse is, however, increased to $100,000 (indexed for inflation after 1998) per calendar year. IRC section 2513(i). In 2007, the amount is $125,000. Rev. Proc. 2006-53, 2006-48 I.R.B. 996 (11/27/2006). However, as previously mentioned, a gift to an ILIT where the non-U.S. citizen spouse has a Crummey withdrawal right is limited to the gift tax annual exclusion amount of $10,000 (indexed for inflation) under IRC section 2503(b). In 2007, the gift tax annual exclusion amount is $12,000. Id.
3A.7 DATE OF COMPLETED GIFT TO ILIT
A grantor’s irrevocable contribution to an ILIT on December 31 is a completed gift as of that date (for gift tax purposes), even though the beneficiary does not receive notice of the contribution until several days later and the beneficiary’s Crummey withdrawal right does not expire until 30 days thereafter. Rev. Rul. 83-108, 1983-2 C.B. 167.
If the grantor dies shortly after delivery of a gift check to the ILIT trustee, the gift check will be considered a completed gift in the calendar year for which completed gift treatment is sought, if certain conditions are met.
According to Rev. Rul. 96-56, 1996-2 C.B. 16 (modifying Rev. Rul. 67-396, 1967-2 C.B. 351), the delivery of a check to a noncharitable donee will be deemed to be a completed gift for federal gift and estate tax purposes on the earlier of (i) the date on which the donor has so parted with dominion and control under local law as to leave in the donor no power to change its disposition, or (ii) the date on which the donee deposits the check (or cashes the check against available funds of the donee) or presents the check for payment, if it is established that (1) the check was paid by the drawee bank when first presented to the drawee bank for payment; (2) the donor was alive when the check was paid by the drawee bank; (3) the donor intended to make a gift; (4) delivery of the check by the donor was unconditional; and (5) the check was deposited, cashed, or presented in the calendar year for which completed gift treatment is sought and within a reasonable time of issuance. See also, John A. Metzger v. Commissioner, 100 T.C. 204 (1993), aff ’d, 38 F.3d 1181 (4th Cir. 1994).
Practice Point: To be assured of completed gift treatment for the calendar year in which the check is written, a year end gift check by the grantor to the ILIT trustee should be immediately deposited, or the grantor should issue a certified check, a bank money order, or a bank cashier’s check to the ILIT trustee in lieu of a regular check.
Footnotes:
1. [Add Footnotes Here]
2. [Add Footnotes Here]
3. [Add Footnotes Here]
4. [Add Footnotes Here]
5. [Add Footnotes Here]
6. [Add Footnotes Here]
7. [Add Footnotes Here]
8. [Add Footnotes Here]
9. [Add Footnotes Here]
10. [Add Footnotes Here]