Irrevocable Life Insurance Trusts Drafting Flexible ILITs to Achieve Tax Benefits and Plan for Future Circumstances

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1 Presenting a live 90 minute webinar with interactive Q&A Irrevocable Life Insurance Trusts Drafting Flexible ILITs to Achieve Tax Benefits and Plan for Future Circumstances TUESDAY, FEBRUARY 15, pm Eastern 12pm Central 11am Mountain 10am Pacific Td Today s faculty features: Diana S.C. Zeydel, Shareholder, Greenberg Traurig, Miami, Fla. Mary Ann Mancini, Partner, Bryan Cave, Washington, D.C. The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10.

2 A Complete ILIT Tax Guide Just About Everything You Need to Know to Create and Administer a Successful Irrevocable Life Insurance Trust Diana S.C. Zeydel Diana S.C. Zeydel All Rights Reserved. An irrevocable life insurance trust (ILIT) is probably the most frequently used irrevocable trust in estate planning. One reason is that life insurance continues to be a highly tax favored asset. However, the tax aspects of forming and administering an ILIT are often misunderstood. Drafting for flexibility while minimizing transfer and income taxation of the policy proceeds requires a thorough understanding of the complex tax rules affecting ILITs. Successful navigation of the tax pitfalls provides a substantial opportunity for leverage by delivering the policy proceeds to the ILIT beneficiaries with minimum tax. Purposes of Forming an ILIT An irrevocable life insurance trust is typically established to achieve one or more of the following basic objectives: (1) to pass the life insurance proceeds down to the next generation free of transfer tax in the estate of the insured and, if married, also the estate of the insured s spouse; (2) to avoid gift tax on payments of premiums by the insured to fund the insurance; (3) to retain income tax free receipt of the policy proceeds; (4) to provide liquidity at the insured s death to pay any debts, expenses and/or taxes due, to support any business assets, to fund cash bequests, and to support the intended beneficiaries of the decedent s estate; and (5) to control the timing of receipt of the proceeds by individual beneficiaries. There are other possible benefits as well. Life insurance proceeds may not be subject to creditors claims under applicable local law. There may be a general exclusion from creditor claims, but a transfer of the policy to an irrevocable trust will enhance the protection of the proceeds. Life insurance proceeds payable to an irrevocable life insurance trust may also be excludible in determining a surviving spouse s elective share of the decedent s estate. 1 It should be noted that estate planning that involves irrevocable trusts created with both spouses knowledge and consent may also have the collateral consequence of removing the trust assets from the marital estate for equitable distribution purposes. 2 A life insurance This Article has been published in two parts by Estate Planning Magazine: D. Zeydel, A Complete Tax Guide for Irrevocable Life Insurance Trusts, 34 Estate Planning 7 (July 2007) and D. Zeydel, How to Create and Administer a Successful Irrevocable Life Insurance Trust, 34 Estate Planning 2 (June 2007). The author wishes to thank Jonathan G. Blattmachr for his insightful comments to an earlier draft of this Article. 1 See, e.g., N.Y. E.P.T.L. 5-l.1(b)(2) and Sections (6) and (1)(d), Florida Statutes (insurance proceeds generally excluded from the elective estate, but, if payable to the surviving spouse, will satisfy the elective share). 2 Query whether the estate planner has a duty to so advise the spouses in the context of a joint representation for estate planning purposes. Compare Schneider v. Schneider, 864 So.2d 1193 (Fla. 4 th D.C.A. 2004)

3 trust can also be used to transfer property estate tax free to a non-citizen spouse without the need satisfy the special marital deduction rules applicable to such a transfer. 3 Section 2056A 4 contains additional requirements to qualify a trust for the marital deduction in the case of a non-citizen surviving spouse beyond the requirements contained in Section These include that at least one trustee must be a U.S. trustee and that no distribution (other than income or distributions for hardship) may be made unless the U.S. trustee has the right to withhold estate tax. A life insurance trust can avoid the requirements of Section 2056A in the case of a non-citizen spouse by removing assets from the insured s gross estate (thus avoiding the need for marital deduction qualification), while nevertheless giving the noncitizen spouse a beneficial interest. Basic Provisions of Section 2042 In general, Section 2042 of the Code provides that the proceeds of an insurance policy on the life of a decedent are includible in the decedent s gross estate for estate tax purposes if the proceeds are receivable by the decedent s executor or if the decedent s possessed any incidents of ownership over the policy. Payable to the Decedent s Executor. Section 2042(1) provides that the proceeds of an insurance policy on the decedent s life are included in the decedent s gross estate if the proceeds are receivable by the decedent s executor as insurance under policies on the life of the decedent. The term executor is defined under Section 2203 to include an administrator or, if there is none within the U.S., any person in actual or constructive possession of any property of the decedent. Treasury Regulation (b) provides that proceeds payable to the decedent s estate or payable to a beneficiary subject to contribution to defray legal obligations of the decedent s estate (such as taxes, debts or expenses) are includible under Section 2042(1), in the latter case, to the extent of such obligations. On the other hand, where the beneficiary may, but is not legally obligated to, make payments to the estate, the power to volunteer should not cause inclusion of the proceeds under Section 2042(1). 5 Incidents of Ownership. Section 2042(2) provides that the proceeds of an insurance policy are also includible in the decedent s gross estate if the decedent, at the time of the decedent s death, possessed any of the incidents of ownership over the policy. The decedent is deemed to possess incidents of ownership exercisable either alone or in conjunction with any other person. 6 Incidents of ownership include the power, individually or as trustee, to change the beneficiary, to change the beneficial ownership in the policy or its proceeds, or (irrevocable life insurance trust created by husband for parties children without the wife s knowledge and consent was part of the marital estate and wife was entitled to be compensated out of other assets) with Hedendal v. Hedendal, 695 So.2d 391 (Fla. 4 th D.C.A. 1997) (irrevocable education trust created by husband for parties son was not a marital asset for equitable distribution purposes). 3 Under Section 2056(d), no estate tax marital deduction is allowed for transfers to or for the decedent s surviving spouse except for a transfer to a qualified domestic trust described in Section 2056A. 4 All references to a Section or unless otherwise indicated are to a section of the Internal Revenue Code of 1986, as amended. 5 See, e.g., Rev. Rul , C.B I.R.C. 2042(2). 2

4 the time or manner of enjoyment thereof, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, and to obtain from the insurer a loan against the surrender value of the policy. 7 Power to Remove and Replace the Trustee. Although there used to be a concern that the power to remove and replace a trustee always causes the powers of the trustee to be attributed to an insured/trustee, 8 Revenue Ruling clarifies that no powers of a trustee will be attributed to a grantor for purposes of Section 2036 or Section 2038 so long as a power to remove trustees is not coupled with a power to appoint related and subordinate trustees within the meaning of Section 672(c). In PLR , the IRS extended the rational of Revenue Ruling to Section 2042(2) and ruled that a grantor s power to appoint trustees of an insurance trust would not cause inclusion of policy proceeds under Section 2042(2). 10 Grantor as Trustee. Treas. Reg (c)(4) provides that a decedent is considered to have an incident of ownership in an insurance policy on the decedent s life held in trust if, under the terms of the policy, the decedent, either alone or in conjunction with any person or persons, has the power (as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment thereof, even though the decedent has no beneficial interest in the trust. The regulation also warns that if the decedent created the trust, such a power may result in Section 2036 or Section 2038 inclusion if, for example, the decedent has the power to surrender the policy, and if the income otherwise used to pay policy premiums would become currently payable to a beneficiary of the trust. In other words, the regulations view the ability to surrender the policy, in such a case, as control over the beneficial enjoyment of the trust property or its income, triggering Section 2036 and/or Section The case law diverges on the question of whether the insured as trustee must have the right to economic benefits under the policy in order to have an incident of ownership, causing estate tax inclusion under Section Revenue Ruling states that the insured as trustee has an incident of ownership only if either (1) the insured has transferred the policy or any consideration for purchasing and maintaining the policy to the trust, or (2) the insured as trustee can exercise the trustee s powers for the insured s individual benefit. Even if the insured cannot exercise the insured s powers as trustee for the insured s individual benefit, the insured might be deemed to have incidents of ownership if there is some prearranged plan to benefit the insured in which the insured participated. In an expansion of the position taken in Revenue Ruling , the IRS ruled in PLR Treas. Reg l(c)(2) and (4). For a more thorough discussion of the incidents of ownership test see C. McCaffrey, Estate, Gift and Generation-Skipping Transfer Tax Aspects of the Life Insurance Trust, 49th Annual N.Y.U. Institute (1991). 8 Rev. Rul , C.B. 325, revoked by, Rev. Rul , C.B C.B Note that neither a private letter ruling nor a technical advice memorandum may be cited as precedent under Section 6110(k)(3). 11 See Terriberry v. U.S., 517 F.2d 286, cert. denied, 424 U.S. 977 (1976); Skifter Est. v. Commissioner, 468 F. 2d 699 (2d Cir. 1972) C.B

5 that the grantor may act as trustee of a trust owning insurance on the grantor s life transferred to the trust by the insured, and nevertheless avoid estate tax inclusion, if the grantor, as trustee, has no powers with respect to the policy and the grantor s authority over trust distributions are limited by an ascertainable standard so that Section 2036 and Section 2038 (relating to retained income in and control over property transferred by the decedent) do not apply. Nevertheless, if would appear prudent to discourage the grantor from acting as trustee of his or her own ILIT. It will certainly raise inquiry by an examining IRS agent, and will require a most carefully drafted ILIT to avoid a direct or indirect incident of ownership in the policy and to avoid any interest, power or authority that would attract Section 2036 or 2038 inclusion. Beneficiary as Trustee of a Trust Owning Insurance on the Beneficiary s Life. In PLR , the IRS considered the following facts. Husband created a discretionary trust for Wife and descendants. After Husband s death, the trustees were to set aside a percentage of the trust in a marital type trust for Wife and the balance of the trust was payable to descendants. The trust provided that a beneficiary acting as trustee was prohibited from participating in making decisions affecting the disposition of trust property to himself of herself. Husband died and the trust for Wife was created with Wife and Father as trustees. The taxpayers proposed to have Wife resign as co-trustee and thereafter invest a portion of the trust estate in a policy on Wife s life. Wife would receive all the income from the trust, but taxpayers represented that only principal would be used to pay policy premiums and Wife would not pay any policy premiums personally. The IRS concluded that Wife would not be deemed to have any incidents of ownership in the policy nor to have transferred any incidents of ownership in the policy under Section 2042(2). In addition, the proceeds would not be includible in the Wife s estate under Section 2035(a) 13 if the Wife were to die within three years of her resignation as trustee. The taxpayer s position in the ruling appears to have been very conservative. It would seem, given the prohibition on participating in distribution decisions by a beneficiary who is also a trustee, that it would have been sufficient for the Wife, as trustee, to renounce the ability to participate in any decisions concerning the investment in a policy on her own life. Perhaps, the taxpayers believed that such a renunciation of fiduciary authority would not be effective, and therefore opted for a complete resignation prior to investment in the policy. Payment of policy premiums by the Wife should not have caused her to be deemed to have an incident of ownership in the policy, and payment out of her income interest should have been treated similarly, although perhaps the concern was that she would have an interest in the policy by reason of her income interest in the trust if premiums were paid out of income. Other Powers and Interests. Other powers and interests can give rise to incidents of ownership. A greater than 5% reversionary interest (valued immediately before the decedent s death) in a trust owning a policy on the grantor s life is an incident of ownership. 14 On the other hand, an ILIT that eliminates the insured s spouse as a trust 13 Under Section 2035(a)(2), property that would have been included in the decedent s gross estate under Section 2036, 2037, 2038 or 2042 is still included if the decedent made a transfer, for less than full and adequate consideration in money and money s worth, of the interest or power that would have caused the inclusion if held at death during the 3-year period ending on the date of the decedent s death. 14 Treas. Reg l(c)(3). 4

6 beneficiary in the event of divorce should not cause incidents of ownership to be attributed to the insured, but rather should be considered a fact of independent significance with no estate tax inclusion consequence. 15 The power to convert a group term policy to an individual policy may not be an incident of ownership. 16 An issue does arise if a surviving spouse can exercise elective share rights over an ILIT. Revenue Procedure states that if a transfer to a charitable remainder trust can be reached by a surviving spouse for elective share purposes, the charitable remainder trust is disqualified unless the spouse waives the spouse s elective share rights as to the trust. The application of Revenue Procedure was deferred and the grandfather provisions extended by Notice Nevertheless, query whether potential application of a surviving spouse s right of election to an ILIT, for example because the trust was created within one year of death, could cause Sections 2042(1) or (2) to apply to the proceeds upon the death of the insured who created the trust unless a spousal waiver of the right of election is obtained because the trust estate is available to satisfy an obligation of the insured s estate. Incidents of Ownership Through a Corporation. In general, incidents of ownership in a policy owned by a corporation on the life of a controlling shareholder (owning more than 50% of the total combined voting power) are attributed to the shareholder through the shareholder s stock ownership. Treas. Reg (c)(6) provides that in the case of economic benefits of a life insurance policy on the decedent s life that are reserved to a corporation of which the decedent is the sole or controlling shareholder, the corporation s incidents of ownership will not be attributed to the decedent through the decedent s stock ownership to the extent the proceeds of the policy are payable to the corporation. This is an important exception to the attribution of incidents of ownership rule. Proceeds payable to a creditor of the corporation for a valid business purpose so that the net worth of the corporation is increased by the amount of the proceeds are considered payable to the corporation. The decedent will not be deemed to be the controlling stockholder unless, at the time of the decedent s death, the decedent owned stock possessing more than 50% of the total combined voting power of the corporation. The decedent is considered to own (i) the stock to which the decedent had legal title, (ii) the stock in which the decedent had a beneficial interest through a voting trust and (iii) the stock held in any other trust with respect to which the decedent was treated as the owner under the income tax grantor trust rules immediately prior to the decedent s death. Thus, if estate planning with the stock of a closely held corporation using grantor trusts has been implemented, and the proceeds of an insurance policy owned by the corporation are not payable to the corporation, stock ownership must be carefully tallied. Jointly owned stock is counted to the extent of the proportionate consideration furnished by the decedent. However, in the case of group term 15 See Estate of Tully v. U.S., 528 F.2d 1401 (Ct.Cl. 1976); Rev. Rul , C.B. 272 (provision in trust instrument to include after-born or after-adopted children is not retention of a power to change beneficial interests within the meaning of Sections 2036(a)(2) and 2038(a)(1)). 16 See Estate of Smead v. Commissioner, 78 T.C. 43 (1982), acq., I.R.B I.R.B , I.R.B

7 insurance under Section 79, the power to surrender or cancel the policy by a corporation is not attributed to any decedent through the decedent s stock ownership. Incidents of Ownership Through a Partnership. Revenue Ruling concludes that the proceeds of an insurance policy owned by a general partnership in which the decedent was a one-third partner should be included in the decedent s gross estate under Section 2042(2) because the policy proceeds were payable to the decedent s child for a purpose unrelated to the business of the partnership. On the other hand in Estate of Knipp v. Commissioner, 20 the decedent was a 50% general partner in a partnership that owned 10 insurance policies on the decedent s life payable to the partnership. The Tax Court held that the decedent, in his individual capacity, had no incidents of ownership in the policies under Section 2042(2), acknowledging that to hold otherwise would cause double inclusion of the proceeds, once under Section 2042 and once under Section 2031 as part the value of the decedent s partnership interest. Thus, so long as the proceeds of a policy owned by a partnership are payable to the partnership, estate tax inclusion results only in proportion to the partnership interest retained by the decedent, which is similar to the rule described above with respect to corporations Gift Tax Issues Gifts of Policies and Premium Payments. A transfer, to the extent made for less than full and adequate consideration in money or money s worth, is a gift for federal gift tax purposes. Hence, the gratuitous transfer of a policy to an ILIT, a transfer of cash to an ILIT and the payment of a premium on a policy owned by an ILIT are gifts. The gift is equal to the fair market value of the property transferred. Valuation of an Existing Policy Transferred to an ILIT. In general, the gift tax value of an existing policy, depending on the type of life insurance, has been determined using such concepts as replacement cost, 21 interpolated terminal reserve plus a proportionate part of the premium covering the post-gift period, 22 or for group term, the unearned premium. 23 However, different valuation principles for life insurance have recently been articulated in other areas of the law. For example, consideration might be given to Revenue Procedure which, although addressed specifically to the employee benefits area, could become applicable to a gift of a life insurance policy because the gift tax regulations provide only that value may be approximated by interpolated terminal reserve plus unexpired premiums, but do not abandon the general rule that the value of a gift is its fair market value at the time of transfer. Revenue Procedure provides safe harbors for determining the fair market value of a life insurance policy distributed from a qualified retirement plan requiring the use of the greater of (i) interpolated terminal reserve plus unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for the C.B T.C. 153 (1955). 21 Gugenheim v. Rasquin, 312 U.S. 254 (1941). 22 Treas. Reg (a). 23 See, generally, ABA Section of Real Property, Probate and Trust Law, The Insurance Counselor: Federal Gift, Estate and Generation-Skipping Transfer Taxation of Life Insurance at 8 (1991) C.B

8 policy year based upon company performance (a new requirement) and (ii) a more complex formula based on premiums, earnings, reasonable charges and a surrender factor. Query also whether the current activity in the life settlement market has bearing on the valuation of an insurance policy contributed to an ILIT. If the test is what a willing buyer would pay a willing seller for the policy, 25 perhaps the opportunity for life settlement is relevant to the determination of value for gift tax purposes. Funding an ILIT Using the Annual Exclusion. Requirement of a Present Interest. Section 2503(b) permits a donor to exclude as a taxable gift annual transfers of property not exceeding $10,000 (indexed for inflation) per donee. Section 2503(b) requires, in order for a transfer to qualify for the annual exclusion for gift tax purposes, that the transfer be a gift of a present interest, and not a future interest. Treas. Reg (a) defines a future interest to include reversions, remainders and other estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession or enjoyment at some future date or time. Thus, a transfer in trust, because enjoyment does not generally commence until a future time such as when the trustee determines to make distributions, does not typically qualify for annual exclusion treatment. The Supreme Court in Fondren v. Commissioner 26 held that it is not enough to bring the exclusion into force that the donee has vested rights. The court stated: In addition, he must have the right presently to use, possess or enjoy the property.... The question is of time, not when title vests, but when enjoyment begins. Whatever puts the barrier of a substantial period between the will of the beneficiary or donee now to enjoy what has been given him and that enjoyment makes the gift one of a future interest within the meaning of the regulation. 27 In Fondren, the trustee was authorized to distribute income and corpus of the trust for support, maintenance and education, but only in the event of need (which was not contemplated at the time the trust was created). 28 Accordingly, the donee was held not to have a present interest in the assets contributed to the trust. On the other hand, an income interest in a trust will constitute a present interest if the income must be paid. An outright gift of a life insurance policy qualifies as a present interest. 29 However, a requirement that the beneficiary receive all the net income of a trust holding a life insurance policy at least annually will be treated in its entirety as a future interest because 25 As a general rule, the value of property for gift tax purposes is the price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell, and both having reasonable knowledge of the relevant facts. Treas. Reg (a) U.S. 18 (1945). 27 Id. at See also Commissioner v. Disston, 325 U.S. 442 (1945) (discretion to apply income for maintenance and support as necessary did not create a present interest). 29 Treas. Reg (a) confirms that an insurance policy is not per se a future interest. 7

9 the policy is a non-income producing asset. 30 In contrast, the payment of premiums by the insured on a policy owned by someone else will be treated as gifts of a present interest. 31 Section 2503(c) Trust. Section 2503(c) provides an exception to the present interest requirement for a trust satisfying the specific requirements of the Section. Thus, contributions to a life insurance trust for the benefit of a beneficiary under the age of 21 structured to satisfy the requirements of Section 2503(c) should qualify for the annual exclusion until the beneficiary attains age Section 2503(c) provides that no part of a gift to an individual who has not attained the age of 21 years on the date of such transfer shall be considered a gift of a future interest in property for purposes of Section 2503(b) if the property and the income therefrom (a) may be expended by, or for the benefit of, the donee before attaining the age of 21 years, and (b) will to the extent not so expended either pass to the donee upon attaining age 21 or, in the event the donee dies before attaining age 21, be payable to the estate of the donee or as the donee may appoint under a general power of appointment as defined in Section 2514(c). 33 Typically, a Section 2503(c) trust confers on its beneficiary the right, upon attaining age 21 and for a limited period of time, to withdraw all the assets of the trust. If the Section 2503(c) trust were an ILIT, this would mean that the beneficiary would have the right to withdraw and retain the insurance policy. In addition, unless the beneficiary s power of withdrawal continues after age 21, subsequent contributions to the trust may not qualify for the annual exclusion because the beneficiary may have no present right to receive those contributions. Although it might not often be the case, a Section 2503(c) trust should not be ruled out as a possible form of ILIT because it will avoid an annual power of withdrawal and the need for the annual notices required in a so-called Crummey power ILIT, discussed below. And if the policy becomes paid up during the period prior to the beneficiary attaining age 21, no further contributions to pay premiums would be required. 30 See Phillips v. Commissioner, 12 T.C. 216 (1949); see also Treas. Reg (c) Example (2) (income distributions that begin only after an insurance policy matures is a gift of a future interest). 31 Treas. Reg (c) Example (6). 32 See Duncan v. U.S., 368 F.2d 98 (5 th Cir. 1966). 33 Note that if the beneficiary is a skip person for generation-skipping tax purposes, a Section 2503(c) trust may be sufficient to obtain a zero inclusion ratio under 2642(c). Section 2642(c) provides that a transfer that is not treated as a taxable gift by reason of Section 2503(b) is a direct skip that has an inclusion ratio of zero. A transfer to a trust for the benefit of an individual qualifies as a non-taxable gift if during the life of such individual no portion of the trust may be distributed to or for the benefit of any other person and 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. Until age 21, a Section 2503(c) trust is also solely for the benefit of a single beneficiary, and is fully includible in the beneficiary s gross estate if the beneficiary dies. However, typically, in a Section 2503(c) trust, the donee is given a power to withdraw all the assets of the trust at age 21 for a limited period of time, after which the power of withdrawal typically lapses, but the trust continues. However, if the general power of appointment lapses as to any portion of the trust in a manner that avoids estate tax inclusion, for example because the lapse is not treated as a release under Section 2514(e) to the extent it is equal to the greater of $5,000 or 5% of the trust corpus, the trust may no longer qualify as a good Section 2642(c) trust. That is because Section 2642(c) requires that the entire trust corpus either be distributable to the beneficiary or be includible in the beneficiary s gross estate until the beneficiary s death. Thus, it may be that the beneficiary s power of withdrawal cannot lapse if the trust is intended also to qualify for Section 2642(c) treatment. See, e.g., PLR

10 Completed Gift Requires Surrendering Dominion and Control. A transfer will not qualify for the annual exclusion unless the transfer is complete for gift tax purposes. Treas. Reg provides that a gift of property is complete when the donor has so parted with dominion and control as to leave the donor no power to change its disposition, whether for the donor s own benefit or for the benefit of another. A transfer of an existing policy to an irrevocable trust is usually a completed gift for gift tax purposes. The irrevocable designation of a beneficiary of a policy is also a completed gift. However, a gift is incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves. But a gift is not considered incomplete merely because the donor reserved the power to change the manner or time of enjoyment by, for example, delaying or accelerating the time when the donee s enjoyment is realized. Note that a retained power to affect the timing of enjoyment, even if the gift is complete, may cause the property subject to the power to be included in the donor s estate under Section 2038, unless the power is limited by an ascertainable standard. 34 The foregoing rules again weigh in favor of avoiding the designation of the insured as the trustee of his or her own ILIT so as to ensure a complete gift to the ILIT and avoid potential estate tax inclusion. Transfers by Cash or by Check. A gift of cash to a trust is complete when the transferor relinquishes dominion and control. 35 If the gift is made by check and state law permits the transferor to stop payment, the gift is not complete until payment of the check by the transferor s bank when the trustee cashes it. 36 More recently, however, courts have been willing to apply the doctrine of relation back in a non-charitable context where checks were delivered to the donee and presented for payment within a short time and within the tax year, even though not honored until the following year. 37 On the other hand, if a check is delivered to the donor s agent, no completed gift occurs. 38 Accordingly, if trust contributions are made by check, the best practice will be for the trustee to negotiate the checks within the taxable year to ensure that the gifts by the transferor are complete in that year. Crummey Powers of Withdrawal. In order to qualify contributions to an ILIT for the annual exclusion, the beneficiaries of the trust are usually given what is known as a Crummey power of withdrawal, named after the case Crummey v. Commissioner. 39 In Crummey, each of four children, two of whom were minors, were given the power from the time of the addition to the trust until December 31 of the year in which the transfer to the child s trust was made to demand in writing, in cash, the lesser of $4,000 or the amount of the transfer. The court held that whether a present interest exists turns on whether the donee is legally and technically capable of immediately enjoying the property. The court found 34 See Treas. Reg (a) (Section 2038 is applicable to a power reserved by the grantor of a trust to accumulate income or distribute it to A, and to distribute corpus of A, even though the remainder is vested in A or A s estate, and no other person has any beneficial interest in the trust). 35 Treas. Reg (b). 36 See Dillingham v. Commissioner, 88 T.C (1987), aff d, 903 F.2d 706 (10th Cir. 1990) (court refused to extend the relation back doctrine applicable to charitable gifts to non-charitable gifts). 37 See Metzger v. Commissioner, 38 F.3d 118 (4 th Cir. 1994). 38 See Estate of Holland v. Commissioner, 32 T.C.M. (CCH) 3236 (1997) F.2d 82 (9th Cir. 1968), rev g on this issue T.C. Memo (1966). 9

11 that the parent could make a demand on behalf of the minor, and that it would be up to the trustee to petition the court for a legal guardian to receive the funds. The court declined to establish a test based upon the likelihood that the demand right would be exercised. 40 As most frequently used, a Crummey power is a power, for a limited period, to withdraw an amount of the contribution not in excess of the annual exclusion available (generally, $10,000, indexed, or $20,000, indexed, if the transferor and the transferor s spouse elect split-gift treatment under Section 2513 and the powerholder is not the transferor s spouse) legally exercisable by a beneficiary or his or her guardian, whether or not a guardian has been appointed. Although IRS rulings indicate at least 30 days notice is required, the IRS has acquiesced in the result in the Estate of Cristofani v. Commissioner, 41 which held that a right of withdrawal not in excess of the annual exclusion exercisable by the decedent s children and five contingent remainder grandchildren for a period of 15 days following a transfer to the trust to constitute gifts of a present interest in each case within the meaning of Section 2503(b). In Cristofani, all trust income was payable equally to decedent s two children and upon the decedent s death, the trust was divided into two equal trusts for the benefit of the decedent s children and payable to them upon surviving the decedent by 120 days. The court found that the decedent intended to benefit his grandchildren based upon the trust provisions, and that there was no agreement or understanding among the decedent, the trustees and the beneficiaries that the decedent s grandchildren would not exercise their withdrawal rights, even though the rights were not exercised and the grandchildren never received trust distributions. 42 On the other hand, where the facts and circumstances indicate a prearranged understanding that the withdrawal right would not be exercised, the annual exclusion may be denied especially in the case where the powerholders have no other interest in the trust. 43 The beneficiary must have not only prompt notice but also a reasonable opportunity to exercise the right of withdrawal. 44 Caution dictates notifying the beneficiary of the exact amount of the contribution and the amount that can be withdrawn. In TAM , the IRS ruled that a waiver of contemporaneous notice as to future gifts to a trust disqualified those gifts as present interests because [w]ithout the current notice that a gift is being transferred, it is not possible for a donee to have the real and 40 See Rev. Rul , C.B. 321 (gift in trust for the benefit of a minor should not be classified as a future interest merely because no guardian was in fact appointed, if there is no impediment under the trust or local law to the appointment of a guardian and the minor donee has a right to demand distribution); Rev. Rul , C.B. 329 (when a trust instrument gives a beneficiary the power to demand immediate possession of corpus, the beneficiary has received a present interest) T.C. 74 (1991), acq. in result only, I.R.B See also Estate of Kohlsaat, T.C. Memo (1997) (sixteen contingent remainder beneficiaries with 30 day demand rights held to qualify transfers for the annual exclusion; court refused to infer an implied understanding that the beneficiaries had agreed with the decedent not to exercise their withdrawal rights). 43 See, e.g., PLR Rev. Rul. 81-7, C.B. 474 (right to withdraw corpus qualifies as a present interest if the beneficiary has notice of the withdrawal right and a reasonable opportunity to exercise the power). See, e.g., PLR (if the trustee gives prompt notice of the contribution to the beneficiary or the beneficiary s custodian and there is no express or implied agreement that the withdrawal right will not be exercised, contributions to the trust will qualify for the annual exclusion). 10

12 immediate benefit of the gift. Accordingly, contemporaneous notice (within a reasonably short time of the transfers to the trust) coupled with proof that notice was given is the best practice to establish qualification for the annual exclusion. It may also be possible to satisfy the notice requirement by providing a schedule of contributions, such as, for example, in the case of a group term policy where the employer pays premiums directly, with an undertaking to notify the beneficiaries if the amount or timing of the contributions changes. 45 Actual notice will also suffice, but the difficulty will be proving that the notice took place. However, in clean-up mode a written acknowledgment of actual notice by the beneficiaries may save the day. If the parent of a minor trust beneficiary with a withdrawal right is the trustee of the trust, there is no need to record written notice from the trustee to the parent. 46 Potential Gift and Estate Tax Consequences to Holders of Crummey Powers. A Crummey withdrawal right is a general power of appointment within the meaning of Section 2514(c). The lapse of a Crummey power of withdrawal will be considered a release of the power, and consequently a taxable transfer by the powerholder to the extent the value of the property subject to the power exceeds of the greater of $5,000 or 5% of the then value of the trust. 47 Revenue Ruling describes the application of this 5 and 5 exemption to multiple transfers to a single trust and transfers to multiple trusts and the requirement of aggregation and adopts an annual approach so that the 5% limitation is measured by the value of the trust on the date of each lapse of a power of withdrawal during a given calendar year, and the highest value may be used. However, having multiple lapse dates, which may have appeal from the standpoint of limiting the opportunity that the beneficiaries will have actually to withdraw trust funds, can be a record-keeping nightmare. Accordingly, many practitioners adopt the method originally articulated in the Crummey case, which is to extend all withdrawal rights to December 31 of each calendar year or, to the extent of contributions made during December, to extend those to December 31 of the following year. Whether the lapse of a withdrawal right in excess of the $5,000/5% amount under Section 2514(e) is a current gift by the powerholder for gift tax purposes will depend on the terms of the trust instrument. If the property subject to the right of withdrawal is held in a trust for the exclusive benefit of the powerholder and the powerholder has a testamentary nongeneral or general power of appointment, no completed gift will occur because the powerholder has not relinquished dominion and control over the property. 49 If Crummey powers of withdrawal in excess of the amount under Section 2514(e) are permitted to lapse creating a current taxable gift by the powerholder, a portion of the trust may nevertheless be includible in the gross estate of the powerholder under Section 2041(a)(2). Section 2041(a)(2) requires inclusion in the gross estate of a proportionate share of the trust with respect to which there has been a release of a general power of appointment to the extent that the post-lapse interests in the property, if the powerholder had owned and 45 See TAM (authorizing an annual notice). 46 See Estate of Holland v. Commissioner, 32 T.C.M. (CCH) 3236 (1997). 47 Sections 2514(b) and (e) C.B See Sanford s Estate v. Commissioner, 308 U.S. 39, reh. den., 308 U.S. 637 (1939). 11

13 transferred such property to the trust, would have caused inclusion under Sections 2035, 2036, 2037 or This is another example of the application of both gift and estate tax to the same transfer. Thus, even if a completed gift occurs by reason of the lapse of a power of withdrawal, there could be estate tax inclusion. Here s why. The lapse of a power of withdrawal treated as a taxable gift will cause the powerholder to be treated as the settler of any continuing trust. If the powerholder has a continuing interest in the trust (for example, as a discretionary beneficiary), the trust will be treated as a self-settled trust. And a discretionary interest in a self-settled trust that can be reached by the settlor s creditors under applicable State law will cause the trust to be included in the powerholder s gross estate. 50 In addition, the amount over which the powerholder has a current Crummey power of withdrawal at his or her death will be includible under Section 2041(a)(2). As previously stated, a completed gift as a result of the lapse of a power of withdrawal may be avoided if the powerholder has a testamentary power of appointment over the property with respect to which the lapse occurred. 51 Even if no taxable lapse has occurred because the powerholder has a power of appointment over the continuing trust making the powerholder s deemed transfer to the trust an incomplete gift, a portion of the trust will be includible in the powerholder s gross estate under Sections 2041(a)(2) and 2038 because the powerholder has retained the right to determine who will receive the property. Hanging Powers. One solution to both the gift and estate tax exposure described above is to avoid a taxable lapse (that would constitute a release) of the power of withdrawal through the use of a hanging power. A hanging power is a power to withdraw all of each addition up to the maximum amount permitted under the annual exclusion, that lapses only to the extent of $5,000 or 5% of the trust principal. The balance hangs into future calendar years until the lapse of the power will not be treated as a release under Section 2514(e). 52 The amount subject to a hanging power of withdrawal can build up rapidly in the early years of the trust in view of the $5,000 or 5% maximum lapse permitted under Section 2514(e). Although it may not be the intention that any beneficiary actually exercise the power (no implied understanding, please), the occasional beneficiary will give it a whirl. One suggested way to cope with this possibility is to require the consent of another person (such as the trustee) with respect to the portion that hangs beyond the original Crummey 50 See Outwin v. Commissioner, 76 T.C. 153 (1981) (transfer to a trust that could be reached by the settlor s creditors was incomplete for gift tax purposes). Treasury Regulations (d)(4) and l-3(d)(5) explain how to calculate the includible portion of the trust, and indicate that lapses in multiple years will cause an ever increasing fraction of the trust to be includible because the fractions for each year are added to create a cumulative total, not to exceed the total assets over which the powers could have been exercised. 51 Whether a testamentary special power of appointment is sufficient to avoid a completed gift is not entirely clear. The examples under Treas. Reg (b) state that a gift is incomplete with respect to a transfer to a trust for the exclusive benefit of the transferor and over which the transferor has retained a testamentary special power of appointment. Thus, it is possible that a trust which includes other current beneficiaries is not within the foregoing exception. 52 Care should be taken to draft the hanging power in such a way that it will not be characterized as a condition subsequent. See TAM In addition, one commentator has expressed the view that a hanging power may not be effective if the trust is funded with term insurance, even if the policy can be withdrawn by exercise of the power, because the value of the policy reaches zero by the end of the term; hence, the value of the trust is less than the value of the hanging power. 12

14 withdrawal period. If the consentor is a person who is not the creator of the trust and who has no substantial interest in the trust adverse to the exercise of the hanging power, the power should continue to be a general power of appointment with respect to the powerholder. 53 Accordingly, no lapse of a general power of appointment should occur by requiring consent to the exercise of the hanging power. Note that consent may not be required for purposes of exercising the original Crummey power without violating the present interest rule. 54 However, after the initial withdrawal period, the continuing withdrawal right that avoids the lapse of a general power could require consent for its exercise. One commentator has suggested a form of hanging power that specifically provides for a pro rata termination, taking account of the current Crummey power and all unlapsed hanging powers from prior years, but acknowledges that, alternatively, the powers could lapse in the order of created. 55 The pro rata termination method requires allocating the permissible lapse amount among the current and hanging powers proportionately and carrying over the balance. In all events, the manner in which the successive lapses are to occur should be made clear in the instrument to avoid a construction that because it cannot be determined what lapses when, the powers hang indefinitely. The simplest method is to have a single lapse date each year and require the earliest withdrawal right to lapse first. Gift-Splitting Considerations. Section 2513(a)(1) provides that a gift made by one spouse to any person other than his or her spouse shall, for gift tax purposes, be considered made one-half by each spouse. Gift splitting is permitted only if the following conditions are met: (1) at the time of the gift, both spouses are either citizens or residents of the United States so that each is fully subject to U.S. gift tax under Section 2502; (2) the spouses are married at the time of the gift, and if they subsequently divorce during the taxable year neither remarries prior to the end of the calendar year; and (3) both spouses consent to giftsplitting. However, gifts with respect to which the consenting spouse has an interest, unless the interest of third parties is ascertainable at the time of the gift and hence severable from the interest transferred to the spouse, may not be split. 56 This rule will affect most ILITs which usually create an interest in the consenting spouse. In PLR , Wife created a trust for Husband and three children. Husband was the trustee of the trust. Husband s authority to distribute property to himself was limited by an ascertainable standard. The trust provided that upon each transfer by gift to the trust, each descendant of Wife could withdraw an amount from the trust equal to the lesser of the annual exclusion or a pro rata share of the contribution based upon the number of beneficiaries at that time. The taxpayer represented that contributions to the trust would not exceed twice the available annual exclusion multiplied by the number of Wife s descendants who possessed a power of withdrawal. The powers of withdrawal would lapse, but only as to $5,000 or 5% of the assets subject to withdrawal in each year. The ruling 53 Section 2041(b)(1)(C); see Rev. Rul , C.B See Treas. Reg (b) (only an unrestricted right to immediate use, possession or enjoyment of property is a present interest). 55 Practical Drafting at 1812, R. B. Covey ed. July Treas. Reg (b)(4). 13

15 concludes that split gift treatment was available because [t]he right of the trustee to make discretionary distributions to either Husband or the descendants is subordinate to the right of the descendants to exercise their withdrawal right. Thus, the gifts were deemed made to the holders of the powers of withdrawal, not to the trust of which the Husband was a beneficiary, for purposes of analyzing whether split gift treatment was available. However, a more recent PLR cast doubt on the foregoing treatment of powers of withdrawal. In PLR , Husband established an irrevocable trust for the primary benefit of Husband and Wife s children. The Husband s descendants had a noncumulative right to withdraw all or part of each contribution to the trust. The trust contained a qualified terminable interest property (QTIP) marital trust for Wife in the event Husband died within three years from the date of funding and a substantial portion of the trust estate were included in Husband s gross estate for federal estate tax purposes. No gift tax returns were filed in the first two years that contributions were made to the trust. In the following three years, gift tax returns were filed and Husband signified Wife s consent to split gifts on his gift tax return, but Wife never signed the return. The IRS concluded that split gift treatment was available for all five years because Wife s interest is susceptible of determination and therefore severable from the gifts to the other beneficiaries. Thus, to the extent the value of the transfers to the trust exceeded the actuarial value of Wife s interest as determined under Section 7520, split gift treatment was available. The IRS also concluded that since no returns were filed for years 1 and 2, split gift treatment would be available under Section 2513(b)(2)(A) which permits consent to split-gift treatment to be signified on the first filed return for the year. Because Husband and Wife evidenced their intention to elect split gift treatment for years 3, 4 and 5 on Husband s return, and Wife did not file her own return, the consent to split gift treatment was effective for those years as well. Unfortunately, the effect of the Crummey powers on split gift treatment was not analyzed. But to the extent contributions to the trust did not exceed the amount subject to the powers of withdrawal, the existence of Wife s QTIP trust should have been irrelevant to the analysis of whether splitgift treatment was available. The IRS has also ruled that a spouse who consents to split gift treatment under Section 2513 with respect to transfers made by the other spouse will not become a transferor to the trust for purposes of Section 2036 or In addition, the consenting spouse acting as trustee of the trust will not be deemed to have a general power of appointment so long as distributions may not be made to satisfy the spouse s support obligations and distributions to the spouse are limited by an ascertainable standard. However, the consenting spouse will become a transferor of one-half the property transferred to the ILIT for GST purposes. 58 Use of Loans to Pay Premiums.. In PLR , Husband was the owner and insured of a life insurance policy having an interpolated terminal reserve value of $X. Wife was owner and insured of a life insurance policy having an interpolated terminal reserve value of $Y. Both policies were transferred to a Trust created by Husband and Wife and by their four children with Child as trustee. The Trust was revocable by any of the four children, in which case the trust estate would be distributed equally to those children. The 57 See, e.g., PLR Treas. Reg (b)(1) Example 9. 14

16 Trust issued a deferred obligation to Husband and Wife represented by a note with a face value of $X + $Y less the amount of anticipated available annual exclusions. The intent was to exchange the two policies for a single second to die policy insuring the lives of Husband and Wife having a face amount of $Z that would be the property of the Trust. Each beneficiary acknowledged the gift to the Trust and the intent to contribute sufficient funds to the Trust to satisfy the deferred obligation and to pay ongoing premiums on the policy. Husband and Wife acknowledged that a split gift was made to the four children equal to the allowable annual exclusions. The life insurance agent presented documents and Husband and Wife assumed they were properly done, but the new policy was issued to Husband and Wife as the owners rather than to the Trust. All premium notices were sent to Child as trustee and Child paid the premiums. Husband and Wife did not file United States Gift (and Generation-Skipping Transfer) Tax Returns, Forms 709, in year 1. A few months later on January 1 of year 2, Husband and Wife executed a Declaration of Gift and Forgiveness of Note. Taxpayers requested rulings that the policy could be reformed and assigned to the Trust as owner without gift tax consequences, and that the proceeds of the policy would not be included in the gross estate of either Husband or Wife under 2035 if one or both were to die within 3 years of the reformation and assignment. The IRS ruled that there would be no taxable gift as a result of the reformation and assignment and that 2035 did not apply. Nevertheless, spontaneously for purposes of sound tax administration, the IRS ruled that the deferred obligation was part of a prearranged plan with an intent to forgive the note. Facts cited in support were forgiveness a few months later, in a different tax year, and the fact that no payments on the note were ever made. Accordingly, the ruling concludes the note was part of prearranged plan to avoid gift tax. Thus the note did not constitute adequate and full consideration in money or money s worth resulting in a gift in year 1 equal to the principal of the note, rather than a gift in year 2 eligible for a second round of annual exclusions. The use of notes to fund an ILIT may be viewed as problematic because the ILIT may not be able to satisfy the criteria to support the note as bona fide debt. A number of factors have been identified by the courts as indicative of bona fide debt, which include the ability to pay interest currently and to have assets sufficient to satisfy the debt, perhaps independent of the asset acquired with the proceeds of the loan. 59 However, because an ILIT is typically a grantor trust, the issue of interest income and the deductibility of the 59 See Miller v. Comm'r., 71 T.C.M (1996), aff d, 113 F.3d 1241 (9 th Cir. 1997) ( The mere promise to pay a sum of money in the future accompanied by an implied understanding that such promise would not be enforced is not afforded significance for Federal tax purposes, is not deemed to have value, and does not represent adequate and full consideration in money or money s worth.... The determination of whether a transfer was made with a real expectation of repayment and an intention to enforce the debt depends on all the facts and circumstances, including whether: (1) There was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was any security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) any actual payment was made, (7) the transferee had the ability to repay, (8) records maintained by the transferor and/or the transferee reflected the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax purposes is consistent with a loan ). See, also, Santa Monica Pictures, LLC v. Comm'r, TC Memo But see, Estate of Rosen v. Commissioner, T.C. Memo

17 interest expense does not arise. 60 Thus, perhaps an accrual of interest until the policy matures can be justified without raising other tax issues. Additional Estate Tax Issues Section 2035 provides that life insurance proceeds are includible in the decedent s gross estate even if the decedent has no incidents of ownership at death, if the decedent transfers within three years of the decedent s death an interest in the policy that would have caused the proceeds to be includible in the decedent s gross estate had the decedent retained the interest (Sections 2035(a)). Section 2035(d) provides an exception for transfers for full and adequate consideration. Deemed Transfer Rule. Under the now discredited deemed transfer rule articulated in Bel v. United States, 61 the proceeds of an insurance policy acquired by a trust within 3 years of death may be includible in the decedent s gross estate even if the decedent never actually possessed any incidents of ownership. Under the rule, a decedent may be held responsible for the existence of the policy at death (and thus treated as if he or she had owned the policy), either because the decedent paid premiums or otherwise controlled the actual owner, and is therefore deemed to have made a transfer creating the contractual rights in the policy beneficiary. The deemed transfer within three years of death causes the entire proceeds to be includible in the decedent s gross estate. The deemed transfer rule, if applied, in effect resurrects the old payment of premiums test for inclusion of life insurance proceeds when the policy is acquired within three years of death. However, subsequent cases have discredited the deemed transfer rule. In Estate of Headrick v. Commissioner, 62 the Commissioner sought to include the proceeds of an insurance policy purchased within three years of death by the trustee of an ILIT created by the decedent. The decedent alone made contributions to the trust. The Tax Court, in a unanimous reviewed decision, held that the proceeds were not includible in the decedent s gross estate following its decision in Estate of Leder v. Commissioner. 63 The court found that the bank/trustee was not acting as the decedent s agent, and rejected applying the constructive transfer theory articulated in Bel. 64 An interesting point is that the Commissioner apparently conceded that the decedent s right to remove any trustee at will and appoint a successor bank trustee was not an incident of ownership. 65 In Estate of Perry v. Commissioner, 66 the court held that proceeds from life insurance policies purchased within three years of the decedent s death were not includible in his gross estate, despite the fact that he had signed an application for insurance as proposed insured, 60 Under Rev. Rul , C.B. 184, a loan between a grantor and a grantor trust is not recognized for federal income tax purposes F.2d 683 (5th Cir. 1971), cert. denied, 406 U.S. 919 (1972) T.C. 171 (1989), aff d, 918 F.2d 1263 (6th Cir. 1990) T.C. 235 (1987), aff d, 893 F.2d 237 (10th Cir. 1989). 64 Note Action on Decision CC (July 3, 1991) announcing that the Service will no longer litigate this issue and recommending acquiescence. 65 Cf. Rev. Rul , supra T.C.M. (CCH) 65 (1990), aff d, 927 F.2d 209 (5th Cir. 1991). 16

18 and had paid the premiums. The application designated the decedent s three sons as coowners, and the court found that the decedent never held any ownership, economic, or other contractual rights in the policies. In light of Perry, the trustee of the ILIT should apply for the insurance and the insured should be careful not to sign the application as the owner, but only consent to the application as the insured. Note that even if a transfer of the policy is made within three years of death, a portion of the proceeds may nevertheless be excludible. In Estate of Silverman v. Commissioner, 67 the court held that the portion of the proceeds of a life insurance policy includible in the decedent s gross estate under Section 2035, if the assignee paid the premiums during the three year inclusion period, should be calculated by multiplying the entire proceeds by a fraction, the numerator of which is the amount of premiums paid by the decedent, and the denominator of which is the entire amount of premiums paid since the inception of the policy. Use of a Protective Marital Deduction Trust. If existing policies are transferred to an ILIT by a married individual, the ILIT should contain a provision creating a trust that qualifies for the marital deduction in the event of the insured s death within the three-year inclusion period (or if estate tax inclusion occurs for any other reason). Because an insurance trust is irrevocable, any provisions for the benefit of the surviving spouse should be thought through carefully in light of the realities of possible divorce and second family circumstances. A so-called QTIP trust within the meaning of Section 2056(b)(7) is preferable because the settlor will control the ultimate disposition of the proceeds upon the spouse s death and the amount of marital deduction used. 68 In addition, if the definition of surviving spouse is modified either to exclude an existing spouse in identified situations or include a future spouse, care should be taken to make sure tax sensitive powers (such as powers to maintain grantor trust status discussed below) take account of any modified definition of spouse. Transfers for Full and Adequate Consideration. Section 2035(d) creates an exception to the application of the transfer within three years of death rule for transfers for adequate and full consideration in money or money s worth. To the extent a policy is owned by the insured and would thus be includible under Section 2042(2), a transfer to an ILIT for full and adequate consideration should avoid estate tax inclusion of the policy proceeds. 69 Caution should be exercised in establishing the appropriate value of the policy T.C. 338 (1973), aff d, 521 F.2d 574 (2d Cir. 1975), acq., C.B A QTIP trust qualifies for the marital deduction only to the extent elected. If the insured s spouse may not be a U.S. citizen when the insured dies, the trust should be in the form of a QDOT. 69 For a more comprehensive discussion of the topic, see M. Gans & J. Blattmachr, Life Insurance and Some Common 2035/2036 Problems, 139 Trusts & Estates 58 (May 2000), reprinted in 26 ACTEC Notes 39 (Summer 2000). 70 Although Treas. Reg permits value to be estimated by interpolated terminal reserve plus unexpired premiums, in the context of qualified plans other factors have been used. See Rev. Proc , C.B It would seem that values that may be established by the life settlement market are too fluid to be relevant. If death is imminent value may approach face. See Pritchard v. Comm r, 4 T.C. 204 (1944). 17

19 A transfer for full and adequate consideration can potentially avoid the application of all of Sections 2036, 2038 and Section 2036 could apply if the insured s spouse has at any time been the owner of the policy and is intended to be a beneficiary of the ILIT. Section 2038 could apply if the transferor is intended to be a trustee of the ILIT. A transfer for consideration also raises the issue of whether full and adequate consideration is measured by the value of what would have been included in the estate (the policy proceeds) or the fair market value of the policy at the time of transfer. The better view is that it should be the latter based upon the principle of arms length dealing articulated in Treas. Reg since no arms length purchaser would pay more than current value for the policy. 71 Some argue that under the Allen 72 case involving the sale of an income interest in a trust, fair market value is measured by what would have been included in the gross estate at death, which in the case of a life insurance policy would be the policy proceeds. But that analysis would seem flawed because in the case of a purchase of a policy, the entire asset is transferred. In Allen, only the income interest was sold in order to exclude the underlying principal of the trust from the gross estate under Section 2036(a)(1). That result should be distinguished from the case where the remainder interest is sold for its actuarial value, a result that has been upheld because the remainder interest over the life expectancy of the beneficiary would grow to equal the value of the trust. 73 Moreover, the ILIT will likely have a continuing obligation to pay premiums in order to receive the policy proceeds. The payment of those premiums, in the view of the insurer, is actuarially appropriate consideration for the right to receive the death benefit. Accordingly, payment of an amount equal to the current fair market value of the policy, plus payment of future premiums, is economically equal to the value of the death benefit, and there is no windfall to the taxpayer in the transaction. So long as the trust is a wholly grantor trust for income tax purposes, a sale of assets to the trust by the grantor is disregarded. If the non-contributing spouse has a discretionary interest as to both income and principal, the trust should be wholly grantor under Section 677(a)(1) as to the contributing spouse. Accordingly, no income tax realization event occurs and the policy proceeds should be excluded from both estates. 74 Application of the Reciprocal Trust Doctrine. If both husband and wife contemplate creating an ILIT, consideration should be given to the potential application of the reciprocal trust doctrine. The U.S. Supreme Court set forth the doctrine in its current form in the seminal case U.S. v. Grace. 75 In Grace, husband and wife created virtually identical trusts for one another. The decedent s trust was created within 15 days of the wife s trust. The wife s trust, at issue in Grace, provided that the trustees were to pay all the income to the husband, with principal payable in the discretion of the trustees. The husband also had a testamentary special power of appointment in favor of the wife and their descendants. The wife used funds given to her by the decedent to create the trust. The Supreme Court held that the two trusts were interrelated and, to the extent of mutual value, left the settlors in 71 Compare U.S. v. Allen, 293 F.2d 916 (10 th Cir. 1961). 72 Id. 73 See, e.g., Estate of D Ambrosio v. Comm r, 101 F.3d 309 (3 rd Cir. 1996). 74 See, e.g., PLR U.S. 316 (1969). 18

20 approximately the same position as they would have been in had they created trusts naming themselves as life beneficiaries. Accordingly, to the extent of the mutual value, the wife s trust was includible in the husband s estate under the predecessor to Section 2036(a)(1). In other words, husband was deemed the settlor of the trust for husband s benefit created by wife. Importantly, the Court ruled that the reciprocal trust doctrine is dependent neither upon a finding that each trust was created as a quid pro quo for the other nor upon the existence of a tax-avoidance motive. In Estate of Bischoff v. Commissioner, 76 the Tax Court extended the application of the reciprocal trust doctrine to trusts created by a husband and wife in which neither had any beneficial interest. Each of Bruno and Bertha Bischoff created four trusts, one for each of their four grandchildren, naming each other as sole trustee. The trustee was authorized to apply income and principal for the benefit of the grandchild, and to accumulate income not so applied. The trusts were created within 2 days of each other. Bruno died approximately 2 years before Bertha. The Tax Court refused to limit the application of the reciprocal trust doctrine to crossed economic interests, and held that the trusts created by Bruno and Bertha were includible in their respective estates under Section 2036(a)(2) and Section 2038(a)(1). Note that this is not exactly what the Grace court did. The Grace court would have included the trusts created by Bruno in Bertha s estate and vice versa. In other words, Grace would treat each spouse as the settlor of the trust in which that spouse has the tax includible power. In Sather v. Commissioner, 77 each of three brothers and their wives attempted to make annual exclusion gifts to their own children and to each others children. The court denied the annual exclusion for the gifts to nieces and nephews under the reciprocal trust doctrine, treating those gifts as if made by the parents. All gifts were of family stock and were made on the same day and in the same amounts. On the other hand, in Estate of Levy v. Commissioner, 78 the Tax Court held that the reciprocal trust doctrine did not apply to two similar trusts created by decedent and his wife. The two trusts were identical, except that the husband s trust conferred on the wife, individually and not as trustee, a special power of appointment entitling her to appoint income and corpus of the husband s trust at any time during her lifetime to any person or persons other than herself, her creditors, her estate or the creditors of her estate. The trusts were created on the same day. Each trust appointed the other spouse as sole trustee. It appears that the spouses had no other interests in the trusts. Moreover, in Estate of Green v. U.S., 79 the Sixth Circuit refused to apply the reciprocal trust doctrine based solely on fiduciary powers (expressly discrediting the Bischoff decision) where husband created a trust for the benefit of one granddaughter, naming wife as trustee, and wife created a trust for the benefit of a different granddaughter, naming husband as trustee. The trustee had the power to accumulate income and time the distribution of income and corpus until the beneficiary reached age 21. The trusts were T.C. 32 (1977) F.3d 1168 (8 th Cir. 2001) T.C.M. (CCH) 910 (1983) F.3d 151 (6 th Cir. 1995). 19

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