How Much Premium Can be Transferred to a Trust Without Gift Tax? The 5 X 5 Limitation

 Situation: I’m often confronted with the situation where a financial representative is working with a wealthy client with a need for life insurance for estate liquidity. The classic recommendation is for the client to establish a trust as the owner and beneficiary of the policy to avoid having the life insurance proceeds subject to estate tax. Eventually, the questions turn to how much premium can be transferred to a trust without incurring gift tax. This Counselor’s Corner addresses this question.

Solution: The amount that can be transferred to a trust without incurring gift tax depends on the terms of the trust and the number of trust beneficiaries. To begin, a person can transfer $19,000 of gifts of a “present inter­est” in property to any person during a calendar year. The first $19,000 of gifts qualifies for the gift tax annual exclusion and is not included in the computation of tax­able gifts of the donor during that year. (The $19,000 is 2025 indexed for inflation.) This amount can be increased to $38,000 when spouses elect gift splitting. The annual exclusion does not apply to gifts of a “future interest.” A gift is classified as a future interest if the beneficiaries’ possession, use, or enjoyment of the transferred property is deferred to a later time.

Many individuals/grantors that want to take advantage of the annual exclusion are unwilling to place substantial sums of money at the immediate disposal of their intend­ed beneficiaries. As a result, an irrevocable trust is often established to maintain some degree of control over the assets transferred until some specified time in the future. Since the primary purpose of using the trust is to postpone the beneficiaries’ immediate enjoyment of the property, the transfers will generally be gifts of a future interest and not eligible for the gift tax annual exclusion unless the trust is carefully structured to result in present interest gifts.

One way to overcome the future interest problem inher­ent in transfers to a trust is to grant the trust beneficiaries a Crummey withdrawal right. When a grantor gives a trust beneficiary a Crummey right he is giving the individual the right to withdraw transfers to the trust for a limited period of time. As long as the Crummey right is properly administered, the grantor’s cash transfers to the trust will be treated as present interest gifts that qualify for the gift tax annual exclusion.

So, if there are four trust beneficiaries with properly administered Crummey withdrawal rights, the grantor can shelter up to $76,000 of cash transfers ($152,000 with gift splitting) from his or her gift tax.

Generally, the beneficiaries do not exercise their Crum­mey withdrawal rights, and the cash gifts are used to pay the annual premium. When the beneficiaries fail to exercise their Crummey withdrawal right, they may be treated as having made a transfer subject to gift tax to the other trust beneficiaries. Absent additional terms or conditions in the trust, the gift by a trust beneficiary is subject to gift tax to the extent the beneficiary’s trans­fer exceeds the greater of $5,000 or five percent of the trust assets. Thus, the limitation on how much premium can be transferred to a trust generally depends on the amount the trust beneficiary is able to transfer without gift tax.

Fortunately, various strategies have evolved to minimize or avoid the beneficiary’s gift tax limitation. However, before discussing these strategies, it is first necessary to have an understanding of the beneficiary’s 5 X 5 limita­tion.

Background to Beneficiary’s Gift Tax Limitation: The Lapse Problem.

A beneficiary’s power to withdraw trust property consti­tutes a general power of appointment since the benefi­ciary can direct that the funds be used for his/her own benefit. In the event the beneficiary does not withdraw the funds subject to the power during the prescribed peri­od, the general power of appointment expires (technically this is referred to as a lapse of a power of appointment). A lapse of a general power of appointment is treated for gift tax purposes as a transfer of the property subject to the power. In other words, when a beneficiary allows the with­drawal right to expire he/she is treated as having made a gift.

The Internal Revenue Code provides a safe harbor excep­tion that shelters “small transfers” from gift tax. Under the safe harbor, only transfers greater than $5,000 or five percent of the aggregate value of the assets out of which the exercise of the lapse power could have been exercised will be subject to gift tax. Note: This “5 X 5 limit” affects the trust beneficiaries – not the grantor/donor.

In other words, a grantor may avoid gift tax on a transfer equal to the full gift tax annual exclusion; however, a beneficiary allowing the lapse of a Crummey power in ex­cess of the permitted $5,000 or 5 percent limitation will, absent additional trust terms or conditions, be deemed to have made a gift to the other trust beneficiaries. Further­more, since the trust will likely require the excess amounts to be retained by the trust, the beneficiary’s gift is of a fu­ture interest. Thus, the gift tax applicable exclusion amount of the beneficiary who lets his/her withdrawal right lapse will be reduced by the amount of the lapse in excess of the 5 X 5 limit. If the beneficiary has exhausted the gift tax applicable exclusion amount, the deemed transfer will be a taxable gift.

Continuing our previous example, let’s assume that the four beneficiaries have been given properly drafted Crummey withdrawal rights and adequate time to exer­cise their withdrawal rights. If they choose not to exercise their rights, the $76,000 transfer qualifies for the grantor’s annual gift tax exclusion and he/she escapes the impo­sition of gift tax. However, the tax problem lies with the beneficiaries. Absent additional terms or conditions, each beneficiary will be deemed to have made a taxable gift of $14,000 (the amount in excess of the 5 X 5 safe harbor lim­it). Fortunately, various strategies are available to minimize the beneficiary’s gift tax.

Each of the alternative strategies discussed below has benefits and drawbacks, depending upon the interests and objectives of the grantor and the beneficiaries. In addition, the methods have received different levels of acceptance (or resistance) by the Internal Revenue Service (IRS). Consequently, all aspects of a client’s situation must be assessed with the client’s advisor before any judgment can be made which strategy might be best.

Alternative Solutions to the “5 X 5 Limit”

If the trust has only one beneficiary, the problem does not arise because, when the Crummey withdrawal power laps­es, there is no other trust beneficiary to whom an imputed gift can be made.