The Internal Revenue Service has issued a batch of guidance that could affect life insurance policyholders and others who use trusts to transfer policies.
The guidance, given in Revenue Ruling 2007-13, deals with a grantor insured by a life insurance policy who owns 2 grantor trusts.
The grantor, G, puts the policy in one grantor trust, then transfers the policy to the second grantor trust in exchange for cash.
In a second, related case, G puts the policy in one grantor trust, then transfers the policy to a second trust that is not a grantor trust in exchange for cash.
Determining what rules govern the transfers is important, because the rules affect the incomes that the recipient of the death benefits must pay.
Section 101(a)(2) of the Internal Revenue Code “provides, generally, that if a life insurance contract, or any interest therein, is transferred for a valuable consideration, the exclusion from gross income…shall not exceed an amount equal to the sum of the actual value of the consideration and the premiums and other amounts subsequently paid by the transferee,” writes Chris Lieu, an IRS official, in the revenue ruling.
But other sections of the Internal Revenue Code provide that “transfer for a valuable consideration” does not apply to a transfer of a life insurance contract or any interest in the contract to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or an officer.
In one 1985 ruling, the IRS treated a grantor who acquired a trust in exchange for an unsecured promissory note as the owner of the trust, and the exchange of a promissory note for the trust assets is not recognized as a sale for federal income tax purposes, Lieu writes.
If Grantor G owns 2 grantor trusts and transfers a life policy from 1 trust to the other in exchange for cash, “there has been no transfer of the contract within the meaning of Section 101(a)(2),” Lieu writes.
In the second example, the policy is being transferred for valuable consideration, but the transfer will not lead to Section 101(a)(2) tax problems, because, in that case, the insured is simply transferring the policy to the insured, Lieu writes.