IRREVOCABLE LIFE INSURANCE TRUSTS
IRREVOCABLE LIFE INSURANCE TRUSTS
LAWRENCE M. LIPOFF, C.P.A., C.E.B.S.
The following discussion regarding irrevocable life insurance trusts is meant to review current literature, identify areas of professional uncertainty, and to provide certain new planning concepts for the experienced estate planner. While not all of the issues are mentioned, matters like incidents of ownership, transfer and income tax implications, and certain administrative items are addressed. An item which needs to be considered but is not mentioned in this study are the complications of transfer for value.
Internal Revenue Code Section (“Sec.”) 2042(1) provides for life insurance proceeds to be included in an insured’s gross estate if he designates his representative or estate as his 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 will be included in the computation of gross estate under Sec. 2042(2). Reeves, et.al. in Guide to Practical Estate Planning, based upon Treasury Regulation (“Reg.”) 2042-1(c)(2) define the term to mean “essentially the right of the insured or the insured’s estate to the economic benefits of the policy.” Per Commissioner v. Estate of Karagheusion, 56-1 USTC 11,605, 233 F2d 197 (2nd Cir. 1956), a retained right exercisable only in conjunction with another person will cause inclusion.
Sec. 2042 does not define incidents of ownership. A good summary of ownership rights that are and are not considered incidents of ownership can be found in Appendix 9F of Guide to Practical Estate Planning. Interestingly, in Revenue Ruling (“Rev. Rul.”) 84-179, fiduciary powers, conferred in an unrelated transaction by another person, which are not exercisable for the decedent’s benefit and for which the decedent did not transfer the policy or provide funds for maintenance by a trust were held to prevent inclusion.
Based upon Estate of Noel v. Commissioner, 380 US 678 (1965), possession of incidents of ownership without physical ability to make effective use of same (Noel was killed after signing the application) will lead to inclusion. However, illegal use of incidents of ownership will not cause inclusion per Estate of Bloch, Jr. v. Commissioner, 78 TC 850 (1982). On this issue, Estate of O’Daniel v. U.S., 6 F3d 321, 93-2 USTC 60,150 (5th Cir. 1993) cited Estate of Bartlett, 54 TC 1590 (1970) with the same result. Also, attempts to transfer incidents of ownership, which were prevented by an error of an insurance agent, were treated as if the transfer took place preventing inclusion in National Metropolitan Bank v U.S., 87 F. Supp. 773 (Ct. Cl. 1950), Schongalla v. Hickey, 149 F2d 687 (1945), and Watson v. Commissioner, 36 TCM 1084 (1977).
A more than 5% value reversionary interest, in addition to creating a grantor trust under Sec. 673, is considered by Reg. 2042-1(c)(3) to be an incident of ownership. The availability of the policy or proceeds to return to the decedent or his estate, and the power of disposition of the decedent or his estate are incidents of ownership.
Calculation of reversionary interest is done by multiplying the Table S (per Proposed Reg. 1.642(c)-6(e)(4) and listed in Publication 1457’s Alpha Volume) applicable remainder factor (for Section 7520 rate for the decedent’s month of death) by the face value of the policy. This reversionary interest calculation is then compared to the face value of the policy to test for the percentage of reversion.
Sec. 2035(d)(2)’s three-year rule includes powers under Sec. 2036, 2038, and 2042. This is an exception to the Sec. 2035(d) general repeal of the rule for estates of decedents dying after December 31, 1981. Should the three-year rule apply, payment of estate taxes will be determined by Sec. 2205 and 2206 unless the decedent’s will directs otherwise. These sections mandate:
Sec. 2205. “If the tax or any part thereof is paid by, or collected out of, that part of the estate passing to or in the possession of any person other than the executor in his capacity as such, such person shall be entitled to reimbursement out of any part of the estate still undistributed or by a just and equitable contribution by the persons whose interest in the estate of the decedent would have been reduced if the tax had been paid before the distribution of the estate or whose interest is subject to equal or prior liability for the payment of taxes, debts, or other charges against the estate, it being the purpose and intent of this chapter that so far as is practicable and unless otherwise directed by the will of the decedent the tax shall be paid out of the estate before its distribution.”
Sec. 2206. “Unless the decedent directs otherwise in his will, if any part of the gross estate on which tax has been paid consists of proceeds of policies of insurance on the life of the decedent receivable by a beneficiary other than the executor, the executor shall be entitled to recover from such beneficiary such portion of the total tax paid as the proceeds of such policies bear to the taxable estate. If there is more than one such beneficiary, the executor shall be entitled to recover from such beneficiaries in the same ratio. In the case of such proceeds receivable by the surviving spouse of the decedent for which a deduction is allowed under section 2056 (relating to marital deduction), this section shall not apply to such proceeds except as to the amount thereof in excess of the aggregate amount of the marital deductions allowed under such section.”
Failure of the executor to pay transfer taxes can lead to personal liability imposed upon the insurance’s beneficiaries under Sec. 6324(a)(2) and 6901(a)(1) and the several cases cited in the 1996 Cumulative Supplement No. 1 of Tax Planning with Life Insurance, pages S3-29 thru S3-32 by Howard M. Zaritsky and Stephan R. Leimberg.
Private Letter Ruling (“PLR”) 9533001 stated that the three-year gross estate inclusion rule does not alter the character of the initial transfer as a taxable gift. Accordingly, a credit will be available for gift taxes paid and will be indicated on line 25 of page one of Form 706 for “prior payments (explain in an attached statement).”
Properly structured and without three-year rule inclusion, an irrevocable life insurance trust will obviate the need to consider a reversion of the life insurance policy because the trust is irrevocably transferred. Should the beneficiaries die, then the next line of beneficiaries (often their children) or the beneficiaries’ estate will become the beneficiary of the trust and therefore the policy. Recently, the Service ruled in PLR 9602010 that insurance on the lives of beneficiaries of an irrevocable life insurance trust will not be included in their gross estates.
Should an “experienced policy” be transferred to an irrevocable life insurance trust, the insured will need to live for three years to prevent inclusion in the insured’s gross estate. Should the insured be in good health such that he is not “rated or uninsurable,” a life insurance family limited partnership may offer an alternative. Based upon Estate of Knipp v. Commissioner, 25 TC 153 (1955), acq. in result, 1959-1 C.B. 4, aff’d on another issue 244 F.2d 436 (4th Cir.), cert. denied, 355 US 827 (1957), no incidents of ownership will be present and only a percentage share (the insured’s partnership percentage) of the total policy proceeds will be included in the gross estate. Rev. Rul. 83-147 should also be reviewed.
Some commentators object to reliance upon Knipp because (1) a partnership formed for later distribution to objects of the general partner’s bounty is really a trust rather than a business, and (2) in Knipp, the life insurance policies were purchased for a partnership purpose. This author does not believe that the first argument is correct and that the second argument can be dealt with by considering the partnership an investment partnership. Whether other investments should be held by the partnership besides life insurance policies is of current discussion. PLR 9309021 permitted a partnership with only life insurance. However, word of mouth from commentators seems to indicate that the Service is backtracking from this position.
An excellent opportunity to use a life insurance partnership would be to purchase life insurance policies from a pension plan. The life insurance, and especially the first year administrative costs, had been paid for with pre-tax dollars. Should the insured die with the policy in the retirement plan or within three years of, purchase from the plan and placement in an irrevocable life insurance trust, the policy proceeds would be included within the insured’s estate.
Whether a technique popularized by Andrew J. Fair to permit creation of an irrevocable life insurance subtrust within a pension plan to prevent estate inclusion works, consider Louis A. Mezzullo’s concept in Integrating Retirement Benefits into the Estate Plan: Practical Planning and Forms, National Law Foundation, that this will violate Sec. 401(a)(13) which says a “trust shall not constitute a qualified trust under this section unless the plan of which such trust is a part provides that benefits provided under the plan may not be assigned or alienated.” Furthermore, he believes that a subtrust would disqualify the entire plan i.e. even for participants without a subtrust. For those who believe that Fair’s position will prevail, Maurice R. Kassimir and Melvin L. Maisel’s “The ‘Revocable-Irrevocable’ Life Insurance Trust, The CPA Journal (September 1995) provides interesting planning flexibility.
Regarding the use of life insurance partnerships, several good discussions exist in the literature including Margaret W. Brown and S. Stacy Eastland’s, The Use of Partnerships in Planning for Life Insurance, Trusts & Estates, April 1995, and Richard L. Chaney and Linda S. Fogarty’s, Family Limited Partnerships, General American which includes documents for various word processors.
For second-to-die (survivorship policies), Bernard Weinberg and Robert C. Shadur advocate “The Survivorship Life Stand-By Trust: A New Planning Alternative” in Estate Planning, October 1996 which delays the need for an irrevocable life insurance trust until the death of the first spouse. They provide for a “survivor life stand-by trust” which can be revocably established by the spouse with the longer life expectancy. They feel that spouse can pay the premiums directly. Upon the death of the first spouse, the trust becomes irrevocable. Weinberg and Shadur raised an issue which they did not resolve. Can a spouse be a beneficiary of a trust that holds a survivorship policy on that spouse’s life? “If the spouse is a beneficiary of the trust, is she considered a beneficial owner of the insurance policy, and is this an incident of ownership that would cause inclusion of the insurance proceeds in the spouse’s estate under Section 2042?”
Weinberg and Shadur refer to PLR 9451053 where the surviving spouse had a right to receive net income of the trust after payment of policy premiums. The Service ruled that there would not be incidents of ownership.
Georgiana L. Slade’s Bureau of National Affairs portfolio Personal Life Insurance Trusts says “the spouse should probably not be a discretionary beneficiary of a trust that holds a second-to-die policy, even if the spouse is not the grantor, did not initially acquire the policy, and the discretionary power over the trust distributions is held by an independent trustee. It is uncertain as to whether the possibility of the spouse receiving the policy as a distribution qualifies as ‘an economic right’ to the policy or its proceeds or is a ‘reversionary interest’ of more than 5%, both of which are Section 2042(2) incidents of ownership.” She adds “whether the spouse may be designated as trustee, the treatment of a limited power held in a fiduciary capacity (e.g. a power as trustee to make discretionary distributions to decedents) is more complex than the language of the regulation suggests. As discussed at III, B, 1, b, above, the issue has been litigated many times with contradictory results.”
To temporarily mitigate the effect of three-year rule inclusion, Zaritsky and Leimberg in Tax Planning with Life Insurance mention the use of a “self-destructing trust clause” to qualify for the estate tax marital deduction. The drafting technique that they least favor is to a qualified terminal interest property (“QTIP”) trust. They are particularly concerned whether the executor will take the position to elect QTIP treatment or denote the election with a contingent QTIP election.
A practitioner should be aware that by avoiding a QTIP trust, the technique of having the surviving spouse purchase the remainder interest of the QTIP to effectively lower overall transfer taxes will be obviated. To benefit from this technique which will change the marital deduction from a transfer tax deferral to partial reduction technique, Richard B. Covey in The Marital Deduction: Planning & Drafting, National Law Foundation suggests not providing any invasion powers into the trust which would reduce the value of the remainder interest. Should the surviving spouse have adequate funds for health and maintenance, the clause would not have material value. Consideration should be given as to whether a gift tax return should be filed, possibly with a zero value gift, and whether Sec. 2702(a) creates a gift by the children to the wife, or Sec. 2519 creates a gift by the wife to the children.
Should the marital deduction option not be available, Zaritsky and Leimberg refer to Section 2206 which “authorizes the personal representative of an insured’s estate to recover from the beneficiary any incremental estate taxes attributable to the inclusion of the proceeds in the insured’s taxable estate.”
A gift of an experienced life insurance policy, irrespective of which type of entity the policy is transferred to, is to be valued as it would be for estate tax purposes under Reg. 20.2031-8. Per Reg. 25.2512-6(a), Example 4, the value is determined by adding an interpolated value between the terminal value at the beginning and end of the policy year to the policy’s terminal reserve at the beginning of the policy year. Example 3 of this regulation requires that the value of any loans against the policy be subtracted from and accrued dividends added to this value. Consideration of income tax consequences should be given prior to transfer of a policy to an irrevocable life insurance trust where the policy loan exceeds basis.
Calculation is done by the insurance company and reported on Form 712 (Life Insurance Statement) [see Appendix] which should be requested well prior to the due date of a gift tax return. Should the insured have become rated or uninsurable, a different valuation technique is required under Reg. 25.2512-6(a). Terminal illness is addressed in PLR 9127007. Should there be a concern that the insured’s health may turn bad within the three-year period, Estate of Silverman v. Commissioner, 61 TC 338 (1973), aff’d, 521 F2d 574, 75-2 USTC 13,084 (2d Cir. 1975), acq. 1978-1 CB 2, Estate of Friedberg v. Commissioner, 63 TCM 3080 (1992), Reg. 20.2042-1(a)(1), and PLR 9128008 may lead to the suggestion that a high premium relative to death benefit be paid by the transferee of the policy to reduce estate tax inclusion. Some refer to this concept as the “Silverman Doctrine.”
In Estate Planning Law and Taxation, David Westfall and George P. Mair make the point that the three-year rule may not apply to a seasoned policy if the policy was initially acquired by someone else or if the decedent had transferred ownership of a policy on the life of another person.
In determining the amount of the trust subject to a Crummey power (to be discussed) in the year of transfer, the amount shown on Form 712 needs to be added to contributions to the trust for premium payments for the rest of the year. Should a Crummey power be exercised, the trustee must have access to sufficient liquidity. A potential diminution of liquidity would be a policy dividend reinvestment provision.
PLRs have sanctioned use of Crummey powers even in situations where policies did not have cash value. Consideration of having the trustee hold payment of premiums until after the demand period, or drafting a provision to allow payment of a fractional interest in a policy, should be given where a private ruling will not be sought and liquidity is not available.
Reg. 20.2042-1(b)(1) establishes that if an irrevocable life insurance trust’s governing instrument instructs the trustee to pay the insured’s estate taxes, then the policy proceeds are receivable for the benefit of and included in the estate. Duncan v. U.S., 66-2 USTC 12,434, 368 F2d 98 (5th Cir. 1966) and Illinois National Bank of Springfield v. U.S., 91-1 USTC 60,062 (C.D. Ill. 1991) held that the requirement for the trustee to “apply all available funds and assets of the trust towards the payment of any premiums due on life insurance policies now or hereafter comprising any portion of trust corpus” is not a “substantial restriction” of the trustees discretion and would not be an incident of ownership.
In Estate of Headrick, 918 F2d 1263 (CA-6, 1990) , aff’g 93 TC 171 (1989), Estate of Leder, 893 F2d 237 (CA-10, 1989), aff’g 89 TC 235 (1989), Estate of Perry v. Commissioner, 927 F2d 209 (5th Cir. 1991), and now Action on Decision (“AOD”) 1991-012 allows an insured to discuss the purchase of life insurance with the trustee and to pay personally for the insurance without having inclusion in his gross estate. Based upon PLR 9113027, this presumes no incidents of ownership by the insured. Still, a conservative approach would be to have the trust establish a bank account to pay insurance premiums.
John M. Beehler’s “IRS Action Makes it Easier to Keep Proceeds Out of an Insured’s Estate, The Journal of Taxation, November 1991 does an excellent job in addressing AOD 1991-012. What can be seen as an issue subsequent to reading the article is whether, after an experienced policy is transferred to an irrevocable life insurance trust, the insured can directly pay the premiums. Practically, many insureds will pay the premiums out of the funds of a closely-held business’ account. Will noninclusion still prevail?
However, should the assumptions of Estate of Headrick, Leder, and Perry as well as AOD 1991-012 exist, the Internal Revenue Service’s “beamed transfer” position in Bel v. U.S., 452 F2d 683 (CA-5, 1971), will no longer be an issue. The position of the Internal Revenue Service had been, if an insured initiated the purchase of a life insurance policy and paid the premiums, then he was using the trust as his agent and therefore would be imputed incidents of ownership.
The question regarding whether a policy application being made by the insured rather than the trustee cause estate inclusion was addressed in PLR 9323002. Based upon state law, the insurance contract did not become effective until the first premium payment. Section 2035(d)(2)’s requirement for inclusion that the insured have incidents of ownership, which he subsequently transferred, were not met. Accordingly, there should be no estate inclusion.
PLRs 9348009 and 9511046 together appear to indicate that a corporation’s split-dollar interest in a life insurance policy meeting the requirements of Rev. Rul. 64-328 will not be imputed to the corporation’s majority shareholder. These rulings follow some uncertainty that was created under the historical development of Rev. Rul. 76-274 (especially Example 3), Rev. Rul. 79-129, Rev. Rul. 82-145, PLR 9204041, and Reg. 20.2042-1(c)(6).
Lawrence Brody and Lucinda Althauser provide an interesting discussion on this topic in “Transfer Tax Issues Relating to Split-Dollar Life Insurance in the April 1995 issue of Trusts & Estates. They note that after Rev. Rul. 82-145, two drafting positions were taken. Specifically, the controlled corporation’s interest was established as either a secured creditor with limited policy rights collaterally assigned or, being more conservative, as an unsecured creditor. They feel that recent Internal Revenue Service rulings have only confused the issue. For instance, they feel that the request that PLR 9348009 responded to, asked a much narrower question: would an election by a surviving spouse (who owned 50% of a corporation) cause any incidents of ownership. Regarding the three-year rule, they mention Rev. Rul. 90-21 which says that if a corporation owns a policy on the life of its controlling shareholder and the shareholder reduces voting interest below 50%, then the rule applies. [If a non-heir now controls the corporation, where will the funds to pay the estate tax come from? What if stock is contributed to a charity and then the corporation redeems the stock so that the family remains in control, what happens in valuing the charitable gift?]
In terms of drafting for split-dollar situations, Brody and Althauser write for “policies subject to a split-dollar arrangement [which] are owned by a trust, special drafting of the Crummey power is required, because unless the arrangement is contributory, there is no contribution to the trust on which the Crummey powers can work; in those cases, the Crummey power must be broad enough to allow withdrawals of direct contributions to the trust and amounts equal to any indirect gifts to the trust (i.e. the implicit gift which results when a policy is subject to a third party owner split-dollar arrangement).” [Their italics were removed]
Recently, PLR 9636033 permitted a private reverse family split-dollar arrangement with an irrevocable trust without potential estate tax inclusion. Also, PLR 9639053 allowed a split-dollar arrangement between an irrevocable life insurance trust and a business partnership.
While a family split-dollar arrangement with an irrevocable trust provides flexibility (since a spouse can borrow against the cash surrender value without the entire policy proceeds being included in either spouse’s gross estate), use of a lifetime QTIP trust in place of spousal involvement can provide even more benefits considering Examples 10 and 11 of Reg. 25.2523(f)-1(d). This new regulation allows an income interest to be retained by a husband after his wife’s earlier death to be taxable in his wife’s estate. However, Slade writes “whether the transfer of assets by a grantor to a trust is a completed gift where the grantor retains an interest in the trust will depend upon the enforceability of the grantor’s interest under applicable state law. For example, where the grantor is the income beneficiary of a trust, the Internal Revenue Service ruled that under applicable state (New York) law, the grantor’s creditors could reach the trust assets and, therefore, the gift was not complete.”
Returning to Crummey powers which were mentioned earlier, the concept allows a gift of what would otherwise be a future interest into a present interest which can qualify for the $ 10,000 per donor annual gift exclusion under Sec. 2503(b) and Reg. 25.2503-3(c). The case which established this technique was D. Clifford Crummey v. Commissioner, 397 F2d 82 (9th Cir. 1968)(22 AFTR2d 6023, 68-2 USTC 12,541), aff’g and rev’g TC Memo 1966-144 and accepted by the Internal Revenue Service in Rev. Rul. 73-405. The Crummey power is an absolute and inviolate demand power that will last for only a short period of time. A realistic possibility to exercise must be given to the power holder in order that a meaningful present interest be deemed to exist.
In PLRs 8813019, 8134135, 8103074, 8024084, 8006048, and 8004172, a thirty day demand period was considered acceptable. Rev. Rul. 81-7 rejected a three day demand period. Should a demand period overlap two years (e.g. a December 15, 1996 transfer was subject to a thirty day demand period), Rev. Rul. 83-108 allows a present interest for the year the transfer was made (in the example, for 1996 rather than 1997).
Notice of withdrawal right must be made known to the power holder. Technical Advice Memorandum (“TAM”) 9532001 considered notice a fundamental requirement. “Because the grandchildren lacked current notice that subsequent gifts were being transferred to the trust, they did not have the real and immediate benefit of those gifts.” For a minor beneficiary, Zaritsky and Leimberg recommend drafting in the trust agreement, per Perkins v. Commissioner, 27 TC 601 (1956), a parent or guardian be allowed to exercise the demand power. A minor’s legal inability to exercise a demand power was a problem in Naumoff v. Commissioner, 46 TCM 852 (1983).
For multiple Crummey power holders, a governing instrument provision should be made for the possibility that demand powers exceed available funds. In such a situation, Rev. Rul. 80-261 required demand apportionment.
The concept of “naked Crummey powers” was tested in Estate of Maria Cristofani v. Commissioner, 97 TC 5 (1991), acq’d in result only, where grandchildren had the ability to share in the demand power only if their parent did not survive their grandfather for 120 days. The proper test according to the Tax Court is whether power holders have a legal right (rather than a likelihood) to obtain benefits. TAM 9628004 declares that a nominal beneficiary’s “non-exercise indicates that there was some kind of prearranged understanding with the donor that these rights were not meant to be exercised or that their exercise would result in undesirable consequences, or both.” Owen G. Fiore and John F. Ramsbacher in “IRS Takes a Tougher Position on Crummey Trusts in New TAM,” Estate Planning, November 1996 properly state that “if the donor does not place restrictions on the gift (the withdrawal power), the donee’s action or inaction is irrelevant.” They proceed to advocate that practitioners do due diligence audits of existing Crummey trusts and suggest occasional exercise of withdrawal rights.
Per Sec. 2514(e), “[t]he lapse of a power of appointment created after October 21, 1942, during the life of the individual possessing the power shall be considered a release of such power. The rule of the preceding sentence shall apply with respect to the lapse of powers during any calendar year only to the extent that the property which could have been appointed by exercise of such lapsed powers exceeds in value the greater of the following amounts: (1) $5,000, or (2) 5 percent of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied.” Therefore, should one person have a Crummey power, the withdrawal right will be $ 5,000 until the transfer to the trust exceeds $ 100,000. A lapse of a Crummey demand power is therefore a release of a general power of appointment and a taxable gift to the trust. Should a beneficiary die with any trust power subject to a demand power, then the amount of the demand power is includible in the beneficiary’s gross estate under Sec. 2041. To mitigate inclusion, some draft a provision that in the year of death, the beneficiary must be alive on December 31 for the power to be effective.
For lapses exceeding the greater of $ 5,000 or 5% (“five and five rule”), Form 709 should indicate the trust as donee as well as the trust’s beneficiaries. Should a spouse allow a lapse in excess of the five and five rule, the unlimited gift tax marital deduction under Sec. 2523 should be available.
As an irrevocable life insurance trust’s existence continues over a number of years, yearly transfers in excess of the five and five rule can erode a beneficiary’s unified $600,000 transfer tax exemption. A technique known as a “hanging Crummey power” provides for the Crummey demand power to lapse only to the extent of the greater of $ 5,000 or 5% each year. Any excess is remains subject to an ongoing demand power to the extent of the greater of $ 5,000 or 5% of the trust funds each year. Upon cessation of contributions to the trust (for example, after a five year guaranteed premium period), or upon the trust fund (presumably trust corpus) exceeding $ 100,000, the hanging power amount will begin to decrease. For an excellent illustration, see Example 5-15 thru Example 5-18 in Zaritsky and Leimberg’s Tax Planning with Life Insurance
Slade mentions other techniques to deal with diminution of a beneficiary’s $ 600,000 lifetime transfer tax exclusion including a trust with a limited power of appointment (only one beneficiary who has a limited power of appointment), and a vested trust (only one beneficiary whose estate receives the trust property upon his death). Since there will only be one beneficiary, no gift is made upon the lapse of a Crummey power. She also mentions that the use of multiple trusts (a donor’s lapse in each trust would be within the five and five rule) appeared viable until Rev. Rul. 85-88 which looked to aggregate withdrawal powers of each donee. It is uncertain what may happen if the issue is litigated.
Jonathan G. Blattmachr and Georgiana J. Slade in “Life Insurance Trusts: How to Avoid Estate and GST Taxes,” Estate Planning, September/October 1995 develop the concept of a “cascading Crummey power” which provides that upon lapse of a demand power in excess of the five and five rule, a grandchild (a child of the power holder) has a right to demand the excess above the five and five amount. This gift by child to grandchild (1) will allow the child to claim a $ 10,000 annual exclusion, and (2) causes the child to become the transferor for generation skipping transfer purposes (to be discussed).
Generation skipping transfer tax planning opportunities regarding Crummey powers were offered by Robert J. Adler in “Beyond Leverage: Split-Dollar Funding of the GST-Exempt Trust,” Trusts & Estates, April 1996. Relying upon Internal Revenue Service pronouncements addressing split-dollar insurance (Rev. Rul. 64-328 and 78-420, as well as PLR 8003094), he states that “[a] strong technical argument can be made that, in the case of term insurance and in the limited context of split-dollar plans, a life insurance trust can remain exempt from generation skipping transfer tax without the need to allocate generation skipping transfer exemption to premium payments each year.” Adler adds “payment of premiums by the employer to the extent of the ‘current’ insurance protection [the lower of P.S. 58 costs or the insurer’s term rates], are deemed income to the employee and gifts from the employee to the trust or other third party insurance owner.” Should the insured die within the first policy year, (if still available) an after tax exemption allocation could be made to create a zero inclusion ratio. Since after the end of a policy year, prior employer-provided pure insurance coverage would have expired. Based upon the mechanics of Sec. 2642(d)(2)(B)(ii), the value of the inclusion ratio of the denominator is the value of current gifts plus the value of all property in the trust (now zero). Therefore, each year’s allocation would be the value of the P.S. 58 coverage.
Section 2642(c) provides that for an inclusion ratio to be zero for a direct skip [must have a skip person as beneficiary] which is a nontaxable gift “during the life of such individual [one skip person], no portion of the corpus or income of the trust may be distributed to (or for the benefit of [presumably including a general power of appointment]) any person other than such individual, and (B) if the trust does not terminate before the individual dies, the assets of such trust will be includible in the gross estate of such individual.”
Reg. 26.2601-1(b)(1)(ii)(C) provides that a fully funded irrevocable inter vivos insurance trust to which no additions or constructive additions are made after September 25, 1985 is not subject to the generation skipping transfer provisions contained in Chapter 13. A Chapter 11 or 12 taxable transfer, will be a constructive addition under Reg. 26.2601-1(b)(1)(i) that will cause a taint to this exception. The summary to PLR 9541029 implies that a lapse of a Crummey power in excess of the Sec. 2514(e) five and five rule, will be a constructive addition to the trust. As long as a non-general power of appointment does not postpone or suspend an interest in the trust in excess of the perpetuity period, Reg. 26.2601-1(b)(1)(B)(2) will not consider the trust subject to Chapter 13. To the extent that there are additions to the trust, the trust will be proportionately subject to Chapter 13. A method for calculation of the taxable portion of the trust is mandated in Reg. 26.2601-1(b)(1)(iv).
ADDITIONS TO IRREVOCABLE TRUSTS —
(A) IN GENERAL.
If an addition is made after September 25, 1985, to an irrevocable trust which is excluded from chapter 13 by reason of paragraph (b)(1) of this section, a pro rata portion of subsequent distributions from (and terminations of interests in property held in) the trust is subject to the provisions of chapter 13. If an addition is made, the trust is thereafter deemed to consist of two portions, a portion not subject to chapter 13 (the non-chapter 13 portion) and a portion subject to chapter 13 (the chapter 13 portion), each with a separate inclusion ratio (as defined in section 2642(a)). The non-chapter 13 portion represents the value of the assets of the trust as it existed on September 25, 1985. The applicable fraction (as defined in section 2642(a)(2)) for the non-chapter 13 portion is deemed to be 1 and the inclusion ratio for such portion is 0. The chapter 13 portion of the trust represents the value of all additions made to the trust after September 25, 1985. The inclusion ratio for the chapter 13 portion is determined under section 2642. This paragraph (b)(1)(iv)(A) requires separate portions of one trust only for purposes of determining inclusion ratios. For purposes of chapter 13, a constructive addition under paragraph (b)(1)(v) of this section is treated as an addition. See paragraph (b)(4) of this section for exceptions to the additions rule of this paragraph (b)(1)(iv). See section 26.2654-1(a)(2) for rules treating additions to a trust by an individual other than the initial transferor as a separate trust for purposes of chapter 13.
(B) TERMINATIONS OF INTERESTS IN AND DISTRIBUTIONS FROM TRUSTS.
Where a termination or distribution described in section 2612 occurs with respect to a trust to which an addition has been made, the portion of such termination or distribution allocable to the chapter 13 portion is determined by reference to the allocation fraction, as defined in paragraph (b)(1)(iv)(C) of this section. In the case of a termination described in section 2612(a) with respect to a trust, the portion of such termination that is subject to chapter 13 is the product of the allocation fraction and the value of the trust (to the extent of the terminated interest therein). In the case of a distribution described in section 2612(b) from a trust, the portion of such distribution that is subject to chapter 13 is the product of the allocation fraction and the value of the property distributed.
(C) ALLOCATION FRACTION —
(1) IN GENERAL.
The allocation fraction allocates appreciation and accumulated income between the chapter 13 and non-chapter 13 portions of a trust. The numerator of the allocation fraction is the amount of the addition (valued as of the date the addition is made), determined without regard to whether any part of the transfer is subject to tax under chapter 11 or chapter 12, but reduced by the amount of any Federal or state estate or gift tax imposed and subsequently paid by the recipient trust with respect to the addition. The denominator of the allocation fraction is the total value of the entire trust immediately after the addition. For purposes of this paragraph (b)(1)(iv)(C), the total value of the entire trust is the fair market value of the property held in trust (determined under the rules of section 2031), reduced by any amount attributable to or paid by the trust and attributable to the transfer to the trust that is similar to an amount that would be allowable as a deduction under section 2053 if the addition had occurred at the death of the transferor, and further reduced by the same amount that the numerator was reduced to reflect Federal or state estate or gift tax incurred by and subsequently paid by the recipient trust with respect to the addition. Where there is more than one addition to principal after September 25, 1985, the portion of the trust subject to chapter 13 after each such addition is determined pursuant to a revised fraction. In each case, the numerator of the revised fraction is the sum of the value of the chapter 13 portion of the trust immediately before the latest addition, and the amount of the latest addition. The denominator of the revised fraction is the total value of the entire trust immediately after the addition. If the transfer to the trust is a generation-skipping transfer, the numerator and denominator are reduced by the amount of the generation-skipping transfer tax, if any, that is imposed by chapter 13 on the transfer and actually recovered from the trust. The allocation fraction is rounded off to five decimal places (.00001).
The following examples illustrate the application of paragraph (b)(1)(iv) of this section. In each of the examples, assume that the recipient trust does not pay any Federal or state transfer tax by reason of the addition.
EXAMPLE 1. POST SEPTEMBER 25, 1985, ADDITION TO TRUST.
(I) On August 16, 1980, T established an irrevocable trust. Under the trust instrument, the trustee is required to distribute the entire income annually to T’s child, C, for life, then to T’s grandchild, GC, for life. Upon GC’s death, the remainder is to be paid to GC’s issue. On October 1, 1986, when the total value of the entire trust is $400,000, T transfers $100,000 to the trust. The allocation fraction is computed as follows:
|Value of addition||$100,000 (divided by)|
|Total value of trust||$400,000 + $100,000|
|Allocation fraction||= .20|
(ii) Thus, immediately after the transfer, 20 percent of the value of future generation-skipping transfers under the trust will be subject to chapter 13.
EXAMPLE 2. EFFECT OF EXPENSES.
Assume the same facts as in Example 1, except immediately prior to the transfer on October 1, 1986, the fair market value of the individual assets in the trust totaled $400,000. Also, assume that the trust had accrued and unpaid debts, expenses, and taxes totaling $300,000. Assume further that the entire $300,000 represented amounts that would be deductible under section 2053 if the trust were includible in the transferor’s gross estate. The numerator of the allocation fraction is $100,000 and the denominator of the allocation fraction is $200,000 (($400,000 – $300,000) + $100,000). Thus, the allocation fraction is .5 ($100,000/$200,000) and 50 percent of the value of future generation-skipping transfers will be subject to chapter 13.
EXAMPLE 3. MULTIPLE ADDITIONS.
(I) Assume the same facts as in Example 1, except on January 30, 1988, when the total value of the entire trust is $600,000, T transfers an additional $40,000 to the trust. Before the transfer, the value of the portion of the trust that was attributable to the prior addition was $120,000 ($600,000 x .2). The new allocation fraction is computed as follows:
|Total value of additions||$120,000 + $40,000||= $160,000|
|Total value of trust||$600,000 + $40,000||=$640,000|
|New allocation fraction||=.25|
(ii) Thus, immediately after the transfer, 25 percent of the value of future generation-skipping transfers under the trust will be subject to chapter 13.
EXAMPLE 4. ALLOCATION FRACTION AT TIME OF GENERATION – SKIPPING TRANSFER.
Assume the same facts as in Example 3, except on March 1, 1989, when the value of the trust is $800,000, C dies. A generation-skipping transfer occurs at C’s death because of the termination of C’s life estate. Therefore, $200,000 ($800,000 x .25) is subject to tax under chapter 13.
A key to understanding the impact of the generation skipping transfer tax regarding irrevocable life insurance trusts is the concept delineated in the examples contained in Reg. 26.2652-1(a)(6) that a transfer to a trust subject to a beneficiary’s right of withdrawal is treated as a transfer to the trust rather to the beneficiary. This position is the opposite of the Internal Revenue Service’s former position in TAM 8901004 that the transfer would be to the skip person rather than the trust.
For a transfer to an irrevocable life insurance trust, where some but not all of the beneficiaries are skip persons, the transfer is not a direct skip; the trust is not a skip person. Per Sec. 2612(a) and (b), a skip occurs upon a taxable distribution to a skip person or upon a taxable termination. Under Sec. 2623, a tax-inclusive rather than a tax-exclusive calculation per Sec. 2642(a) for a direct skip is needed.
Imposition of the generation skipping transfer tax is upon the transferor for a direct skip, the transferee for a taxable distribution, and the trustee for a taxable termination per Sec. 2603 subsections (a)(3), (a)(1), and (a)(2) respectively. Income tax deductions may be available for direct skips and taxable terminations under Sec. 691(c)(3) and taxable distributions based on Sec. 164(a)(4). While direct skips are reported by the transferor or his representative on a gift or estate tax return, taxable distributions are reported on Form 706GS(D) with trustee prepared Form 706GS(D-1) attached and taxable terminations are shown on Form 706GS(T). Sec. 2654(a)(1) allows a basis adjustment for the amount that fair market value exceeds the basis prior to the adjustment (including a Sec. 1015 basis adjustment).
Since Sec. 2642(c)(1) only allows a $ 10,000 annual exclusion for direct skips, the mechanics of allocation of the $ 1,000,000 lifetime generation skipping transfer tax lifetime exclusion (Sec. 2631(a) to a non-skip person trust become extremely important.
Furthermore Sec. 2642(c)(2)’s rule that no portion of the trust (whether corpus or income) be used for the benefit of any person other than the skip person, Reg. 26.2612-1(e)(2)(i) dealing with interests in trust provides that a fiduciary’s discretion or action pursuant to state law to satisfy the skip person’s parent’s support obligation will not mean that a non-skip person has an interest in the trust.
Sec. 2632(b) provides that a direct skip inter vivos transfer is automatically allocated generation skipping transfer tax exemption unless the transferor affirmatively elects out. A transfer that is not a direct skip must be allocated exemption on the transferor’s gift tax return per Sec. 2642(b)(1). Such allocation is revocable until the return’s due date. Accordingly, a late filed return’s allocation is irrevocable.
Since pure life insurance (separate from any investment portion in a whole, variable, or universal policy) expires on an annual basis, when to allocate generation skipping transfer tax exemption is subject to planning. Should the insured survive the year, a late allocation may be preferable. Due to the high administrative costs in the early years of a non-term policy, the fair market value of the policy (assuming no adverse health) will remain close to zero. Since Reg. 26.2632-1(b)(2)(ii)(A)(1) allocates exemption on a late filed return based upon the property’s fair market value on the deemed filing date, leverage of the lifetime exemption is available.
A wait and see position can delay decision regarding allocation until the gift tax return is filed on April 15 of the year following the transfer. Furthermore, the gift tax return can be extended until October 15. Should allocation not be made on a timely filed return, death or faltering health of the insured will adversely effect the leveraging of the exemption. Upon death of the insured, Reg. 26.2642-2(b)(1) will require allocation of exemption against the policy proceeds.
Should an experienced policy be transferred to an irrevocable life insurance trust, the amount of generation skipping transfer exemption needed to protect the trust on a timely filed gift tax return is the gift tax value previously discussed. For a late filed gift tax return, the value is the policy’s fair market value at time of allocation.
A question as to whether a parent who allows a Crummey power to lapse in excess of the five and five rule will become a transferor for generation skipping transfer purposes exists. [Please refer back to Blattmachr and Slade’s cascading Crummey power.] A second concern exists in a situation where a child of the insured predeceases his parent during the trust period and the child’s issue steps into the place of the child as a trust beneficiary. The Sec. 2612(c)(2) predeceased child exception only applies to direct skips after the child dies. The section specifically states that if “as of the time of the transfer, the parent of such individual who is a lineal descendant of the transferor (or the transferor’s spouse or former spouse) is dead, such individual shall be treated as if such individual were a child of the transferor and all of that grandchild’s children shall be treated as if they were grandchildren of the transferor.” A planning possibility in this scenario is to have the child’s interest pass to his estate. A second concept is to create separate trusts as permitted in First Agricultural Bank v. Coxe, 406 Massachusetts 879, 550 NE2d 875 (1990).
Since an irrevocable life insurance trust creates a need for Crummey withdrawal powers, the complexities of the grantor trust rules is required. Except for funded trusts (other assets besides insurance being in the trust and for which income tax returns may be required), the main importance of the grantor trust rules is after the insured’s death.
Under the grantor trust rules delineated in Sections 671-678 of the Internal Revenue Code, the grantor or sometimes a third party is considered the “owner” of a portion or all of the income and principal of a trust. The intent of Congress was to halt tax abuse by shifting income from high tax bracket grantors to low tax bracket beneficiaries. Compression of tax brackets have lessened the “issue” that Congress intended to correct.
The grantor trust rules create a dichotomy between the legal relationship between grantor and trust compared with income tax consequences where the trust may be wholly or partly considered as not existing as a separate entity. To the extent that the grantor is considered the owner of the trust, he is required to include in his income tax return all items of income, deduction, and credit (including capital gain).
Where a trust is a partial grantor trust or more than one person is considered an owner of the trust, reasonable apportionment must be made. For undivided fractional shares, a pro rata share of each item must be allocated. An example of a complication that can occur if a trust is not completely a grantor trust can be seen in Treas. Reg. 1.1361-1(k)(1) which permits a grantor QTIP trust to be a shareholder of an S corporation in item (i) but not in (ii) and (iii) where the trust is a partial grantor trust. Item (ii) in the regulations is correctable with a qualified subchapter S trust (“QSST”) election within 2 months and 15 days of the divorce that in the particular caused a grantor trust to become a partial grantor trust.
Generally, the trustees of a grantor trust must file Form 1041. However, the Form 1041 does not have to include any part taxable to a grantor. Rather, a statement is attached to the return indicating the name and information regarding the grantor as well as items taxable to him. Item A of Form 1041 should have the box for grantor type trust checked as well as have a statement citing and explaining application of Reg. 1.671-4. Should a trust be a partial grantor trust and partial complex trust, both boxes should be checked on Item A.
Ronald D. Aucutt has an excellent summary of “The New Grantor Trust Reporting Regulations” in the August 1996 edition of ALI-ABA Estate Planning Course Materials Journal. He raises an interesting question as to whether an owner of trust income but not corpus can use one of the two new methods: transparent or reporter. Based upon his reasoning and the analysis of trust ownership for Crummey trusts, it is questionable whether the new methods will be applicable for irrevocable life insurance trusts.
If a person is both grantor and trustee for the entire year and is treated as owner of all assets for the taxable year, then per Reg. 1.671-4(b)(1), Form 1041 is not required. Also, a separate employer identification number is not needed. Rather, all items are simply reported on the grantor’s Form 1040.
Under Section 677, grantors are taxable to the extent that trust income is used to discharge their or their spouse’s legal liability. A funded irrevocable life insurance trust that uses investment earnings to pay life insurance premiums had the dividends taxed to the grantor in Wadewitz Estate v. Commissioner, 32 T.C. 538 (1959). See also Weil v. Commissioner, 3 TC 679 (1944), acq. Rev. Rul. 66-313 which stated that a beneficiary’s written instructions to the trustee to use trust income to pay premiums creates a grantor trust. Sec. 677(a)(3) added that a trust’s payment of insurance premiums on the life of the grantor’s spouse is taxable to the grantor. Regarding this and related matters, Margaret Conway provides an excellent analysis of G.F. Moore, 39 BTA 808, Dec. 10, 672 (acq.), Corning v. Commissioner, 104 F2d 329 (6th Cir. 1939), Rand v. Helvering, 116 F2d 929 (8th Cir. 1941), Conner v. Gagne, 42 F. Supp. 231 (D. N.H. 1941), Iverson v. Commissioner, 3 TC 756 (1944), Rand v. Commissioner, 40 BTA 233 (1939), and Meyers v. Commissioner 3 TCM 468 (1941) in “Life Insurance Trusts” in the September 1994 issue of The CPA Journal
Section 678 established that a person other than the grantor who has a power (right not actual distribution is key per Koffman v. U.S. 300 F.2d 176) exercisable solely by himself to vest corpus or income of any portion of a trust in himself is considered the owner of that portion. Should he partially release or modify the power but retain control, so that if he were the grantor he would be considered the owner, then he (the power holder) will be treated as the owner. Rev. Rul. 81-6 applies this rule even if the person is a minor where state law requires appointment of a legal guardian. PLRs 9034004, 9226037 and 9335028 stated that upon lapse, if in the discretion of a nonadverse party income can be distributed to the person who allowed the lapse, the person who allowed the lapse will still be considered the owner.
Rev. Rul. 67-241 held that Crummey withdrawal rights make the beneficiaries taxable as owners of both their income and corpus portion of the trust. Abbin, et. al., Income Taxation of Fiduciaries and Beneficiaries, relying upon Sec. 2514 and 2041 believe that Sec. 678(a) requires an accumulative method to determine how much of a trust is subject to grantor trust treatment. This implies that a trust needs books and records. For $ 10,000 annual drawdown powers, they believe the calculation is made by dividing the aggregate drawdown opportunity (number of years times $ 10,000) by the fair market value of the trust at the end of the drawdown period. However, they admit that there is no specific guidance from the Service and that various commentators have opined for other treatment.
Zaritsky and Leimberg argue in Tax Planning with Life Insurance that “proper allocation of Section 678 should be based on both the percentage of the trust that the beneficiary could withdraw and the length of the demand right.” In doing so, they reference Reg. 1.671-3 and Krause v. Commissioner, 56 TC 1242 (1971). They note that Early’s article (which they agree with) “Income Taxation of Lapsed Powers of Withdrawal: Analysing Their Current Status,” in 62 Journal of Taxation 148 (1985) “suggests that the release referred to in Section 678(a)(2) must be an affirmative act and not a mere passive lapse.”
Zaritsky and Leimberg state that “Section 678(b) says that if the grantor holds a power under Sections 673 thru 677 and the beneficiary holds a Section 678 power over the income, the beneficiary’s power is disregarded, and the grantor is taxed as the owner of the trust income.” They further note that “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 over the trust’s principal, the most logical view would be to treat them as co-owners of the trust, with each of them taxable on a proportionate share of the items of income, deduction, gain, and loss allocated to trust principal.
David Westfall and George P. Mair in Estate Planning Law and Taxation mention that Simmons, “Drafting the Crummey Power,” 15 University of Miami Institute on Estate Planning 1701, 1713.4 (1981), Huff, “The ‘Five and Five’ Power and Lapsed Powers of Withdrawal,” ibid. 701, 706.2, and Mason, “An Analysis of Crummey and the Annual Exclusion,” 65 Marquette Law Review 573, 587 (1982) agree with Early’s position. They also mention the narrower view of J. Peschel and E. Spurgeon in Federal Taxation of Trusts, Grantors and Beneficiaries that Section 678 “is inapplicable to the lapse of a noncumulative, amount-limited power, such as the 5 and 5 power.” They then group these two opinions together as the “noncumulativists” as opposed to the “cumulativists” which could be viewed as the opinion of Abbin, et. al. cited above.
Westfall and Mair note that PLRs 8142061 (after analysis), 8521060, 8613054, 8707001, 8805032, 8809043, 9311021, and Mallinckrodt v. Nunan, 146 F2d 1, 45-1 USTC 9134 (8th Circuit 1945), cert. denied, 324 US 871 (1945) [sometimes now called “Mallinckrodt powers”] can be seen as support for the cumulativists and Ruth M. Oppenheimer, TC 515 (1951) is of limited support to the noncumulativists. Sprunt, et. al., Practitioners 1041 Deskbook, read PLRs 8142061 and 8809043 to make the Crummey power holders the owner of the trust for the period of the withdrawal power.
The above referenced Rev. Rul. 67-241 discussed being an owner of income and corpus of a trust. Reg. 1.671-3 discusses attribution should there be a grantor trust for just income or corpus portions of the trust. Section (C) of the regulation includes an interesting discussion of expense allocation. “If only income allocable to corpus is included in computing a grantor’s tax liability, he will take into account in that computation only those items of income, deductions, and credit which would not be included under Subparts A through D in the computation of the tax liability of the current income beneficiaries if all distributable net income had actually been distributed to those beneficiaries. On the other hand, if the grantor or another person is treated as an owner solely because of his interest in or power over ordinary income alone, he will take into account in computing his tax liability those items which would be included in computing the tax liability of a current income beneficiary, including expenses allocable to corpus which enter into the computation of distributable net income. If the grantor or other person is treated as an owner because of his power over or right to a dollar amount of ordinary income, he will first take into account a portion of those items of income and expense entering into the computation of ordinary income under the trust instrument or local law sufficient to produce income of the dollar amount required. There will then be attributable to him a pro rata portion of other items entering into the computation of distributable net income under Subparts A through D, such as expenses allocable to corpus, and a pro rata portion of credits of the trust. For examples of computations under this paragraph, see paragraph (g) of section 1.677(a)-1.”
While the establishment of an irrevocable life insurance trust should be done without the preconceived notion that the insured will borrow money, at times down the road, access to cash becomes a necessity. While a family split-dollar arrangement (trust owns the insurance and the insured’s wife owns the cash surrender value of the policy – see PLR 9636033 for one approach) may allow a couple access to cash surrender value without insurance inclusion in the insured’s estate. At times, especially when considering a second-to-die policy, this option is not available. Should borrowing from the trust be required, then a note with proper collateral 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 his fiduciary responsibility to the trust’s beneficiaries.
Englebrecht, et. al.’s excellent article “Grantors Should Beware When Borrowing From a Trust” in the October 1996 issue of Trusts & Estates discusses the income tax implications of a direct or indirect loan of income or corpus not being completely repaid by the beginning of a taxable year. They cite Perrett v. Commissioner, 74 TC 111 as an indication that loans without a genuine debtor-creditor relationship will be seen as lacking economic substance. One can consider the article’s implications, both during the life of the insured and after his death. However, normally the trust will either loan money to the estate or purchase assets from the estate.
They end by discussing Estate of Wall, 101 TC 300 and the Service’s subsequent issuance of Rev. Rul. 95-5835 which revoked Rev. Rul. 79-353. This introduced the new flexibility available with irrevocable life insurance trusts.
Two interesting articles on creating flexibilty with irrevocable life insurance trusts are “Selection of Trustees: Tax and Other Issues, Including Sample Provisions” by Jonathan G. Blattmachr, Georgiana J.Slade and Madeline J. Rivlin in The Chase Review and “The Flexible Irrevocable Trust” by Stephen M. Margolin and Andrew M. Curtis in the January 1996 issue of the Journal of the American Society of CLU & ChFC
Since Blattmachr, et. al. were uncertain regarding the Internal Revenue Service’s opinion after the Wall decision as well as creditor rights of a beneficiary, they advocate the use of a “trust protector” more commonly seen with offshore trusts. The trust protector could name a successor trustee. They reference PLR 9332006 as support for this concept. They continue by saying that the key is the separation of the powers to remove and appoint a trustee. They feel that it would be “safe” to allow the trust protector to remove the old trustee and the beneficiaries to appoint a replacement, or vice versa without incidents of ownership. They conclude with a sample draft for a trust protector provision.
Margolin and Curtis discuss making the insured’s spouse a trust beneficiary upon divorce, allow the insured to remove a beneficiary while guaranteeing a sufficient number of donees, allowing the trustee to reduce the amount subject to a Crummey power, and allowing the trustee to terminate the trust. For an inflexible trust (depending upon the fact pattern), they discuss having the insured purchase the insurance policy from the trust and then selling it to a new trust for which he, the insured, will be considered the owner under the grantor trust provisions.
Among the less technical requirements of an irrevocable life insurance trust are sending out annual Crummey power notices, obtaining an employer identification number, determination of fiduciary accounting and calculation of trustee commissions.
Reg. 301.6109-1(a)(2) states “[i]f a trust does not have a taxpayer identification number and the trustee furnishes the name and taxpayer identification number of the grantor or other person treated as the owner of the trust and the address of the trust to all payors pursuant to section 1.671-4(b)(2)(i)(A) of this chapter, the trustee need not obtain a taxpayer identification number for the trust until either the first taxable year of the trust in which all of the trust is no longer owned by the grantor or another person, or until the first taxable year of the trust for which the trustee no longer reports pursuant to section 1.671-4(b)(2)(i)(A) of this chapter. If the trustee has not already obtained a taxpayer identification number for the trust, the trustee must obtain a taxpayer identification number for the trust as provided in paragraph (d)(2) of this section in order to report pursuant to section 1.671-4(a), (b)(2)(i)(B), or (b)(3)(i) of this chapter.” Due to the complexities of the grantor trust rules that are still subject to professional discussion, it appears that a trustee should submit Form SS-4 and obtain an employer identification number.
Many of the previously discussed issues bifurcated an irrevocable life insurance trust between principal and income. To the extent that the trust is not classified as a grantor trust, it will be a complex trust for which page two of Form 1041 requires a figure for accounting income. Therefore, a fiduciary accounting (or at least a yearly accounting income calculation) may be appropriate.
For certified public accountants, a professional issue is whether SSARS No. 1 applies. It seems that the American Institute of Certified Public Accountants has taken the position that preparation of a fiduciary accounting is the practice of public accounting and therefore an accountant’s letter is required.
Trustees of a life insurance trust are entitled to receive a commission. Sec. 2039 of New York’s Surrogate Court Procedures Act provides the trustee with one percent of all sums of money paid out to be allocated from trust corpus. Additionally, annual commissions of $ 10.50 per $ 1,000 of the first $ 400,000 of principal, $ 4.50 per $ 1,000 of the next $ 600,000, and for the remaining principal, $ 3.00 per $ 1,000. The annual commissions are to be allocated one-third from income and two-thirds from principal.
While not all of the issues were addressed, it is a hoped that this article provides a practitioner with a summary of the many interrelated issues that must be considered upon recommending and then instituting an irrevocable life insurance trust.
© 1996, LAWRENCE M. LIPOFF
CERTIFIED PUBLIC ACCOUNTANT
CERTIFIED EMPLOYEE BENEFITS SPECIALIST
PRINCIPAL, LIPOFF AND COMPANY, C.P.A., P.C.
Co-Chair of the New York State Society of Certified Public Accountants’ 1997 Estate Administration Conference
Immediate Past President and Trustee of the Tax and Estate Planning Council of Rockland County
Member of the Estate Planning Committee of the New York State Society of Certified Public Accountants
Member of the Income of Estates and Trusts Committee of the New York State Society of Certified Public Accountants
Member of the Estate Planning Committee of the Westchester Chapter of the New York State Society of Certified Public Accountants
Member of the Marital Accounting Committee of the New Jersey Society of Certified Public Accountants
Member o f the Estate Planning Study Group of the United Jewish Appeal
Instructor for Farleigh Dickinson University for the Certified Employee Benefits Specialist program
Estate Planning for Divorcing and Remarrying Individuals, Irrevocable Life Insurance Trusts, Pension Distribution Planning, Income in Respect of a Decedent, Business Succession Planning, Selected Form 1041 Issues, Alternative Minimum Tax, Insolvency Taxation, S Corporation Taxation, Analysis of Income Tax Returns for Attorneys, Analysis of Income Tax Returns for Bankers, Alternative Minimum Taxes and Interplay with Financial Statements for Bankers, State Tax Update, Improving Cash Flow, Individual Tax Return Preparation.
Article and Memorandum Topics:
Irrevocable Life Insurance Trusts, Term Insurance and the “Three-Year Rule,” Medicaid versus Prenuptial Planning, Defective Grantor Retained Annuity Trusts, Is a “Simple” Trust Always “Simple”?, “Phantom Income” Created for Trusts, Business Succession Planning, Phantom Stock Arrangements, Tax Aspects of S Corporation Stock Transactions, Validity in Estate Planning of Multiple Valuations for Singular Closely-Held Businesses, Income in Respect of a Decedent, Pension Distribution Planning, QTIPs as Pension Distribution Designated Beneficiary, Spousal Waiver Requirements for Pension Plans, Excludable Gifts in Excess of $10,000 Per Year, Corporate Acquisitions via Employee Stock Ownership Trusts, Insolvency Taxation, Interest Deductions, Alternative Minimum Tax, and Corporate Charitable Deductions and the New York State Net Operating Loss.
Thanks to Larry Lipoff for allowing me to reproduce his seminar handout.