THE 14 MYTHS OF LIFE INSURANCE PLANNING

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1 THE 14 MYTHS OF LIFE INSURANCE PLANNING (ADVANCED ESTATE PLANNING ISSUES WITH LIFE INSURANCE) Presented To: Centennial Estate Planning Council November 13, 2008 L. WILLIAM SCHMIDT, JR. Of counsel th Street, Suite 3200 Denver, CO Phone (303)

2 TABLE OF CONTENTS I. MYTH 1: LIFE IN INSURANCE IS A BAD AINVESTMENT@ 1 A. An Ideal Wealth Transfer Strategy B. But, Is Life Insurance a Good AInvestment@? C. Selection of the Appropriate Policy II. III. MYTH 2: MY SPOUSE AND I CAN CREATE TAX-FREE LIFE INSURANCE TRUSTS FOR EACH OTHER 2 A. The Reciprocal Trust Doctrine B. The Estate Tax Problem C. Solutions to the Problem MYTH 3: THERE IS NO WAY TO TRANSFER AN EXISTING POLICY WITHOUT ADVERSE TAX CONSEQUENCES (THE 3-YEAR RULE FOR ESTATE TAXATION) 3 A. Internal Revenue Code '2035(a) B. Problem 1: Gifting Existing Policies C. Problem 2: Transactions Out of Proper Sequence (The Problem of the Hungry Insurance Agent D. Avoiding the Problem (Sale by Insured to Trust) E. The Barrier of the Transfer for Value Rule IV. MYTH 4: AN ORAL LIFE INSURANCE TRUST IS INVALID 5 A. Applicability of Oral Trusts to Life Insurance Planning B. Implementing the Technique C. Validity of Oral Trusts V. MYTH 5: YOU CAN=T REMOVE A POLICY FROM AN ILIT 6 A. The Problem B. Create a New ILIT Funded With a New Policy C. Appoint a Special Power Holder D. Distribution Directly to a New Trust E. Termination by Consent F. Sale of Policy From Trust A to Trust B G. Sale to the Grantor/Insured VI. VII. MYTH 6: PREMIUM PAYMENTS ON AN ILIT-OWNED POLICY MUST BE MADE BY THE TRUSTEE FROM A SEPARATE TRUST ACCOUNT 8 A. Payment of Premiums B. The Issue: Qualification for Gift Tax Present Interest MYTH 7: WRITTEN CRUMMEY NOTICES MUST BE GIVEN ANNUALLY TO EACH BENEFICIARY 10 A. Why Notice? B. Basic Requirements

3 C. Actual Notice D. Notice to Minor Beneficiaries E. Timing of Demand Rights VIII. MYTH 8: I CAN CREATE UNLIMITED CRUMMEY POWERS 12 A. Present vs. Future Interest B. Converting to a Present Interest ( Thank You Dr. Crummey) C. Contingent Beneficiaries (Can I Give My Mother-in-Law a Crummey Power?) IX. MYTH 9: THE MAXIMUM GIFT TAX ANNUAL EXCLUSION IS AVAILABLE FOR ALL MY CRUMMEY BENEFICIARIES (LAPSING POWERS) 12 A. The Issue B. Limit Withdrawals to %5,000 or 5% X. MYTH 10: DRAFTING A GENERATION-SKIPPING ILIT IS A PIECE OF CAKE. 16 A. The GST Annual Exclusion B. Danger of Beneficiary Becoming the ATransferor@ C. Late Allocation of GST Exemption D. Deemed Allocation for Lifetime Transfers E. The Spousal ETIP Problem XI. MYTH 11: AN ILIT CANNOT DIRECTLY PAY THE INSURED=S ESTATE TAX LIABILITY OR BE PAYABLE TO THE INSURED=S ESTATE. 18 A. Authority to Pay Insured=s Estate Taxes B. Contingent Marital Deduction or Distribute to Estate XII. MYTH 12: AN ILIT IS INFLEXIBLE 19 A. Give Beneficiary Power to Remove Trustee B. Removal of Trustee by the Settlor C. Give Beneficiaries Testamentary Limited Power of Appointment D. Donor=s Power to Alter Crummey Withdrawal Rights XIII. MYTH 13: THERE IS NO WAY TO AVOID PREMIUM GIFTS (PREMIUM FINANCING) 20 A. Technique B. The Advantages C. The Disadvantages XIV. MYTH 14: I CAN AVOID LAWYERS BY HAVING MY SON OWN THE POLICY Appendix A Appendix B Appendix C Appendix D Appendix E Internal Rate of Return Analysis PLR B Reciprocal Trusts PLR B Transfer for Value Rule Oral Trust Agreement PLR B Sale of Policy from Trust A to Trust B B No Transfer for Value

4 Appendix F Appendix G Appendix H Appendix I Appendix J PLR B Direct Payment of Premium PLR B Single Continuing Crummey Notice PLR B Notice to Minor Crummey Beneficiary PLR B Lapsed Crummey Right Subject to Power of Appointment PLR B Payment of Insured=s Estate Tax by ILIT

5 THE 14 MYTHS OF LIFE INSURANCE PLANNING (ADVANCED ESTATE PLANNING ISSUES WITH LIFE INSURANCE) L. William Schmidt, Jr., Esq. Schmidt, Horen & Lockwood LLP Denver, CO I. MYTH 1: LIFE INSURANCE IS A BAD AINVESTMENT@ A. An Ideal Wealth Transfer Strategy. Most tax-oriented estate planning emphasizes freezing the value of the estate and discounting the taxable transfer value of assets. Life insurance is one of the best assets to use for such purposes because (1) the value of premiums is small compared to the death benefit, (2) the gift tax value of the premium is often negligible or nothing, (3) the value of the death benefit being transferred can be removed from the taxable estate, (4) the generation-skipping transfer tax can be avoided in most cases, (5) the death benefit will be exempt from creditors of the decedent, and (6) the transferor will keep control over the bulk of his or her assets during lifetime. B. But, Is Life Insurance a Good AInvestment@? No one really likes the idea of life insurance. One of the biggest arguments used to avoid consideration of life insurance is something like this, AIf I put the same amount as the premium in an irrevocable trust and invest it over my lifetime, I will end up with more money than by putting the same amount of money in life insurance. Life insurance is a lousy investment.@ This argument has its basis in three faulty assumptions. First, it assumes the client will live to life expectancy. Second, it assumes the client will be committed to making the investment each year. Third, it assumes the client will really outperform the life insurance company. Statistical studies have demonstrated the difficulty of this assumption. Appendix A shows an analysis of the rate of return on the premiums for a Survivorship Policy on a husband and wife both age 50. Death in the early years of the policy obviously shows an enormous internal rate of return on invested premium capital. However, even if one of the insureds lives to age 100, the internal rate of return is still a respectable 4.29%. C. Selection of the Appropriate Policy. The usefulness of life insurance in an estate plan is only as appropriate as the safety of the policy and the

6 insurance company backing up the promise of a death benefit. You want the life insurance policy to live longer than your client. Initially, recommend only policies issued by the strongest insurance companies. A good starting point is reference to The Insurance Forum published by Joseph Belth which publishes an annual rating of all North American insurance companies (P.O. Box 245, Ellettsvillle, Indiana 47429). Included are financial strength ratings by A.M. Best, Fitch Ratings, Moody=s Investor Service, and Standard & Poor=s. Periodically obtaining an in-force ledger from the insurance company will alert you to significant variances between the projected longevity of the policy using the insurance company=s current crediting rate and the policy guarantees. An excellent source for information on how to analyze an insurance policy is the monograph, ALife Insurance Due Care (Carriers, Products and Illustrations)@ published by the Real Property, Probate and Trust Law Section of the American Bar Association. II. MYTH 2: MY SPOUSE AND I CAN CREATE TAX-FREE LIFE INSURANCE TRUSTS FOR EACH OTHER A. The Reciprocal Trust Doctrine. This issue arises where husband and wife (or even unrelated persons) each create an ILIT at approximately the same time with essentially the same provisions naming each other as the primary beneficiary of the other=s trust. The doctrine was first enunciated in United States v. Grace, 395 US 316 (1969) in which the Supreme Court said the reciprocal trust doctrine applies when trusts are interrelated and the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries. B. The Estate Tax Problem. Under IRC '2036, the value of the surviving settlor=s trust will be included in the estate of the first of the settlors to die. Since the deceased spouse is treated as having never given up any economic interest in the policy on his or her life, the retained life interest of the surviving spouse is imputed to the decedent. Therefore, all assets of the deceased insured (held by the ILIT created by the surviving spouse) are included in the estate of the deceased spouse. C. Solutions to the Problem. This seem to be a simple answer. Simply create trusts that have different provisions. For example, one trust may give the surviving spouse mandatory distributions of income only, and the other trust will give the surviving spouse discretionary rights to both income and principal for needs based upon the trustee=s judgment. Another option would be for one trust to give the spouse/beneficiary a special testamentary power of appointment while the other trust omits such a power. The more and greater the differences in the beneficial interests of the spouses, the lesser the possibility of violating the reciprocal trust doctrine. (Appendix B B PLR 2

7 ) III. MYTH 3: THERE IS NO WAY TO TRANSFER AN EXISTING POLICY WITHOUT ADVERSE TAX CONSEQUENCES (THE 3-YEAR RULE FOR ESTATE TAXATION) A. Internal Revenue Code '2035(a). The general rule for inclusion of life insurance proceeds in the estate of the insured applies only if the proceeds are either (1) payable to the insured=s executor, or (2) the insured retained incidents of ownership in the policy. However, although the old universal rule regarding transfers within 3 years of death no longer apply, Section 2035(a) does bring back into the estate certain lifetime transfers, including life insurance. B. Problem 1: Gifting Existing Policies. Often, the client will already own an older life insurance policy at the time of the initial estate planning consultation. Or the policy may have been transferred to the insured=s spouse at a time before the enactment of the unlimited marital deduction when such ownership was often recommended. Without proper planning, gifting the policy to an irrevocable life insurance trust within 3 years of death will be ineffective to remove the death benefit from the taxable estate. C. Problem 2: Transactions Out of Proper Sequence (The Problem of the Hungry Insurance Agent). In a recent unreported litigated case, the insurance agent had the insured complete the insurance application naming an ILIT as the owner and beneficiary. However, the attorney had not yet completed the trust agreement. Subsequently, the policy was reissued in the name of the ILIT. The insured died 2 years and 11 months later. Guess who paid the estate tax? D. Avoiding the Problem (Sale by Insured to Trust). The insured sells the policy to the ILIT. Structured properly, this will remove the death benefit from the insured=s estate, even if the insured dies within three years of the sale. E. The Barrier of the Transfer for Value Rule. The problem is to avoid the ugly Atransfer for value rule@ which states that life insurance proceeds, normally exempt from income taxation under IRC ' 101(a)(1), will not be exempt to the extent the life insurance contract or any part thereof is Atransferred for a valuable consideration.@ 1. Sale Safe Harbor. IRC '101(a)(2) provides six safe harbors from the transfer for value rule. The one which is most important to ILIT planning provides that the rule does not apply where the sale is Ato the insured.@ This exception extends to the sale to a Agrantor trust@ which is considered the alter ego of the insured for income tax purposes. PLR , PLR , PLR , and 3

8 PLR (See Appendix C.) However, for the exception to apply, the policy must be sold for full and adequate consideration. The interpolated terminal reserve value of the policy (typically the replacement value reflected on the Form 712 issued by the insurance company) represents full and adequate consideration. PLANNING CAUTION: With the increased sales of insurance policies to investors and the use of stranger-owned life insurance (SOLI), some planners have suggested that the true value of a policy is its value in the market place rather than the interpolated terminal reserve. In Revenue Ruling , IRB 684, the IRS ruled that the transfer of a policy to a grantor trust was not a transfer for value in two situations. First, the sale of a policy on the life of a grantor from one grantor trust to another grantor trust (the insured grantor is treated as the owner of all assets in both trusts). Second, the sale of a policy on the life of a grantor from a non-grantor trust to a grantor trust (the transfer to the grantor trust is treated as a transfer to the insured ). 2. Qualifying as a Grantor Trust. IRC ' provides for grantors and others treated as substantial owners for income tax purposes. a. Insurance on Grantor=s Life. Section 677 relates to income for the benefit of the grantor, and '677(a)(3) provides that the grantor is treated as the owner of any portion of a trust whose income may be applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor=s spouse. 4

9 Trustee Power to Purchase Life Insurance. The Trustee may purchase and hold as a trust asset a policy or policies of insurance on the life of the Settlor, or on the life of any person in whom any trust beneficiary has an insurable interest, naming the trust as beneficiary. The Trustee may use the net income and principal of the trust to pay premiums on any such life insurance policy. The Trustee may also receive any such policy as a gift to the trust and hold and deal with any such policy as owner thereof. With respect to any policy, the Trustee shall have the following powers stated by way of illustration and not to the exclusion of any other powers: (a) to execute any automatic premium loan agreement with respect to any policy or to elect that any such automatic premium loan agreement provision thereof shall be effective or to cancel the same; (b) to borrow money with which to pay premiums due on any policy either from the company issuing the policy or from any other source and to assign such policy as security for the loan; (c) to exercise any option contained in such policy with respect to any dividend or share of surplus apportioned thereto; (d) to reduce the amount of such policy or to convert or exchange the same; (e) to elect any paid-up insurance or extended term insurance nonforfeiture option contained in such policy; (f) to surrender such policy for its cash value; (g) to sell such policy at its fair market value to the insured or to anyone having an insurable interest in the insured; (h) to exercise any other right, option or benefit contained in the policy or permitted by the insurance company issuing the policy; and (i) upon the termination of the trust to transfer and assign such policy in distribution of the trust property, including, so far as practicable, transferring to a beneficiary any policy insuring his or her life as part of his or her distributive share, the Trustee determining the value of the policy in making such distribution. b. Income for Benefit of Spouse. Section 677(a)(1) provides that the grantor shall be treated as the owner of any portion of a trust whose income without approval or consent of any adverse party may be distributed to the grantor s spouse, or may be accumulated for future distribution to the grantor s spouse. Therefore, an ILIT having the grantor s spouse as a beneficiary would qualify the trust as a grantor trust. c. Grantor Power to Substitute Assets. Section 675(4)(C) provides that a grantor is treated as owner of any portion of a trust with respect to which the grantor has a power Aexercisable in a nonfiduciary capacity,@ to reacquire the trust assets by substituting other property of an equivalent value. This power has routinely been used by planners to create intentionally defective income trusts (IDIT). 5

10 Power to Substitute Assets. The Settlor shall have the power during the Settlor=s lifetime at any time, acting in a non-fiduciary capacity, without the approval or consent of any person, including the Trustee, to acquire the assets of any trust other than life insurance policies issued on the Settlor=s life or on the joint lives of the Settlor and the Settlor=s spouse, by substituting property of an equivalent value. The Settlor directs that this power is not assignable, and any attempted assignment will make this power void. The Settlor may at any time during the Settlor=s lifetime release such power by delivery of a written instrument to the Trustee, and any such release to be irrevocable. d. Possible Conflict of '675 With Estate Taxation. The use of the '675(4)(A) power to cause grantor trust status has recently been complicated by PLR which requested an opinion of the estate taxation of a grantor=s power to acquire trust property by substituting other property of equivalent value when the power could only be exercised in a Afiduciary@ capacity. Relying on the case of Jordahl v. Commissioner, 65 T.C. 92 (1975), acq C.B. 1, this power was held to not cause estate taxation, but the ruling seemed to imply that if the power was exercisable in a Anonfiduciary@ capacity, then the power would cause estate taxation. It would appear that grantor trust status for income tax purposes could still be obtained without estate tax consequences if the power to exchange assets is held by a third party since '675(4)(A) applies to the power exercisable by Aany person.@ Also, it is arguable that the rationale for excluding property when the power is held as a fiduciary would be applicable to powers held as an individual but the power, under local law, had to be exercised in good faith and subject to fiduciary standards. IV. MYTH 4: AN ORAL LIFE INSURANCE TRUST IS INVALID A. Applicability of Oral Trusts to Life Insurance Planning. This is another strategy which has been suggested for solving the problem of having a life insurance policy in error issued with the insured as owner rather than the insured=s ILIT. This may have resulted from an error by the insurance company, or it may have been caused by the delay of the attorney in preparing the trust agreement and the need to have the policy issued before the insurance proposal lapsed. B. Implementing the Technique. The insured and the trustee of the ILIT sign a document memorializing the oral agreement that a trust has been created 6

11 and having a subsequent written document set forth the terms of the oral trust. Appendix D is a form of oral trust agreement prepared by Manulife Financial for consideration by financial advisors. C. Validity of Oral Trusts. Restatement Third, Trusts '20 provides, AExcept as required by a Statute of Frauds, a writing is not necessary to create an enforceable inter vivos trust, whether by declaration, by transfer to another as trustee, or by contract.@ The Restatement then goes on to say that most states have enacted provisions similar to Section 7 of the English Statute of Frauds which requires a written agreement for an enforceable trust for real estate. Some states have apparently extended the Statute of Frauds to trusts of personalty. Uniform Trust Code '407, Evidence of Oral Trust, codifies Restatement Third, Trusts '20. The existence of an oral trust must be established by clear and convincing evidence. Colorado s Statute of Frauds requires a written trust agreement where the subject matter consists of real estate. This has been interpreted to permit an oral trust for personalty (eg. an insurance contract). HOWEVER, this does not mean that the Internal Revenue Service would necessarily accept evidence of an oral trust to eliminate the operation of the 3-year rule for transfers in contemplation of death. V. MYTH 5: YOU CAN=T REMOVE A POLICY FROM AN ILIT A. The Problem. Due to changing family dynamics, reduced or eliminated estate tax considerations, or policy under performance, it may be desirable to remove an insurance policy from an ILIT formed many years earlier, or to transfer the policy to a new ILIT which better serves the needs of the insured and the insured=s family. B. Create a New ILIT Funded With a New Policy. In some cases, a new policy may be appropriate because premiums may have actually come down since the inception of the old policy, or the insured has better health and can get a better rating, or it is desirable to switch from a term to a permanent policy. C. Appoint a Special Power Holder. Grant an individual the power, during the insured=s lifetime, to appoint the trust property to anyone other than the power holder, the power holder=s estate, the creditors of the power holder, or the creditors of the power holder=s estate. The power holder should not be the insured, the grantor of the trust, a donor to the trust or a permissible of the trust. 7

12 Appointment of Special Power Holder. During the Settlor=s lifetime, NAME may appoint the principal of the trust as hereinafter provided. If s/he dies or is unable to exercise the power, or if s/he relinquishes the power, NAME may exercise the power. If s/he dies or is unable to exercise the power, or if s/he relinquishes the power, NAME may exercise the power. The holder of the power hereunder may appoint the principal of the trust only to or for the benefit of the Settlor=s spouse and descendants, and such power may not be exercised in favor of (1) the Settlor, (2) the power holder, or (3) the estates, the creditors, or the creditors of the estates of the Settlor or the power holder. In addition, this limited power of appointment may not be exercised in a manner which would serve to discharge any legal obligation of such power holder or the Settlor. Such power of appointment may be exercised only during such power holder=s lifetime by a written instrument delivered to the Trustee. The property subject to such power may be appointed in equal or unequal proportions, and on such terms and conditions, either outright or in trust, as the power holder shall select. D. Distribution Directly to a New Trust. The trust will usually contain broad provisions allowing distributions by the trustee for the maintenance and support of a broad class of beneficiaries including the grantor=s spouse, children and grandchildren. The trust may also specifically allow the trustee to make distributions to another trust created by the grantor the benefit of essentially the same beneficiaries. If the trustee believes the best interests of the trust beneficiaries can be served by transferring the policy to a new trust without violating the trustee=s fiduciary responsibility (or perhaps even because it would better meet the grantor=s goals), the trustee can make a direct assignment to the new trust without gift or estate tax consequences. An alternative would be to transfer the policy directly to the beneficiaries, to a partnership or other entity controlled by the beneficiaries. E. Termination by Consent. Restatement Third, Trusts ' 65 allows a trust to be terminated with the consent of the settlor and all of the beneficiaries. However, if termination would be inconsistent with a material purpose of the trust, the beneficiaries cannot compel termination without the consent of the settlor. Upon termination, the Restatement states that the mere fact that the settlor created the trust for successive beneficiaries does not prevent the beneficiaries from terminating or modifying the trust to reallocate the beneficial interests among themselves. 8

13 Early Termination of Uneconomical Trust. The Trustee, excluding any person who would be entitled to receive assets or who would receive any economic benefit as a consequence of exercising this power of termination, shall have the discretionary power to terminate the trust or any separate share established by this trust agreement whenever continuation of the trust or such share is no longer economical, in the opinion of the Trustee, because of its small size. In exercising this power, the Trustee shall consider the costs and other disadvantages of continuing the trust against the financial or other advantages to the beneficiaries of continuing the trust. Upon termination, the trust assets shall be distributed outright and free of trust to the then mandatory or permissive income beneficiary of the trust or such separate share. If there is more than one mandatory or permissive income beneficiary of the trust or such share, then the distribution shall be made, per stirpes, to the beneficiaries. The Trustee=s judgment shall be final and binding upon all interested parties, and the Trustee shall not be liable for failing or refusing at any time to terminate the trust as herein authorized. The distribution of the trust assets upon termination shall relieve the Trustee of any further responsibility. F. Sale of Policy From Trust A to Trust B. Several IRS rulings have held that a sale of life insurance policies from one grantor trust to another will be ignored for federal tax purposes. Because the transfers are not recognized for income tax purposes, there is no transfer for purposes of the transfer for value rule. Therefore, the transfer for value rule does not apply to cause the beneficiaries to have taxable income on receipt of the death benefit. PLR , PLR , PLR , PLR (Appendix E, PLR ) G. Sale to the Grantor/Insured. Such a sale would not be a transfer for value because a sale to the insured in an exception under IRC ' 101(A)(2)(b). The consideration for the purchase would then be an asset of the trust. Under the provisions allowing termination for a small or uneconomical trust, the cash would then be distributed to the beneficiaries. Of course, unless the insured then pursues other planning options, the death benefit will be taxable in the insured=s estate. VI. MYTH 6: PREMIUM PAYMENTS ON AN ILIT-OWNED POLICY MUST BE MADE BY THE TRUSTEE FROM A SEPARATE TRUST ACCOUNT A. Payment of Premiums. Unless the trust has been funded with sufficient assets, the premium will usually be paid by the insured (in the case of an individually owned policy) or by the insured=s employer (in the case of a 9

14 group policy). Payment of the premium by the insured will result in a gift to the trust beneficiaries. Regs. ' (c), Ex. (6). If the insured pays the premium, there are three methods for making such payments. 1. Check Payable to the Trust. The insured writes a check to the trust. The trustee deposits the check to a trust checking account. The trustee writes a check to the insurance company. 2. Endorsement of Check Method. The insured writes a check to the trust. The trustee endorses the check on the reverse side payable to the order of the insurance company. 3. Direct Payment to Insurance Company. The insured writes a check directly to the insurance company. In the case of a group policy, the employer corporation will always be paying the premium directly to the insurance company. B. The Issue: Qualification for Gift Tax Present Interest. Since the Crummey power authorizes the beneficiary to require immediate distribution of any gift to the trust, the method of paying premiums and the time that the premium gifts remain in the trust may affect the ability of the beneficiary to make withdrawals and thereby jeopardize the availability of the annual exclusion for such gifts. The Service has approved the qualification of a trust which held only a life insurance policy where the trustee had authority to satisfy the demand rights with fractional interests in the policy. PLR (for a whole life policy) and PLR (for a term policy). See Appendix F for PLR dealing with premium payments with respect to a group term policy wherein the premiums were paid directly to the insurance company. The availability of the annual exclusion can be further assured by authorizing the trustee to borrow funds or take other actions to create the liquidity necessary to satisfy outstanding withdrawal rights. See Zaritsky and Leimberg, Tax Planning With Life Insurance '5.03(g). Assets Subject to Withdrawal. The Trustee shall, at all times that a power to demand distribution is outstanding, attempt to retain sufficient liquid assets or transferable assets in the trust in order to satisfy any withdrawal rights which are then outstanding. The Trustee may satisfy the exercise of any right of withdrawal by distributing cash or other assets to the beneficiary making the withdrawal, including insurance policies held hereunder, or any interest therein. To the extent that distributable assets are not conveniently available, the Trustee is authorized to borrow, upon such terms as are reasonably necessary, the funds necessary in order to provide for payment of amounts required by any exercise of withdrawal rights by a beneficiary hereunder. 10

15 VII. MYTH 7: WRITTEN CRUMMEY NOTICES MUST BE GIVEN ANNUALLY TO EACH BENEFICIARY A. Why Notice? Although the original Crummey case did not seem too overly concerned about the issue of notice to the trust beneficiaries of their right to make withdrawals, the IRS has consistently stressed the need for the beneficiaries to have actual notice. The obvious issue is that a beneficiary cannot exercise a right which he or she does not know exists. B. Basic Requirements. The two basic requirements are that the trustee give timely notice and that the beneficiary has sufficient time to exercise his or her withdrawal right. In Rev. Rul. 81-7, C.B. 474, the Service ruled that the notice was insufficient because the right was given on December 29 and lapsed on December 31. Notice of Withdrawal Rights. Within fifteen days after the creation of the trust, the Trustee shall give written notice to each person then entitled to make withdrawals of such person=s continuing annual withdrawal rights. Such notice shall be delivered by hand or by mail to the last known address of such person, informing such person of the existence and nature of his or her right to make withdrawals. Thereafter, the Trustee shall take appropriate action to assure that each beneficiary continues to have any information necessary to make decisions regarding the making of any withdrawals permitted under this trust. C. Actual Notice. Does this require that the trustee send a written notice each time there is a premium payment? Can the beneficiary waive the requirement of notice? These are hotly debated questions. Accordingly, the conservative approach has been to require the trustee to give actual written notice to the beneficiaries each time a premium is made. The problem arises because trustees forget to send the required notices. And it doesn t make a lot of logic to require notice to beneficiaries who know that premium gifts are being made each year B especially when the beneficiary is also the trustee. Therefore, it made sense when the Service ruled that a single notice can serve as a continuing notice. Seep Appendix G for PLR More recently, the Service ruled that the requirement of Acurrent notice@ does not mean that notice must be given each time a gift is made to the trust. It is sufficient that the notice correctly inform the beneficiaries of the date of the gift, the size of the gift and the existence of the withdrawal right. PLR The once-onlyreturn-receipt-requested is suggested in Zaritsky and Leimberg, Tax Planning With Life Insurance'5.03(3)(c). That treatise also suggests that even oral notice should be sufficient. 11

16 D. Notice to Minor Beneficiaries. Since minors and incapacitated beneficiaries cannot receipt for notice or make decisions regarding withdrawal rights, notice should be given to the parents. If the parent is also the trustee, notice should not be relevant. In PLR , the Service did not require written notice to the trustee who was also a beneficiary of the trust and the guardian of minor children who had demand rights. If both parents are settlors (as in the case of a trust holding a second-to-die policy), although there is no case or ruling on point, there may be a concern that giving the parents/settlors the power to make withdrawals may constitute a reserved power under IRC ' 2036 or ' Giving the right to notice and withdrawals to a guardian other than the parents, even if no such guardian currently exists, should suffice so long as there is no impediment under the terms of the trust or local law to the appoint of a guardianship. Rev. Rul , C.B. 321; PLR See Appendix H for PLR E. Timing of Demand Rights. The notice must give the beneficiary time to demand the withdrawal amount. This often is expressed as thirty days after the notice. This is burdensome where the premiums are paid more often than annually. This problem can be resolved by giving the beneficiary the right to make withdrawals as to all gifts to the trust during the year. The right to any amounts not demanded before December 31 would lapse. However, with respect to gifts made at the end of the year, the right would extend for a designated time past the end of the year. The Service has ruled that the gift tax annual exclusion is available for the calendar year in which the gift is made, regardless of the year in which the withdrawal right terminates. Rev. Rul , C.B. 167; PLR Exercise and Lapse of Withdrawal Rights. The withdrawal right of a beneficiary shall become vested as of the date of the gift to the trust which results in the withdrawal right. This power to withdraw is noncumulative and shall lapse with respect to all gifts made in each calendar year at the end of the calendar year in which such gift is made, or until the expiration of forty-five days after the date of such gift, whichever shall last occur (the Awithdrawal period@) to the extent that a withdrawal has not been made. Withdrawals shall be made by delivering a written request to the Trustee during the withdrawal period. If a beneficiary entitled to make a withdrawal is incapacitated during part or all of a withdrawal period, the beneficiary=s legal or natural guardian or conservator (but not the Settlor) shall be informed of and may exercise the withdrawal right on behalf of such incapacitated beneficiary. If there is no legally authorized personal representative for a beneficiary, the Trustee may designate an appropriate adult individual (but not the Settlor) who may make withdrawals on behalf of an incapacitated beneficiary. 12

17 VIII. MYTH 8: I CAN CREATE UNLIMITED CRUMMEY POWERS A. Present vs. Future Interest. An unfunded ILIT normally receives, directly or indirectly, gifts from the insured with which to pay premiums. These transfers constitute gifts to the beneficiaries of the trust. The problem is that the annual gift tax exclusion only applies to gifts of a present interest in property. Payment of insurance premiums on a policy owned by an ILIT are gifts of a future interest and would normally not qualify for the annual gift tax exclusion. The result would be the necessity of filing annual gift tax returns and perhaps eventually paying a gift tax. B. Converting to a Present Interest (Thank You Dr. Crummey). A gift qualifies as a present interest IF the donee has the unrestricted right to the immediate use, possession or enjoyment of the property. Treas. Reg. ' The beneficiary of a trust typically has no such immediate use. However, a Chicago physician (with the misfortune of having the last name of the case which made him famous) and his attorney decided to give each beneficiary of an irrevocable trust the power to proportionately withdraw ascertainable amounts each year that gifts were made to the trust. Such powers were held to convert future interests to present interests. Crummey v. Commissioner, 397 F.2d 82 (9 th Cir. 1968). C. Contingent Beneficiaries (Can I Give My Mother-in-Law a Crummey Power?) The Ninth Circuit in Crummey decided against the IRS position that, if the facts and circumstances indicated that a withdrawal was unlikely, there was not a present interest (a factdependent test). The Courts since then have held that the only requirements are (1) the right to make a demand, and (2) the right cannot be legally resisted by the trustee. Cristofani, 97 TC 74 (1991); Kohlsaat, T.C. Memo ; Holland, 73 TCM 3236 (1997). HOWEVER, these cases do not stand for the proposition that you can simply add the number of Crummey beneficiaries needed to eliminate premium gifts in excess of the aggregate annual exclusions. The Crummey beneficiary MUST have some beneficial interest in addition to the Crummey power. For example, a trust could be created for the benefit of the settlor=s children and grandchildren, all of whom could be given Crummey powers. The grandchildren would have the right to discretionary distributions of income and principal during the insured settlor=s lifetime and would be the ultimate beneficiaries of separate generation-skipping shares carved out for their parent at the death of the insured. Even the IRS apparently sanctioned this approach in an Action on Decision issued in 1996 (A.O.D (July 15, 1996). 13

18 IX. MYTH 9: THE MAXIMUM GIFT TAX ANNUAL EXCLUSION IS AVAILABLE FOR ALL MY CRUMMEY BENEFICIARIES (LAPSING POWERS) A. The Lapse Issue. The beneficiary of a Crummey withdrawal power has a general power of appointment in an amount equal to the withdrawal power. A release of a general power of appointment is treated as though the powerholder exercised the withdrawal right and then gifted the property back to the trust. However, the lapse of a general power of appointment is not a taxable transfer if the withdrawal amount is limited to the lesser of $5,000 or 5% of the value of the trust assets out of which the power can be exercised. IRC ' 2514(e). There are several ways to avoid the lapse problem. Also, lapse of a Crummey power by a skip person (a grandchild) could also result in a generation-skipping transfer for GST tax purposes. B. Limit Withdrawals to $5,000 or 5%. An exception to the lapsing power of appointment problem is provided in IRC ' 2514(e) which states that the lapse or release of a general power of invasion is not a taxable gift unless it exceeds the greater of $5,000 or 5% of the trust funds from which it could have been satisfied. This limits the amount of taxfree annual premium gifting but avoids the gift tax problem of the beneficiary. GENERAL RULE: This approach will almost always be required when drafting for multi-generation trusts (eg. spouse and children, or children and grandchildren). 14

19 Beneficiary Withdrawal Provision. During the Settlor=s lifetime, if a gift is made or deemed to have been made to the trust by an actual or constructive transfer to the trust by any donor, the Settlor=s spouse, if then living, and each of the Settlor=s then living children shall have the right at any time during the remainder of the calendar year in which such gift is made, or until the expiration of forty-five days after the date of such gift, whichever shall last occur (the Awithdrawal period@), to make withdrawals from the trust in the amounts and in the manner hereinafter described. The value of a gift made to the trust by a donor shall be determined in the same manner that the value of such gift would be determined for such donor=s federal gift tax purposes. However, any gift that is accompanied by a written notice from the donor that all or any portion of the gift shall not be subject to withdrawal shall be excluded from consideration as though the gift had not been made. Any transfer to the trust which is not a gift for federal gift tax purposes shall not be subject to withdrawal by the beneficiaries. Amount Subject to Withdrawal. The Settlor=s spouse may first withdraw an amount equal to the entire value of any gift to the trust; provided, however, the total amount of such withdrawals during the withdrawal period shall not exceed the greater of $5,000 or 5% of the value of the trust estate as valued on the date of such gift. The value of any gift to the trust in excess of the amount which the Settlor=s spouse is entitled to withdraw in any year may be withdrawn in equal shares by those of the Settlor=s children who are living on the date of such gift; provided, however, the total amount of such withdrawals by any one child during the withdrawal period shall not exceed the greater of $5,000 or 5% of the value of the trust estate as valued on the date of such gift. C. Separate Shares With Power of Appointment. Another solution, when all beneficiaries are of the same generation, is to draft separate trust shares for each beneficiary during and after the death of the insured settlor. Each gift to the trust is allocated equally to the separate shares. Each beneficiary is entitled to make withdrawals up to the limit of the gift tax annual exclusion only from his or her separate share. Any lapsed withdrawal amount remains in that beneficiary=s separate share, and the beneficiary has a general or limited testamentary power of appointment over the trust. The Service has ruled that no gift by the beneficiary results from the lapse of the power when the funds subject to the Crummey power must ultimately be paid to the beneficiary, the beneficiary=s estate, or persons designated by the beneficiary under a testamentary power of appointment. PLR (Appendix I) and PLR

20 Beneficiary Withdrawal Rights During Settlor=s Lifetime. While the Settlor is living, if a gift is made or deemed to have been made to the trust by an actual or constructive transfer to the trust by any donor, each of the Settlor=s then living children shall have the right at all times during the remainder of that calendar year, or until the expiration of 45 days after the Trustee receives the gift, whichever shall occur last (the Awithdrawal period@), to demand and receive immediate distribution of an amount equal to the lesser of (1) the amount of the gift divided by the number of children then having a right to make a withdrawal with respect to the gift; or (2) the Aannual exclusion amount@ remaining available to the donor at the time of the gift for gifts by such donor to such child in the calendar year in which the gift is made. For purposes of this trust, Aannual exclusion amount@ means the amount excludable from gifts for federal gift tax purposes under Section 2503(b) of the Internal Revenue Code of 1986, or any successor thereto, as in effect in the year in which a gift is made to the trust. For purposes of determining the identity of a donor and the amount of available gift tax exclusion remaining to such donor, any gift of property made by a married person shall be deemed to have been made one-half by that person and one-half by the spouse of that person unless either of those persons is not a citizen of the United States or the gift is accompanied by a statement that this presumption does not apply. The cumulative amount of gifts made to the trust estate by a donor shall be determined in the same manner that the amount would be determined for such donor=s federal gift tax purposes. Any transfer to the trust which is not a gift for federal gift tax purposes shall not be subject to withdrawal by the beneficiaries. Notwithstanding the foregoing provisions, any gift that is accompanied by a written notice from its donor that the gift shall not be subject to withdrawal shall be excluded from consideration as though the gift had not been made. Exercise and Lapse of Withdrawal Rights. The withdrawal right of a beneficiary shall become vested as of the date of the gift to the trust which results in the withdrawal right. The power to withdraw is noncumulative and shall lapse with respect to all gifts made in each calendar year at the end of the withdrawal period hereinabove described to the extent a withdrawal has not been made. Withdrawals shall be made by delivering a written request to the Trustee at any time or times during the withdrawal period. If a beneficiary entitled to make a withdrawal is incapacitated during part or all of a withdrawal period, such beneficiary=s legal or natural guardian or conservator (but not either of the Settlors) shall be informed of and may exercise the withdrawal right on behalf of such incapacitated beneficiary. Any amount of a child=s pro rata share of any gift not withdrawn shall be added to such child=s separate trust share. D. Hanging Powers. This solution utilizes a cumulative general power of appointment which has been labeled a Ahanging power.@ The power to withdraw lapses in stages. Each beneficiary may withdraw an 16

21 amount equal to the gift tax annual exclusion (qualifies for the gift tax annual exclusion of the donor/insured) but provides that any amount not withdrawn lapses at the end of each year only to the extent of $5,000 or 5% of the value of the trust (avoids a taxable gift by the powerholder). The withdrawal rights do not lapse but instead accumulate until they (1) are exercised, or (2) lapse in later years when 5% of the trust assets is not only large enough to lapse that year=s gift but also previous years= gifts. The Service has never approved the use of hanging powers and has issued several rulings opposing hanging powers in contexts other than the Crummey trust. For example, see PLR which cites Proctor, 142 F2d 824 (4 th Cir. 1944). The following is an example of a hanging power. Amount Subject to Withdrawal. The portion of any gift that may be withdrawn by each beneficiary shall be the smaller of (1) the beneficiary=s proportionate share determined by dividing the amount of the gift by the number of beneficiaries having withdrawal rights, or (2) the Aannual exclusion amount@ remaining available to the donor at the time of the gift for gifts to such beneficiary in the calendar year in which the gift is made. For purposes of this trust, Aannual exclusion amount@ means the amount excludable from gifts for federal gift tax purposes under Section 2503(b) of the Internal Revenue Code of 1986, or any successor thereto, as in effect in the year in which a gift is made to the trust. Lapse of Withdrawal Rights. A beneficiary=s withdrawal rights with respect to contributions to the trust shall continue from year to year until exercised (including after Settlor=s death), except that on December 31 of each year the beneficiary=s aggregate withdrawal rights shall lapse as to the amount specified in Internal Revenue Code Section 2514(e) in effect from time to time (currently the greater of $5,000 and 5% of the value of the trust estate), and except further that those withdrawal rights shall lapse upon the death of the beneficiary. Any withdrawal right with respect to a contribution made fewer than forty-five days before the end of a calendar year shall not lapse at the end of such calendar year but shall remain exercisable until the end of such forty-five day period, without regard to the fact that it occurs in the following calendar year. X. MYTH 10: DRAFTING A GENERATION-SKIPPING ILIT IS A PIECE OF CAKE. The ILIT is an ideal vehicle for keeping insurance proceeds immune from federal estate taxation for several generations. However, several critical problems exist if the ILIT is to qualify as a generation-skipping trust. A. Gift Tax Annual Exclusion. By including grandchildren in the class of beneficiaries having Crummey withdrawal powers, it is possible 17

22 to increase the amount of insurance premium which can be gifted without using any of the lifetime gift exemption. However, although a gift to a grandchild might be within the annual gift tax exclusion, it may, nevertheless, be tainted by the GST annual exclusion limitations and the deemed transferor rules. B. The GST Annual Exclusion. An outright transfer to an individual skip person (a grandchild) that qualifies for the $12,000 annual gift tax exclusion will also be exempt from GST tax. HOWEVER, this rule does not apply to transfers to a trust unless (1) the trust has only one beneficiary, (2) no portion of the trust principal or income may be distributed to a person other than the beneficiary, (3) if the trust terminates during the beneficiary s lifetime, distribution of the entire trust must be made to him or her, and (4) if the trust does not terminate during the beneficiary s lifetime, the trust assets must be includable in the beneficiary s estate. IRC ' 2642(c). These rules would allow allocation of GST annual exclusion gifts only to separate trusts for Askip@ persons (eg. grandchildren). Gifts to trusts for Anonskip@ persons (eg. children) for life with remainder to grandchildren would not qualify for the GST annual exclusion and would require the filing of a gift tax return with allocation of the gift to the donor=s GST Exemption ($2,000,000 in 2008). C. Danger of Beneficiary Becoming the ATransferor@. If the lifetime beneficiary of a generation-skipping ILIT (eg. a child) has a Crummey withdrawal power which exceeds the 5x5 amount, the lapse of the power with respect to the excess gift over the 5x5 amount is a lapse of a general power of appointment. The result is that the powerholder (the child) becomes the Atransferor@ for GST purposes of the excess amount, unless there has been no completed gift because he or she has a special power of appointment or hanging power, and, unless the child then files a gift tax return and allocates a portion of his or her GST exemption to the lapse, the benefit of the trust for GST purposes is gradually eroded over the years. PLANNING POINTER: limit the beneficiary=s withdrawal power to the 5X5 amount. D. Late Allocation of GST Exemption. In order for the ILIT to be exempt for GST purposes, the donor of the premiums must make a timely allocation of his or her GST Exemption ($2,000,000 in 2008). Fortunately, the Tax Act of 2001 automatically allocates a donor=s GST Exemption to lifetime transfers that are not direct skips, but are made to generation-skipping trusts. This applies to transfers made after December 31, Unfortunately, generation-skipping gifts made prior to this date must have GST Exemption allocated to them on a timely filed gift tax return. Late allocation to an ILIT cannot be applied to the cumulative premium gifts but 18must be applied to the Ainterpolated terminal