Irrevocable Life Insurance Trusts (“ILIT's”) remain a wonderful planning tool. Not only do they have excellent tax advantages, but they also are a way to achieve capital formation for the family that can last for generations, free from creditors, the IRS and family imprudence as well. The Grantor creates an irrevocable trust for the benefit of designated family members, has the trustee apply for a life insurance policy on the Grantor, and makes annual gifts to the trust sufficient to pay the policy premiums.
On the death of the Grantor the policy death benefit is collected free of all transfer taxes and is held according to the trust provisions. While income is generally paid out to the trust beneficiaries, the principal of the trust is often suspended and invested for future generations, limited only by human sanity and the rule against perpetuities in those states where it still exists.
Well,how about those premium contributions to the trust over the years to sustain the policy? You guessed it, they are treated as taxable gifts to the trust beneficiaries. Often the annual gift tax exclusion ($13,000 per donee or $26,000 if the gifts are split with a spouse) will be more than the annual premium gift, so we need to inquire whether the annual exclusion applies. The annual exclusion applies to gifts only if they are "present interest gifts." If the beneficiary’s interest is regarded as a "future interest", then the gifts do not fit within the annual exclusion.
The seminal case on how to manage ILIT’s so as to preserve the annual exclusion for contributions to the trust is Crummey v. Commissioner 397 F2 82 (9th Cir. 1968). Crummey established a road map for the legal community and has been followed by careful practitioners ever since. The well-established procedure is to have the Grantor contribute the policy premium to the trust and following each deposit provide the beneficiaries a limited right of withdrawal for a period of 30 days. Careful planners have always insisted that the trustee to give the beneficiaries notice of the gift and their right of withdrawal. If the right of withdrawal is not exercised not exercised it will expire at the end of the 30 day period. This procedure is so well known that these notices of the right of withdrawal are universally called "Crummey Notices” and the powers to withdraw called “Crummey Powers."
Notice that that the Grantor contributes the policy premium to the trustee, who after giving notice and the lapse of the 30 days, pays the premium. The reason for this circuitous routing is twofold. First, a concern that paying the premium directly may constitute an indirect gift to the trust beneficiaries not qualifying for the annual exclusion? Further, if the premium gift is not in the trust, would the right of withdrawal be illusory since there would be no funds against which the withdrawal could be exercised.
The second part of the procedure is the Crummey Notice to the beneficiaries. There has always been concern that beneficiaries who did not receive notice of the deposit and their right of withdrawal could not be held to have any meaningful access to support the present interest gift requirement.
This procedure only worked effectively if the beneficiaries did not withdraw the gift, since doing so would indirectly destroy the trust established for their benefit. This worked most of the time, but there are legendary stories out there about undisciplined beneficiaries who firmly believed in the "bird in hand" theory and exercised their right of withdrawal in the face of likely disinheritance. These cases are relatively rare but “children will be children.“
Along comes Clyde Turner whose attorneys drafted him a model ILIT. Two of his children were trustees and policies on Clyde’s life were purchased by the trust. Clyde was undoubtedly told about the proper procedure for further funding of the policy premiums, but he may have neglected to tell his children, or maybe he just thought all that stuff was “ legal gobbledygook.” In any event Clyde did a normal thing, when he got the bills for the policy premiums, he just paid them directly to the life insurance companies.
It should also come as no surprise that no "Crummey Notices" were ever sent to trust beneficiaries. One suspects that the children-trustees may have not paid any attention to the trust and did whatever Dad told them to do. The other beneficiaries may not even have known about the trust. This non-observance of protocol arises more often than you would think, particularly with individual trustees. Defects in the procedural formalities sometimes can inadvertently happen even where there are institutional trustees.
The big issue in Clyde’s case, Turner v. Commissioner, T.C. Memo 2011-209, was not the ILIT, but rather a Family Limited Partnership created by Clyde and his wife Jewell. While, the creation of the partnership was on its face legally sufficient, the action of the Turner family in funding and administering the FLP, and its lack of a non-tax purpose are a virtual check list on how to get your FLP ignored by the IRS and the FLP assets included in the founder’s taxable estate. For those interested in FLP’s, the decision makes for interesting reading. One suspects that if the only issue had been the ILIT, the trust issues may have never been litigated.
The IRS conceded that Clyde’s payment of insurance premiums constituted indirect gifts to the trust beneficiaries, but contended that those indirect gifts were not eligible for the annual exclusion because they were not gifts of present interests under IRC Section 2503(b).The court in relying on Crummey v. Commissioner, supra, and its progeny stated :
“In distinguishing present interests from future interests for Federal Gift Tax purposes, the test is not whether the beneficiary was likely to receive the present enjoyment of the property, but whether he or she had the legal right to demand it.”
Concluding that the beneficiaries of Turner’s ILIT could have legally demanded the distribution that they were entitled to and the Trustees could not legally resist such demand, the court concluded that the beneficiaries’ interests were present interests sufficient to support the application of the annual exclusion. In Cristofani v. Commissioner 97 T. C. 74 (1991) on which the Turner court also relied, the court stated that it made no difference that the beneficiaries were minors, since their rights could have been exercised by their guardians.
Drafting Point: The court in discussing "indirect gifts" noted that Clyde's trust specifically provided that additions to the trust could be "direct or indirect gifts." Check your document. This is a freebie. It's like buying insurance on your clients own infallibility!
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Does this mean that we should abandon the present procedure of making direct gifts to the trust and sending out Crummey notices? No, I think not, as the IRS has not yet conceded the issue surrounding the need for Crummey notices. Turner is a welcome decision, however, for clients and trusts where the formalities have hereto fore been largely ignored. The Turner decision is best used as a shield and not as a sword. But if the “fat’s in the fire” you cite Turner v. Commissioner as if it had been handed down by Oliver Wendell Holmes himself.
