If the donor’s estate will likely be subject to federal estate tax, or if the donor wants to provide creditor protection to beneficiaries, the donor should also establish an irrevocable life insurance trust (ILIT). The trustee of the ILIT purchases a life insurance policy on the donor’s life with a death benefit usually equal to the value of the property transferred to the charitable reminder unitrust (CRUT).

How the Technique Works

If the donor’s estate will likely be subject to federal estate tax, or if the donor wants to provide creditor protection to beneficiaries, the donor should also establish an irrevocable life insurance trust (ILIT). The trustee of the ILIT purchases a life insurance policy on the donor’s life with a death benefit usually equal to the value of the property transferred to the charitable reminder unitrust (CRUT). Sometimes the death benefit is greater than the value of the property transferred to allow for projected appreciation in the property that would have passed to heirs. This can avoid “freezing” the value of the heirs’ inheritance at its current level. But even if the death benefit equals the value of the property transferred, the avoidance of federal estate tax on the life insurance through use of the ILIT may wholly or partially offset the lost appreciation in the donated asset.

The donor has the option to use the income payouts from the CRUT, along with the tax savings from the charitable deduction, to make annual gifts to the ILIT in amounts sufficient to enable the trustee of the ILIT to pay the insurance premiums. If the insurance policy pays dividends, they also may be used to defray premium costs.

There is no taxable event triggering a capital gain when appreciated property is transferred to the CRUT. And because the trust is income tax—exempt, there is no capital gain when the trustee sells the property and reinvests the proceeds. However, capital gains realized inside the trust will be subject to the tier system, so the income beneficiary (donor or third party) may have to report capital gains realized inside the trust as income when trust distributions are received.

As noted, the donor makes annual gifts of cash or appreciated property to the ILIT to enable the trustee to purchase and pay the premiums on an insurance policy on the donor’s life. “Crummey” withdrawal powers are used to qualify these gifts as present interests eligible for the gift tax annual exclusion [IRC Sec. 2503(b); see Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968); Rev. Rul. 73-405, 1973-2 C.B. 321]. Crummey powers give the beneficiaries of the ILIT a right to demand a distribution of these annually gifted amounts for a limited period each year after each addition is made to the trust. Provided the beneficiaries decline to exercise these powers, the trustee will have the funds to pay premiums until such time as the policy becomes self-supporting.

At the donor’s (or surviving donor’s) death, the life insurance death proceeds are paid into the ILIT, where they are administered by the trustee in accordance with the terms of the trust instrument and eventually distributed to the donor’s beneficiaries in accordance with the trust terms. Meanwhile, at the expiration of the income interest in the CRUT, usually upon the death of the donor or surviving spouse, the remaining balance of the trust is paid to the designated charitable remainderman. The result: the donor has provided a significant gift to charity while maintaining the size of the original estate for family members.

Capital Gains and the Four-Tier System

While the sale of an appreciated asset inside a CRUT does not produce current capital gains tax for the donor, such gain does become subject to the tier system for taxing trust distributions. Income paid to the beneficiaries of a CRUT is taxable to these recipients in one of four tiers or categories, in the following order of priority:

1. Ordinary Income
2. Capital gain income, with net short-term capital gains deemed distributed before net long-term capital gains
3. Other income (generally meaning tax-exempt income)
4. Tax-free return of principal.

If the trust earns ordinary income from dividends, interest, rents, or other sources, this income retains its taxable character when paid out to and reported by the beneficiaries. All ordinary income is distributed before any capital gains income is distributed.

Likewise, before any tax-free “other income” can be reported, all capital gain attributable to the trust assets prior to donation to the trust must be accounted for as the income is paid. After all such pre-gift capital gain is accounted, the income may be tax-free. Thus, it is impossible for a CRUT to pay tax-free income immediately following the donation of appreciated assets and the subsequent sale of these assets and reinvestment of the proceeds in tax-exempt bonds.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 created new rates for taxing dividends and capital gains. Within the capital gains category there are now separate classes of gain taxed at different rates. The order of distribution remains the same, but distributions from each tier are made in the order of that item subject to the highest tax rate. The IRS provides guidance in Reg. Sec.1.664-1(d)(1)(ii). Thus, the new order of distribution would be as follows:

Income Type	Tax Rate
Ordinary
Income	35%
Dividends	15%
Capital Gains
Short-Term	35%
Tangible Personal Property	28%
Depreciation on Real Estate	28%
Long-Term	15% or 5%
Tax Exempt Income	0%
Return of Principal	0%

Of course, after all ordinary income, capital gains, and “other income” have been exhausted, the trust is deemed to make tax-free distributions of principal.

Under the 1997 revision of the Uniform Principal and Income Act, which has been adopted in nearly every state in some form, the trustee of a charitable remainder trust may invest for a “total return,” and the trustee has the power and duty to reallocate this total return annually to either income or principal. For instance, a portion of realized capital gains could be allocated to income, or a portion of interest could be allocated to principal, if the trustee concludes that a particular allocation is necessary to balance the interests of the income and remainder beneficiaries.

In response to the revised uniform act, the IRS issued final regulations on December 30, 2003, to revise the definitions of principal and income for purposes of IRC Sec. 643(b). The final regulations are focused on those Charitable Remainder Trusts whose distributions are based in part on the trust’s income (i.e., a Net Income Charitable Remainder Trust or a Net Income Trust with a Makeup Provision). Under these regulations, the proceeds from the sale or exchange of assets must be allocated to principal and not to trust income to the extent of the fair market value of those assets on the date of their contribution to the trust. Capital gain can be allocated to income only to the extent that the gain accrued after the assets were contributed by the donor or purchased by the trust. A discretionary power to make this allocation may be granted to the trustee under the terms of the governing instrument, but only to the extent that the state statute permits the trustee to make adjustments between income and principal to treat beneficiaries impartially [Reg. Sec.1.664-3(a)(1)(i)(b)(3)]. Trust income cannot be a fixed percentage of the trust annual fair market value even though certain state laws may permit this. The concern is that the state statute may permit a less than 5% payout which would be a violation of Charitable Remainder Trust rules.

More on Crummey Powers

The Crummey power is used to secure the gift tax annual exclusion for periodic gifts to the trust that enables the trustee to pay premiums. The trust beneficiaries are given the power, exercisable annually for a limited period of time, to withdraw the periodic transfers to the trust. The beneficiaries are notified when the trust receives cash or property that is subject to their Crummey powers. Naturally, one hopes they won’t exercise their powers. But the

Where trust corpus is:	The greater of $5,000 or 5% is:
$50,0000	$5,000
75,000	5,000
100,000	5,000
300,000	15,000

mere fact that they can do so is sufficient to convert what might otherwise be future-interest gifts into present interests that qualify for the gift tax annual exclusion. So, if there are four beneficiaries with Crummey powers, up to $48,000 of transfers ($96,000 with gift-splitting) could be sheltered from the federal gift tax in 2008. These withdrawal powers may or may not accumulate if unexercised; they generally lapse after the specified period expires.

Notwithstanding the gift tax annual exclusion amount, the Crummey power for each holder is often limited to the greater of $5,000, or 5% of principal (if that turns out to be less than $12,000). This is the maximum amount that will not be considered a taxable gift to the other trust beneficiaries if the holder of the power allows it to lapse unexercised each year.

If the beneficiary’s annual right of withdrawal does not exceed the five-and-five limits, the amounts the beneficiary could have withdrawn but did not are excludable from the beneficiary’s gross estate—except for the amount that could have been withdrawn in the year of death, which must be included. If the beneficiary’s right of withdrawal exceeds the five-and-five limits, the aggregate excess amounts which could have been withdrawn will be includable in the beneficiary’s gross estate up to a maximum of the full amount of the proceeds.

However, the lapse of the withdrawal power is considered a gift to other trust beneficiaries under IRC Sec. 2514, to the extent that the lapsing right exceeds the greater of $5,000 or 5% of the trust assets subject to the power. If the Crummey power extends over the entire trust, and is not limited to the annual addition to the trust, there is a greater likelihood that the 5% criterion will shelter the lapse from the gift tax. For example: If lapses exceed the $5,000/5% safe harbor, the Crummey power holders will have to draw upon their applicable credit amounts to shelter the resulting taxable gifts from the gift tax.

To avoid this result, Crummey trusts are sometimes drafted to limit the withdrawal right to the lesser of:

• The Crummey beneficiary’s proportionate share of additions to the trust,
• The amount of the gift tax annual exclusion (with gift-splitting, if available), or
• The lesser of $5,000 or 5% of the trust corpus.

If the $5,000/5% criterion turns out to be the least of these amounts, the grantor will not get the full benefit of the gift tax annual exclusion. That unfortunate result has led to some alternative strategies, such as the so-called “hanging power.”

Some Pitfalls to Avoid

• The donor could transfer an existing life insurance policy to the ILIT, or purchase a new policy and transfer it to the ILIT. But, the death proceeds would be includiable in the donor’s gross estate if he or she died within three years of the transfer [IRC Sec. 2035(a)(2)] or if the donor retained some string on the policy that was an incident of ownership [IRC Sec. 2042(2)]. The safer course is to have the ILIT apply for, own, and pay the premiums on the policy.
• The validity of Crummey powers can be put in jeopardy. For example, if the trust beneficiaries are given only a brief time in which to exercise their withdrawal powers, the IRS may view such powers as illusory [see Priv. Ltr. Rul. 8047131]. Some authorities recommend a minimum 30-day period before the powers lapse. Also, the ILIT trustee should give formal, written notice of withdrawal rights to the beneficiaries each year to avoid the appearance of a sham.
• When the premium payment is substantial, there may not be enough beneficiaries to shelter the annual transfers to the trust under the gift tax annual exclusion. Grantors have tried to get around this by “manufacturing beneficiaries” who have no rights in the trust except the Crummey powers. The IRS has attacked this practice in letter rulings. But the IRS received something of a setback in Estate of Maria Cristofani v. Comm’r [97 T.C. 74 (1991)]. The Tax Court ruled that the unexercised rights of withdrawal by several beneficiaries allowed additions to the trust to qualify for the gift tax annual exclusion. The IRS later acquiesced in the result in Cristofani [Action on Decision 1992-09, 1992-1 C.B. 1 and Action on Decision 1996-10, 1996-2 C.B. 1], but indicated that it will continue to press the issue. Specifically, the IRS will seek to deny exclusions when: (1) Under the Crummey power, holders have no other interests in the trust, (2) there is a prearranged understanding that the powers will not be exercised, or (3) the withdrawal rights are not in substance what they purport to be in form [TAM 9628004, Action on Decision 1996-10]. To be safe, beneficiaries should have some other interest in the trust besides their Crummey withdrawal powers.
• It can be fatal to the arrangement for the donor to serve as trustee of the ILIT. The control the donor could exercise over the beneficial enjoyment of the trust, even though exercisable only in a fiduciary capacity, will jeopardize a key part of the ILIT strategy: to keep the life insurance proceeds out of the gross estate of a donor who expects to be subject to the estate tax [Rev. Rul. 81-128, 1981-1 C.B. 469; Rev. Rul. 84-179, 1984-2 C.B. 195]. The IRS position seems to be that incidents of ownership held by the insured in a fiduciary capacity will taint the death proceeds for purposes of IRC Sec. 2042(2) if:
  • The insured can exercise the incidents of ownership for his or her own benefit, or
  • The insured can exercise the incidents so as to control the beneficial enjoyment of the trust by third parties.

  The Circuit Courts of Appeals and the Tax Court have been divided in their attempts to resolve the issue. For example, the Sixth Circuit has said that the insured’s mere possession of incidents of ownership as trustee is not sufficient to reach the proceeds under IRC Sec. 2042(2) unless the insured can benefit himself or his estate by exercising the incidents [Estate of Fruehauf v. Comm’r, 427 F.2d 80 (6th Cir. 1970)]. The Fifth Circuit, on the other hand, says that mere possession of the incident is sufficient under IRC Sec.2042(2) and it doesn’t matter whether the insured can benefit himself [Rose v. U.S., 511 F.2d 259 (5th Cir. 1975); Terriberry v. U.S., 517 F.2d 286 (5th Cir. 1975), cert. denied 424 U.S. 977].

  Suppose the policy was transferred to the ILIT by a third party owner. Does the fact that the insured did not retain the incidents but only “fell into them” as trustee save the day? No, says the IRS, not if the insured:

  • Furnished some or all of the consideration for purchasing and maintaining the policy, and
  • Was named trustee as part of a prearranged plan in which the insured participated [Rev. Rul. 84-179, supra].
• The potential impact of the generation-skipping transfer tax (GSTT) must be considered when drafting and implementing the ILIT. When a taxable event occurs in a trust that is subject to the GSTT, the tax rate on the transfer is a flat rate that coincides with the top federal estate tax rate (45% in 2008). Each transferor has an exemption of $2 million (indexed amount for 2008) that can be used for both lifetime and death transfers [IRC Sec. 2631]. In 2004 the GSTT exemption became the same as the federal estate tax applicable exclusion amount.Married persons may elect to split a generation-skipping transfer and treat it as if it were made 50% by each spouse, even though the transferred property actually came from only one of the spouses [IRC Sec. 2652(a)(2)]. Thus, a married couple has a combined $4 million GSTT exemption (in 2008).There are complex rules regarding the allocation of the exemption to particular generation-skipping transfers [IRC Sec. 2632]. Certain allocations are automatic; e.g., lifetime direct skips, unless elected otherwise on a timely filed gift tax return. Individual transferors or their executors have some discretion over the allocation of the exemption. Allocations of the exemption to particular transfers are irrevocable.Planning pointer: In order to keep the assets of an irrevocable life insurance trust from being subject to the GSTT, transfers to the trust should qualify for the annual exclusion, and that part of the exemption is allocated to each transfer. This is done on a timely filed gift tax return.
• Both charitable remainder trusts and irrevocable life insurance trusts must be drafted in strict accordance with the technical requirements of tax and trust law. Clients should always have the benefit of expert tax and legal advice in planning and implementing the wealth replacement technique.
• The trustee of the CRUT must be sure that the trust avoids investments that would jeopardize its tax-exempt status, i.e., unrelated business taxable income (UBTI). Previously, any instance of UBTI would result in the loss of exemption of the charitable remainder trust for that tax year, even if it were only $1 of UBTI. However, the Tax Relief and Health Care Act of 2006 replaced the loss of exemption rule with a straight 100% excise tax on the UBTI.

In Sum

The wealth replacement technique is not a solution for all client situations. The benefit of the arrangement generally hinges on being able to support the policy premium costs from the income paid out by the CRUT (along with income tax savings from the charitable deduction). If the donor is a substandard insurance risk, premium rates on a single-life policy may be higher than the CRUT payout. However, if a second-to-die policy is appropriate given the client’s situation, and if one of the spouses is insurable at standard rates, the coverage usually can be secured even if the other spouse is a substandard risk.

The Charitable Gift Annuity

A Charitable Gift Annuity (CGA) could be a powerful way for your clients to make a long-lasting contribution to Indiana University and provide them with guranteed fixed payments for life.

You and your clients can receive an illustration from our staff based on specific possible CGA scenarios that fit your client’s circumstances.

Please note that the minimum gift for establishing a CGA is $5,000.