One of the primary techniques used to reduce a person’s taxable estate is for him or her to make gifts during life to other individuals, usually children or grandchildren, using the annual gift tax exemption ($14,000 in 2014). An individual can make a gift of up to $13,000 to as many other people as he or she wants in any given year. In other words, if Thomas wants to make gifts of $13,000 to each of his ten grandchildren, he could reduce his taxable estate by $130,000 each year. However, Thomas will most likely want to retain some sort of control over the gifts—such as if a grandchild is not yet mature enough to handle large amounts of money, has a drug or alcohol addiction, has creditor issues or has a divorce pending. Thomas can place limitations on the gifts by establishing an irrevocable Gift Trust or an Irrevocable Life Insurance Trust (“ILIT”) and making the gifts to the trust rather than to the beneficiaries outright. The trustee will then administer the trust as provided by Thomas in the trust document. Such trusts are irrevocable and, therefore, require significant thought and consideration of whether the creator (the “giftor”) is willing to part with the assets and under what terms he wishes to make the gifts.
The IRS requires that the giftor follow established procedures for payment and notice in order for the transfer to be considered a present interest gift (see “Definition of the Month” in Newsletter #8), which is necessary for the assets to be excluded from the giftor’s estate. For example, assume that Thomas establishes an ILIT for the benefit of his grandchildren. The intention is that by establishing the ILIT to own the life insurance policy, the proceeds of the policy at Thomas’ death, along with the premiums that are paid during his life, will be outside of Thomas’ taxable estate at his death.
In order for this goal to be accomplished, the process for making the gifts and paying the premiums must be as follows: first, Thomas must make the gift (the amount of premium due) to a bank account established by the trustee of the ILIT; second, notice must be given to the beneficiaries of the ILIT in the form of “Crummey Notices” (named after the case establishing the requirement—see “Definition of the Month” in Newsletter #5) stating (a) that a gift has been made to the ILIT, (b) the amount that the beneficiary is entitled to withdraw, and (c) the date by which such withdrawal must be made; and third, after such date has passed, the trustee may pay the premium to the insurance provider. Only by following these steps can the giftor properly make a present interest gift that will be excluded from his taxable estate.
An issue that is far too common arises when the trust is established but the trustee fails to ensure that the necessary procedures are being followed on an annual basis—for example, the giftor makes the premium payment directly from his personal bank account to the insurance company or the trustee fails to send notice to the beneficiaries that a gift has been made. Such a failure can result in significant Gift Tax consequences and essentially eliminate the benefits that the giftor intended to achieve by establishing the ILIT in the first place.
It is critical that the attorney communicate and the giftor understand the requirements of maintaining an irrevocable trust so that the intended goals can be accomplished. An affordable and efficient solution is to have the preparing attorney maintain the irrevocable trust by making sure that the annual notices are prepared and sent in a timely manner. Since the attorney is familiar with the goals and intentions of the giftor as well as the personal situations of the beneficiaries, this is often the best way to ensure that the proper procedures are followed. When done properly, the irrevocable trust is an invaluable tool for reducing Estate and Gift Tax liability.