The Grantor Trust rules of Internal Revenue Code Section 671 – 679 offer some interesting planning opportunities.
For example, planners have long used “Income Defective Trusts” to take advantage of the differences between the income tax rules and the estate tax rules governing trusts. Such trusts are often designed to remove trust assets from the donor’s taxable estate, while the donor remains responsible for the income taxes on the trust’s taxable income.
The IRS has even recognized the planning opportunities in this area. In Revenue Ruling 2004-64, the IRS ruled that a grantor’s payment of the income taxes for his defective grantor trust was not a taxable gift to the trust, even though the payment of taxes by the grantor effectively added economic value to the trust.
With federal estate taxes affecting less than 1% of decedent estates (at least for a few more years), defective trust planning has taken a 180 degree turn. Increasingly, planners are considering the use of “Estate Defective Trusts” in which the trust income is taxable to the trust or its beneficiaries, while the trusts assets remain taxable in the donor’s estate. Such trusts provide tax benefits that are similar to the old Clifford Trusts, which were effectively gutted in the mid-1980s by tax law changes.
In January 2007, the IRS issued Revenue Ruling 2007-13 (2007-11 IRB) which provided that in many instances, the sale of a life insurance policy from one grantor trust to another grantor trust would not violate the transfer-for-value rules and therefore does not result in the treatment of the insurance proceeds as ordinary income. While a number of PLRs had been issued on this topic in the past (e.g., PLRs 200228019, 200514001, 200514002), this was the first time a Revenue Ruling had directly addressed the issue. While many planners believed this was the proper interpretation of the tax code, the onerous income tax cost of being wrong caused most planners to avoid inter-trust sales between trusts, except in dire circumstances.
Before delving into the unexpected complexities of the Revenue Ruling, it is useful to examine the provisions of some of the applicable code sections:
Code section 677(a) provides that “the grantor shall be treated as the owner of any portion of a trust, … whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, or both, may be…applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse…”
Code section 101(a) (1) provides that except in certain limited circumstances, “gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.”
Code section 101(a)(2)(B) provides that if there is a transfer for “a valuable consideration, by assignment or otherwise, of a life insurance contract” the proceeds of the policy are generally taxable as ordinary income unless the “transfer is 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 officer.”
For years, planners have created irrevocable life insurance trusts (“ILITs”) to move life insurance out of the taxable estate of the insured. Because the trust, not the insured, owns and controls the policy, the policy is kept out of the insured’s state and federal taxable estate.
Although ILITs are often used by estate planners, the word “irrevocable” has created a lot of concerns for clients and practitioners over the years. Even though limited powers of appointment, trustee removal provisions and other trust terms can create significant flexibility in an ILIT, its fundamental irrevocability can create problems when the expectations that occurred at the time of the creation of the trust are no longer valid.
For example, do you really want a belligerent ex-spouse as beneficiary of your life insurance trust? What happens when kids (who were 3-years-old when you created the ILIT) have now gone bad and are strung out on drugs?
There are a number of alternatives, including:
(1) The client can stop making payments on the policy. If it is a term policy, the policy will typically terminate within a year. If the trust has no other assets, it effectively will also terminate. If the insured is still insurable he can create a new policy in a new ILIT and start the process all over. But if the insured is uninsurable and/or the policy has a significant cash value, this approach is generally not viable.
(2) If permitted by the ILIT’s terms, the trustee could distribute the policy to one or more beneficiaries. However, if the point of revising the insurance plan is to move the policy away from one or more beneficiaries (e.g., a wayward child or disgruntled ex-spouse), this may also not be viable.
(3) The trustees might sell the policy back to the insured/grantor. Assuming that issues of the policy’s fair market value (see below) and arms length dealings can be overcome, this approach creates the problem that the life insurance proceeds are now includible in the donor’s taxable estate for state and federal estate tax purposes. A subsequent gift of the policy out of the insured’s hands starts the running of a new 3-year rule under Code section 2035(a). Inclusion in the insured’s estate may not be a gamble anyone wants to take.
(4) The trustees might sell the policy to a partnership or LLC in which the insured is a nominal, non-controlling partner. Code section 101(a)(2)(B) provides that the policy is cleansed from the transfer for value rules, but at least a percentage of the policy proceeds will remain in the insured’s taxable estate.
Revenue Ruling 2007-13 confirms that there is another device for moving the life insurance to a more desirable trust, without pulling the life insurance policy into the insured’s estate, or causing the life insurance proceeds to be subject to income taxes. In the ruling, the Internal Revenue Service provided two simple fact patterns.