Irrevocable Life Insurance Trusts: Annual Gifting & The "5 and 5" Limit*

Contributions to an irrevocable trust are considered gifts to the beneficiaries of the trust, and are therefore taxable.  Ideally, the trustmaker would use the $13,000 annual gift tax exclusion to help offset any gift taxes that may arise.  If there is more than one beneficiary of the trust, the maker could give up to $13,000 per beneficiary.  Under ordinary circumstances, however, the gift is not eligible for the $13,000 annual gift tax exclusion because the beneficiaries do not actually have the free use of the gift presently.  The amount of the gifts would instead reduce the maker's lifetime gift tax exemption amount (currently set at $5,000,000 in 2011), or if that is insufficient, they would then be subject to gift tax.

In order to qualify gifts to an Irrevocable Life Insurance Trust for the annual gift tax exclusion, the beneficiaries must have a "present interest" in the amount given to the trust.  A present interest can be created by giving the beneficiaries the right to withdraw the asset from the trust under a provision known as a withdrawal right, sometimes called a Crummey power.

In a famous court cases in the late 1960s (Crummey v. Commissioner), the courts decided that if an irrevocable trust's beneficiary is given the right to withdraw a gift made to the trust for a reasonable period of time after the gift is made, the gift will qualify for the annual exclusion.  The number of annual exclusions that are allowed for a gift to an ILIT is equal to the number of beneficiaries who have a demand right.  For example, a demand right can be given to children and grandchildren.  If there are two trustmakers, then $26,000 per beneficiary can be given to the ILIT and still qualify for the annual exclusion.

The right to withdraw assets means that the demand right beneficiary has a power of appointment during the time in which he or she can withdraw the assets.  The Internal Revenue Code stipulates that the release or lapse of the power of appointment results in a gift of a "future interest to the other beneficiaries."

This means that if a beneficiary does not exercise his or her right to withdraw, that beneficiary is making gifts to the other beneficiaries of the amount that was given up. If this amount exceeds (the greater of) $5,000 or 5% of the total assets in the trust, then the beneficiary is considered to have made a gift of a future interest to the other beneficiaries.  The is called a gift over amount.

The amount of this gift reduces the beneficiary's own exemption equivalent amount.  As a result, though many clients desire to use the full $13,000 annual gift tax exclusion limit, they find it creates tax problems for their beneficiaries.

One solution is to have each beneficiary allow his or her right to lapse with respect to the "5 and 5" amount, but retain an ongoing power to withdraw the excess amounts which have been contributed to the trust.  These are called "hanging powers."

Another solution is to create a separate share for each beneficiary.  Using this strategy, when the beneficiary allows his demand right to lapse, the lapsed amount is allocated to a separate share which that beneficiary ultimately receives.  no other person benefited and, therefore, there is no gift over problem.

*Adapted from the Planning Partners Press.