3B: Gift Tax Issues[Continued]

3B.8 GIFT TAX ANNUAL EXCLUSION FOR IRC SECTION 2503(C) MINOR’S TRUST

A gift to a trust for the sole benefit of the individual who is under 21 on the date of the gift, is considered a gift of a present interest in the property for purposes of IRC section 2503(b), provided:

  • The gift/property and the income therefrom may be expended by, or for the benefit of, the donee before attaining age 21; and
  • The trust property will either pass to the donee upon attaining age 21,18 or if the donee dies before age 21, the trust property is either payable to the donee’s estate or as the donee may appoint under a testamentary general power of appointment. IRC section 2503(c).1

Thus, a gift to an IRC section 2503(c) trust that owns (or is authorized to own) life insurance qualifies for the annual gift tax exclusion without giving the donee a Crummey withdrawal right over the gift contribution. John A. Duncan v. U.S., 368 F.2d 98 (5th Cir. 1966). However, IRC section 2503(c) trusts are generally not desirable to hold life insurance on the grantor’s life because of the age 21 payout requirement.2 See, section 5.7(c) concerning GST issues and IRC section 2503(c) trusts.

Practice Point: A gift of a life insurance policy to a non- IRC section 2503(c) trust that is required to pay all of its income at least annually to the beneficiary will not qualify as a gift of a present interest if the life insurance policy does not pay income until the insured’s death. Treas. Reg. §25.2503-3(c), Example 2; Jesse S. Phillips v. Commissioner, 12 T.C. 216 (1949).

3B.9 ILIT BENEFICIARY’S EXERCISE OF INTER-VIVOS LIMITED POWER OF APPOINTMENT MAY BE SUBJECT TO GIFT TAX

Limited powers of appointment are often included in ILITs to provide some flexibility in what is otherwise an irrevocable transaction. However, the lifetime exercise of a limited power of appointment over the trust corpus by the trust’s income beneficiary is a gift equal to the present value of the beneficiary’s income interest. IRC section 2511. The beneficiary’s exercise of the power over the corpus does not terminate the income interest; rather, when trust corpus is transferred, income generated by the transferred corpus is also (gratuitously) transferred to the transferee of the corpus, thus resulting in a gift of the beneficiary’s transferred income interest. Estate of Ruth B. Regester v. Commissioner, 83 T.C. 1 (1984). This rule is of importance where the ILIT beneficiary (such as the grantor’s spouse) holds an intervivos limited power of appointment over the trust corpus during the grantor’s lifetime, with the ability to appoint the ILIT corpus (including insurance policies held by the ILIT on the grantor’s life) to another person (including the insured grantor, but excluding the appointing beneficiary, the appointing beneficiary’s estate, or the creditors of either). Any such appointment may result in a gift being made by the appointing beneficiary, who will then become the “new” transferor for GST tax purposes of the appointed property. Rev. Rul. 79-327, 1979- 2 C.B. 342; Treas. Reg. §§25.2514-1(b)(2); 25.2514-3(e), Examples 1 and 3; 26.2652-1(a)(2).

If the appointing beneficiary’s interest in the trust is purely discretionary or subject to an ascertainable standard, the beneficia ry’s exercise of an intervivos limited power of appointment may still result in a gift being made by the appointing beneficiary. Priv. Letter Ruls. 200243026, 9451049, 9419007, and 8535020.

Practice Point: The ILIT can give the grantor-insured’s spouse (unless the ILIT owns a survivorship policy), the insured’s child, or another trusted individual a limited power of appointment, during the grantor-insured’s life- time, to appoint trust income and principal to anyone other than the powerholder, the powerholder’s estate, or the creditors of either. With such a provision, the powerholder could appoint the policy back to the grantor insured or directly to a new ILIT with revised terms. If the policy is returned to the grantor-insured, the death proceeds will be included in his or her gross estate if the policy is still owned at death. However, the mere existence of this form of limited power of appointment in the ILIT, whether or not exercised, will not cause the property still in the trust to be included in the grantor- insured’s gross estate. Because the power to distribute the policy is exercisable only in the absolute discretion of the powerholder, the value of the reversionary interest is less than 5%. IRC section 2042(2). Because the limited power of appointment is not exercisable by the grantor- insured, it is not a general power of appointment. IRC section 2041(a)(2). Because the limited power of appointment is not exercisable by the grantor-insured, the insured does not have the power to alter, amend, revoke, or terminate the transfer. IRC section 2038(a)(1). If there was no understanding, express or implied, between the grantor-insured and the power holder that the powerholder would later distribute trust income or principal to the grantor-insured, then the grantor-insured will not be treated as having retained the right to possess or enjoy the trust property. IRC section 2036(a)(1). See, Paragraph 4.2 of Sample ILIT.

3B.10 GIFT SPLITTING AND LARGE GIFT CONTRIBUTIONS TO ILIT

Gift splitting used in conjunction with a hanging Crummey withdrawal right, or with trust beneficiaries having separate trust shares coupled with testamentary powers of appointment, permits the grantor to make annual gifts to the ILIT that are twice the amount of the grantor’s available annual gift tax exclusion amount. Gift splitting is available to the grantor if:

  • Each spouse is a resident of the United States or a U.S. citizen;
  • The spouse is married to the grantor at the time of the gift;
  • The spouse is alive at the time of the gift; and
  • The spouse does not remarry during the remainder of the calendar year. IRC section 2513; Treas. Reg. §25.2513- 1(b)(1); Rev. Rul. 55-506, 1955-2 C. B 609; Priv. Letter Rul. 200408014 (gifts made by a surviving spouse after the other spouse’s death cannot be gift split with the deceased spouse).

Gift splitting is particularly helpful in large premium cases. However, a donor cannot elect gift splitting with respect to gifts to his or her spouse (i.e., a donee spouse cannot elect to split gifts to himself or herself ). IRC section 2513(a)(1) (first sentence). Nor can the donor elect to split gifts with his or her spouse concerning a gift to a third party if the consenting spouse holds a general power of appointment (“GPOA”) over the gifted property. IRC section 2513(a)(1) (second sentence). This is because the consenting spouse’s GPOA over the property gifted to the third party is the equivalent of the consenting spouse receiving outright ownership of the property; and as previously mentioned, a spouse cannot elect to split gifts to himself or herself. A consenting spouse can, however, hold a testamentary limited power of appointment over property that is gifted to third parties and is elected for gift splitting. For example, the IRS allowed gift splitting where a wife transferred assets to a trust for the benefit of her children and husband (each of whom had Crummey withdrawal rights over the gifts), and the husband also had a testamentary limited power to appoint the trust assets to one or more of his wife’s descendants. Priv. Letter Rul. 200130030.3 This ruling suggests that a donee (consenting) spouse’s limited power of appointment over property transferred by a donor will not preclude gift splitting; otherwise, the donee (con-senting) spouse’s election to split gifts would render the gift incomplete and the issue of gift splitting would be moot because there would be no completed gift. See also, Priv. Letter Rul. 200213013 where the IRS ruled that a split gift to an irrevocable GST tax exempt dynasty trust (where there were no Crummey withdrawal rights) was complete and that the gifted property would not be includable in either the donor’s estate or the consenting spouse’s gross estate, even though the consenting spouse was given a contingent remainder interest in the trust property (subject to an ascertainable standard) and was given a testamentary limited power of appointment over her contingent remainder interest to appoint the trust property to anyone other than her estate or her creditors. Said the IRS, “[A]lthough Spouse will consent under § 2513 to treat the gift to Trust made by Settlor as if made one-half by Spouse, §2035(a) and §§2036 through 2038 do not apply to property interests that the decedent [consenting Spouse] did not actually own and thus did not transfer. Accordingly, assuming only Settlor makes transfers to Trust, [consenting] Spouse will not be the transferor of property to Trust for purposes of §2035(a), and §§2036 through 2038. See Rev. Rul. 82-198, 1982-2 C.B. 206; Rev. Rul. 74- 556,1974-2 C.B. 300; Rev. Rul. 54-246, 1954-1 C.B. 179.” Another interesting aspect of Priv. Letter Rul. 200213013 is that the irrevocable GST tax-exempt dynasty trust stated that if any of the trust property was includable in the donor-husband’s gross estate, the trustee of the irrevocable GST tax-exempt dynasty trust was to distribute the property either to the donor-husband’s estate or to any revocable trust the donor-husband had established before his death. In this regard, the IRS ruled: “Under the terms of Trust, Trust is irrevocable and Settlor [donor-husband] will have no right, title or interest in or power over, privilege or incident of ownership in regard to any trust property. Settlor has retained no beneficial interest in the trust and has not retained any right to alter, amend, revoke, or terminate the Trust within the meaning of §2038, or the right to designate the persons who will possess or enjoy the property or the income therefrom within the meaning of §2036.” This ruling suggests that a gift to an irrevocable trust can be complete and irrevocable, despite that fact that any trust property that is includable in the donor’s gross estate is to be distributed to the donor’s estate or the donor’s revocable trust. This should be of comfort to practitioners who have drafted ILITs that require ILIT property which is includable in the grantor’s gross estate to be distributed to the grantor’s revocable trust.

If a donor transfers property in part to the doneespouse and in part to third parties, the election to split such a gift by the doneespouse is effective, but only “with respect to the interest transferred to third parties only insofar as such interest is ascertainable at the time of the gift and hence severable from the interest transferred to [the donee] spouse.” Treas. Reg. §25.2513-1(b)(4) (emphasis added). See, Para-graph 3.1(A)(1) of Sample ILIT which further defines “contribution” by excluding any amount that has been gift split by the doneespouse. If the donee (consenting) spouse has an annuity, life estate, remainder interest, or other determinable or ascertainable interest, the third parties’ interests would be ascertainable and would be eligible for gift splitting.

When the donee (consenting) spouse and other beneficiaries have Crummey withdrawal rights over the gifted property, the amount subject to withdrawal by the other beneficiaries would be ascertainable and thus eligible for gift splitting (assuming the rights of the income and corpus beneficiaries are subordinate to any unlapsed Crummey withdrawal rights). See, Priv. Letter Ruls. 200422051, 8044080, 8112087, 8138171, 8138170, 8143045, and 200130030. See, Paragraph 3.1(A)(1) of Sample ILIT. However, the amount subject to withdrawal by the donee (consenting) spouse would not be eligible for gift splitting. If the donee (consenting) spouse does not have a Crummey withdrawal right over the gift property but does have a general power of appointment over all the gift property, the gift cannot be split. Treas. Reg. §25.2513-1(b)(3).

If the gift is not subject to withdrawal rights and the trust is a common “pot” trust from which the donee (consenting) spouse and the other beneficiaries may receive discretionary distributions, the gift cannot be split because there are no readily ascertainable interests. See, Rev. Rul. 56-439, 1956-2 C.B. 605; Max Kass v. Commissioner, T.C. Memo 1957-227 (1957); and Stanley L. Wang v. Com- missioner, T.C. Memo 1972-143 (1972). See also, Priv. Letter Rul. 200551009. This is because the donee spouse’s and the other beneficiaries’ interests cannot be ascertained. However, if the trustee is directed (i.e., “shall” in contrast to “may”) to make distributions pursuant to an ascertainable standard (e.g., for the donee spouse’s health, education, support, and maintenance), the value of the third-party (nonspouse) beneficiaries’ interests should be ascertain- able. See, TAM 9419007; Estate of Ruth B. Regester v. Commissioner, 83 T.C. 1 (1984); Rev. Rul. 79-327, 1979-2 C.B. 342 (which relate to taxable gifts upon the exercise of a limited power of appointment over a trust with ascertainable standards). In such an instance, that portion of the gift could be split with the donee (consenting) spouse. If the donee (consenting) spouse does not have a Crummey withdrawal right but the other beneficiaries have Crummey withdrawal rights over the gifted property, the amount subject to withdrawal by the other beneficiaries would be ascertainable and eligible for gift splitting. Treas. Reg. §25.2513-1(b)(4).

The amount of the gift that may be split is the value of the property transferred by the donor less the donee (consenting) spouse’s ascertainable interest in the property, which is a factual determination. See, Sands G. Falk v. Commissioner, T.C. Memo 1965-22 (1965).

Merely consenting to split gifts made in trust with the donor spouse does not make the donee (consenting) spouse, who is also a trust beneficiary, a transferor for purposes of the retained interest rules of IRC sections 2035–2038, nor does it make the donee (consenting) spouse a “grantor” for income tax purposes under IRC sections 673-677. IRC section 2513(a)(1); Priv. Letter Rul. 200130030. See, Rev. Rul. 82-198, 1982-2 C.B. 206; Rev. Rul. 74- 556, 1974-2 C.B. 300; Rev. Rul. 54-246, 1954-1 C.B. 179. However, gift splitting does make the donee spouse a transferor for GST tax purposes as to the one-half of the entire gift amount with- out regard to the consenting spouse’s ascertainable interest in the gift, and the consenting spouse must allocate his or GST tax exemption to the gift amount. See, section 5.22, below.

Caution: To avoid the IRC section 2036 trap inherent when an ILIT income beneficiary transfers assets to an ILIT (such as transfers by the grantor and the grantor’s spouse, where the spouse is also an ILIT beneficiary), only the grantor should make gifts to the ILIT, and any gifts of the grantor in excess of the IRC section 2503(b) amount should be split with the spouse under IRC section 2513.

Practice Point: Do not split gifts when transferring an existing life insurance policy into generation-skipping ILIT. If the transferor-grantor dies within three years of the transfer, the policy proceeds will be included in his or her estate under IRC section 2035 (thus changing the identity of the transferor for GST tax purposes) and the consenting spouse’s previously allocated GST tax exemption will be lost and wasted, resulting in an inclusion ratio of .50 (instead of 0). The better approach is to not split gifts, but instead have the transferor grantor allocate his or her GST tax exemption to the trust at the time of the initial transfer of the life insurance policy. Also, although the portion of the gifted property includable in the grantor’s gross estate under IRC section 2035 is not included in the consenting spouse’s adjustable taxable gifts for purposes of IRC section 2001(b)(i)(B)(b), all future tax liability is determined with regard to the split gifts and the gift tax rate will be based on the prior split gifts.

Practice Point: In describing the amount available for withdrawal by a beneficiary, do not condition the amount on the donor spouse’s election to split the gift. Priv. Letter Rul. 8022048. The reason is that the IRS has ruled that the annual exclusion is not available for the spouse’s portion of the split gift if the amount of the withdrawal power is conditioned upon the election being made. Priv. Letter Rul. 8044080. Therefore, state that the amount available for withdrawal is based on the assumption that a married donor’s spouse will elect to split the gift amount, whether or not the election is made. See, Paragraph 3.1(A)(3) of Sample ILIT.

Caution: Once elected, gift splitting applies to all gifts made by either spouse during the calendar year in question. IRC section 2513(a)(2). Also, gift splitting makes both spouses jointly and severally liable for the gift tax. IRC section 2513(d).

3B.11 GIFT TAX CONSEQUENCES OF LAPSE OF A CRUMMEY WITHDRAWAL RIGHT

Most ILITs use Crummey withdrawal rights to convert a future interest gift into a present interest gift that qualifies for the gift tax annual exclusion under IRC section 2503(b). See, section 3.5, above. A Crummey withdrawal right is a general power of appointment. IRC sections 2514 and 2041. Be very careful when inserting Crummey withdrawal rights in an amount greater than $5,000 or

5% of the value of the trust assets. IRC section 2514(b) indicates that the exercise or release of a general power of appointment will be treated as a transfer by the individual who released the power. Under IRC section 2514(e), a lapse of a power of appointment is considered a release. A specific exception to this rule is set forth under IRC sections 2514(e)(1) and (2), which state that the lapse of a power (in contrast to a release or a waiver of the power) not exceeding $5,000 or 5% of the value of the assets out of which the power can be satisfied, will not be treated as a transfer. What this means is that a lapse of a Crummey withdrawal right in excess of the five-by- five limits will be treated as a transfer to the other trust beneficiaries by the Crummey withdrawal beneficiary. Furthermore, if the lapse of the excess amount is a completed gift, the withdrawal right beneficiary’s retained interest in the excess amount will be valued at $0 for gift tax purposes if the remainder beneficiaries/donees of the excess amount are members of the withdrawal right beneficiary’s family. IRC section 2702(a)(2). Priv. Letter Rul. 9804047. A lapsed withdrawal right within the five-by-five limits will continue to be treated as a transfer by the donor.

A lapse in excess of the five-by-five statutory protection amount can cause disastrous estate, gift, and GST tax consequences. For example, if a trust was established with an initial gift contribution of $11,000, and the spouse was the only Crummey withdrawal right beneficiary and was given an $11,000 withdrawal right that lapsed, the spouse would be deemed to be the transferor (for gift tax purposes) of the amount of the withdrawal right in excess of $5,000, to wit, $6,000. In this example the spouse would be the deemed transferor of 55% of the trust assets ($6,000 excess ÷ $11,000 trust value) and because the spouse held a life interest in the trust, 55% of the trust assets would be includable in the spouse’s estate for federal estate tax purposes. Treas. Reg. §20.2041-3(d)(4). Furthermore, the spouse would also be a transferor for GST purposes over the $6,000 and the grantor’s previously allocated GST tax exemption would be lost and wasted. This would require the spouse to allocate his or her GST tax exemption to maintain a zero inclusion ratio. Treas. Reg. §26.2652-1(a)(5) Example 5. Because of the ETIP rules contained in Treas. Reg. §26.2632-1(c)(2) (see, section 5.17, below), the spouse cannot effectively allocate GST tax exemption until the close of the ETIP. This may result in a larger amount of GST tax exemption having to be allocated, especially if the ETIP ends on the insured’s death (and the life insurance policy “matures”). Another potential problem because of the ETIP rules, is that the grantor’s GST tax exemption may not be allocated effectively until the close of the spouse’s ETIP. These potential GST and estate tax issues underscore the need for making sure that Crummey withdrawal rights lapse within the annual five-by-five safe harbor amounts.

3B.11(a) Apply The Five-By-Five Safe Harbor Lapse Amount Against The Entire ILIT Trust Estate

The 5% portion of the five-by-five safe harbor lapse amount under IRC section 2514 is measured against “the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapse power could be satisfied.” IRC section 2514(e)(2). Thus, to obtain the largest 5% lapse protection amount, the 5% should be measured against the entire trust estate, and not against the amount of the periodic gift contribution. See, Paragraph 3.2(L) of Sample ILIT. See, section 3.17, below, concerning the aggregation of multiple Crummey withdrawal rights held by a beneficiary.

3B.11(b) Limiting The Beneficiary’s Crummey Withdrawal Right

Because a lapse in excess of five-by-five constitutes a taxable release by the powerholder, it is usually best to limit a beneficiary’s Crummey withdrawal right amount to the lesser of: (1) the gift contribution amount; or (2) the greater of five-by-five. This will ensure that when the withdrawal right lapses it will fall within the safe harbor amount of IRC section 2514(e).4 Without such a limitation on the amount of the Crummey withdrawal right, the lapse of the withdrawal right in excess of five-by-five (absent a hanging Crummey power (see, section 3.13, below) or the beneficiary having a separate trust share and holding a testamentary power of appointment over the amount of the withdrawal right in excess of five-by-five (see, section 3.12, below))5 will constitute both a taxable release under IRC section 2514(b) and an immediate gift of a future interest to the other ILIT beneficiaries by the powerholder.

3B.12 AVOID TAXABLE RELEASE OF A CRUMMEY WITHDRAWAL RIGHT BY CREATING SEPARATE TRUST SHARES WITH TESTAMENTARY CONTROLS

One way to deal with a Crummey withdrawal right beneficiary’s potential taxable release and a completed gift of a future interest to other ILIT beneficiaries problem (see, section 3.11, above) is to initially establish separate trust shares for each ILIT beneficiary and give the beneficiary a testamentary limited power of appointment over his or her trust share for the amount in excess of the five-by-five safe harbor amount. This will prevent the lapsed amount in excess of five-by-five from being a completed gift to the other trust beneficiaries. Treas. Reg. §25.2511-2(b); Priv. Letter Ruls. 9030005, 8517052, 8229097, 8142061, and 8011123. However, the separate-trust share coupled with a testamentary limited power of appointment will not avoid the taxable release problem of IRC section 2514(e). Consequently, when the beneficiary dies, the assets over which the beneficiary retained a testamentary limited power of appointment (i.e., the amounts in excess of five-by-five) will be included in the beneficiary’s gross estate under IRC section 2041(a)(2). Additionally, because the beneficiary has a retained interest in the separate trust share, all or a portion of the value of the trust share will be included in the beneficiary’s gross estate upon his or her death. IRC section 2036(a); Treas. Reg. §20.2041-3(d)(4). The effect of cumulative taxable releases with a retained interest by the beneficiary may result in all (or a significant portion) of the beneficiary’s separate trust share being included in his or her gross estate. Treas. Reg. §20.2041-3(d)(5). Furthermore, the beneficiary will become the (new) transferor for GST tax purposes of the trust share that is includable in his or her gross estate, thus wasting any GST tax exemption that was previously allocated to the trust share. IRC section 2652(a)(1); Treas. Reg. §26.2652-1(a)(2). See, section 5.10, below. Generally, the testamentary limited power of appointment approach will work best in ILITs where:

  • The grantor’s spouse is not a beneficiary;
  • The ILIT is not designed to be a long-term generation skipping dynasty trust;
  • There is a single trust with a single beneficiary (or there are separate trust shares for each beneficiary who possess a Crummey withdrawal right); and

(4) The beneficiary’s estate would most likely incur little or no federal estate tax (because of its modest size) if the beneficiary were to die before the termination of his or her interest in the ILIT.

Practice Point: An alternative to separate trust shares with testamentary limited powers of appointment, is to use a vested trust for the benefit of a sole beneficiary and have all of the trust property be includable in the beneficiary’s gross estate when he or she dies. This can be accomplished by granting a testamentary general power of appointment to the beneficiary over his or her trust share or by having the trust share be paid to the beneficiary’s estate. See, Priv. Letter Ruls. 8545076 and 8517052 (testamentary general power of appointment granted to beneficiary over his trust share). In Priv. Letter Rul. 8142061, the IRS ruled “where the trust instrument provides that the sole-beneficiary or his estate will receive the trustcorpus, the lapse of the annual demand right (or its release) will not result in a taxable gift as a result of the lapse (or release) of such general power of appointment.” However, if the insured’s desire is to avoid the policy’s inclusion in the beneficiary’s gross estate, this arrangement will not be viable.

3B.13 AVOID TAXABLE RELEASE OF A CRUMMEY WITHDRAWAL RIGHT BY USING A HANGING CRUMMEY POWER

Another way to deal with a Crummey withdrawal right beneficiary’s potential taxable release and completed gift of a future interest to other ILIT beneficiaries problem (see, section 3.11, above) is to allow the beneficiary’s Crummey withdrawal right to continue with regard to any amount in excess of the five-by-five safe harbor amount, and allow the excess amount to annually lapse within the five-by-five safe harbor amount.6 This is known as a hanging  Crummey withdrawal right (or a hanging Crummey power).7 See, Paragraph 3.2 (D) (alternative 2) of Sample ILIT. A hanging Crummey withdrawal right allows the beneficiary to withdraw up to the gift tax annual exclusion amount (or twice that amount if there is gift splitting under IRC section 2513). Under a hanging Crummey power, the beneficiary has a continuing right to withdraw the amount of the gift that has not lapsed.8 In some instances, the beneficiary may have a continuing right of withdrawal that will last for several years. Under a hanging Crummey power, any amount that is not withdrawn each year by the beneficiary will automatically lapse (typically on January 31 or December 31 of the year in question) within the safe harbor amounts of 5% or $5,000, per IRC section 2514(e).

Although the IRS has not favorably ruled on the use of hang-ing Crummey powers, the one ruling on this issue seems to suggest that if the hanging power is not drafted as a condition subsequent, it should be effective. Priv. Letter Rul. 8901004. A spouse should never be given a hanging Crummey power in a generation-skipping trust, because the spouse’s power may be deemed to create an Estate Tax Inclusion Period (“ETIP”) under IRC section 2642(f), which will prevent the grantor from allocating his or her GST tax exemption to the ILIT until the close of the ETIP. See, section 5.17, below.

The purpose of a hanging Crummey power is twofold. First, a hanging Crummey power permits larger ILIT contribution amounts that qualify for the gift tax exclusion annual amount. Second, a hanging Crummey power avoids adverse estate and gift tax consequences under IRC sections 2514(b) and 2036(a) to the ILIT beneficiaries who hold Crummey withdrawal rights. This is achieved by having the beneficiary’s withdrawal right be a cumulative power of withdrawal that lapses every calendar year in the amount specified in IRC sections 2514(e)(1) and (2).

There are two disadvantages to using a hanging Crummey power. First, the beneficiary has a continuing right of withdrawal that he or she can exercise at any time (even though the gift amount that is subject to the continuing right of withdrawal has been used by the trustee to pay life insurance premiums). This potential issue can be mitigated by requiring a disinterested or independent trustee (who is not an adverse party or the creator of the power) to consent to the beneficiary’s exercise of his or her continuing right of withdrawal.9 See, Paragraph 3.2(D) (alternate 2) of Sample ILIT. The consent of a disinterested or independent trustee over the unlapsed portion of the gift amount does not cause the gift to be a gift of a future interest. This is because beneficiary could have withdrawn the full gift amount in the year of the gift. Also, the consent of the disinterested or independent trustee does not cause the beneficiary’s right of withdrawal to be illusory or to be treated as a non-general power of appointment. See, IRC section 2514(c)(3). Second, if a beneficiary dies while possessing a hanging power that has not fully lapsed, the value of the unlapsed hanging power will be included in the beneficiary’s gross estate. IRC section 2041(a)(2). The beneficiary will also become the (new) transferor for GST purposes of the ILIT amount included in his or her estate, and the beneficiary’s executor may need to allocate GST tax exemption to the included amount.

A hanging Crummey withdrawal right works best where:

  • The ILIT holds sufficient assets to absorb the hanging (unlapsed) amount, i.e., either the 5% of the five-by-five safe harbor lapse amount is increasing each year;
  • The ILIT holds a quick (or limited) pay life insurance policy or a “vanishing premium” policy,10 neither of which require continuing premium payments during the insured’s lifetime11; or
  • The ILIT continues for a substantial time after the insured’s death so that the handing power amount can lapse. See, Paragraph 3.2(E) of Sample ILIT.

3B.14 GIFT TAX CONSEQUENCES OF AN UNLAPSED CRUMMEY WITHDRAWAL RIGHT

There are no gift tax consequences to a beneficiary while he or she holds a Crummey withdrawal right that has not yet lapsed.

3B.15 GIFT TAX CONSEQUENCES OF WAIVER OR RELEASE OF A CRUMMEY WITHDRAWAL RIGHT

Because a Crummey withdrawal right is a general power of appointment, a beneficiary’s waiver of the right of withdrawal constitutes a taxable release (and not a lapse) of a general power of appointment and constitutes a taxable gift of a future interest to the other trust beneficiaries. IRC section 2514(b). To avoid this adverse tax consequence, the beneficiary should not waive the right to withdraw the ILIT contribution. Instead, the beneficiary should merely permit the right of withdrawal to lapse. Also, a lapse of a beneficiary’s Crummey withdrawal right in excess of five-by-five constitutes a taxable release of a general power of appointment and constitutes a taxable gift of a future interest to the other trust beneficiaries. To avoid this adverse tax consequence, the beneficiary’s right of withdrawal should either be limited to five-by-five (See, Alternative 1 to Paragraph 3.2(D) of Sample ILIT) or be subject to continuing lapse under a hanging power of withdrawal that lapses annually at the rate of five-by-five(See, Alternative 2 to Paragraph 3.2(D) of Sample ILIT).

3B.16 GIFT TAX CONSEQUENCES OF THE DELAWARE TAX TRAP

If in exercising an intervivos non-general power of appointment created after October 21, 1942, another power of appointment (general or non-general) is created, which under applicable local law can be validly exercised so as to postpone the vesting of the appointed property or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of the creation of the first power (i.e., extend the original perpetuities period with respect to the appointed property), the exercise of the intervivos non-general power of appointment will be treated as the exercise of an intervivos general power of appointment by the donee, and will result in a taxable gift being made by the donee. IRC section 2514(d). (The donee will also become the (new) transferor of the appointed property for GST tax purposes).12 See, Paragraph 8.1(A) of Sample ILIT, which negates the occurrence of the trap.

3B.17 LIMIT ON ANNUAL FIVE-BY-FIVE SAFE HARBOR LAPSE AMOUNT FOR A BENEFICIARY WITH MULTIPLE CRUMMEY WITHDRAWAL RIGHTS

Rev. Rul. 85-88, 1985-2 C.B. 201, holds that only one five-by-five safe harbor lapse is permitted per calendar year per donee for all powers of withdrawal (granted under all trusts) available to that donee during the year. Multiple withdrawal rights held by the same donee over the same or different trusts that are also subject to a five- by-five lapse must be aggregated to determine whether they violate the five-by-five safe harbor amount.13 See also, G.C.M. 39371 (1985). In this regard the ILIT can contain an ordering rule for a donee who holds multiple withdrawal rights that are subject to a five-by-five lapse.14 The ILIT can provide that the donee’s unexercised withdrawal right in the ILIT property shall lapse after all other unexercised withdrawal rights previously granted to the donee (whether under the ILIT or another instrument) have lapsed. Alternatively, the ILIT can provide that all unexercised withdrawal rights held by the donee shall be aggregated to determine the maximum amount that can lapse within the five-by-five safe harbor provisions of IRC sections 2514(e)(1) and (2).15 See, Paragraph 3.2(L) of Sample ILIT.

3B.18 GIFT TAX CONSEQUENCES OF GRANTOR’S PAYMENT OF ILIT’S INCOME TAXES

The payment of a defective grantor trust’s income tax liability by the grantor does not result in the grantor making an additional gift to the trust beneficiaries. Rev. Rul. 2004-64, 2004-27 I.R.B. 7. However, the grantor’s right to be reimbursed by the trust for the payment of the incomes taxes (including a discretionary right to reimbursement), may have adverse estate tax consequences to the grantor. See, section 4.2(b), below.

3B.19 GIFT TAX CONSEQUENCES OF LIFE INSURANCE PROCEEDS PAID TO NON-OWNER

If the beneficiary of the life insurance policy is not the owner of the policy, the owner will be deemed to have made a gift of the life insurance proceeds to the beneficiary to the extent of any interest not retained by the owner. If the policy owner’s spouse is the beneficiary of the policy, the proceeds may qualify for the unlimited marital deduction pursuant to IRC section 2056. Adele F. Goodman v. Commissioner, 4 T.C. 191 (1944), aff’d, 156 F.2d 218 (2d Cir. 1946); Rev. Rul. 81-166, 1981-1 C.B. 477; Rev. Rul. 77-48, 1977- 1 C.B. 292. Thus, if an ILIT is the owner of the life insurance policy, the ILIT should be the beneficiary of the policy.

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