To fund the life insurance within an ILIT, the grantor typically pays the annual premium. The payment will constitute a potentially taxable gift, unless it qualifies for the annual gift tax exclusion (2010: $13,000). To qualify for the exclusion, the payment must constitute a gift of a present interest. This, in turn, brings up the so-called five-and-five rule.

The five-and-five power refers to the maximum amount a beneficiary can withdraw or allow to lapse and still retain the benefits of the annual gift tax exclusion. The Tax Code sets up a safe harbor provision, which states that, if the trust beneficiary (the trustee) is permitted to withdraw the greater of $5,000 or 5 percent of the trust corpus, the lapse of such power is not considered a gift by the beneficiary.

The $5,000 limitation causes some concern, since the annual exclusion is currently set at $13,000. As a result, the lapse of demand powers in excess of the five-and-five limitation creates gift tax exposure. If the beneficiary possessing the withdrawal power has no other beneficial interest in the trust, the lapse in excess of the five-and-five power may be treated as if the beneficiary donated his or her own assets to the other beneficiaries. This would result in a taxable gift that will not qualify for the annual exclusion — an outcome referred to as the gift-over problem. The only sure way to avoid the gift-over problem is to stay within the five-and-five limitation and avoid the use of hanging powers.

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