Crummey powers are limited rights granted to trust beneficiaries to withdraw property gifted to a trust. They are often used in an irrevocable life insurance trust. Cash gifts to the trust by the grantor used to pay the insurance premiums can then qualify for the gift tax annual exclusion as gifts of present interests. Even though recent proposals to eliminate Crummey powers have failed, planning for their possible elimination  is prudent. Therefore, you may want to consider alternatives to Crummey powers and think about exit strategies from new and existing insurance trusts.

Direct Ownership of Insurance

One of the primary objectives of an insurance trust is to remove insurance proceeds from your and your spouse’s taxable estates. If you intend your adult children to be the sole beneficiaries of the insurance proceeds, you may not need an insurance trust. Your children may simply acquire the policies themselves, in which case the insurance proceeds would not be includable in your estate. Your payment of the premium generally qualifies for the annual gift tax exclusion (assuming that your children can independently exercise ownership rights), and Crummey powers are not needed to pay the premiums. Alternatively, you could make cash gifts to your children or grandchildren for them to pay the premiums. These gifts would not only qualify for the annual gift tax exclusion but, in the case of gifts to grandchildren, would also not be subject to generation-skipping transfer tax.

If your intent is to solely benefit your spouse, in certain situations you can own the policy and simply name your spouse as the beneficiary. The payment of the insurance proceeds to your spouse will qualify for the estate tax marital deduction. On your spouse’s death, however, any remaining insurance proceeds will be subject to estate tax. If you survive your spouse, the proceeds will be subject to estate tax on your death.

The disadvantages of direct ownership of an insurance policy may include the beneficiary’s loss of protection against the claims of creditors and the possible loss of protection from statutory forced share rights of a surviving spouse in the event of your death. You must look to state law to determine what may happen.

Funding an Insurance Trust With Income-Producing Property

Another alternative to using Crummey powers is to fund your insurance trust with income-producing property. The contribution of income-producing property to the trust incurs gift tax liability to the extent the contribution exceeds the annual gift tax exclusion. Additional gifts to the trust would be unnecessary because the income generated by trust investments pays the insurance premiums. The trust income is taxed to you if it is used to pay the premiums on policies insuring you or your spouse.

Existing Insurance Trusts

If a change in the current law eliminates Crummey powers and does not exempt existing insurance trusts from the new rules, then several options will exist:

Make taxable gifts to the insurance trust. Perhaps the simplest alternative is for you, as grantor of the trust, to make taxable gifts to the trust to pay the premiums. Note, however, that the beneficiaries will still have the power to withdraw the trust contributions unless the trust allows you to prohibit withdrawals at the time the gifts are made. If you want to avoid making large taxable gifts, private split-dollar arrangements can reduce the size of the taxable gifts by allowing two parties to split the costs and benefits of a life insurance policy.

Collapse the trust. Some insurance trusts contain a “collapse” provision that allows the collapse of the trust in favor of the current beneficiaries -- in which case, the beneficiaries will then own the policy. After the collapse, the beneficiaries may wish to contribute the policy to a new trust, although the results of such a transfer are unclear and may result in estate tax inclusion for the beneficiaries. Rather than collapse the insurance trust, you may want to transfer the policy into a new insurance trust. Some insurance trusts contain language that gives the trustee the power to distribute assets to another trust with similar provisions.

Sell the policy. Another possibility is for the trust to sell the policy to you, and you make a gift to a new trust. As long as you are the insured, there will be no adverse tax consequences. If not, there may be taxable gain on the sale and the proceeds may be subject to income tax. Use caution with second-to-die policies. The drawback is that the transfer to a new trust by you as grantor causes the proceeds to be includable in your estate if you die within three years. Similar income tax effects can result from the sale of the policy to a new trust. For the new trust to purchase the existing policy, a gift would need to be made to the new trust.

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