14. Life Insurance in Charitable Planning, Part 2 of 4

14. Life Insurance in Charitable Planning, Part 2 of 4

Article posted in General on 13 July 2016| comments
audience: National Publication, Russell N. James III, J.D., Ph.D., CFP | last updated: 14 July 2016

An Introduction to the Law and Taxation
of Charitable Gift Planning

By: Russell James III, J.D., Ph.D.

14. Life Insurance in Charitable Planning, Part 2 of 4

Links to previous sections of book are found at the end of each section.

The previous examples presented a simplified process for using an ILIT.  However, it can be helpful to understand a bit more about the different steps in creating and operating an ILIT and their potential consequences.
Although the donor can create the rules of the ILIT, even determining the exact wording of the trust document, the donor may not continue to directly control the assets in the ILIT once it is created.  Thus, unlike, for example, a Charitable Remainder Trust, the donor may not continue to act as trustee of the ILIT.  Doing so gives enough ongoing control to the donor that the ILIT will be included in the donor’s estate which would eliminate the estate tax benefits.

The amount a donor may transfer to another person without gift tax consequences is limited.  Each year, a donor can make present interest gifts to other people up to this limit (e.g., $14,000 per donee in 2015) without any gift tax consequences.  The amount applies to each donee and each donor.  For example, a married couple with two married children each with two children of their own would have eight natural donees.  Because both spouses have their own separate annual exclusions, this would allow the transfer of $224,000 (8x2x$14,000) each year without gift tax consequences.

Unfortunately, direct gifts to an ILIT do not qualify for the annual present interest gift exclusion.  Thus, direct transfers to the ILIT will have gift tax consequences.  Specifically, any direct transfers will reduce the donor’s available estate and gift tax exemption.  This would eliminate the benefit for the donor who ultimately gifted more dollars to pay premiums than the death benefit paid by the insurance policy.  Every dollar of direct gifting to the ILIT will reduce the estate tax credit because gifts to the ILIT are not “present interest” gifts.  Direct gifts to an ILIT do not qualify as “present interest” gifts because the beneficiaries of the ILIT do not receive any funds until sometime in the future.  One extra step is required to avoid this bad result.

Instead of making transfers directly to the ILIT, the donor makes transfers to the ILIT but with the provision that some beneficiaries of the ILIT (such as the donor’s children) have, and are notified in writing of, a 30 day right to take the transfer as an immediate cash gift to them.  Because the beneficiaries have a right to take the gift immediately as a cash gift, the gift from the donor becomes a “present interest” gift.  This “present interest” gift then qualifies for the gift tax annual exclusion.  For example, in 2015, each donee could receive a right to claim up to $14,000 of the transfer from each donor as immediate cash.  This $14,000 transfer would generate no gift or estate tax consequences for the donor.  The appellate court case that authorized this type of temporary power as a way to claim the present interest gift tax exclusion involved a taxpayer by the name of Crummey.  Hence, these are known as “Crummey” powers.  These “Crummey” power holders must also be potential beneficiaries of the ILIT.  The tax courts have permitted contingent beneficiary power holders, such as grandchildren who will receive a share only if their parent predeceases them before the distribution.

The assumption in this planning is that the recipient of the Crummey powers will choose not to take advantage of their right to an immediate cash withdrawal and will instead allow the money to go to the ILIT.  Otherwise, the tax advantages of the planning process would be defeated.  This is one reason why such rights are typically given in a family situation where the donor has sufficient informal influence over the recipient to prevent the cash withdraws.  Any overt or formal attempts to influence the powerholder’s decision may nullify the tax effects of the Crummey power.
Although the present interest annual gift tax exclusion is relatively small (e.g., $14,000 in 2015), it can be used for every donor and every donee.  When combined together for a large number of donees, these add up to substantial annual transfers.  For example if a married couple were making transfers with “Crummey” powers given to their two children, the children’s two spouses, and four grandchildren, this would allow for the use of 8 separate annual present interest gift tax exclusions for each donor spouse (e.g., $14,000 X 8 X 2, or $224,000).
When this much money is used for annual premium payments, it can purchase a significant amount of life insurance – especially for younger and healthier donors.  The annual present interest gift tax exclusion is also indexed for inflation (although changes occur only in $1,000 increments), allowing for potential funding increases over time.
The use of “Crummey” powers solves one problem by converting the transfers into “present interest” gifts for the donors.  At the same time, it creates a new problem.  The new problem is that when the holder of the “Crummey” power chooses not to use his or her rights, he, in effect, makes a gift to the beneficiaries of the ILIT.  If the power holder were the only beneficiary of the ILIT, then this would not be a problem.  No gift would have occurred because the ILIT would benefit no one other than the “Crummey” power holder.  But, the typical ILIT has more than one beneficiary.  This means that failing to exercise the right to immediately withdraw the money results in a gift benefitting others.  Once again, the same problem arises here, because the gift to the other ILIT beneficiaries is not a present interest gift.  (As before, these beneficiaries must wait until the death of the insured to receive benefits from the expired withdrawal rights.)  Because the choice not to use these powers is not a present interest gift, the annual present interest gift tax exclusion will not apply, causing the gift to reduce the “Crummey” power holder’s gift and estate tax exemption. 
However, the beneficiary may release this type of power up to the greater of 5% of trust assets or $5,000 each year without gift or estate tax consequences.  This does not normally allow for the release of the full annual present interest gift tax exclusion ($5,000 is less than $14,000).  One approach is to allow the beneficiaries’ gift and estate tax exemption to absorb the difference, thus dispersing and postponing the tax effects to the next generation.  There is also another alternative.

The “Crummey” powers may allow each beneficiary to keep the right to demand his or her share of the cash transferred to the ILIT indefinitely, with this right expiring only at the rate of the greater of $5,000 or 5% of the value of the ILIT per year.  This type of provision is called a “hanging power” because the recipient hangs on to the right to demand the cash for a long time.  With this drafting, the beneficiary never gives up more than the gift-tax-free amount of his or her right to receive cash (i.e., $5,000 or 5% of trust assets), preventing the beneficiary from making a taxable non-present-interest gift to the ILIT.

The use of hanging powers prevents the beneficiary from using up her own gift and estate tax exclusion amount, but can create problems of its own.  The ability of the “5 and 5” powers to eliminate the accumulation of such hanging powers is limited.  In fact, each beneficiary can use only one “5 and 5” exemption each year, regardless of how many ILITs or other trusts for which they have such powers.  Over time, these hanging powers can continue to accumulate, meaning that the beneficiary has an increasingly large right to receive immediate cash.  Creditors could take this right, and the beneficiary’s estate will include any unexpired rights for estate tax purposes.  Eventually, the “5 and 5” powers can begin to reduce the total hanging powers if, for example, “Crummey” gifts cease to be made.  This could occur if the life insurance policy becomes fully-funded at some future point.  Additionally, after the death of the insured, the ILIT will hold the entire death benefit.  At this point, 5% of the trust assets may be worth far more than $5,000.  Because the greater of these two amounts can be lapsed, this would allow for a rapid reduction in the total hanging powers for as long as the ILIT holds such substantial assets prior to distribution.

A generation skipping transfer tax can apply when the donor makes a gift (or estate transfer) to a “skip person,” such as a grandchild.  A skip person is anyone two or more generations below the donor.  However, if the skip person’s parent (who is also the donor’s descendent) has died, the skip person is treated as being one generation older.  Transfers to such skip persons are subject to a generation skipping transfer tax of 40% in addition to the estate tax of 40%.  The theory here is that normally, every generation must pay estate taxes on its transfer to the next generation.  Giving wealth to a grandchild or great-grandchild “skips” out on taxation that would have been collected at the death of the previous generation.  There is an exemption for generation skipping transfers, which is the same size as the estate tax exemption amount.  For those transferring more than this exemption amount the potential application of both the 40% estate or gift tax and the 40% generation skipping transfer tax is disturbing.  (Because the 40% generation skipping transfer tax is applied to the amount left after payment of estate tax, the net result is a combined tax rate of 64%.)

Crummey powers allow gifts to an ILIT without gift or estate tax consequences up to the annual exclusion limit ($14,000 per donor per donee in 2015).  However, a Crummey power does not automatically exclude these gifts from generation skipping transfer taxes.  If the ILIT benefits skip persons (e.g., grandchildren with living parents), it is a generation skipping trust and transfers to it will reduce the donor’s generation skipping transfer tax credit.  The only exception is that if an ILIT is established solely for the benefit of a single skip person (e.g., a single grandchild) and the ILIT assets will be included in the skip person’s estate, then gifts up to the annual exclusion limit will also be excluded from generation skipping transfer tax consideration.  (Including the ILIT in the skip person’s estate is accomplished by giving him or her a general power of appointment to decide who will get the funds if he or she dies before receiving all ILIT assets.)  In this way, such transfers to a single-beneficiary ILIT can avoid generation skipping transfer tax.  However, benefitting multiple skip persons in this way would require the creation of multiple ILITs, each with a single skip-person beneficiary. 

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