Life insurance held within an Irrevocable Life Insurance Trust (ILIT), often referred to broadly as **Trust Owned Life Insurance (TOLI)**, is a cornerstone of advanced estate planning. The primary goal is to ensure the death benefit is received by beneficiaries **estate-tax-free** and **income-tax-free**, providing essential liquidity to pay estate taxes or equalize inheritances. However, achieving this tax efficiency requires meticulous administrative compliance by the **Trustee**. The Trustee’s duties extend far beyond simply paying premiums; they involve navigating complex tax statutes like the **Crummey Power** rules and adhering to strict fiduciary standards designed to protect both the trust corpus and the donor’s tax status. Administrative failure in TOLI is catastrophic, often resulting in the policy proceeds being pulled back into the taxable estate.

I. The Trustee’s Core Fiduciary Duties

The Trustee of an ILIT has a unique and demanding role because the single asset—the life insurance policy—is highly technical and its value is non-liquid until maturity. State trust laws and the Uniform Prudent Investor Act (UPIA) govern these duties.

1. The Duty of Prudence and Policy Review

The Trustee must manage the ILIT asset with the care, skill, and caution of a prudent investor. This duty includes an ongoing obligation to monitor the policy’s performance.

• **Performance Testing:** The Trustee must regularly obtain “in-force illustrations” to project the policy’s viability. For Universal Life products (IUL/VUL), this means testing worst-case scenarios to ensure the policy does not lapse prematurely due to poor performance or rising Cost of Insurance (COI) charges.
• **Carrier Review:** The Trustee should periodically review the financial strength ratings of the issuing carrier, as the solvency of the insurance company is the sole guarantor of the trust asset.
• **Suitability (Replacement):** In some cases, the Duty of Prudence may necessitate a **1035 Exchange** to a better-performing or more solvent carrier. However, the Trustee must document that the administrative cost and reset of the contestability period are justified by the net tangible benefit to the beneficiaries.

2. The Duty of Loyalty and Disclosure

The Trustee must administer the trust solely in the interest of the beneficiaries. This involves strict adherence to the Crummey notice requirement.

II. The Crummey Power Mechanism: Ensuring Tax-Free Gifts

The gifts made to the ILIT (premiums) are generally considered gifts of a “future interest,” which are ineligible for the annual **Gift Tax Exclusion** (IRC Section 2503(b)). To qualify the gift for the exclusion, a **Crummey Power** must be included in the trust document.

1. The Mechanics of the Withdrawal Right

The Crummey Power grants the trust beneficiaries a temporary, non-cumulative right to withdraw the amount of the annual premium contribution made by the donor.

• **The Notice Requirement:** The Trustee must provide **timely, written notice** to each beneficiary (or their guardian) informing them of the contribution and their right to withdraw the funds (e.g., within 30 days).
• **The Bona Fide Intent:** Although beneficiaries rarely exercise this right (as doing so defeats the trust’s purpose), the right must be genuine. The IRS requires the beneficiary to have reasonable opportunity and knowledge of the right. Failure to provide timely notice makes the contribution a gift of a future interest, requiring the donor to use their lifetime Gift Tax Exemption.

2. The Danger of “Naked” Crummey Powers

A “Naked” Crummey power exists when the beneficiary has no vested interest in the trust other than the temporary withdrawal right. The IRS may challenge this arrangement if the beneficiary is so remote (e.g., a contingent grandchild) that their right is not considered substantial. Fiduciaries typically require beneficiaries to have a genuine current or vested future interest in the trust corpus to satisfy the “substance over form” doctrine.

III. Managing the Lapse: The “5 and 5” Rule

A significant tax trap for the beneficiary themselves is the lapse of the Crummey withdrawal right. When the beneficiary allows the right to lapse, they are considered to be making a taxable gift back to the trust.

1. The Tax Trigger (IRC Section 2514(e))

A lapse of a general power of appointment (the withdrawal right) is only tax-free to the beneficiary if the amount is less than the greater of:

$$ \text{Five Thousand Dollars } (\$5,000) \text{ or } \text{5\% of the aggregate value of the assets subject to the power.} $$

This is known as the **”5 and 5″ Power**. If the Crummey contribution for a beneficiary exceeds the 5 and 5 limit, the excess lapse is considered a taxable gift by the beneficiary to the remaining beneficiaries of the trust.

2. The Solution: Hanging Crummey Powers

To fund large premiums without triggering the 5 and 5 tax trap, planners use **Hanging Crummey Powers**.

Mechanism: The withdrawal right for the excess amount (above the 5 and 5 limit) does not lapse. It “hangs” in the trust until such time as the trust assets are large enough for the accumulated hanging amount to lapse tax-free within the 5% limit. This sophisticated drafting strategy preserves the donor’s annual exclusion while preventing unintended gifts from the beneficiary.

IV. The Risks of Administrative Failure

Poor administration can result in the entire policy being drawn back into the donor’s taxable estate, making the ILIT effort moot.

1. Policy Underfunding and Lapse

If the Trustee fails the Duty of Prudence and neglects to request in-force illustrations, the policy may run out of cash value and lapse. Because the trust has no other assets, the donor may have to reinstate the policy themselves, potentially violating the “three-year rule” (discussed in prior analysis) or triggering the **Transfer for Value** trap if the policy is transferred between trusts without proper planning.

2. Violating the “Incidents of Ownership”

The donor must never retain any **Incidents of Ownership** (e.g., the right to change beneficiaries, borrow the cash value, or cancel the policy). If the Trustee is the donor’s spouse, sibling, or anyone subject to the donor’s explicit control, the IRS can argue the donor indirectly retained control, leading to **Estate Inclusion** of the death benefit under IRC Section 2042.

V. Conclusion: The Administrative Imperative

The TOLI structure is a powerful shield against estate taxation, but its efficacy is completely dependent on ongoing, diligent administration. The Trustee must be a sophisticated fiduciary, constantly monitoring policy health, meticulously documenting Crummey notices, and ensuring all actions comply with the 5 and 5 tax thresholds. The cost of a professional trustee or robust internal governance is negligible compared to the 40% loss of the death benefit that results from a single, critical administrative error.

Disclaimer: This content is for informational purposes only and does not constitute legal or tax advice. TOLI administration is a specialized field; proper management requires regular consultation with an estate planning attorney and a trustee familiar with state trust law and federal tax codes.