SUCCESSIONS

Turner v. Commissioner: New Tax Court Case Helps Life Insurance Trusts

Families often use Irrevocable Life Insurance Trusts (ILITs) to hold life insurance policies to keep the death benefit free from estate tax.  Premium payments are often satisfied by the creator of the trust (the “Grantor”) who makes transfers of cash to the trustee who then pays the life insurance premium.  This transfer of cash to the trustee is a taxable gift.  However, ILITs are usually designed so that most, if not all, of the premium payment qualifies for the annual gift tax exclusions ($13,000 per donee/$26,000 per donee if a spouse elects to split the gift).  To qualify for annual gift tax exclusion treatment, beneficiaries of the ILIT must be given a power to withdraw the transfer for a certain period of time-often 30-45 days from the date of the transfer.  This is commonly known as a “Crummey” withdrawal power, named after the court case validating this technique.

By design, the typical ILIT is structured to work as follows:

  1.  Grantor makes a gift of cash to trustee;
  2. Trustee deposits cash in trust checking account;
  3. Trustee sends written notice to each beneficiary who has a right to withdraw notifying them of their withdrawal right (e.g. if trust beneficiaries are Grantor’s three children, trustee sends notices to each child that they have a right to withdraw their share of the gift).  For example, if the annual premium payment is $30,000, each child would have the right to withdraw $10,000.
  4. Time period for withdrawal (e.g. 30 or 45 days) expires without any beneficiary making a withdrawal.
  5. Trustee makes premium payment.

That’s what happens when things are perfectly implemented each year.  However, ILIT administration may not be perfect.  Sometimes a gift to the trust is not made prior to the premium payment date and the grantor pays the premium directly to the insurance company.  This is what occurred in Turner.  The IRS argued that it was not a contribution to the trust that was subject to a withdrawal power because it was never actually made to the trustee.  The IRS also argued that the beneficiaries were not given any notice of the premium payment and since they didn’t know a payment or transfer was made, any beneficiary’s withdrawal power was “illusory” – how could they exercise a power they didn’t know they had?  For both of these reasons, according to the IRS, the premium payments were not eligible for the annual gift tax exclusion and were taxable gifts.

Fortunately, Mr. Turner’s ILIT was carefully drafted and provided that a beneficiary could withdraw any “direct or indirect” transfers to the trust.  The Tax Court held that the direct payment of insurance premiums was an “indirect” addition subject to the withdrawal powers under the terms of the trust agreement.  Furthermore, the Court noted that under the original case of Crummey v. Commissioner, actual notice to the beneficiary of his or her withdrawal power is not required.  Based on this, the Tax Court concluded that the premium payments did qualify for the annual gift tax exclusion.

The Lesson?  Not all ILITs are created equal.  All formalities should be followed as outlined above.  However, ILITs should be carefully drafted to plan for not-so-perfect implementation.  Unfortunately, many are not.

Turner was a success in this regard, but also had a darker side as a taxpayer defeat for Family Limited Partnerships which will be discussed in a later post.