Estate Planning, Trusts
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Real Estate Transactions


Putting Too Much Insurance in a Life Insurance Trust Is Risky

All gifts to a trust are subject to gift tax. However, if certain rules are followed, each person can give $10,000 a year in trust without paying any gift tax (legally known as the “annual gift tax exclusion”).

When gifting to a trust, one must give a “Crummey withdrawal right” to the trust beneficiary in order to qualify for the annual gift tax exclusion. Basically, a Crummey withdrawal right is the right of a beneficiary to withdraw trust funds for a certain period of time, usually 60 days. A “Crummey withdrawal right” gives the donee the right to withdraw the gift from the trust and allows the gift to qualify for the $10,000 annual gift tax exclusion.

There are, however, tax consequences of the Crummey right during the 60 days when the donee has the right to withdraw the trust funds. In addition, when the 60 days expire, and the beneficiary does not withdraw the funds, there is another set of tax consequences. Each consequence is discussed separately below:

While the Right is Outstanding

  1. The assets covered by the withdrawal right is included in the donee’s estate if that donee should die in that period
  2. The donee is taxed on the income of that asset

When the right terminates (lapses)

Rule: Any right to withdraw more than $5,000 or 5% of the value of the life insurance trust, whichever is greater, has adverse estate and income tax consequences because the beneficiary will be treated as the owner of a portion of the trust.

An Estate Tax Example

Assume that grandparents set up a life insurance trust for their 15 year old grandchild and that the premiums are $8,000 a year for a $500,000 death benefit. Assume further that the grandchild will receive income from the trust until age 30 after which he will receive the principal. At year 1, the policy had no cash value. At year 2, the policy had a cash value of $5,000. At year 3, the policy had a cash value of $12,000.

After making payments for 3 years, the grandparents die. The grandchild is 18. Assume further that the grandchild dies at age 25 before being entitled to receive any of the trust proceeds from the insurance policy on his grandparent’s life. Even though the grandchild never received the insurance proceeds, the grandchild’s estate will be taxed on about $375,000 of the proceeds.

The insurance premium, and hence the gift to the trust, exceeded the greater of $5,000 or 5% of the value of the trust. Even though the amount in excess of the $5,000/5% safe harbor rules was only $9,000, the Internal Revenue Code sections governing the lapse of withdrawal rights attributed an estate tax on $375,000 of the proceeds.

Avoiding the Tax Trap

To avoid the adverse consequences, the grandparents in the above example could have:

  1. Bought a smaller policy to limit the insurance premium and hence the gift to the trust to the $5,000/5% safe harbor; or
  2. Used a policy with a larger premium but limit the withdrawal right to the $5,000/5% safe harbor using the unified credit for the excess; or
  3. Structured the right as a hanging power, which means that the withdrawal right over the $5,000/5% safe guard “hangs” after the 60-day withdrawal period and continues to be operative. As the cash value of the policy grows, the donee could withdraw the excess “hanging” power in later years.

Caveat: A transferor’s spouse cannot be given a ‘hanging power” in a generation skipping insurance trust. Further, at the donee’s death, any part of the trust subject to the hanging power will be subject to estate tax in the donee’s estate. Use “hanging Crummey powers” only after understanding the tax risks involved.

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