Foreign Irrevocable Life Insurance Trusts Can Save Estate and Income Tax
Published by: Journal of Taxation of Investments; Warren, Gorham & Lamont
Author: Howard Rosen, Esq.
Date of Publication: Autumn 1992
On the tax side of rendering estate planning services, the estate planner is faced with Federal income, gift, estate, and generation-skipping tax issues.(1) All of these issues (and more) must be addressed in the context of an irrevocable life insurance trust (“ILIT”) established in a foreign jurisdiction.(2)
The traditional object and focus of the ILIT in the estate planning arena is to effect the exclusion of the proceeds of transferred life insurance policies and the premium payments thereon from the settlor’s gross estate and the gross estate of the settlor’s spouse (and possibly others as well), while at the same time incurring little or no gift tax liability and maintaining the availability of the policy proceeds, albeit indirectly, for the liquidity needs of the estate, and for the benefit of the trust beneficiaries.
This is typically accomplished through an irrevocable transfer of life insurance policies, or the funds with which to acquire such policies,(3) to a trust under the terms of which the settlor, the settlor’s spouse, and possibly other beneficiaries, retain no interests or powers of a nature which would cause gross estate inclusion.(4) The trustee is customarily authorized to purchase assets from, and/or to make loans to, the settlor’s estate to satisfy its liquidity needs, and trust income (and corpus) is ordinarily distributable to the settlor’s spouse and family.
In considering the use of a foreign situs ILIT, long-range family financial planning should be included in the list of goals sought to be attained.(5)
I.GIFT TAX ISSUES
The gift tax issues faced by the U.S. settlor of the foreign situs ILIT are no different than those which must be addressed by the settlor of the domestic ILIT. The manner in which those issues are resolved, however, may be quite different.(6)
“gifts” for gift tax purposes.(7) Gifts in trust are deemed to have been made to the beneficiaries of the trust.(8) Thus, the initial and subsequent transfers to the ILIT will be included in the settlor’s taxable gift base, unless the transfers qualify for the annual gift tax exclusion of $10,000 per donee.(9) In order for a gift to qualify for the annual exclusion, it must constitute a gift of a “present interest” in the property transferred to the donee.(10) Whether a gift in trust will so qualify depends upon the terms of the trust instrument.(11)
In the context of an ILIT funded with a life insurance policy and little or no other income producing property, one effective and commonly utilized means of providing a beneficiary with a present interest is for the trust instrument to grant one or more of the beneficiaries the absolute right to withdraw any contribution to the trust (up to specified limits) for a limited period of time. These withdrawal powers are referred to as “Crummey”powers after the Ninth Circuit case of the same name.(12)
Crummey powers are utilized, the trust instrument must provide the beneficiary with notice of, and a reasonable period of time within which to exercise the withdrawal right.(13) The “reasonableness” of the time specified in the instrument will depend to some extent upon the facts and circumstances of each case, but the Internal Revenue Service has indicated in private letter rulings that 30 days constitutes a reasonable period of time between notice of the withdrawal right and its termination,(14) although some such rulings suggest that where the powerholders are minors, the period between notice and termination should be long enough to permit the appointment of a guardian under state law (although the actual appointment of a guardian is not required).(15) A sixty day period would seem more than adequate for this purpose.
If the Crummey powers are conferred upon a beneficiary other than the settlor’s spouse, the settlor can annually gift up to $20,000 per donee if gift-splitting is elected by the settlor and his spouse.(16) Thus, where a properly drafted instrument confers Crummey powers upon the married settlor’s 3 children, annual insurance premiums of up to $60,000 could be paid through the trust gift and estate tax free. Such present interest gifts are excluded from the transferor’s taxable gift base, and, accordingly, do not reduce his unified credit.(17)
Crummeypowers, it was indicated that the withdrawal powers are typically granted for a limited period of time. If the power is not exercised by the powerholder within such period it is said to “lapse”. The lapse of a power of this type constitutes a transfer by the powerholder of the property subject to the power.(18) Such a transfer will constitute a gift by the powerholder (beneficiary) to the extent that in any calendar year the value of the property subject to the lapsed power exceeds the greater of $5,000 or 5% of the aggregate value (on the date of the lapse) of the assets from which the lapsed power could have been satisfied.(19) In order to preclude the lapse of the withdrawal power from being treated as a gift by the powerholder, a properly drafted ILIT should limit the amount of the lapse to the greater of $5,000 or 5% of the value of the trust principal (on the date of the lapse) during each calendar year. The value of the property subject to the withdrawal power which is in excess of the “5 & 5” amount permitted to lapse gift tax free will, depending upon the terms of the trust instrument, either remain eligible for withdrawal,(20) or be eligible for testamentary disposition by the beneficiary in his will. These excess amounts, sometimes referred to as being subject to “hanging powers”, may, in a properly drafted instrument, be diminished during years when contributions to the trust are reduced below the 5 & 5 level.(21) In the event the beneficiary dies while possessed of a hanging power, the value of the property subject to the power would be included in the beneficiary’s gross estate.(22)
II.ESTATE TAX ISSUES
The estate tax issues to be addressed in planning for the foreign situs ILIT are no different than those to be addressed in planning for the domestic ILIT. For this reason, these issues are dealt with in the following material in a summary fashion.
Section 2042(2) provides that the decedent’s gross estate includes the proceeds of life insurance policies on the life of the decedent with respect to which the decedent possessed at his death any of the incidents of ownership, exercisable either alone, or in conjunction with any other person.
In addition, where the insured/decedent does not possess an incident of ownership at his death because of his prior assignment of such interests, 2035(d)(2) will nevertheless cause the inclusion in the insured/decedent’s gross estate of the proceeds of policies with respect to which the insured had assigned one or more of the incidents of ownership within the 3-year period ending with his death. Under existing law, the 3-year rule can be effectively avoided by funding the ILIT with cash and by the trustee making the initial application for the policies of life insurance.
Utilizing this procedure, no transfer of the incidents of ownership takes place. In such a case, the ILIT must be carefully drafted to authorize, but not require, the trustee to purchase the life insurance. If the instrument were to require (rather than merely authorize) the trustee to purchase the insurance, the Internal Revenue Service could contend that the trustee was acting as the agent of the insured in acquiring the policy, or that there had been a deemed transfer of the life insurance policy by the insured, and that the 3-year inclusion rule applies.(23)
The Regulations(24) provide some guidance as to what constitutes the “incidents of ownership” of a life insurance policy for purposes of 2042(2). In general, the term refers to rights to the economic benefits of the policy,(25) and includes, for example, the power to:
- Change the beneficiary;
- Surrender or cancel the policy;
- Assign the policy;
- Revoke an assignment of the policy;
- Pledge the policy for a loan;
- Borrow against the cash surrender value from the insurer;
- Change the settlement options;
- Option the repurchase of the policy from an assignee; or
- Veto any change in beneficiary designation, assignment, or cancellation of the policy.
Since many, if not all, of the above-listed incidents of ownership will be held by the trustee of the ILIT, it is important that the settlor not serve or be eligible to be appointed as a trustee, and that the settlor retain no power whatsoever over the trustee which would permit the Internal Revenue Service to contend that the settlor, by being the trustee, by being eligible to be appointed as a trustee, or by retaining certain powers or controls over the trustee, had in effect retained the incidents of ownership of the insurance policy (through “attribution” to him of the powers held by the trustee).(26) If the Internal Revenue Service were able to successfully contend that the settlor held the trustee’s powers, the proceeds of the life insurance policies would be included in the settlor’s gross estate under 2042(2).
III.GENERATION-SKIPPING TAX ISSUES.
The Generation-Skipping Tax (GST) applies to transfers of property which “skip” a generation of estate or gift taxation through the use of trusts and other means.(27) In the typical case, an ILIT has the potential for generation-skipping transfers, and consideration must, therefore, be given to planning for the most effective utilization of the transferor’s GST exemption.
and may allocate it as desired to inter vivos transfers.(29) This exemption can be significantly “leveraged” by allocating it to the ILIT transfers. For example, assume that $100,000 of cash values and premiums were transferred to initially establish and maintain an ILIT funded with a $2,000,000 life insurance policy which ultimately constituted a GST transfer. If the transferor did not allocate his GST exemption to the transfers,(30) then upon the occurrence of the generation-skipping transfer, a GST of approximately $550,000 would be incurred.(31) If, however, the transferor were to allocate $100,000 of his GST exemption to the transfers to the ILIT, not only would the $550,000 tax be entirely avoided, but $900,000 of the transferor’s other generation skipping transfers would also escape the GST,(32) effectively leveraging the transferor’s GST exemption to $2,900,000, and saving an additional $495,000 in tax, for a potential total generation-skipping tax savings (in this example) of $1,045,000.
Thus, it is generally advantageous to allocate the GST exemption to the ILIT when the life insurance proceeds will be significantly larger than the amounts transferred to the trust by the settlor as the initial transfer (policy or cash) and subsequent premium payments. Although the ILIT discussed in this article would presumably be a foreign situs trust at the time of any generation-skipping transfer, the GST would still be applicable, making the foregoing exemption allocation planning imperative.
The inter vivos allocation is made on a timely filed gift tax return.(33)
IV.INCOME TAX ISSUES
A. WITH RESPECT TO THE SETTLOR
Under specified circumstances, a settlor will be considered to be the “owner” of all or a portion of a trust for income tax purposes.(34) Such trusts are referred to as “grantor trusts”, and, if a particular trust is a grantor trust, the settlor will be required to report the income, deductions, and credits of the trust (or portion thereof) of which he is considered the owner.(35) Section 677(a)(3) provides that a settlor is considered the owner of a trust whose income is or may be applied to the payment of premiums on policies of insurance on the settlor’s life or on the life of the settlor’s spouse. Thus, the typical ILIT is a grantor trust for income tax purposes. In addition, if the settlor were not otherwise taxable under 677(a)(3), or under the other provisions of Subpart E, he would be taxable under 679 if the trust were a foreign trust and it had (or was treated as having) a U.S. beneficiary.
Classification of a trust for income tax purposes as a grantor trust has no connection with, or effect upon, the exclusion of the value of the trust from the settlor’s gross estate for estate tax purposes. Thus, an ILIT which is wholly a grantor trust for income tax purposes may be excluded from the settlor/insured’s gross estate if the estate tax requirements for exclusion are satisfied.
Since the ILIT does not ordinarily produce much taxable income during the settlor’s lifetime, the grantor trust issue has historically had relevance only for preserving interest deductions for the settlor on pre-transfer policy loans, where such interest is otherwise deductible.(36)
B. WITH RESPECT TO THE BENEFICIARIES AND THE TRUST
The discussion of the income taxation of the beneficiaries and the trust is combined under one heading since it is between and among these persons that the incidents of post-death income taxation can be shifted.
“conduit” income tax regimen generally applicable to trusts and their beneficiaries, a beneficiary will include in his gross income all amounts required to be distributed to him under the terms of the trust,(37) and other amounts properly paid, credited, or required to be distributed.(38) To the extent trust income is not distributed (or required to be distributed) pursuant to the trust instrument, it is taxable to the trust.(39) To the extent the grantor trust rules apply to a trust, the foregoing conduit rules do not apply. It is with respect to these income tax issues that the impact of the settlor’s gift tax choice regarding the utilization of Crummey powers in the foreign situs ILIT will be most significant.
previously released or otherwise modified such a power,(40) where such person retains, following such release or modification, an interest in or power over the trust of a nature as would, under the grantor trust rules contained in 671-677, subject a grantor of a trust to treatment as the owner thereof.(41) Applying 678(a) to the typical ILIT, the beneficiary’s Crummey power — both before and after its lapse — would result in the beneficiary being treated as the owner for income tax purposes (ie, taxable on the income) of an increasing portion of the trust.(42) In the context of a domestic trust, considering our currently compressed income tax brackets, this issue may not be of particular importance, since someone — either the beneficiary, the trust, or each as to a portion — will be taxable on all of the trust’s taxable income in each taxable year in any event.
A foreign trust not engaged in a U.S. trade or business at any time during a taxable year is subject to U.S. income taxation on its U.S. source fixed or determinable, annual or periodical income, certain miscellaneous types of income, and certain gains.(44) Such “non-engaged” trusts are not subject to U.S. income tax on non-U.S. source income,(45) nor are they subject to U.S. income tax on U.S. source capital gains, unless the 183 day “presence” test is met.(46) U.S. real property gains, and capital gains recognized during a taxable year during which the fiduciary of the trust was “present” in the U.S. for periods aggregating 183 days or more are subject to U.S. income taxation.(47) Properly administered and invested, a foreign trust may effectively avoid current U.S. income taxation on its earnings. The wisdom of including the Crummey withdrawal powers in such a trust, resulting in the income taxation of the trust’s beneficiaries on the trust’s income under 678(a)(1) and (2) — income which, if accumulated by the trust, might avoid current taxation — should be carefully weighed in comparison to the potential for future income tax planning opportunities which could be realized through the elimination of such powers from the foreign situs trust.(48)
“DNI”) of a foreign trust — the measure of the beneficiary’s taxability on distributions to him(49) — is computed in a manner similar to that used to compute the DNI of a domestic trust, by including its worldwide income, plus one important addition.(50) The DNI of the foreign trust is computed by including net capital gains in DNI.(51) Thus, even though the trust may accumulate certain items of its income tax-free, distributions to its U.S. beneficiaries will be fully taxable in the U.S., regardless of source, except to the extent they represent tax-exempt interest.(52) In addition, a distribution to its beneficiaries of the trust’s income accumulated after the settlor’s death carries a simple (nondeductible) 6% interest charge, based upon the income tax imposed on the beneficiary as a result of the accumulation distribution and the number of years the trust accumulated the income being distributed (while it was not a grantor trust).(53)
Although distributions (within the meaning of 662) of income accumulated subsequent to the grantor trust period carry out trust income and are subject to the 6% interest charge, as described above, 663(a)(1) provides that the payment of a gift or bequest of a specific sum of money or of specific property under the terms of a trust is not considered a distribution under 662, and therefore does not carry out trust income to the beneficiary. In order to constitute a “specific sum of money” or “specific property” for purposes of 663, the amount of money or the identity of the specific property must be ascertainable as of the date of the inception of an inter vivos trust.(54) Specifically excluded from qualifying as a specific sum of money or as specific property under 663 are:
- An amount which can be paid or credited only from the current or accumulated income of the trust;
- An annuity, or periodic gifts of specific property having the effect of an annuity;
- The corpus of a trust (distributed and identified as such);
- A gift or bequest paid in three or fewer installments where the governing instrument requires its payment in more than three installments.(55)
Since the maturity values of the insurance policies held by the trust are known at its inception, and the tax-free growth of such amounts at a given (minimal) rate of return can be projected with a reasonable degree of certainty, the planning potential for the use of 663(a)(1) in conjunction with a foreign situs life insurance trust is significant. For example, a foreign situs ILIT funded with a $2 million policy provides for the payment to its beneficiary of $ 2,900,000 ten years following the settlor’s death. This would constitute a gift of a specific sum of money, and would be paid out of the foreign trust to the beneficiary income tax free under 663(a)(1), and, since a 663(a)(1) payment is not a distribution for purposes of 662, such payment would also be free of the 6% foreign trust interest charge.(56) Such an amount could be accumulated in ten years under tax-free circumstances by investment of the trust corpus in an investment yielding a mere 4% per annum. Even in today’s low interest rate environment, this would seem to be an easily attainable goal. Any remaining trust corpus could be paid out to the beneficiaries in a taxable, residuary, distribution.
V. EXCISE TAX ISSUES.
Section 1491 imposes an excise tax on certain transfers, including gratuitous transfers, by a U.S. person to a foreign trust.(57) The tax is imposed at the rate of 35% on the excess of the fair market value of the property transferred over the sum of the adjusted basis of the property transferred plus any gain recognized to the transferor at the time of the transfer.(58) In order for 1491 to apply, the transfer must be to a “foreign” trust. As discussed above, the ILIT will be a wholly grantor trust; even so, the trust is considered to be a foreign trust.(59) In Revenue Ruling 87-61(60), however, the Internal Revenue Service adopted the position that the 1491 excise tax does not apply to transfers to a foreign grantor trustuntil such time as the grantor ceases to be the owner of the trust under Subpart E.(61) It is the italicized language which may cause the estate planner concern. Death is unquestionably an event which terminates the grantor trust status of the ILIT. Any termination of grantor trust status is, according to the ruling, when the transfer takes place, and when the 1491 tax might be imposed. The ruling did not specifically address the death termination situation, however, and no authority exists on this point. It would seem that a cogent argument could be advanced, however, that even if the “transfer” does occur at death, that both the fair market value of the trust and its adjusted basis at that time are equal, and thus, the application of 1491 results in no tax on a foreign situs ILIT at such time. The Internal Revenue Service could of course argue that there was a nanosecond between the time the grantor trust status terminated and the time the estate tax step-up occurred, so that the 1491 tax could be imposed. This seems a little far-fetched, however, even for the Service. This theoretical issue can be sidestepped entirely by utilizing two active U.S. trustees and one inactive foreign trustee during the settlor’s lifetime.(62) Upon the settlor’s death and the ILIT’s receipt of the insurance proceeds, the domestic trustees would, pursuant to the trust instrument, be terminated along with any U.S. administrative and investment connections.(63) The trust would therefore become a foreign trust following the settlor’s death, and, importantly, clearly at a moment in time when its fair market value and adjusted basis are equal, rendering the 1491 issue moot.(64)
The foreign situs irrevocable life insurance trust is an important estate planning tool which offers very significant estate, gift, generation-skipping, and income tax advantages for the appropriate taxpayer. It is crucial to carefully evaluate the potential income tax savings available through the tax-free accumulation and payout of trust income versus the potential estate/gift tax cost of excluding Crummey powers from the trust. Depending upon the type of life insurance held by the trust, it may be advisable to file a timely gift tax return or a late gift tax return to allocate the settlor’s GST exemption to trust transfers. Estate planners must also address the 1491 issue in structuring the foreign situs trust. In summary, the foreign irrevocable life insurance trust is an intricate estate planning tool offering significant benefits, but which must be used with great care.
1. All section references in this article shall, unless otherwise indicated, refer to provisions of the United States Internal Revenue Code of 1986 (the “Code”), as amended, and to United States Treasury Regulations (the “Regulations”) promulgated in interpretation of the Code, as in effect, amended, or proposed. All references to specific taxes and/or tax consequences shall, unless otherwise indicated, be deemed to refer only to United States taxes and/or tax consequences.
2. The ILIT discussed in this article is assumed to be one with respect to which the Settlor has retained no powers or benefits, nor any incidents of ownership with respect to the insurance policies included therein. It is also assumed to have been established by a U.S. person in a foreign jurisdiction under whose laws it would incur no income tax on its offshore earnings.
3. If the trust instrument directs the trustee to acquire life insurance policies on the settlor’s life with the transferred funds, as opposed to authorizing the trustee to so act, 2035(d)(2) could cause the inclusion of the proceeds of such policies in the settlor’s gross estate if the settlor were to die within three years of the transfer. See Kurihara Est. v. Comr., 82 T.C. 51 (1984).
4. The nature of a power or interest in an ILIT which would result in gross estate inclusion depends upon the identity of the person holding the power or interest. For example, a mere income interest granted to the settlor’s spouse would not alone result in the ILIT being included in the spouse’s estate, while an income interest retained by the settlor would result in inclusion of the trust in the settlor’s estate. Examples of other interests or powers which might result in the inclusion of the ILIT in the settlor’s gross estate abound: the settlor’s power to remove and replace the trustee, Rev. Rul. 79-353, 1979-2 C.B. 325, mod., Rev. Rul. 81-51, 1981-1 C.B. 458; the insured/trustee’s power, as trustee, to select a settlement option, Terriberry v. U.S., 517 F.2d 286 (5th Cir. 1975), cert. denied, 424 U.S. 977 (1976); see also Rev. Rul. 84-179, 1984-2 C.B. 195, GCM 39333 (January 29, 1985), GCM 39317 (December 12, 1984), and GCM 38751 (June 12, 1981).
5. See Kanter, AARP — Asset Accumulation, Retention and Protection: Prelude to Transmission, TAXES, The Tax Magazine (Dec. 1991), at p. 767.
6. See discussion of the income taxation of the beneficiaries and the trust, infra, where the settlor’s gift tax planning choices will have significant future income tax effects on the trust and its beneficiaries.
7. Treas. Reg. 25.2511-1(g)(1); 25.2512-8.
8. See, e.g., Comr. v. Montague, 126 F.2d 948 (6th Cir. 1942), and Treas. Reg. 25.2511-1(h).
11. Treas. Reg. 25.2503-3(a).
12. Crummey v. Comr., 397 F.2d 82 (9th Cir. 1968). The Internal Revenue Service has taken the position that a Crummey powerholder must have a beneficial interest in the trust beyond the Crummey power itself, and that such interest must constitute more than a remote contingent interest. TAM 9045002; PLR 8727003; but the Tax Court rejected the Internal Revenue Service position in Cristofoni Est. v. Comr., 97 T.C. 74 (1991).
13. Rev. Rul. 81-7, 1981-1 C.B. 474.
14. See PLR 9030005; PLR 8712014; PLR 8134135; PLR 8103074.
15. See, e.g., PLR 8022048; PLR 7922107.
20. After the initial withdrawal period has passed, the trust instrument may effectively limit the withdrawal power by requiring the written consent of the disinterested trustee for its exercise. The power would continue to retain its general power character. See 2041(b)(1)(C), Treas. Reg. 20.2041-3(c); 2514(c)(3); Treas. Reg. 25.2514-3(b).
21. Care must be exercised in drafting this type of “erosion” provision so that it will not be classified as a “condition subsequent”. See TAM 8901004; see also Comr. v. Procter, 142 F.2d 824 (4th Cir. 1944), cert. denied, 323 U.S. 756 (1944), further hearing, 4 T.C.M. 359 (1945), aff’d, 151 F.2d 603 (4th Cir. 1945), cert. denied, 327 U.S. 785 (1946).
23. Kurihara Est. v. Comr, 82 T.C. 51 (1984); Detroit Bank & Trust Company v. U.S., 467 F.2d 964 (6th Cir. 1972), cert. denied, 410 U.S. 929 (1973).
24. Treas. Reg. 20.2042-1(c)(2).
26. There is a split among the circuits regarding whether Treas. Reg. 20.2042-1(c)(2) (which equates economic benefits to incidents of ownership) limits the application of Treas. Reg. 20.2042-1(c)(4) (which provides that an insured is considered to have an incident of ownership in an insurance policy where he holds the power, as trustee or otherwise, to change the beneficial ownership in the policy or its proceeds, or the time or manner of the enjoyment thereof). See 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 (1976) (proceeds included in gross estates), Skifter Est. v. Comr., 468 F.2d 699 (2d Cir. 1972), Hunter v. U.S., 624 F.2d 833 (8th Cir. 1980), Rockwell Est. v. Comr., 779 F.2d 931 (3d Cir. 1985) (proceeds excluded from gross estates).
27. See generally, 2611 – 2613.
29. Inter vivos allocations are made on a gift tax return (Form 709). If the return is timely filed (as determined under 6075(b)), the value utilized in allocating the GST exemption is the value as at the date of the transfer; if the allocation is made on a late filed gift tax return, however, the value utilized is the value as at the date of the late allocation. 2642(b)(3). Pending the possible issuance of regulations to the contrary, a planning opportunity exists in filing a late allocation (and utilizing the values as at the date thereof) where an irrevocable life insurance trust holds a term policy. In such a case, the allocation (and hence, the utilization of the transferor’s GST exemption) would only include the last premium paid (since the value of the preceding premiums would then be zero). Nevertheless, the entire trust would be exempt from the GST.
30. And the trust was not a “skip person”, so no automatic allocation was made. See 2613(a)(2) and 2632(b)(1).
31. Computed as follows: Amount of GST transfer: $2,000,000
Taxable Amount: $1,000,000
Tax Rate: 55%
GST: $ 550,000
32. Since that amount of the transferor’s exemption would be available under these facts.
33. See fn. 29.
34. See generally, 671 – 679.
36. See 163; 264(a)(2).
39. 651(a); 661(a).
40. Although 2041(b)(2) defines a release of a power to include its lapse (with respect to amounts in excess of the 5 & 5 limitations), 678 contains no such cross-definition. However, in private rulings the Internal Revenue Service has taken the position that, for 678 purposes, a lapse does equate to a partial release. See PLR 9034004; PLR 8701007; PLR 8521060; PLR 8517052.
41. The second part of this requirement is not difficult to satisfy: presumably the trust income may be held or accumulated for future distribution to the powerholder. Such a possibility would constitute an interest in the trust of a nature which would, as discussed above, subject a grantor of a trust to treatment as the owner thereof, thus satisfying the second portion of the 678(a) requirement.
42. As gifts to the trust eligible for Crummey power withdrawal continue to be made, the portion “owned” by the beneficiary/powerholder will grow. Because of 678(b), however, the beneficiary would not be taxable on amounts allocated to trust income (as differentiated from amounts allocated to trust corpus, such as capital gains) during the settlor’s lifetime. Following the settlor’s death, however, the beneficiary would be treated as the owner of both types of income under 678(a).
43. 7701(a)(31); Treas. Reg. 1.871-2(a). In this article it is assumed that the entity in issue is a trust, and that, at the time so specified herein, that it is a foreign trust because of the insubstantiality of its U.S. contacts. See Treas. Reg. 301.7701-1(c) for a definition of “trust”, and B.W. Jones Trust v. Comr., 132 F.2d 914 (4th Cir. 1943) for a discussion of the facts and circumstances which will render a trust “foreign”. For a thorough discussion of the dual issues of whether a trust is a trust, and if so, whether it is a foreign trust, see Zaritsky, 416-2nd T.M. Foreign Trusts, Estates, and Beneficiaries.
44. 871(a); Treas. Reg. 1.871-7.
45. And on income from within the United States which is considered non-U.S source, such as interest on U.S. bank deposits. 871(i)(2)(A).
46. Treas. Reg. 1.871-7(d)(2).
47. 897; 871(a)(2); Treas. Reg 1.871-7(d)(2).
48. If the Crummey powers are eliminated, every dollar of every transfer to the trust would be included in the settlor/transferor’s taxable gift base, and would utilize the settlor’s unified estate/gift tax credit, or result in the payment of a gift tax. However, the settlor could optimally transfer as much as $600,000 in policies and premium payments to the trust before the first dollar of gift tax actually became payable.
As a possible aggressive alternative to the foregoing, the settlor could annually make direct gifts to his children (and, if minors, to a custodian) who could then in turn loan (at the appropriate applicable Federal rate, payable at maturity) the funds to the trust with which it would then make the premium payments. Properly structured, with no “strings” attached to the gift, such a plan could secure the full annual gift tax exclusions for the settlor, while at the same time avoiding the grantor trust issues, discussed above, with respect to the beneficiaries. Of course, when the life insurance policies mature, these loans would be repaid in full, and the remainder of the trust would be available for the benefit of the settlor’s spouse and other beneficiaries (which could include the lending beneficiaries).
49. 652(a); 662(a).
50. 643(a); 643(a)(6).
52. 652(b); 662(b).
53. 668. The Internal Revenue Service has held that the subsequent domestication of the foreign trust cannot avoid the 6% interest charge. SeeRev. Rul. 91-6, 1991-4 I.R.B. 4.
54. Treas. Reg. 1.663(a)-1(b)(1).
55. Treas. Reg. 1.663(a)-1(b)(2).
56. See, e.g., Treas. Reg. 1.663(a)-1(b)(2), Examples 3 and 4; 668.
57. See 1491.
58. In lieu of payment of the 1491 tax, the transferor can elect to recognize gain at the time of the transfer pursuant to 1057. Generally speaking, based upon today’s maximum 1 rate of 31%, this would be preferable to the 35% 1491 tax.
59. See Rev. Rul. 87-61, 1987-2 C.B. 219.
60. 1987-2 C.B. 219.
61. Rev. Rul. 87-61, 1987-2 C.B. 219, revoking Rev. Rul. 69-450, 1969-2 C.B. 168.
62. Such factors as a majority of the trustees being U.S. persons, the administration of the trust taking place in the U.S., the corpus of the trust being located in the U.S., and the beneficiaries being U.S. persons would result in the trust initially being classified as a domestic trust.
63. Thus, after the settlor’s death, the sole trustee would be foreign, the trust would be administered outside of the U.S., the trust corpus would also be located outside of the U.S., and the trust (by its terms) would be governed by the laws of a foreign jurisdiction, with the result that the trust would only become a foreign trust at such time, thereby avoiding the potential for conflict with the Service on the 1491 issue.
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