We're all familiar with the irrevocable life insurance trust (ILIT). It's an excellent device for creating estate liquidity. Usually, Mom and Dad create an irrevocable trust, designate a trustee, and name their children as beneficiaries. The trustee then acquires joint and survivor life insurance on Mom and Dad, who fund the life insurance premiums by giving money to their children via the trust. The trustee then pays the premium out of the gifted funds. At the death of the second spouse, the ILIT collects the policy benefit, buys assets from the decedent's estate, or lends money to it, providing the liquidity to pay the estate clearance costs. After everything is settled, the trust continues for the heirs' benefit, or the trustee settles the estate and distributes the assets to the heirs. Of course, the key value here is that the policy benefit escapes estate taxes. In addition, the policy benefit is protected from creditors' claims.
To recap, the trust and policy premiums are funded by gifts to the children. There are two ways to make those gifts and avoid any liability for gift taxes. Any well-drafted ILIT will provide for both. One way is to use the annual gift tax exclusion, and the other is to use the lifetime gifting exclusion.
The Annual Gift Tax Exclusion
The most commonly used gifting technique is the annual gift tax exclusion. Usually, Mom and Dad want the premium gifts to qualify for the annual exclusion (currently $12,000 per donor per donee), preserving their lifetime gifting exclusion for other purposes. First, Mom and Dad give the premium funds to the ILIT. Then, the trustee sends a Crummey letter or letters. Once the letters have been returned, the premium is paid.
Mr. Crummey's attorney devised the letter. It says -- more or less -- to the trust beneficiary, "We [Mom and Dad] have given $XX,XXX for you to our irrevocable trust, the Mom and Dad Irrevocable Life Insurance Trust, dated January Y, YYYY. If you would like to have it, please contact John Doe, Trustee of the Mom and Dad Irrevocable Life Insurance Trust, dated January Y, YYYY, and tell him to send you the money. If you don't want it, please sign and date this letter and return it to Mr. Doe in the enclosed, postage-paid envelope within 30 days."
That letter, once it has been signed and returned to the trustee, makes the gift one of a present interest, qualifying it for the annual gift tax exclusion. Of course, because the gifts are meant to pay the life insurance premiums, the kids are not supposed to ask for the money.
The Challenges of the
Annual Gifting Exclusion
This time-honored technique preserves the lifetime gifting exclusion. It has, however, several challenges.
For example, to effectively use the annual exclusion, the children must be involved in the process. They will, after all, receive the letters. They need to know what's coming and accept the plan. That means that Mom and Dad, the trustee, the attorney, and the accountant must meet with the children and explain the situation to them. We hope they will not have to say "... and you had better not ask for the money, because if you do the whole plan will collapse like a house of cards."
There may not be enough children to qualify the entire premium payment for the annual exclusion. At that point, Mom and Dad either will have to invade their lifetime exclusion to some extent, or find some contingent beneficiaries. Whether or not the contingent beneficiaries will be acceptable to the tax court, should the IRS contest their status as contingent beneficiaries, is open to question. The annual gift tax exclusion is now $12,000 per donor per donee per year. If Mom and Dad are faced with a $100,000 premium and have only two children, they will want more beneficiaries. They may include their children's spouses and also may include the grandchildren as either beneficiaries or contingent beneficiaries. That may or may not be Mom's and Dad's preference, and it may be contested by the IRS.
Everyone may agree on the need to put the money in the ILIT. However, the financial circumstances of one or more of the children may change, putting that child or children in the position of needing the money. Therefore, when the Crummey letter goes out, that child, or children, may want to take the money, which could be detrimental to the overall plan.
Divorce is common today. If one of the children divorces, the ILIT may become a problem or a bargaining issue. After all, it's quite likely that any child's spouse will come to know of the trust and of the gifts to it.
There also are timing considerations. The money first has to go to the ILIT. Then the trustee has to send the Crummey letters. Then there has to be the 30-day wait. The trustee has to receive the return letters, make sure they're properly executed, then store them against the eventuality of an audit of a deceased spouse's federal estate tax return.
There may be continuity problems with the trustee. If the trustee is an individual, that individual may die unexpectedly, not having made adequate transition plans. The trustee may retire, not having made adequate transition plans. That could mean that the files are lost, or that the Crummey letters aren't sent. The alternative to an individual trustee might be the trust department of a commercial bank. Banks don't retire or die unexpectedly. Unfortunately, they do charge significant fees. And, of course, an individual trustee would charge fees as well.
Other Issues to Consider
o The Crummey letters have to be sent every year, so it's possible that the concept will have to be re-sold to the children every year.
o Mom and Dad may want to use their annual gift tax exclusion for other gifting purposes.
o This may have to go on for decades. And each year, it presents an opportunity for a child or children to have a change of heart.
o There's always Murphy's Law: "If it can go wrong, it will, and at the worst possible moment." And then there is the corollary to Murphy's Law, author unknown: "Murphy was an optimist."
Given this list -- and it's certainly not all-inclusive -- it surprises me that any ILITs using the annual gift tax exclusion are ever created.
There is a very strong advantage to using the annual gift tax exclusion. If you don't use it, it will be lost. That is, if Mom and Dad don't use their annual exclusion for the year 200X, it will be gone. It isn't cumulative; it can't be used in year 200X+1. Like so many things, if you don't use it you lose it. Therefore, if you can reasonably use it -- and can afford to use it -- it makes sense to use it. Unfortunately, as I've listed above, there are many disadvantages to using it to fund an ILIT.
SILIT: a Simpler Way to Use the Lifetime Gifting Exclusion
Isn't there a simpler way to do this? Yes, the Simple ILIT, or SILIT if you like acronyms. In the Simple ILIT, annual gifting would not be used. Rather, Mom and Dad would use their lifetime gifting exclusion. Mom and Dad each have a $1 million lifetime gifting exclusion. That covers a lot of life insurance premiums.
The annual gift tax exclusion applies only to gifts of a present interest, like gifts given at Christmas. The lifetime gifting exclusion can apply to gifts of a present interest, but it also applies to gifts of a future interest. If Mom and Dad don't send the Crummey letter, their gifts to the trust become gifts of a future interest, in the sense that the children will receive the fruits of the gift, usually after Mom and Dad both have passed away.
There are several advantages to the SILIT approach:
o The annual gift tax exclusion will be preserved for other gifting; helping with present concerns, improving their home, buying a home, starting a business, taking vacations, replacing a car, and so on. These are things that will make a child's or grandchild's life a little better.
o We don't have to sell the concept to the kids.
o We don't have to worry about any of the children falling on hard times and needing the cash.
o We don't have to worry about the ILIT becoming a problem in a divorce, or worry about a spouse pressuring the donee spouse to take the money instead of putting it in the life insurance.
o Not being limited to annual exclusion gifts might mean that Mom and Dad can put more money into the policy faster, reducing the total premium requirement and reducing the number of years it takes to adequately fund the policy.
Gift Tax Returns
Must Still Be Filed
There are disadvantages to this technique. Primary among them is that annual gift tax returns, using Form 709, have to be filed. And the lifetime gifting exclusion is at least partially used. This will reduce the amount of property that can pass estate-tax free to Mom's and Dad's heirs. The good news is that Form 709s are almost as simple as 1040EZ forms.
David K. Smucker, CPA, CFP, CLU, ChFC, is a senior consultant in the advanced sales department of Nationwide Insurance. Mr. Smucker began his career as an Internal Revenue Agent. After the IRS, he was a sole practitioner for several years, then joined a regional accounting firm based in Columbus. He was recruited by Nationwide for its advanced sales department in 1989, and has been there ever since. As a senior consultant, Mr. Smucker designs business succession plans, estate plans, and executive compensation programs, consults on qualified and non-qualified plans, and works with Nationwide producers.
