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Crummey Note

A Crummey note is used in conjunction with a life insurance trust to enable a life insurance policy owner to avoid taxes.  This arrangement is not difficult to create.

Estate taxes & life insurance

Under current federal tax law, life insurance proceeds are already exempt from estate tax.  However, the life insurance policy itself is an asset which becomes part of your estate and can be taxed.

For example, suppose that you own a life insurance policy on yourself.  The policy's offers a death benefit of $1 million and, at the time of your death, is valued at $50,000.  (For tax purposes, the value of a life insurance policy is determined by the IRS.)

The death benefit goes to someone else, so it is not taxed; but your taxable estate is increased $50,000 because of your ownership of the life insurance policy.  Even though estate taxes are at an all-time low in 2011, that could entail another $17,500 in estate taxes.

But if you keep your life insurance policy out of your estate, you enjoy the protection of insurance, without the higher estate taxes.

Keeping the policy out of your estate

It makes sense to keep the policy out of your estate.  The problem is that if you're paying all or part of the premiums for the policy, you legally possess incidents of ownership in it.  Like it or not, it will fall within your estate.

You can overcome this catch-22 by using a Crummey note and an irrevocable life insurance trust (ILIT).

What is an ILIT?

An ILIT (or "irrevocable life insurance trust") is an arrangement which puts responsibility for a life insurance policy into the hands of another person (the trustee), who is required to manage the policy according to instructions which you agree upon.  (This definition is vague because you have a great deal of freedom in deciding the terms of the trust.)

You can designate a person (e.g. trusted friend, financial professional) or an institution (e.g. bank, credit union, etc.) as the trustee.  (You don't want to designate yourself as trustee because you won't be alive to distribute the death benefit when the time comes.)

Under an ILIT, the trust itself is the owner and beneficiary of the life insurance policy.  For legal purposes, it is the entity that makes the premium payments, and it is the entity that receives the death benefit.

The trust will have one or more beneficiaries of its own.  These beneficiaries are the ones who ultimately receive the life insurance policy's death benefit.  Your trust can distribute the death benefit among them in any way you dictate.

An ILIT is "irrevocable," meaning that you (the grantor) relinquish any right to alter the terms of the trust following its creation.

How to create an ILIT

The soul of an irrevocable life insurance trust is a document (which can be written by yourself).  For your ILIT, you should stipulate the following:

  • Require that the trustee pay the premiums necessary to keep the life insurance policy in force
  • Forbid the trustee altering the terms of the life insurance policy (e.g. changing the beneficiary)
  • Indicate what is to be done with the death benefit, once it is received

That's pretty simple isn't it?  Simplicity notwithstanding, it is prudent to involve an attorney in planning and writing the document.  Also, it's good practice to have your trust notarized.  Enlisting the services of an attorney and notary public may cost you a few shekles, but not anywhere near the $17.5K you'd save in estate tax (per the foregoing example).

How to fund an ILIT

Recall that the ILIT is the legal owner of your life insurance policy, and it is in charge of paying the life insurance premiums.  But your trust doesn't have an income of its own; you need to supply it the money that it will use to pay insurance premiums.  However, since the trust is a legal entity distinct from you, you can't just transfer money to it pell-mell without incurring taxes on the transfer.

However, you can make cash gifts to the trust.  And if your gifts are small enough to fall beneath the gift tax exclusion, then you can fund your trust tax-free.  Starting in 2009, the annual gift tax exclusion has been $13,000.  (The calculation for this exclusion is prescribed in the Internal Revenue Code §2503.)  For every beneficiary in your ILIT, you can multiply that amount.  E.g. if you have 4 beneficiaries, you can put $52,000 per year into the ILIT, tax free.  That buys a lot of insurance.

Here is where the need for a Crummey letter comes into the picture: for your payments to count as gifts, your beneficiaries need to have a present interest in each of your payments to the trust.  That means that they're free to remove the funds from the trust, which can really throw a wrench into the gears.

What is a Crummey note?

A Crummey note, also called a Crummey letter or Crummey power note, is a document which allows your beneficiaries a limited present interest to the funds in the trust.  It alerts beneficiaries to each gift and stipulates that the gift funds are available to them for only a limited time (e.g. one month or one year).  After that time, there's no danger of a beneficiary trying to access them, so your life insurance trust is free to use those funds to pay for premiums.

By using a Crummey letters, you create the present interest necessary to qualify your payments as gifts and also a safety mechanism which ensures that there will be no conflict for your funds at the time they are used to pay insurance premiums.

How to create a Crummey note

As with the document for the irrevocable life insurance trust, a Crummey letter is rather simple and can be written by yourself.  Again, however, we recommend consulting with a legal professional.

Be sure to perform the following in each Crummey letter:

  • Identify the trust where your contribution was made
  • State the date and amount of the contribution
  • State how long the beneficiary has a right to withdraw money

Here are a number of sample Crummey letters to get you started:

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