PLANNING WITH IRREVOCABLE LIFE INSURANCE TRUSTS. September 14, R. Glenn Davis Scott, Hulse, Marshall, Feuille, Finger & Thurmond, P.C.

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1 PLANNING WITH IRREVOCABLE LIFE INSURANCE TRUSTS September 14, 2009 R. Glenn Davis Scott, Hulse, Marshall, Feuille, Finger & Thurmond, P.C. 201 East Main, 11 th Floor El Paso, Texas (Office) (Facsimile) 201 North Church Street, Ste. 201 Las Cruces, New Mexico COMMUNITY FOUNDATION OF SOUTHERN NEW MEXICO 16TH ANNUAL ESTATE PLANNING INSTITUTE November 6-7, 2008 Las Cruces, New Mexico

2 R. Glenn Davis Shareholder 1100 Chase Tower 201 East Main Drive El Paso, Texas Telephone (915) Facsimile (915) NORTH CHURCH STREET, SUITE 201 LAS CRUCES, NEW MEXICO TELEPHONE (575) FACSIMILE (575) Legal Experience: Scott, Hulse, Marshall, Feuille, Finger & Thurmond, P.C., El Paso, Texas. Shareholder January 2001 to present; Associate September 1995 to December Practice includes estate planning, asset protection, probate and contested estates. Experience includes eleven years of trial practice in employment, commercial and general litigation. Licensed in Texas and New Mexico and admitted to the federal courts in the Western District of Texas, the District of New Mexico and the United States Court of Appeals for the Fifth Circuit. United States District Court for the Western District of Texas, El Paso, Texas. Law Clerk for Chief Judge Harry Lee Hudspeth August 1994 to August Supreme Court of the State of Texas, Austin, Texas. Intern for Justice Lloyd Doggett January 2004 to May Articles and Speeches: Scheduled Course Director: 2 nd Annual New Mexico State University Estate Planning Conference for Women, January February th Annual Advanced Drafting: Estate Planning and Probate Course. State Bar of Texas Drafting for the Settlement of Estates and Trusts, October 30-31, New Mexico State University Estate Planning Conference for Women Legal and Practical Aspects of Estate Planning, January 23, th Annual Estate Planning Institute. Community Foundation of Southern New Mexico Advanced Planning Techniques with Incapacity in Mind, November 1-2, University of Texas at El Paso Estate Planning Conference for Women Legal and Practical Aspects of Estate Planning, January 24, Estate Planning for Mexican Nationals with U. S. Assets, January 2007 (Co-Author). Education: University of Texas School of Law, J.D. with honors, Order of the Coif May Texas A & M University, B.A. Economics, Magna Cum Laude May Civic and Religious Involvement: Leadership El Paso Class XXIX, Greater El Paso Chamber of Commerce, El Paso, Texas. Participant, Insights El Paso Science Museum, El Paso, Texas. Board Member July 2006 to May 2008; Vice President June 2004 to June 2006; Board Member June 2002 to June Keep El Paso Beautiful, Inc., El Paso, Texas. Vice President 2001 to 2002; Board Member Beth El Bible Evangelical Free Church, El Paso, Texas. Elder December 2001 to May 2008; Member 1995 to present. Memberships: American Bar Association; State Bar of Texas; State Bar of New Mexico; Real Estate, Probate and Trust Section of the State Bar of Texas; El Paso Bar Association; El Paso Estate Planning Council; and Southern New Mexico Estate Planning Council. Family: Married to Laura Davis with four daughters: Emma (9 years), Audrey (7 years), Camille (5 years) and Julia (5 years).

3 TABLE OF CONTENTS I. INTRODUCTION... 1 A Scope of Paper... 1 B. The Problem... 1 C. The Significant Benefits of ILITs Estate Exclusion Estate Liquidity Control of Insurance Proceeds... 2 C. The Significant Limitations of ILITs Irrevocability of the ILIT The Form Must Be Followed Gift Tax and GSTT Consequences Three Year Look Back Period Policy Lapses... 4 D. Alternatives to ILITs Community Property Ownership Spousal Ownership Ownership of Policy by Descendants Policy Ownership by Family Business Entity... 5 II. GENERAL STRUCTURE OF ILITs... 5 A. Avoidance of Incidents of Ownership... 5 B. Identity of the Grantor Insured as Sole Grantor Insured and Spouse as Co-Grantors... 7 C. Identity of Trustee Grantor as Trustee Family Members as Trustee Friends and Acquaintances as Trustee Corporate Trustees... 8 D. Beneficiaries... 8 III. INCOME TAX CONSEQUENCES... 8 A. Grantor Trust Status... 8 B. Benefits of Grantor Trust Status... 9 IV. GIFT TAX CONSEQUENCES... 9 A. Annual Exclusions... 9 B. Valuation Concerns Available Annual Exclusion Existing Policies a. Term Policies b. Whole Life Policies V. GENERATION-SKIPPING TRANSFER TAX CONSEQUENCES A. No GSTT Annual Exclusion B. Two Exceptions C. Allocation of GSTT Exemption VI. CRUMMEY WITHDRAWAL POWERS v1 i

4 A. Power Holder s Tax Consequences B. Drafting to Minimize Tax Consequences to Power Holder Hanging Powers Cascading Powers Sample Language C. Notice Issues VII. ADMINISTRATIVE PROVISIONS A. Limited Trustee Power to Amend B. Removal and Appointment of Trustees C. Trustee Power to Decant or Sell Trust Assets D. Change of Situs E. Power to Make Loans or Purchase Assets from Insured s Estate F. Contingent Marital Deduction Gift G. Savings Provision VIII. CONCLUSION Exhibit A Sample Draft Schedules of Gross Estate... 1 Exhibit B Sample Crummey Notice v1 ii

5 PLANNING WITH IRREVOCABLE LIFE INSURANCE TRUSTS I. INTRODUCTION A. Scope of Paper Second only to the classic bypass or credit shelter trusts and qualified terminable interest property ( QTIP ) trusts, irrevocable life insurance trusts ( ILITs ) are probably the most common irrevocable trusts that estate planning attorneys are likely to encounter and draft. While they are common, ILITs present numerous issues, many of which can lead to devastating results for the unwary. This paper is intended to be a practical introduction to planning with ILITs. It assumes that the audience has a basic understanding of how the federal estate tax works. The reasons for purchasing life insurance also are beyond the scope of this paper. Therefore, it will assume the decision to purchase life insurance has already been made. The paper will therefore concentrate on the use of ILITs in estate tax planning. Beyond the basic structure of ILITs, the paper also will address income tax, gift tax and generation-skipping transfer tax ( GSTT ) consequences to the grantor s gross estate caused by using an ILIT. It also will provide suggested language for certain administrative provisions. B. The Problem In the typical life insurance situation, the person who has decided he or she needs life insurance approaches a life insurance agent and applies for a policy. After underwriting, the proposed insured then pays the premium and names one or more beneficiaries for the policy proceeds. The beneficiaries are typically family members and usually include the surviving spouse if the insured is married. Sometimes, the insured will name his or her estate as the beneficiary. The insured will choose whether to continue paying premiums and will retain the right to change the beneficiaries for life. In fact, the policy typically will list the insured as the policy s owner. Under 26 U.S.C. (the Code ) 2042, the proceeds of a life insurance policy over which the decedent had an incident of ownership are included in the decedent s gross estate for federal estate tax purposes. In the typical situation as described above, the insured is the person with the incidents of ownership over the policy. The policy proceeds therefore will be included in the typical estate involving life insurance. In many estates, the decedent s life insurance is the very asset that makes the estate taxable. In other estates, which would be subject to the estate tax without the inclusion of the life insurance policy, the policy s inclusion simply exacerbates the tax problem. That problem is accentuated when most of the estate s v1 1 assets are illiquid. Because the estate tax is tax inclusive, that is, it taxes the money used to pay the tax, life insurance purchased to provide liquidity to pay the tax only has marginal benefits. If there is not a way to remove the insurance proceeds from the decedent s estate, sufficient insurance would have to be purchased to cover both the tax on the estate s underlying assets and the value of the life insurance proceeds themselves. ILITs are an effective and efficient manner in which to address the concerns related to estate inclusion for life insurance proceeds. There are alternatives to ILITs that can accomplish the goal of removing the life insurance proceeds from the decedent s estate, but each alternative fails to address a multitude of issues for which a well drafted ILIT can be designed. C. The Significant Benefits of ILITs There are three basic reasons for establishing an ILIT. Because of the cost associated with establishing the ILIT and the extra administrative requirements associated with irrevocable trusts in general and those unique to ILITs, the client should weigh the purposes for which he or she is establishing the ILIT and the benefits he or she hopes to achieve. As is the case with most estate planning, ILITs shift the costs, expenses and taxes associated with a client s death from the client s heirs to the client himself or herself. Sometimes, the client will be unwilling to front the expenses despite significant tax savings that might otherwise be achieved. 1. Estate Exclusion The primary purpose of an ILIT is to remove the proceeds of the insurance policy from the insured s estate. The policy proceeds are removed by avoiding the two bases for estate inclusion: (a) the insured s estate as a beneficiary; and (b) incidents of ownership over the policy. See Code Section 2042 of the Code states, in relevant part: The value of the gross estate shall include the value of all property (1) Receivable by the executor. To the extent of the amount receivable by the executor as insurance under policies on the life of the decedent. (2) Receivable by other beneficiaries. To the extent of the amount receivable by all other beneficiaries as insurance under policies on the life of the decedent with respect to which the decedent possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person.

6 Id The first test for estate inclusion is easy to avoid: one must merely ensure the insured s estate is not a beneficiary. To do this, one must also ensure that the recipients of the policy proceeds do not have a legal obligation to pay any of the estate s debts or taxes. Regs (b)(1). The second test, that is, whether the insured has retained an incident of ownership, is of critical importance, especially in the context of an ILIT. ILITs fail when the insured has retained one of the incidents of ownership. It is easy to do. As discussed in greater detail below, one purpose of creating an ILIT is to retain a certain amount of control over what the beneficiaries do with the proceeds. If the insured retains too much control over an aspect of the trust, the primary purpose, that is, estate exclusion, fails. Incidents of ownership and how to avoid them will be discussed in detail, below. 2. Estate Liquidity Life insurance, in general, provides liquidity to an estate by providing a cash infusion at the death of the insured. That liquidity is compromised, however, if the policy proceeds are included in the gross estate for estate tax purposes. As pointed out above, the estate tax is tax inclusive. This means that the tax is imposed on the assets used to pay the tax. Therefore, unless the policy is excluded from the estate, the proceeds only provide marginal liquidity. The ILIT provides, in contrast, dollar for dollar liquidity. That is, every dollar of proceeds can be used to offset the estate tax imposed, without adding to the underlying estate tax exposure. ILITs provide liquidity in a simple straightforward manner. Under the terms of the ILIT, the trustee may, in its discretion, either (a) purchase assets from the estate for their fair market value; or (b) loan cash to the estate for a fair market interest rate. The estate then will use the cash to pay the estate taxes by the due date (9 months from the date of death). The trustee s discretion in providing the cash infusion to the estate is an important factor. If the trustee is required to provide the infusion, the grantor will have retained an incident of ownership and the full amount of the proceeds will be included in the estate. Regs (b)(1). Nevertheless, providing the cash infusion likely will be in the best interests of the ILIT s beneficiaries because they likely will be the same persons who are beneficiaries of the estate. Using fair market values or interest rates for the sale or loan also is important to avoid adverse gift tax consequences. Any sale of assets at below market values is a taxable gift. The net effect of using an ILIT to provide liquidity to an estate is to lower the marginal rate of the tax. The effect can be illustrated in the following two examples v1 2 Example 1. Under current law, the estate tax rate is 45% of the estate s value over the applicable estate tax exemption of $2 million (which will increase to $3.5 million for deaths in 2009). If the estate is valued at $5 million (including a $1 million life insurance policy), the estate taxes will be calculated as follows: Gross Taxable Estate 5,000,000 (Less exemption) (2,000,000) Taxable Estate 3,000,000 Times Tax Rate.45 Tax 1,345,000 Divided by Gross 5,000,000 Estate Marginal Rate.27 Net to Beneficiaries 3,655,000 Example 2. Same as example 1, above, but the $1 million life insurance policy is held in an ILIT. The estate taxes will be calculated as follows: Gross Taxable Estate 4,000,000 (Less exemption) (2,000,000) Taxable Estate 2,000,000 Times Tax Rate.45 Tax 900,000 Divided by Gross 5,000,000 Estate Marginal Rate.18 Net to Beneficiaries 4,100,000 The family in Example 2 will ultimately receive $445,000, or almost 25%, more than the family in Example 1, a significant difference in the opinion of most people. 3. Control of Insurance Proceeds The degree of control available with respect to irrevocable trusts in general also applies to ILITs. Certainly, to avoid estate inclusion, the grantor of an ILIT may not retain such continuing control over the trust that he or she has an incident of ownership over the life insurance policy or a general power of appointment over the trust. Otherwise, all of the options for distributions are available for an ILIT as are available for any other irrevocable trust. Control is the main benefit that sets ILITs apart from the other alternative means to avoid estate inclusion for life insurance policies. Some examples of reasons to exert control over the beneficiaries in the form of an ILIT include: Creditor protection for beneficiaries The ILIT secures creditor protection by segregating the life insurance proceeds from the beneficiaries other assets. Life insurance policies, the policy s cash value and the policy s proceeds are generally

7 protected from both the insured s and the beneficiary s creditors even if they are not in a spendthrift trust. See N.M. STAT , The statutory creditor protection can be lost, however, if the insurance proceeds are commingled with other assets. Invariably the commingling happens over time. Management of assets and distributions by impartial third party for those beneficiaries who might not yet be capable or ready to do so themselves; Creation of generation-skipping or dynasty trusts to avoid succession taxes in succeeding generations at a low cost of exemptions from the generation-skipping transfer tax; Special needs provisions for beneficiaries who might be eligible for governmental benefits; and Control over the manner in which proceeds are distributed to beneficiaries. C. The Significant Limitations of ILITs Like any other estate planning device, ILITs are not free. They have significant limitations that may or may not militate against establishing an ILIT for a particular client. The most significant limitations are discussed below. 1. Irrevocability of the ILIT Irrevocable trusts are by their very nature inflexible estate planning tools. A well drafted ILIT will build into the trust s provisions as much flexibility as possible to allow for unforeseen circumstances. Despite how thoughtful a planner might be, however, circumstances may arise that prove the ILIT to be less than desirable. ILITs and other irrevocable trusts are not, however, as inflexible as they used to be. Trustees may, for example, be given the power to amend the administrative provisions without adverse tax consequences as long as the trustee is prohibited from materially affecting the beneficial interests in the trust. See Regs (b)(1) (excluding such a power from the definition of power of appointment ). Also, under New Mexico law, it is fairly simple to amend an irrevocable trust, especially if the grantor is still alive and competent. See N.M. STAT. 46A-4-410, et seq. Care must be taken, however, to avoid loosing any GSTT exemptions that have been applied to the trust. One can avoid loosing the GSTT exemptions by limiting the amendment such that it does not (a) shift any beneficial interest in the trust to any beneficiary who occupies a lower generation, as defined in Code Section 2651, than the person or persons who held the beneficial interest prior to the amendment; and (b) extend the time for vesting of any beneficial interest in v1 3 the trust beyond the period provided for in the original agreement. See P.L.R ; Regs (b)(4)(i)(D). In appropriate situations, a drafter also may build substantial flexibility into the trust by providing for a trust protector, who can be given broad powers to amend the trust in a substantial way. 2. The Form Must Be Followed ILITs are an example of those estate planning tools that elevate form over substance in a way that make lawyers gleeful with excitement. On the other hand, such devices also cause careful lawyers much trepidation. Clients invariably become tired of the form and start taking shortcuts. When they do, they are removing the basis for excluding the insurance proceeds from their respective estates. There is little reason for the IRS to respect the form of an ILIT over its substance if the grantor also does not respect that form. For this reason, individuals probably are not the best choice to serve as trustees of an ILIT. The typical ILIT will require reminders to the Grantor that the insurance premiums must be paid. Typically, the trustee also must send notices known as Crummey notices to the beneficiaries in a timely manner. Finally, the trustee must pay the premiums. All of this is done year in and year out. Typically, only corporate fiduciaries are set up to do this type of work. Unfortunately, fewer and fewer corporate trustees are willing to serve as trustees of an unfunded ILIT (i.e., an ILIT that owns only a life insurance policy). Unfunded ILITs pose substantial risk for the corporate trustee for little comparative return. The costs associated with hiring a corporate trustee also may seem exorbitant to the client. All of these issues must be considered by a client before undertaking the creation of an ILIT. 3. Gift Tax and GSTT Consequences Like a gift to any irrevocable trust that is designed to remove the trust s assets from the donor s estate, a gift to an ILIT carries with it potential gift tax and GSTT consequences. Unless the beneficiary or beneficiaries have the unqualified power to demand immediate distribution of a gift to an ILIT, the gift will not qualify for the annual gift tax exclusion. Such gifts will therefore use up the client s available estate tax exemption, up to $1 million of the exemption. If the client has already used his or her $1 million gift tax exemption, he or she will have to pay gift taxes for such gifts. Gift tax returns will also be due in either event. If the beneficiary has the requisite demand powers, also known as Crummey powers, gifts to the trust within the donor s annual gift tax exclusion will not be taxable. If the ILIT is a GST trust under Code

8 section 2632(c)(3)(B), each gift to the ILIT also will have GSTT exemption consequences. Most irrevocable trusts, except those that have been specially drafted to avoid the consequence, are GST trusts because they have generation-skipping potential. Unlike direct gifts to a skip person, gifts to a GST trust typically do not qualify for the annual GSTT exclusion. Code 2642(c)(1), (2). Therefore, most gifts to an ILIT use up the donor s GSTT exemption, unless the donor specifically opts not to use the exemption. See Id. 2632(c)(4), (5). In a related vein, an ILIT likely is a GST trust even if it is not designed to skip the primary beneficiaries generation. This is because the typical trust will provide for alternative beneficiaries in the event the primary beneficiary predeceases the distribution event. Unfortunately, the predeceased ancestor rule does not apply to transfers to inter vivos trusts when the ancestor was alive at the time of the transfer. See Code 2651(e)(1) (the predeceased ancestor rule only applies if the ancestor was dead at the time of the transfer). Therefore, to avoid wasting GSTT exemptions, most ILITs should be designed either as (a) a true generation-skipping trust; or (b) a non-gst trust. See Id. 2632(c)(3)(B) (providing terms necessary to avoid creation of GST trust). Each of these issues will be discussed in greater detail, below. Many also overlook one aspect of using a corporate trustee for ILITs. Someone must pay the trustee s administration fees. Typically, the grantor/insured pays for those fees. The payment of fees is a gift and should be included in the gift tax and GSTT analysis related to establishing an ILIT. 4. Three Year Look Back Period The utility of an ILIT is significantly limited if the insured transfers ownership of an existing policy to the ILIT. Under Code section 2035(a)(2), if the insured transfers an existing policy to an ILIT (or any other person), and dies within three years of the transfer, the full value of the life insurance policy benefits is included in the insured s estate. The three year look back period can be avoided simply by making premium gifts to the ILIT s trustee and arranging for the trustee both (a) to apply for; and (b) to purchase the insurance policy. See Code 2035(a)(2) (life insurance policy benefits included in estate only if the decedent transferred an interest or power in the life insurance policy); Estate of Leder v. Commissioner, 893 F.2d 237, 241 (10th Cir. 1989); Estate of Perry v. Commissioner, 927 F.2d 209, 212 (5th Cir 1991). Many times, however, the purchase of a new policy simply is not feasible. For example, the existing policy may have substantial cash value, which the client wants to preserve. (The cash value also causes a gift tax consequence that must be addressed.) Another v1 4 concern may be whether the client still is insurable or insurable at economic rates. In these situations, the three year look back period may not be avoided. The effects of the look back period may be mitigated to a certain extent, fortunately, for those clients who are still insurable. In this situation, the client can transfer the existing policy plus cash for the trustee to purchase a three year term policy in an amount sufficient to cover the expected estate taxes due solely as a result of the three year look back period. Because the trustee purchased the supplementary term policy, its proceeds would not be included in the estate. 5. Policy Lapses For a variety of reasons, a client may choose to allow an insurance policy to lapse. For those policies held either by the insured or family members, the only loss is the value of the proceeds. For policies owned by an ILIT, however, an additional consequence exists. As noted above, the typical ILIT is a GST trust. Therefore, GSTT exemptions are deemed allocated to the trust without further action by the grantor. If the grantor allows the ILIT policy to lapse, the GSTT exemptions allocated to the ILIT are lost and cannot be recovered to apply elsewhere. See Code 2631(b) (allocations of GSTT exemptions are irrevocable). D. Alternatives to ILITs 1. Community Property Ownership Under federal law, state law must be considered in determining whether the insured had an incident of ownership in the policy, thereby causing estate inclusion. Regs (c)(5). In New Mexico and other community property states, all property acquired during marriage is presumed to be community property. N.M. STAT (A). Therefore, in the typical situation encountered in New Mexico, only one-half of the life insurance proceeds will be included in the insured s estate if he or she acquired the policy during marriage. One-half of the proceeds might not be enough to cause concern for estate taxes. 2. Spousal Ownership In common law states (a group to which New Mexico does not belong), a simple and effective way to avoid estate inclusion is for the non-insured spouse to purchase and pay for the insurance policy. If the insured spouse is the only one with the income or assets necessary to pay for the policy premiums, he or she can simply make gifts of the premium payments to the non-insured spouse. Because there is an unlimited marital deduction for gifts between U.S. citizen spouses, there is no gift tax consequence for this arrangement. At the insured spouse s death, he or she does not have any incidents of ownership over the policy and it is therefore not included in the estate.

9 In a community property state (like New Mexico), however, spousal ownership of the policy is not so simple of a proposition. This is because spouses are presumed to own all property acquired during marriage as community property. N.M. STAT (A). Title does not necessarily overcome the presumption. Instead, the presumption can be overcome only by a preponderance of the evidence. C & L Lumber & Supply, Inc. v. Texas Am. Bank/Galeria, 110 N.M. 291, 294 (1990). Given that property can be designated as the separate property of one spouse by written agreement, see N.M. STAT (A)(5), the only safe way to overcome the community property presumption is for the spouses to enter a partition agreement with respect to each and every premium payment. Another draw back to spousal ownership of the insurance policy applies to both common law and community property states. The policy proceeds may escape inclusion in the estate of the first spouse to die. But they will likely be included in the estate of the second spouse to die. This result probably is not much of a concern in a common law state where only one of the spouses is the wage earner, because the inclusion of the proceeds simply means the surviving spouse will have some assets to place in a Bypass Trust on his or her death. If, however, both spouses have significant wealth, which is very likely true for the typical couple in a community property state where estate taxes are an issue, spousal ownership of the policy simply delays taxation. The use of an ILIT, in contrast, can avoid taxation in both spouses estates. 3. Ownership of Policy by Descendants Another simple method for excluding life insurance proceeds from the estate of the insured is to arrange for the intended beneficiaries of the policy to own the policy. Typically, the beneficiaries in this context are the insured s descendants. This method works equally well regardless of whether the insured is a resident of a common law or community property state. Here, the insured typically makes a cash gift to the beneficiary, which the beneficiary then uses to pay the premiums on the life insurance policy. Unlike gifts to spouses, however, gifts to descendants over the annual gift tax exclusion are subject to the gift tax. If there are many beneficiaries, however, high premium payments can be spread among several annual gift tax exclusions. Direct cash gifts to grandchildren for the purposes of premium payments have an added advantage over ILITs. As explained above, the typical ILIT is a GST trust and gifts to the ILIT use up the donor s GSTT exemption. Direct gifts to a skip person like a grandchild, however, are eligible for the annual GSST exclusion. Code 2612(c)(1) (excluding gifts under the annual exclusion amount from the GSTT) v1 5 Therefore, if a donor is concerned about maximization of his or her GSTT exemption, this method should be considered. Ownership of life insurance policies by the descendants also has risks. For example, the descendant may not use the gift for the intended purpose of paying the premium and allow the policy to lapse. The outright gift to the intended beneficiary also will be subject to the claims of the descendant s creditors and payment of the premium might be considered a fraudulent transfer if its effect is to prevent a creditor from gaining access to the funds. See N.M. STAT , et seq. (Uniform Fraudulent Transfer Act). On the other hand, in New Mexico, at least, the life insurance policy, any cash value and the benefits generally are not subject to the claims of the beneficiaries creditors. Id Finally, the proceeds will be part of the descendant s estate, which may or may not pose a tax problem for the descendant. 4. Policy Ownership by Family Business Entity Family business entities, like family limited liability companies ( LLCs ), also are attractive choices to hold life insurance policies. If the client sets up a family LLC, the client may make gifts of fractional interests in the LLC to family members. The gifts may qualify for valuation discounts related to lack of control and restrictions on the right to transfer the interests if the LLC was set up for a valid business purpose. If the client ends up owning only a minority interest in the LLC at death, the estate also may be entitled to the same types of valuation discounts. If that LLC purchased a life insurance policy on the life of the client, the policy proceeds only will be included in the client s estate to the extent he or she had a fractional interest in the LLC, the value of which will include the proceeds if payable to the LLC. Care must be taken, however, for the client to avoid retaining an incident of ownership in the life insurance policy by retaining control over the LLC. See Regs (c)(6) (policy proceeds included in estate if owned by a corporation of which the insured owned greater than 50%). II. GENERAL STRUCTURE OF ILITs A. Avoidance of Incidents of Ownership The ILIT will fail in its purpose of excluding life insurance proceeds from the estate if the insured retains any incidents of ownership of the policy. Code 2042(2). The ILIT therefore must be structured to avoid, at all costs, any incident of ownership. The initial problem in addressing the issue is to determine what an incident of ownership might be. The Code does not provide much guidance in answering the definition question. It explains that an incident of ownership includes a reversionary interest

10 which exceeds 5% of the policy s value immediately before the decedent s death. Code 2042(2). The statute states in relevant part: [T]he term "incident of ownership" includes a reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent. Id. The Regulations provide further guidance. They state that incidents of ownership go beyond ownership in a technical legal sense. Regs (c)(2). Rather, the term refers to the right of the insured or his estate to the economic benefits of the policy. Id. The term therefore includes: [T]he power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy, etc. Id. For a policy held in trust, the insured is considered to have an incident of ownership if he or she has powers over the policy benefits. Specifically, the insured has an incident of ownership if he or she (either alone or in conjunction with someone else): [H]as 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. Id (c)(4). Further, if the insured created the trust, the insured has an incident of ownership if he or she has the power to surrender the policy and divert the trust s income that otherwise would be used for premium payments to the trust s beneficiaries. Id. The Code and regulations also expound on the phrase reversionary interest, which can give rise to an incident of ownership. Code 2042(2); Regs (c)(3). A reversionary interest is described as a possibility that the policy proceeds will come back to the estate through some circuitous route. Code 2042(c). The Code states, in relevant part: The term "reversionary interest" includes a possibility that the policy, or the proceeds of the policy, may return to the decedent or his estate, or may be subject to a power of disposition by him. Id. The regulations go on to state that the reversionary interest may arise by the policy s express terms, some other instrument or operation of law. Regs (c)(3). Neither the terms reversionary interest nor incident of ownership include, however, the possibility that the insured might receive the policy or its proceeds through inheritance or as a surviving spouse. Id. The question then arises as to how one might avoid creating an accidental incident of ownership when drafting an ILIT. The first step, of course, is to be aware of the rights that might give rise to an incident of ownership and assiduously avoid including those rights in the ILIT. A second step is to include savings language in which the grantor/insured specifically disavows any incidents of ownership and reversionary interests. Sample savings language follows: Disclaimed Powers and Interests. Notwithstanding any other provision of this Agreement, no person, including but not limited to the Grantor, shall have any power, right or interest, whether direct or indirect, fixed or contingent, that would cause any portion of the trust income or principal to be included in his or her gross estate for federal estate tax purposes, under the provisions of Code Sections 2031 through 2046, inclusive. Any contrary provision of this Agreement shall be disregarded. The reference to Code section 2042 in the sample savings provision necessarily includes both incidents of ownership and reversionary interests. The references to the remaining Code provisions is intended to act as a catch all for the other sundry ways an asset might be included in a decedent s estate. Its structure is based on the IRS s model charitable lead annuity trust found in Rev. Proc B. Identity of the Grantor Someone has to be the grantor of the ILIT. The decision as to who should establish the ILIT depends on three primary factors: Whether the insured is married; Whether the insured s spouse is an intended beneficiary of the policy proceeds; and Whether the policy is a single or dual life policy. If the insured is single, the decision as to who should establish the ILIT is simple because there are not many options. Technically, a third party could establish the ILIT. Using a third party gains nothing, v1 6

11 except perhaps in rare cases, because the insured still cannot have incidents of ownership or reversionary interests in the policy if the goal is to avoid estate inclusion. Therefore, using a third party generally only complicates matters. If the insured is married, and assuming the insured is a resident of a community property state, there are two choices: Either the insured may be the only grantor, or both the husband and wife may be cograntors. Both choices have their own consequences. 1. Insured as Sole Grantor Clearly, the insured may act as the sole grantor of an ILIT. In a community property state, however, both spouses are presumed to own undivided one-half interests in property acquired during marriage. N.M. STAT (A). Therefore, unless the spouses enter written agreements that all gifts to the ILIT are the separate property of the insured spouse, the noninsured spouse will be deemed to have made gifts to the ILIT. See Id (A)(5) (spouses may designate property as the separate property of one spouse by written agreement). Whether it is a good idea for both spouses to be making gifts to the ILIT depends, primarily, on whether the non-insured spouse is an intended beneficiary of the ILIT. If the spouse will not be a beneficiary, two primary consequences will occur. The first is possible confusion, especially for persons who are not familiar with community property law, because the documents do not clearly indicate the identity of the persons making gifts to the ILIT. The second consequence is that both spouses will be making gifts to the trust and using up either their respective annual gift tax exclusions or their lifetime gift tax exemptions. Depending on the size of the premiums, this consequence may be desirable. Further, both spouses likely will be using up their lifetime GSTT exemptions because there is no annual GSTT exclusion for gifts to a GST trust. In a second marriage situation, where both spouses are engaging in estate planning separate of one another, failing to address these issues could have negative implications. If the spouse is an intended beneficiary of the ILIT, however, the failure to ensure that the noninsured spouse is not making gifts to the ILIT likely will have significant adverse effects. The first consequence will be that at least one half of the policy proceeds likely will be included in the surviving spouse s estate. This result removes one of the primary reasons for establishing the ILIT in the first place. A second consequence will be that the surviving spouse s GSTT exemption will have to be applied to the portion of the trust included in his or her estate, including the value of the proceeds. See Code 2652(a)(1) (for GSTT purposes, the transferor is the person in whose estate the property is included). This v1 7 means that the ability to leverage the GSTT exemption from the premium gift amount to the policy proceeds is lost. To avoid deemed gifts caused by the community property laws, the spouses should enter a written agreement designating all gifts to the ILIT as the insured spouse s separate property. The gift from the non-insured spouse to the insured spouse has no gift tax consequence because of the unlimited marital deduction for U.S. citizen spouses. See Code 2523(a); cf. Id. 2523(i) (marital deduction for gifts to non-u.s. citizen spouses limited to annual gifts of $100,000, indexed for inflation). The initial exchange agreement should cover all future gifts of property to the trust as a fall back position only. New Mexico law is less than clear outside the context of a premarital agreement that spouses may agree that property acquired in the future is separate property. Compare N.M. STAT (A)(5) (separate property includes property designated as separate property by a written agreement between the spouses, including a deed or other written agreement concerning property held by the spouses as joint tenants or tenants in common in which the property is designated as separate property ); Id. 40-3A-4(A)(1) (premarital agreement may apply prospectively to all property acquired during marriage whenever acquired). Therefore, the cautious attorney will arrange for separate property agreements to be executed contemporaneously with each gift of property to the ILIT. A sample exchange agreement is attached as Exhibit A. 2. Insured and Spouse as Co-Grantors If the surviving spouse will not be a beneficiary of the trust and both spouses want to benefit the same beneficiaries, the spouses should consider establishing the ILIT together. A typical example is an ILIT that will hold a dual life policy insuring both the husband and wife. Here, both spouses should be grantors to clarify that both have transferred all of their interests in the policy to the ILIT. The effect on both spouses gift tax and GSTT exemptions also will be clear. There is no need to change the presumption of community property in this scenario. Therefore, the effort of establishing that the gifts to the trust are the separate property of one of the spouses can be eliminated. C. Identity of Trustee 1. Grantor as Trustee For all practical purposes, the insured/grantor cannot serve as trustee of an ILIT. Otherwise, the insured, who also is acting as trustee, will have retained incidents of ownership over the life insurance policy. As such, the insurance proceeds will be included in the insured/trustee s estate. Code 2042(2).

12 2. Family Members as Trustee Family members who are not beneficiaries of the ILIT certainly can serve as trustee without adverse estate and gift tax consequences (assuming the trust does not grant the trustee a general power of appointment). Even a family member who also is a beneficiary of the trust may serve as trustee under certain circumstances. Extra care must be taken to avoid granting the trustee a general power of appointment or the power to make unequal distributions to himself or herself to avoid adverse estate and gift tax consequences if a beneficiary is made a trustee. See Regs (c)(1) (defining general power of appointment ). The easiest way to avoid the general power of appointment is to ensure the trustee may make distributions based only on an ascertainable standard. Id (c)(2) (powers limited by an ascertainable standard are not general powers of appointment). If, however, the beneficiary has a demand right under the ILIT, which is necessary for the grantor to make annual gift tax exclusion gifts to the ILIT, that beneficiary should not be made trustee. The beneficiary must allow the demand right to lapse so that the trustee has assets with which to pay the insurance premiums. The lapse may be considered to be a transfer to the ILIT that is either a transfer with a retained life estate under Code section 2036 or a revocable transfer under Code section If so, the entire trust could be included in the beneficiary s estate. It also is unclear how a lapse that does not exceed $5,000 or 5% of the assets out of which the power could have been exercised would be treated in this situation. See Code 2514(e) (lapse that does not exceed the stated limits is not the release of a power of appointment). The safest course would be to avoid appointing a beneficiary who has a demand power as trustee of the ILIT. The main issues raised by appointing a family member are twofold. The first question that must be addressed is whether the family member has the competence to serve as trustee. Certain administrative actions must be taken at certain times for the ILIT to succeed. Family members typically are not competent to track and administer the trust in the required fashion. The second question is whether the family member has the time. The critical administrative functions will generally come year after year. Failure to address them in a particular year may destroy the effectiveness of the ILIT. For these reasons, family members typically are not the best choices as trustee. competence and time, however, still are quite relevant. Further, people move. Relationships change. Friends die or become sick. Reliance upon a friend to serve as trustee can be a risky proposition. 4. Corporate Trustees Typically, a corporate trustee is the safest alternative to serve as trustee of an ILIT. Adverse estate and gift tax consequences are not an issue. Competency is not, or at least should not be, an issue. Time also is not an issue. On the other hand, fewer and fewer corporate trustees are willing to serve as trustees of an unfunded ILIT (i.e., an ILIT that owns only a life insurance policy). Unfunded ILITs pose substantial risk for the corporate trustee for little comparative return. The costs associated with hiring a corporate trustee also may seem exorbitant to the client. The client will invariably ask: It costs that much a year to receive a single gift, make a single premium payment and to send out a couple of form letters each year? You have to be kidding? Ultimately, the choice is the client s to make. The attorney s job is to explain the risks associated with the choice made. D. Beneficiaries Typically, family members of the grantor are the beneficiaries of an ILIT. If one of the purposes of an ILIT is to provide liquidity to the grantor s estate, the beneficiaries of the ILIT and the beneficiaries of the estate (at least that portion of the estate that will be responsible for estate taxes) should be substantially the same. Otherwise, the trustee might not be able to justify that providing liquidity to the estate is in the best interest of the ILIT s beneficiaries. If the grantor s spouse is intended to be a beneficiary, steps must be taken to avoid the spouse s ownership interest in the assets given to the ILIT to avoid inclusion of the life insurance proceeds in the spouse s estate at the second death. (See section II(B)(1), above.) Care also must be taken to avoid the grantor s estate from being a beneficiary of the ILIT or the life insurance policy itself. Failure will lead to inclusion of the entire proceeds in the insured s estate, the very thing an ILIT is designed to avoid. See Regs (b)(1). Otherwise, there are no legal restrictions on the identity of the beneficiaries of an ILIT. 3. Friends and Acquaintances as Trustee Most of the tax consequences raised with respect to family members do not come into play with friends and acquaintances. The questions related to v1 8 III. INCOME TAX CONSEQUENCES A. Grantor Trust Status The typical ILIT will be a grantor trust. That is, the grantor will be taxed on the ILIT s income during

13 his or her life. See Code 671 through 679. For most practical purposes, a non-grantor ILIT can be difficult to draft, especially if a generation skipping trust is a goal. If a non-adverse party may apply any portion of the trust s income to pay premiums on the life of the grantor or the grantor s spouse, the trust is a grantor trust. Code 677(a)(3). A non-adverse party is anyone who does not fall within the definition of an adverse party. Id. 672(b). An adverse party is, in general terms, a person who has material interests in the trust. Id. 672(a). The Code defines an adverse party as: [A]ny person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. A person having a general power of appointment over the trust property shall be deemed to have a beneficial interest in the trust. Id. The interests of the typical ILIT beneficiary will not be adversely affected by the purchase of life insurance on the grantor s life. Most ILITs therefore are grantor trusts because the acquiescence of an adverse party almost never is required for the premium payments. To avoid the application of section 677(a)(3), the ILIT must either (a) prohibit payment of premiums out of income or capital gains; or (b) require an adverse party to approve the premium payments. Both requirements seem cumbersome and difficult to avoid for practical purposes. Further, most trusts of which the grantor s spouse is a beneficiary also are grantor trusts. Under Code sections 677(a)(1) and (2), the trust is a grantor trust if its income may be distributed to the grantor s spouse, unless the approval of an adverse party is required. A common method of making an irrevocable trust a grantor trust is to reserve for the grantor the power to substitute property of equal value for the property in the trust. See Code 675(4)(C). The IRS recently held that the grantor s retention of such a power, in a non-fiduciary capacity, would not cause the trust corpus to be included in the grantor s estate under Code sections 2036 or Rev. Rul The ruling did not address, however, whether retention of this power is a reversionary interest in a life insurance policy under Code section Therefore, ILITs probably should not include the power of substitution without further guidance from the IRS. There is some ambiguity in the statutes, however, as to whether the grantor remains responsible for income taxes when Crummey withdrawal powers are included in an ILIT. Under Code section 678(a), a v1 9 person, who either (a) has a power to withdraw trust corpus or (b) has released such a power, will be treated as the owner of that portion of the trust. This section does not apply to such a power over income, however, if the grantor is treated as the owner under another Code section. Code 678(b). The exception under Code section 678(b) does not extend to include power over the trust corpus, causing potential confusion. Under a literal reading of the statutes, two persons could be taxed on the ILIT s income generated by the corpus. The IRS has ruled, however, in at least two private letter rulings that the grantor status under Code section 677 essentially trumps over section 678. See, e.g., PLR , PLR B. Benefits of Grantor Trust Status Typically, grantor trust status is beneficial in the context of most ILITs. Most ILITs do not generate any income, so the status generally is of no consequence to the grantor s income tax situation. Even if the ILIT generates income, the grantor does not make an additional gift to the trust s beneficiaries by paying the tax. Rev. Rul Therefore, if the grantor pays the tax, the trust s assets are allowed to grow tax free. In the meantime, the grantor s estate is reduced by the payment of the income taxes. The grantor tax status therefore serves to provide a back door non-taxable gift to the beneficiaries and reduces exposure to estate taxes at the same time. Note that the grantor tax rules were established at a time when the marginal tax rates were substantially higher than they are today and were designed to discourage grantor trusts. This benefit might be lost at some point in the future if the marginal rates are raised again. Grantor trust status also is extremely important in the context of fixing a broken ILIT. One of the few ways to fix a broken ILIT (before the insured s death) is to transfer the existing life insurance policy to a new trust. To satisfy the Trustee s fiduciary obligations to the trust s beneficiaries, the transfer should be by sale to the new trust. The sale of any life insurance policy, however, raises the possibility that the policy proceeds will be taxable under the transfer for value rules. See Code 101. A sale of the policy to a grantor trust, of which the insured is the grantor, however, does not fall under the transfer for value rules because it is considered to be a sale to the insured. Rev. Rul IV. GIFT TAX CONSEQUENCES A. Annual Exclusions Completed gifts to an irrevocable trust are taxable gifts. Regs (h), Ex. 8. But not all taxable gifts are gifts of present interests that are eligible for the annual gift tax exclusion. Code 2503(b). A present interest is the right to the unrestricted, immediate use, possession or enjoyment of the

14 transferred property or the income from the transferred property. Regs (b). The terms of the trust govern whether the gift is one of a present interest. Id (a). There are three basic ways to draft an irrevocable trust such that gifts to the trust qualify for the annual gift tax exclusion. The first is not very useful in the context of an ILIT. If the trust s beneficiary has a right to receive the income from the gift, the annual exclusion applies. Regs (b). However, the Regulations provide that the gift of a life insurance policy to a trust is a gift of a future interest regardless of whether the beneficiary has the right to receive income. Id (c), Ex. 2. The second method may be useful, but only in the context of minors. Gifts to trusts for the benefit of persons younger than 21 years of age automatically qualify for the annual exclusion if the trusts have certain mandatory provisions. See Code 2503(c). The mandatory provisions require that: The minor be the only beneficiary of the principal and income before the age of 21; All the principal and accumulated income be distributed outright to the minor at age 21; If the minor dies before age 21, all the principal and accumulated income be payable to the minor s estate or as the minor may direct pursuant to a general power of appointment. Id. After the minor attains age 21, the grantor could continue making payments for the life insurance premiums directly to the carrier. Regs (c), Ex. 6. Other than provide a means to secure the annual gift tax exclusion and to provide for a trust during minority, however, the section 2503(c) minority trust does not provide many of the benefits of an ILIT. The third method, which includes Crummey withdrawal powers for the beneficiaries, is the most common way to secure the annual gift tax exclusion. The term Crummey power comes from the case, Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968), which first approved the technique. A beneficiary holds a Crummey power if he or she has the right to demand withdrawal of property contributed to the trust for specified period of time after a gift is made to the trust. Slade, 807 T.M., Personal Life Insurance Trusts, II(B)(2)(a)(1) (2006). Regardless of whether the beneficiary exercises the demand right, the gift qualifies for the Code section 2503(b) annual exclusion if the right to demand the withdrawal is unrestricted. Rev. Rul ; Rev. Rul Over the years, the IRS has fashioned some restrictions on Crummey powers that are not found in the fact scenario giving rise to their namesake case. Crummey powers must meet the following requirements to be recognized by the IRS: The power holder must have a beneficial interest in the trust, which may be contingent. See TAM (requiring beneficial interest); Kohlsaat v. Commissioner, T.C. Memo (extending beneficial interest to include a remainder interest); Cristofani v. Commissioner, 97 T.C. 74 (1991) (same); and The power holder must receive notice of the withdrawal power and a reasonable opportunity to exercise the power. Rev. Rul (notice requirement); PLR (30 day period reasonable time). Crummey powers also involve complex, potentially adverse succession tax consequences for the power holder as well. These issues will be discussed in further detail, below. B. Valuation Concerns 1. Available Annual Exclusion For most ILITs, excluding those to which a gift of an existing policy has been made, the only gifts are of cash. Because cash is easy to value, the only valuation issue is whether the funding will qualify for the annual exclusion. Assuming each beneficiary has a valid Crummey withdrawal power as described above, whether the gift qualifies depends on (a) the amount of cash contributed; (b) the annual exclusion available to the donor; (c) the donor s marital status; and (d) the number of beneficiaries. In 2008, the available gift tax exclusion is $12,000. Rev. Proc (1). We should learn the amount available for 2009 in the near future. The amounts are indexed for inflation in $1,000 increments. Code 2503(b)(2). Historically, the annual exclusions have been as follows, beginning in 1998: $10,000; $11,000; and $12,000. See Lischer, 845-2nd T.M., Gifts, IX(A)(1). Each taxpayer has an annual exclusion for each person to whom he or she might make gifts. Code 2503(b). For example, a father may make gifts to his only daughter the cumulative value of which does not exceed $12,000 and additional gifts the value of which do not exceed $12,000 to his only son. The entire $24,000 given to the two children qualify for the annual exclusion. Often overlooked is the fact that all gifts, including birthday, wedding, and Christmas gifts, must be included in calculating the amount of annual v1 10

15 exclusion a donor might have used. In the context of an ILIT, this fact is especially important because the typical beneficiaries of the ILIT also receive other gifts from the grantor. If the donor is married, he or she may be able to double the amount given to an ILIT that also qualifies for the annual exclusion over the amount a single person might make. If the donor is making a gift of separate property, the gift is considered to have been made one-half by the donor and one-half by the spouse, but only if both spouses consent to splitting the gift under Code section On the other hand, if the spouse also is a beneficiary of the ILIT, splitting gifts may jeopardize the ability to exclude the policy proceeds from his or her estate. Similarly, if the gift is of community property, both spouses are necessarily making a gift to the ILIT. Consent under Code section 2513 is not required in this context. Typically, multiple persons are the beneficiaries of an ILIT. The greater the number of beneficiaries, the more the insured may give the ILIT without gift tax consequences. For example, assume the insured is married and has four children and five grandchildren. Also assume the ILIT names all of the insured s descendants as beneficiaries. If the spouse is not a beneficiary and the insured makes gifts of community property to the ILIT, the insured may make up to $216,000, all of which qualifies for the annual exclusion. The amount is calculated as follows: The number of donors (2) times the annual exclusion ($12,000) equals $24,000 times the number of beneficiaries (9) equals $216,000. The available amount decreases dollar for dollar for each gift the insured makes to any one or more of the beneficiaries outside of the ILIT. 2. Existing Policies Gifts of existing policies involve special valuation issues. The exact method of valuing the policy depends on the type of policy gifted. a. Term Policies The value of a term policy is unclear for gift tax purposes. See Slade, 807 T.M., Personal Life Insurance Trusts, II(B)(3). Arguably, the value is the pro rata portion of the premium for the unexpired term. Id. On the other hand, the Regulations suggest that the value of a term policy probably is somewhat higher, especially when the insured s health has changed substantially. Generally, the value of a gift is its fair market value. Regs Further, cost of a policy may not be used if it is not reasonably close to the policy s full value. Id (a). Given the market for viatical settlements, a cautious attorney will investigate the policy s value on the open market. b. Whole Life Policies The value of a whole life policy (defined here to include any that have cash value) is the cost of a replacement policy for the insured at the time of the gift. U.S. v. Ryerson, 312 U.S. 260, 261 (1941); Regs (a), Ex. 1. If the cost is not readily ascertainable, the policy s value may be determined from the policy s interpolated terminal reserve value. Id (a), Ex. 4; Rev. Rul This method may not be used, however, if the approximation is not reasonably close to the full value because of the unusual nature of the contract. Id (a). This exception is likely triggered if the insured s health has changed such that he or she is no longer insurable. See Ryerson, 312 U.S. at 262 (fact that insured is no longer insurable shows that value of the policy is not its cash surrender value); Pritchard v. Commissioner, 4 T.C. 204 (1944) (value of a policy is different for a person who is terminally ill). The policy s interpolated terminal reserve is not the policy s cash value. Rather it is calculated based on the policy s terminal reserve at the end of the policy year in which the gift is made and the terminal reserve at the end of the prior policy year. Regs (a), Ex. 4. The terminal reserve amount must be obtained from the insurance company. See Lischer, 845-2nd, Gifts, VII(C)(3). The regulations contain the following example, which is extremely helpful in understanding what a policy s interpolated terminal reserve might be: A gift is made four months after the last premium due date of an ordinary life insurance policy issued nine years and four months prior to the gift thereof by the insured, who was 35 years of age at date of issue. The gross annual premium is $ 2,811. The computation follows: Terminal reserve at end of tenth year 14, Terminal reserve at end of ninth year 12, Regs (a), Ex Increase 1, One-third of such increase (the gift having been made four months following the last preceding premium due date), is Terminal reserve at end of ninth year 12, Interpolated terminal reserve at date of gift 13, Two-thirds of gross premium ($2,811) 1, Value of the gift 15, v1 11

16 V. GENERATION-SKIPPING TRANSFER TAX CONSEQUENCES A. No GSTT Annual Exclusion The GSTT is implicated with respect to most ILITs because most are GST trusts under Code section 2632(c)(3)(B). With some narrow exceptions, most GST trusts do not qualify for the annual GSTT exclusion. Code 2642(c)(2); also see Regs (a)(5), Ex. 5 (providing that a gift made to a trust subject to a skip person s right of withdrawal is treated as a gift to the trust for GSTT purposes). A GST trust is defined as one that could have a generation-skipping transfer with respect to the grantor. Code 2632(c)(3)(B). Any trust that includes a skip person as a contingent beneficiary will meet this definition because the predeceased ancestor rule does not apply to inter vivos irrevocable trusts. See Id. 2651(e)(1) (the predeceased ancestor rule only applies if the ancestor was dead at the time of the transfer). A beneficiary will be a skip person if he or she is in a generation two or more below the generation of the transferor. Id. 2613(a)(1). About the only way to avoid GST trust status for a trust with multiple beneficiaries is to design the trust to avoid generationskipping potential. See Id. 2632(c)(3)(B) (listing involved requirements to avoid GST trust status). B. Two Exceptions Two specific types of GST trusts qualify for the annual GSTT exclusion, but only if they also qualify for the annual gift tax exclusion. ILITs that are designed specifically for grandchildren probably will qualify under the first exception. Gifts made directly to skip persons qualify for the annual exclusion under Code section 2642(c)(1). A trust is a skip person if all the beneficiaries also are skip persons. Regs (d)(2). Therefore, if the drafter avoids giving an interest in the trust to a non-skip person, the annual exclusion will apply. The Code also establishes a second possibility to invoke the annual GSTT exclusion. If (a) the trust is for the benefit of only one person (both income and principal); (b) the trust s assets will be includable in the beneficiary s estate; and (c) the gift qualifies for the annual gift tax exclusion, the gift will qualify for the annual exclusion from the GSTT. Code 2642(c)(2). In application, this second exception is nothing more than a narrow class of the exception described in the preceding paragraph. Not only must the trust have only one beneficiary, it also may not pass to a remainder beneficiary. Accordingly, this trust does not seem very flexible. GSTT will be imposed on any generation-skipping transfer. Code A generation-skipping transfer is defined, in the context of a trust, to include both taxable distributions and taxable terminations. Regs A taxable distribution is one that is made to a skip person. Id (c)(1). A taxable termination is, generally, a final distribution in favor of a skip person. Id (b). Therefore, if the distribution is to a non-skip person, no GSTT would be imposed. Each person has an exemption to the GSTT equal to the applicable exclusion amount for estate taxes under Code section 2010(c). Code 2631(c). Under Code section 2632(c)(1), the grantor s unused GSTT exemption is automatically allocated to transfers to a GST trust. The automatic allocation protects the unwary taxpayer from the consequences of failing to allocate the exemption to such transfers. Automatic allocation is not, however, always the most beneficial. In the typical family, parents usually predecease their children, who usually predecease their children. If an ILIT is designed such that the skip persons are only contingent beneficiaries, a generation-skipping transfer likely will never occur. If GSTT exemption is allocated to such a trust, the exemption will be wasted. Therefore, an informed client may choose, after due consideration of the risks, to opt out of the deemed allocation. See Code 2632(c)(5); Regs (b)(2)(ii). To opt out, the grantor would have to file a Form 709 U.S. Gift Tax Return opting out for the transfers to the trust. All is not lost if a non-skip person predeceases the insured and leaves descendants who then become beneficiaries of the trust. Absent affirmative action, the insured s remaining GSTT exemption would be applied to the trust at his or her death to the extent available, or, at least to the extent required to provide an inclusion ratio of zero. Regs (d)(2). The cost of relying on allocation at death is that there may be insufficient remaining GSTT exemption to fully cover the life insurance proceeds. Alternatively, the insured may elect to allocate GSTT exemption in a late filed Form 709. Regs (b)(2)(iii)(D) (electing to opt out of automatic allocation has no effect on taxpayer s ability to opt back in); (b)(4) (may file late allocation for prior transfers to a GST trust). The effective date of the allocation is the postmark date. Id (b)(4). The cost here is that the allocation must cover the value of the trust assets as of the month in which the allocation is finally made. Id (a)(2). C. Allocation of GSTT Exemption Most other ILITs, which also are GST trusts, do not qualify for the annual GSTT exclusion. Unless someone s GSTT exemption is applied to the trust, the v1 12 VI. CRUMMEY WITHDRAWAL POWERS As explained above, most ILITs must include Crummey withdrawal powers so the ILIT will qualify for the annual gift tax exclusion. In this section, the

17 paper discusses both the structure of Crummey withdrawal powers and the tax consequences on the power holder. A. Power Holder s Tax Consequences The basic withdrawal right gives the power holder the right to demand distribution of a gift to the trust for a certain period of time. If the right is unrestricted, the transfer to the trust qualifies for the annual gift tax exclusion regardless of whether the power holder exercises the right. Rev. Rul Typically, the power is drafted such that it lapses if not exercised within a certain amount of time. The typical time period is 30 days after notice of the power. See PLR (30 day period approved as reasonable period). Because of the powers granted, the demand right is a general power of appointment over the portion of the trust subject to the right. See Regs (c)(1) (defining general power of appointment ). This structure causes the power holder two separate succession tax consequences. To the extent the power holder dies during a period in which he or she has a withdrawal right, the right is included in his or her estate for estate tax purposes. Code Typically, estate inclusion is of no material consequence to the power holder because Crummey powers usually are limited to the annual gift tax exclusion amount. The lapse of a general power of appointment also may be a taxable gift. Under Code section 2514(e), the lapse of a general power of appointment is a release of that power. Consequently, the power holder is deemed to have transferred the property subject to the withdrawal power. Code 2514(b). On the other hand, the lapse of a general power of appointment that does not exceed $5,000 or 5% of the trust assets is not considered a release of the power. Id. 2514(e). Unfortunately, the annual gift tax exclusion exceeds the 5 and 5 rule in most instances. The trust must have a value of $240,000 before the annual exclusion of $12,000 equal 5% of the trust assets. B. Drafting to Minimize Tax Consequences to Power Holder 1. Hanging Powers A common method for minimizing the tax consequences to the power holder is to draft a hanging power. In this technique, the power holder is given the right to withdraw his or her proportionate share of the gift to the trust, up to the annual exclusion amount (currently $12,000). The power will lapse if not exercised after a certain period, typically 30 days, but only to the extent of $5,000 or 5% of the trust s value. For each subsequent year, the power again lapses up to $5,000 or 5% of the trust. A simple example illustrates how the hanging power works. In year 1, the grantor makes a gift of v1 13 $12,000 to a trust with one beneficiary who holds a hanging power as described above. The trust has no other assets and the grantor makes no further contributions to the trust. In year one, the power holder has the right to demand distribution of the entire $12,000, but does not do so. Thirty days after the transfer, the beneficiary loses the right to demand $5,000. But he still has the right to demand the remaining $7,000. At the end of year two, the beneficiary loses the right to demand another $5,000. Consequently, in year three, the beneficiary may only demand $2,000. At the end of year three, the beneficiary finally loses the right to demand the remainder of the initial gift to the trust. The effect is such that the grantor was able to maximize his annual gift tax exclusion and the beneficiary experienced no tax consequences at all. In the context of most ILITs, however, premium payments are made for several years. If the grantor is forced to maximize his or her annual gift tax exclusion each year, the withdrawal power will grow at a much faster rate than it lapses each year. Further, Code section 2041 still applies and if the power holder dies before the withdrawal powers have completely lapsed, the power will be included in his or her estate. Still, the hanging power seems to be a good compromise as it avoids forcing the power holder to make a taxable transfer each time he or she fails to exercise the power and preserves the possibility that the powers will lapse over time free of tax consequences. 2. Cascading Powers In a simple Crummey power provision, multiple beneficiaries are given equal proportionate rights of withdrawal in an attempt to create sufficient numbers of annual exclusions to cover the annual contributions to the trust. While the method is effective, it limits other planning opportunities. For example, if the trust s beneficiaries include the insured s spouse, and four children, and all are given proportionate Crummey powers, any gift to the trust will be spread among all five beneficiaries. If the annual premium payment is $5,000, the grantor will have used $1,000 of his or her annual gift tax exclusion for each child and would be able to transfer only $11,000 to each child outside of the trust. If, however, the withdrawal rights are structured such that a beneficiary has the right only if necessary, annual exclusions outside of the trust can be maximized. The following two examples illustrate the technique. Example 1. The grantor s spouse and four children are the beneficiaries of the ILIT. The spouse is given the right to withdraw gifts to the trust each year up to $5,000. If gifts to the trust exceed $5,000, the four children are given the right to withdraw the excess up to the annual exclusion amount. The

18 withdrawal rights of all beneficiaries lapse each year under the 5 and 5 rule. If the annual premium payments are $5,000, the spouse has a right to withdraw the entire amount. The children have no rights of withdrawal because of the size of the gift. The effect is that the grantor has preserved the ability to fully utilize the annual exclusions outside of the trust, yet is still able to use them inside the trust if needed or desired. The grantor may make any size of gift to the spouse outside of the trust with no tax consequences because of the unlimited marital deduction for gifts between U.S. citizen spouses. Example 2. The same facts as Example 1, above, except the annual premium payments are $13,000. Here, each child would have a proportionate withdrawal right to the extent the gift exceeds the spouse s right of withdrawal, or $2,000, each. The cascading power technique also can be used to differentiate generations, as well. This way the grantor can maximize annual exclusion gifts outside the trust for grandchildren as well. 3. Sample Language The following is language that incorporates both the hanging power and the cascading power. Beneficiary Demand Powers. The purpose of this Paragraph is to permit certain gifts to this trust to qualify under the Code provisions applicable for the annual gift tax exclusion. This Agreement therefore shall be construed and interpreted in accordance with this overriding intent, and the Trustee shall do all things necessary to qualify any gifts for such annual exclusions. a. Primary Beneficiary s Demand Powers. For each calendar year during which this trust is in effect, including the years of its creation and termination, the Primary Beneficiary has the right and power to demand a distribution of principal in an amount which is the lesser of (1) the net fair market value of any gift made to the trust by each donor during the year in which this special beneficiary demand provision is exercised; or (2) the greater of (i) Five Thousand Dollars ($5,000) or (ii) five percent (5%) of the net fair market value of the assets of the trust, determined as of the first day gifts are made to this trust or the first day of each succeeding fiscal year of the trust. The Primary Beneficiary s demand power terminates on the date of his/her death v1 14 b. Secondary Beneficiaries Demand Powers. Subject to the Primary Beneficiary s demand power granted in subparagraph (a), above, and to the extent a donor s gifts to the trust during a calendar year exceed the Primary Beneficiary s demand power, each living Secondary Beneficiary has the right and power to demand a distribution of trust principal in an amount which is the lesser of the Secondary Beneficiary s proportionate share of: (1) the net fair market value of any gift made to the trust by each donor during the year in which this special beneficiary demand provision is exercised; or (2) the maximum federal gift tax exclusion then available to the respective donor at the date such gift is made with respect to that Beneficiary such that the amount is reduced by all prior gifts during the year in question which the respective donor has made to or for the benefit of that Beneficiary. For purposes of this subparagraph only, and unless the donor directs otherwise in writing, each gift to the trust that exceeds the Primary Beneficiary s demand power shall be deemed to be for the equal benefit of each living Secondary Beneficiary. The termination of the trust does not terminate a Secondary Beneficiary s demand power except as specifically provided in Article III. A Secondary Beneficiary s demand power terminates on the date of his or her death. c. Notice of Gifts to Trust. Except for gifts made subject to subparagraph (h), the Trustee shall notify each Beneficiary who has a demand power with respect to the gift of its receipt of any gifts, and shall inform such Beneficiaries of their demand powers within a reasonable time of receiving the gift. If a Beneficiary is below the age of eighteen (18) years or is incapacitated, then such notice may be delivered or communicated to that Beneficiary's parent, custodian or guardian, whether natural, adoptive or appointed. To the extent a Beneficiary has more than one parent, guardian or custodian, and one is a descendant of Grantor, the Trustee has no obligation to deliver notice under this paragraph to the parent, guardian or custodian who is not a descendant of Grantor. The Trustee may provide such notice in any method which the Trustee deems reasonable under the circumstances. d. Exercise of Demand Powers. Subject to the following subparagraph, a demand power

19 under this Paragraph may be exercised only by written notice to the Trustee within thirty (30) days following notice of the gift pursuant to subparagraph (c). If a Beneficiary fails to notify the Trustee within such thirty (30) day period, then that Beneficiary's withdrawal power shall lapse as provided by the following subparagraph. e. Lapse of Demand Powers. If a Beneficiary fails to exercise his or her demand power in accordance with the provisions of this Paragraph, the demand power shall lapse on the second day of January of each succeeding year as to the greater of (i) FIVE THOUSAND DOLLARS ($5,000), (ii) five percent (5%) of the net fair market value of the assets of the trust, determined as of the first day gifts are made to this trust or the first day of each succeeding fiscal year of the trust, or (iii) the value of a power of appointment that is allowed to lapse during a calendar year without incurring transfer tax consequences to the power holder if increased by legislation enacted subsequent to execution of this Agreement. To the extent a demand power does not lapse, the power shall continue year to year until the Beneficiary exercises the power or it lapses as provided in the preceding sentence. f. Aggregation of Demand Powers. To the extent a Beneficiary has been granted one or more demand powers that lapse each year similar in nature to the demand powers granted in this Paragraph such that such powers must be aggregated under applicable federal gift tax law to determine whether the lapse of a demand power under this Paragraph is a release of a general power of appointment, the lapse of the power as described in the preceding subparagraph shall be limited to an amount measured after subtracting the value of all other demand powers belonging to the Beneficiary that have lapsed during the same calendar year. g. Distribution of Property. Within a reasonable time of receiving notice of the exercise of a demand power, the Trustee shall distribute an amount of property, whether in cash or in kind, including any undivided interest in property, which will fully satisfy the extent to which such power is being exercised. Any such distribution may be v1 15 made by any method authorized in this Agreement. h. Donor s Right to Alter Withdrawal Right. Notwithstanding any other provisions of this Agreement, any donor, including but not limited to the Grantor, may, by written instrument delivered to the Trustee before or contemporaneously with a gift to the trust, alter the Beneficiary s demand powers with respect to such gift in the following manner: (i) alter the amount, duration, notice rights with respect to, or any other aspect of the demanded power; (ii) eliminate any Beneficiary s demand power, and/or (iii) create a new demand power in any individual. The Trustee may, however, refuse to accept any gift subject to such alterations if the Trustee believes the modification causes unacceptable administrative or tax consequences. i. Trustee Reliance. Unless the Trustee is notified in writing, the Trustee may assume without liability to any person that the only gifts a donor has made to a current beneficiary are those made to the Trustee and that the only withdrawal rights a beneficiary has are those given in this Paragraph. C. Notice Issues Drafters should avoid the temptation of requiring the Trustee to take actions that exceed federal requirements. Invariably, the Trustee will make mistakes related to the administration of the Crummey notices. If the trust itself has requirements that go beyond those imposed by federal law, the family may loose the opportunity to fix a mistake. For example, federal law does not require written notice for it to be effective. See Rev. Rul (reasonable notice is required). If a beneficiary received actual oral notice, the notice should suffice if the trustee failed to provide written notice. Also, imposing a time limit on providing notice may be a mistake for the same reasons; only reasonable notice is required. Finally, the termination of the withdrawal period should be tied to the date of notice rather than the date of the gift. Otherwise, notice might be given at a time when it is too late to exercise the withdrawal right. Under general principals of law, a beneficiary should be able to waive his or her right to receive notices. However, the IRS has taken the position that waivers are not sufficient to preserve the annual exclusion. TAM Accordingly, the careful trustee will send notices tied to each gift to the trust. The contents of the notice also should include the

20 amount of the gift. See Rev. Rul. 81-7; PLR While the Trustee may calculate the amount subject to the beneficiary s withdrawal right, the better practice is to simply include a copy of the trust s withdrawal provisions in the notice. This shifts responsibility for computation mistakes to the beneficiary. A sample Crummey notice letter is attached as Exhibit B. It is designed to be as simple as possible for administrative convenience. VII. ADMINISTRATIVE PROVISIONS A. Limited Trustee Power to Amend A major problem with irrevocable trusts is that they tend to be inflexible. One method of preserving administrative flexibility is to grant the trustee the power to amend the trust s administrative provisions. A trustee who has such a right does not have a power of appointment if the trustee cannot substantially affect the beneficial enjoyment of the trust s income and principal. Regs (b). The provision also should specifically refer to the trust s withdrawal provisions. A sample provision follows. The term Independent Trustee is defined elsewhere to mean a trustee who is not related or subordinate to the grantor or a beneficiary within the meaning of Code section 672(c): y. Limited Power to Amend. (1) Administrative Provisions. The Trustee may, within its discretion, amend the administrative provisions of the trust, but only to the extent the amendments do not substantially affect the beneficial enjoyment of the trust income or principal. (2) Withdrawal Power. The Independent Trustee may amend the provisions related to a beneficiary s demand powers under Section II, Paragraph 2.5 to the minimum extent necessary to ensure that contributions to the trust and its beneficiaries qualify for the gift tax annual exclusion for federal gift tax purposes. and their spouses to a greater extent than before any amendment. The Trustee also may not amend the trust or allocate its principal such that the amendment or allocation substantially affects the beneficial enjoyment of the trust income or principal held before the amendment or allocation, except as specifically permitted in this subparagraph. B. Removal and Appointment of Trustees Careful consideration should be given towards the provisions for removal and appointment of the trustee. Under the Uniform Trust Code, a court order is required to remove a trustee. N.M. STAT 46A Further, there must be cause to remove the trustee. Id. Under the statute, cause is defined as (a) a serious breach of trust; (b) a lack of cooperation among cotrustees that substantially impairs administration of the trust; (c) the trustee s unfitness, unwillingness or persistent failure to administer the trust effectively; (d) a substantial change of circumstances affecting the trust; and (e) removal is requested by all of the qualified beneficiaries. Id. 46A-7-706(B). While the Uniform Trust Code provides a default provision for removing trustees, that court approval is required certainly limits its efficiency. One example of a removal power that should be included in any trust is the ability for the beneficiaries to remove and appoint a replacement trustee. Another provision that should be considered in the context of irrevocable trusts is the reserved power in the grantor to remove and replace the trustee. One must be careful to avoid retaining a general power of appointment or an incident of ownership over any life insurance policy, however. If the grantor must replace the trustee with another trustee that is not related to or subordinate to the grantor within the meaning of Code section 672(c), the retention of this power does not cause the trust to be includable in the grantor s estate. See Rev. Rul (not includable under Code sections 2036 or 2038); PLR (not an incident of ownership under Code section 2042). A sample provision follows: (3) Manner of Amendment or Allocation. The Trustee shall make any amendment or allocation in writing and file it in the trust s books and records. (4) Limitation on Power to Amend or Allocate. The Trustee may not, however, amend the trust or allocate its principal in any manner that would cause any portion of the trust assets to be included in the gross estate of the Grantor, the Grantor s current or future spouse or the Grantor s descendants v1 16 j. Removal and Appointment of Trustees During Grantor s Lifetime. The Grantor, or the Grantor s agent appointed under a valid durable power of attorney, may remove a currently serving Trustee or a named successor Trustee, with or without cause, and appoint a successor Trustee. The successor Trustee must be a person who is not related or subordinate to the Grantor or a beneficiary of the trust within the meaning of Code Section 672(c).