Chapter 30 - § 30.2 • TRANSFERS TO THE TRUST AND GIFT TAX ISSUES

• Jurisdiction: Colorado

§ 30.2 • TRANSFERS TO THE TRUST AND GIFT TAX ISSUES

Gift tax issues can arise as a result of the initial transfer of a pre-owned policy into trust, qualification of transfers to the trust for the gift tax annual exclusion, and other events as a result of the dispositive provisions of the trust agreement and the trust contributions. Before examining those issues, a review of some basic gift tax principles is in order.

§ 30.2.1—Gift Tax Generally

The gift tax applies to gratuitous transfers of property made during the lifetime of the donor. The tax is a liability of the donor, not the recipient.⁴ Any type of property can be the subject of a taxable gift. Indirect transfers (e.g., payments of another's debt) are also subject to the gift tax.

In 1976, the gift and estate tax were combined so as to create a unified system. Both taxes used the same tax rate schedule and every individual had, in effect, one applicable exclusion amount that could be used during life or at death to offset gift tax or estate tax, respectively. Although there was a period when the gift tax exclusion was less than the estate tax exclusion (2002 through 2010), currently the exclusion amounts are the same.

§ 30.2.2—Transfer of an Existing Policy

A transfer of a life insurance policy to an irrevocable trust constitutes a gift for purposes of the gift tax. Such transfers in trust are gifts to trust beneficiaries. Treas. Reg. § 25.2503-2(a). Even though a gift of a policy is complete, the policy proceeds are included in the insured's gross estate for estate tax purposes, if the insured owns the policy at death, or transfers the policy and dies within three years of the transfer as a result of I.R.C. § 2035 (discussed in § 30.3.5).

I.R.C. § 2512(a) provides that "if the gift is made in property, the value thereof at the date of the gift shall be considered the amount of the gift." The regulations provide for three different ways to value a life insurance contract, depending on how long the contract has been in force and whether additional premiums must be paid on the policy:

1) If the policy is a new policy (i.e., less than one year old), then the value of the gift is the "cost of the contract," or the total premiums paid. Treas. Reg. § 25.2512-6(a), Example 1.
2) If the policy is an older policy and no additional premiums are due to keep it in force (e.g., a fully paid-up policy or a single premium policy), then the value of the gift is the amount the insurance company would charge for a single premium policy with the same death benefit on the life of a person the same age as the insured. Interestingly, the regulations do not mention whether the rating of the insured is a relevant factor. Treas. Reg. § 25.2512-6(a), Example 3.
3) If the policy is an older policy on which future premiums are payable, the value of the gift is the interpolated terminal reserve of the policy, plus the proportionate amount of the last premium paid that covers the period from the date of the gift to the due date of the next premium. Treas. Reg. § 25.2512-6(a), Example 4. Typically, the donor documents the interpolated terminal reserve of the policy by requesting that the insurance company report the value on a Form 712.

Health of the Insured

When the insured is in poor health, valuation of the policy becomes much less certain and the interpolated terminal reserve value plus unearned premium method may not be the appropriate measure of value.

Example: The insured created an irrevocable trust. The beneficiaries of the trust are the spouse and children of the insured. The insured assigned to the trustee a policy on the insured's life in the face amount of $2 million, having a cash surrender value of $250,000 and an interpolated terminal reserve value of $260,000. The insured acquired the policy 10 years ago. The insured recently suffered a heart attack. How is the policy to be valued for gift tax purposes?

There is some support for the position that the insured's state of health has no bearing on valuation, Estate of Wien v. Comm'r, 441 F.2d 32 (5th Cir. 1971);⁵ however, this position appears, at best, to be difficult to defend. The measure of value (at least where the insured is now uninsurable) is the "cost of replacement" of the policy. See United States v. Ryerson, 312 U.S. 260 (1941), and Estate of Pritchard v. Comm'r, 4 T.C. 204 (1944). Exactly what cost of replacement means is uncertain. At one end of the spectrum, the IRS has ruled that it means nothing less than the death benefit. See PLRs 8806004 and 9413045. The viatical settlement market may provide a possible market value for the policy, which could be relevant because the regulations state that the value can be established "through the sale of the particular contract." The only guiding principle is that the worse the health of the insured, the closer to the death benefit the value is. See H. Zaritsky & S. Leimberg, Tax Planning with Life Insurance § 3.02[2][a][vi] (2000).

Avoiding Gift Policy

Because of the three-year inclusion rule, it is sometimes better to have the insured sell the policy to the insurance trust for its value, established based on the rules above. Assuming the insurance trust is structured as a grantor trust with the insured as the grantor, there would be no adverse income tax consequences from selling the policy. The potential downside of this approach is that the grantor may have to make a taxable gift to the insurance trust to provide the funds necessary to complete the purchase.

§ 30.2.3—Gift Tax Annual Exclusion

A "taxable gift" is defined in I.R.C. § 2503(a) to mean the total amount of gifts made during the calendar year, less certain deductions. Only qualifying gifts to a spouse and charitable gifts qualify as gift tax deductions. I.R.C. §§ 2523 and 2522. Other transfers, however, are "excluded" in determining the amount of gifts made during the year.

The exclusion that applies most commonly to insurance and insurance trusts is the annual exclusion, which applies to the first $10,000 per donee of gifts other than other future interests.⁶ The amount is indexed annually, and as of 2018, the indexed amount is $15,000.

§ 30.2.4—The Future Interest Rule

An annual exclusion gift does not include any gift of a future interest. The regulations define a future interest as that which is "limited to commence in use, possession, or enjoyment at some future date or time." Treas. Reg. § 25.2503-3(a). It is irrelevant for gift tax purposes whether the property is vested; "The question is of time, not when title vests, but when enjoyment begins." Fondren v. Comm'r, 324 U.S. 18, 20 (1945). What matters is that there exists "[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from the property." Treas. Reg. § 25.2503-3(b).

A remainder interest in trust or otherwise will always be a future interest, and gifts in trust might not qualify at all for the annual exclusion if a donor transfers property to a trust and the trust does not mandate current income distributions. Id. Even a brief delay of enjoyment of trust benefits makes the exclusion unavailable, unless other measures are taken. The IRS also takes the position, and some courts have agreed, that an income interest in a trust consisting of non-income producing property (e.g., an insurance policy or raw land) is a gift of a future interest. See Rev. Rul. 69-344, 1969-1 C.B. 225 and Maryland Nat'l Bank v. United States, 609 F.2d 1078 (4th Cir. 1979).

Example: A settlor created a trust that designated the settlor's child as beneficiary. The trust agreement states that the trustee may, within the trustee's discretion, distribute income or principal to the beneficiary. The balance of the trust shall be distributed to the child at age 40. The settlor transferred $10,000 to the trust.

Result: The transfer to the trust constitutes a taxable gift. The gift is a future interest in property because enjoyment of the property is postponed.

Treas. Reg. § 25.2503-3(c), Example 1.

§ 30.2.5—Crummey Powers

Crummey v. Commissioner

To qualify gifts to trust as present interest gifts for the annual exclusion, a "Crummey power" is required. In the landmark case of Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968), the trust instrument included a technique that was intended to qualify a gift into trust as a present interest, even though the beneficiaries of the trust were not entitled to current income distributions from the trust. The beneficiaries, most of whom were minors, were given an immediate right to withdraw additions to the trust. Notwithstanding the fact that the minor beneficiaries did not demand and withdraw the contributions to the trust, the court held that the transfers to the trust constituted gifts of present interests because the beneficiaries had the legally enforceable right to demand the addition and cause withdrawal. It did not matter that it was unlikely that the withdrawal rights would ever be exercised; "It becomes arbitrary for the I.R.S. to step in and decide who is likely to make an effective demand." Id. at 88. The important point is that the right existed and this was enough to classify the gift as a present interest rather than a future interest. The IRS subsequently agreed with the holding in Crummey, provided that there is "no impediment under the trust or local law to the appointment of a guardian and the minor donee has a right to demand distribution." Rev. Rul. 73-405, 1973-2 C.B. 321; Rev. Rul. 80-261, 1980-2 C.B. 279.

Crummey Powers Generally

Taxpayers prior to Crummey successfully used a similar technique to avail themselves of the annual exclusion for contributions to trusts. Contributions to trusts that allowed a beneficiary or a beneficiary's guardian to demand all of the trust property and terminate the trust were held to qualify contributions for the annual exclusion. See, e.g., Kieckhefer v. Comm'r, 189 F.2d 118 (7th Cir. 1951), and Gilmore v. Comm'r, 213 F.2d 520 (6th...