Present vs Future Interests &Crummy Powers

1. Present Interest 

The annual exclusion is only available for gifts of a “present interest.” An outright gift of a life insurance policy to a trust is a non-qualifying gift of future interest. Because of the Crummey demand powers, the future interest can be re-qualified into a present interest.[23] The trustee will give notice to the beneficiaries of the followings rights: 

ü Notice of the right to make a withdrawal 

ü Notice of each gift to which the withdrawal relates 

ü When there are minors: Notice to the guardian or the minor’s parent 

2. Fundamental Right of the Beneficiaries 

The IRS considers the notice as a fundamental requirement that cannot be waived by the beneficiary. It seems that an oral notice will probably suffice as long as the power holder actually is informed of his/her right. However, a written notice is preferable particularly if the IRS asks for proofs of the notices. 

3. Content of Notice 

It is recommended that the notice provide the following: 

ü Inform the beneficiaries that the only expected gifts to the trust are the premium gifts 

ü Gives the beneficiaries a schedule of the dates on which premium gifts will be made to the trust 

ü Informs the beneficiaries of their demand rights 

ü Promises supplementary information only if premium gifts are not made according to this schedule 

The notice is not required to be sent to the beneficiary who is also the trustee. 

4. Length of the Demand Power 

It is required that the demand period be long enough to give the beneficiary a meaningful interest in the property given to the trust. The beneficiary must be given a realistic opportunity to actually withdraw the settlor’s contribution. In Estate of Cristofani v. Commissioner[24] the Tax Court held that a fifteen-day withdrawal period was sufficient. 

There are three kinds of Crummey powers: (1) Five-or-five Crummey power, (2) Crummey powers with testamentary control, and (3) Hanging Crummey powers. 

5. The Five-or-Five Crummey Power 

The most common way to eliminate the beneficiary’s gift tax problem is through limiting each demand power to a noncumulative annual right to withdraw the greater of $5,000 or 5 percent of the value of the trust funds. Section 2514(e) specifically provides that the lapse or release of a general power of invasion is not a taxable gift except to the extent that it exceeds the greater of $5,000 or 5 percent of the trust funds from which it could have been satisfied. 

However, this power restricts the donor’s annual exclusion to $5,000 per donee. If the trust has a principal value of more than $100,000, the 5 percent alternative limitation would increase the demand limitation, but few life insurance trusts have such significant principal values. Thus the $5,000 limitation is commonly applied, and it may not shelter from gift tax all of a grantor’s gifts to a life insurance trust. To the extent that these gifts are not covered by the $5,000 demand powers, the grantor must file gift tax returns and expend his or her unified credit or pay a current gift tax. 

In addition, this power is required to be measured annually. Since the demand power is only exercisable after the receipt of notice of the gift, it compels the donor to make gifts before December 1 in order to leave enough time for the power to lapse by the end of the year. Furthermore, it seems that the power shall lapse and cannot be released. A release could be viewed as a taxable event. 

Finally, multiple demand powers held by the same beneficiary must be aggregated. 

6. Crummey Powers with Testmentary Control 

Another method is to give the beneficiary the power to determine who shall receive any property to which the lapsed withdrawal right relates. Because the beneficiary continues to control the ultimate disposition of the property, a non-completed transfer occurs and no gift tax can be imposed. The entire property transferred in excess of the five-or-five limit will be included in the beneficiary’s estate. 

7. Hanging Crummey Powers 

Another solution is a Crummey demand power that lapses in stages. The power lapses currently to the greatest extent possible under the five-or-five limit. Any excess remains subject to an ongoing demand power, which lapses only to the extent of the greater of $5,000 or 5 percent of the trust funds each year. Multiple hanging Crummey powers are an effective way to increase the annual exclusions for gifts of very large life insurance policies. The use of more beneficiaries and larger gifts makes the 5 percent limitation increase more with respect to each beneficiary’s demand power. 

One of the major problems with a hanging Crummey power is that the beneficiary has a continuing demand right that, if exercised, may frustrate the settlor’s goal of retaining the insurance in the trust. It is more difficult to convince a young beneficiary that he or she should not exercise a demand right when it continues for several years instead of a few weeks. Hanging power should not be used unless the settlor has great confidence in the financial maturity of the beneficiary or the beneficiary’s guardian. 

8. Foreign Beneficiaries 

If the insured is not a U.S. citizen nor a U.S. resident, no special care need be taken to exclude the insurance proceeds from his/her gross estate. If the insured is a U.S. resident, then he/she will be subject to U.S. estate tax on his/her worldwide holdings. 

If one beneficiary is a non-U.S. citizen, the trust design should seek the greatest potential estate tax exclusion if the beneficiary ultimately is a non-resident alien. If the alien has a power of appointment over the trust assets, or the assets will be distributed outright to the beneficiary at some date, the trust should invest in assets situated outside of the United States, such as the stock of foreign corporations, so that the assets distributed are not subject to U.S. estate tax. 

Finally, an alien spouse is not eligible for the estate tax marital deduction unless the assets pass to the spouse through a qualified domestic trust. Because the insured may die within the three-year period, the trust instrument must provide the following: 

ü The surviving spouse must be entitled to all of the trust’s income, distributed at least annually; 

ü The trust must have at least one trustee who is a U.S. citizen or domestic corporation; and 

ü The trust must provide that no distributions (other than distribution of income) can be made without the consent of the U.S. trustee 

9. Surviving Spouse 

Planning an ILIT with a spouse can provide additional flexibility but adds risk. The first advantage is the election of the gift-splitting treatment allowed by the IRS. The donor can file a gift tax return, with the consent of the non-donor spouse, that ½ of the gift is made by one spouse and the other ½ is made by the other spouse. 

The spouse can also be the trustee of the ILIT so long as the spouse does not have a general power of appointment over the policy or the proceeds. If there was such power, the insurance proceeds would be included in the trustee-spouse’s estate under Section 2041. For instance, the power to distribute principal to the insured’s spouse is a general power of appointment. 

In addition, when a couple wants to create an ILIT for each of them, you have to avoid the Reciprocal Trust Doctrine. This doctrine would apply regardless of the nature of the trust funds. Trusts are reciprocals when husband and wife give each other the right to current income from the other grantor’s trust. The doctrine would apply even if the assets included one or more life insurance policies. The safest approach to avoiding the reciprocal trust doctrine is to create two trusts that give the spouses distinctly different interests. While one spouse may be trustee of the other’s trust, there should be an independent trustee of at least one trust while both spouses are alive. Furthermore, the beneficiaries of the two trusts should be somewhat different. Perhaps, for instance, one trust could give the surviving spouse a mandatory income interest and right to invade principal subject to an ascertainable standard, while the other could create a sprinkling trust in favor of the surviving spouse and descendants.