GST exemption allocations to life insurance trusts.

Many irrevocable life insurance trusts are structured with Crummey withdrawal rights, meaning the $10,000 annual gift tax exclusion will apply to transfers to the trust. When there are a sufficient number of beneficiaries with withdrawal rights, the entire transfer may escape gift tax. In some situations, however, the generation-skipping transfer (GST) exemption allocations should be included in a gift tax filing, even though the transfer is fully exempt from gift tax.

This situation was created by a change in the law in the Technical and Miscellaneous Revenue Act of 1988. As originally provided in the Tax Reform Act of 1986, if a gift was exempt from gift tax by reason of the annual exclusion, it was also exempt from GST tax. For transfers to trusts after Mar. 31, 1988, Congress provided that the annual exclusion would shield an outright transfer, such as a transfer to an irrevocable insurance trust, only if the transfer was a "direct skip" to a qualifying trust under Sec. 2642(c)(2). A transfer to an insurance trust is not a direct skip unless only skip persons are beneficiaries of the trust at the time of transfer (among other requirements). Clearly, very few life insurance trusts are structured to be shielded from GST tax by the annual gift exclusion. A gift tax return filing is the only way to be sure that the trust will escape taxation; allocation of the $1 million GST exemption is not automatic for these types of gifts.

The allocation of the GST exemption on a late filing must be based on the value of the trust at the time of the late filing (while a timely filing would allow an allocation based on the gift's value when the gift was made). Because a life insurance policy is designed to increase greatly in value, a late allocation is better than none at all and is often advisable. Generally, the allocation is made to achieve a GST inclusion ratio of zero for the trust. Therefore, a valuation of the life insurance policy is needed as of the date of filing the gift tax return. Care should be taken if the trust holds any other assets (such as cash) to also include the value of these assets as of the filing date.

Of course, most life insurance trusts are intended to benefit a surviving spouse and/or children; grandchildren would only receive payments from the trust if the children die before their parents. Even though this is not the expected sequence of deaths, it may be advisable to provide for this contingency.

The most common scenario in which an allocation of GST exemption to a life insurance trust would not make sense is when the estate plan provides for other assets that will flow to the grandchildren to fully use the exemption and very little, if any, of the insurance money is expected to go to the grandchildren.