Journal of Financial Planning: December 2013
Jon J. Gallo, J.D., chairs the family wealth practice group of Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles, California. Together with his wife, Eileen Gallo, Ph.D., he is a founder of the Gallo Institute and the author of two books on children and money. Their website is www.galloconsulting.com.
Retirement is often a time to re-examine our client’s life insurance. This review may lead to the creation of an irrevocable life insurance trust (ILIT) and the transfer of some or all of the client’s existing life insurance to the ILIT. Two potential problem areas need to be considered before implementing the decision to create and fund an ILIT.
Valuing the Policy
The transfer of an existing life insurance policy to an ILIT is a taxable gift. Unfortunately, in the last 20 or so years, it has become increasingly difficult to determine the amount of the taxable gift.
Treasury Regulation §25.2512-6 sets forth the Treasury’s approach to valuing life insurance for gift tax purposes. If the policy is term insurance, the regulations provide that the gift is measured by the unused portion of the premium. If the policy is a cash value policy and has been in effect for less than one year, the gift is the first year’s premium. If the policy has been in effect for more than one year, value may be approximated by adding together the interpolated terminal reserve (ITR) of the policy and the unused portion of the last premium and dividend accumulations, less outstanding policy loans at the time of the gift.
When Treasury promulgated Reg. §25.2512-6 more than 50 years ago, there were only two types of insurance policies available for purchase: whole life and annual renewable term. All aspects of a whole life policy, including cash values, were fixed and guaranteed by the insurer. Carriers offering whole life policies were required to set aside a reserve each year to meet their contractual obligations to the insurance policy owners. The amount of the reserve at the start of the year was known as the “initial reserve,” and the reserve at the end of the year was known as the “terminal reserve.” Because all aspects of a whole life policy were fixed, one could calculate the amount (it could be interpolated in the language of the regulations) of the terminal reserve at any point during the policy’s existence.
Since Reg. §25.2512-6 was published, life insurance companies have introduced such contracts as universal life, variable universal life, indexed universal life, guaranteed no lapse universal life, and 10- to 30-year level term policies. All of these products have reserves. However, because these products are current assumption products—both current mortality experience and investment performance are passed through to the policy owner—the “terminal reserve” as of the actual anniversary date of the policy cannot be calculated until that date, making it impossible to “interpolate” a terminal reserve for purposes of the Treasury regulations.
To make matters worse, the proliferation of insurance products since the 1960s has resulted in several different types of reserve calculations, including the tax reserve, the statutory reserve, the Actuarial Guideline 38 reserve, and the deficiency reserve.
There is no guidance for gift tax purposes as to which reserve is to be used when attempting to comply with the ITR requirement of Reg. §25.2512-6. Moreover, the life insurance industry is not in agreement as to which reserve is to be used when attempting to comply with the regulations.
In 2009, the Association of Advanced Life Underwriters (AALU) released the study “Life Insurance Valuation: Navigating Uncharted Waters,” which reported on a valuation survey of 14 carriers. Each carrier was asked to determine the gift tax value of two hypothetical $5 million universal life policies insuring the life of a 70-year-old nonsmoker. One policy had secondary guarantees; the other policy did not. Depending on the reserve methodology selected by the insurer, the policy without secondary guarantees was valued between $374,550 and $474,053. The policy with secondary guarantees was valued between $237,930 and $941,803.
The moral: before transferring an existing policy to an ILIT, ask the carrier not only for the gift tax value but also to identify the reserve methodology being used. In some instances, it may be tax efficient to exchange an existing policy for a new policy issued by another carrier that uses a valuation methodology that produces a lower gift tax value. In other situations, consideration should be given to obtaining an independent appraisal that takes the secondary market into consideration.
Are Crummey Clauses Still Worth Including?
Once the policy is owned by the ILIT, the insured provides the funds for the payment of premiums by making annual gifts to the insurance trust. In the past, a great deal of attention was devoted to making those gifts qualify for the gift tax annual exclusion.
Perhaps the most common technique used to make annual gifts qualify as a present interest for gift tax purposes has been a Crummey withdrawal power, named for Crummey v Comm’r, 397 F2d 82 (9th Cir 1968). Such a right permits a beneficiary to withdraw property of a specified value whenever a contribution is made to the trust. Withdrawal rights are customarily noncumulative and will lapse if not exercised within the time limits set forth in the trust instrument.
Crummey withdrawal rights may have adverse estate tax consequences. As these consequences are better understood and the estate and gift tax exemption continues to increase, many clients are deciding to limit the amount subject to a Crummey clause to the so-called “five and five” safe harbor, or to forgo qualifying any portion of gifts to ILITs for the annual exclusion.
Because gifts to the ILIT are used to pay insurance premiums, it is rare that beneficiaries exercise their Crummey withdrawal right. Instead, they allow the withdrawal right to lapse, often creating adverse estate tax consequences.
The Internal Revenue Code distinguishes between the “lapse” and the “release” of a Crummey withdrawal right. IRC §§2041(b)(2) and 2514(e) define a “lapse” as the termination of a withdrawal right over no more than the greater of $5,000 or 5 percent of the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed powers could be satisfied. (This is commonly referred to as the “five and five” safe harbor.) A lapse has no adverse tax consequences. To the extent the withdrawal right may be exercised over more than the safe harbor amount, such excess is a “release.” A release may have adverse tax consequences.
Assume that your client establishes a generation skipping ILIT for the benefit of his son and grandchildren. Each year an appropriate amount of generation-skipping exemption is allocated to the ILIT so that it will not be subject to generation skipping taxes when the son passes away. The son is entitled to net income plus principal for his support, maintenance, and medical care. When the son passes away, the ILIT will be administered for the son’s issue.
Further assume that your client makes a gift of $8,000 to the ILIT to be used to pay premiums and that his son has a Crummey withdrawal right that would permit him to withdraw the entire $8,000. During the period when the withdrawal right could have been exercised, the total value of all assets owned by the ILIT was $90,000. The five and five safe harbor treats $5,000 (the greater of $5,000 or $4,500 (5 percent of $90,000)) as a nontaxable lapse and the remaining $3,000 as a release.
To the extent of the $3,000 release, the son is treated as if he had contributed $3,000 of his own assets to the ILIT. IRC §2036(a) will include in the son’s gross estate for federal estate tax purposes all property transferred to the ILIT because he possesses a life estate in the ILIT. For estate tax purposes, the value of the included interest is not $3,000, but rather is determined by multiplying the fair market value of the trust corpus by a fraction, the numerator of which is $3,000 (the value of the release) and the denominator of which is $90,000 (the fair market value of the entire trust corpus at the time of the release.) The result is to include in the son’s gross estate 3.33 percent of the value of the trust.
Because annual gifts are likely made to pay premiums, each gift will give rise to a Crummey withdrawal power that, in turn, will be allowed to lapse. The percentage that each release bears to the fair market value of trust corpus at the time of such release must be determined separately and the aggregate of such percentage interests will be included in the donee’s estate, per Treas. Reg. §20.2041-3(d)(5). This aggregation rule could potentially result in inclusion of the entire trust principal in the son’s estate for federal estate tax purposes, thereby wasting the generation skipping exemption that had been allocated to the ILIT.
In view of this potentially serious adverse consequence, I am finding that an increasing number of clients creating post-retirement ILITs are either limiting Crummey clauses to an amount not in excess of the five and five safe harbor, or are forgoing qualifying for the gift tax annual exclusion entirely and, in the interests of simplicity, are using a portion of their gift tax exemption when they make annual gifts to their ILIT.