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Financial Planning > Trusts and Estates > Trust Planning

A Breach of Trust

By Tom Virkler

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Back in the old days a Greek philosopher named Sextus Empiricus wrote that, “The wheels of justice grind slowly, but exceedingly fine.” He must have been waiting on some attorney to finish drafting his trust document.

Irrevocable trusts are the most common device used to remove assets from the taxable estate where they are then often leveraged to provide increased value and liquidity by purchasing life insurance on the grantor of the trust. A common problem is the delay that occurs between the time policies are ready for issue and the drafting of the trust by the attorney involved. The circumstance is understandable. Lawyers are busy, too. They strain at the gnat of every detail because they are supposed to and because it is their malpractice insurance that is on the line. And often they are not brought into the process until a carrier is good to go with the coverage to be owned by the yet non-existent trust

But two hard and serious considerations press on an agent and the insured as they await the trust’s birth: first, the insurer’s delivery deadlines and, second, the increasing risk of a change in health as the interim between the offer and placement lengthens

Strong is the temptation for agents to run ahead of their blocking and encourage an insured to take ownership to lock in the underwriting offer and, more important, the death benefit should the worst occur. The bad news is that ownership by the insured incurs many of the tax problems that the trust is meant to avoid. The good news is that, with proper planning, the insured can take ownership of the contract and still avoid the tax pitfalls it might create.

Looking a Gift Horse in the Mouth

The easiest, but least effective, course of action is for the insured to take possession of the policy and then later gift it to the trust. Insured ownership triggers IRC 2035 making the proceeds includible in the estate if the insured dies within 3 years of the transfer. If just a change of health was a concern during the relatively short trust-drafting period then an exchange for a 3-year death watch probably won’t offer appeal. Furthermore, the transfer is a potentially taxable gift in the amount of the fair market value of the policy. Determination of value is a decision for other advisors, but it is helpful to get an opinion from the carrier who will usually report either premiums paid or the policy’s interpolated terminal reserve.

A Sale You Can Trust

The 3-year rule applies only to gifts of insurance made by the donor on his or her own life. This second strategy involves the insured taking the contract and then selling it to the trust once it is established. This successfully avoids the 3-year rule, but raises the specter of a transfer-for-value that could subject much of the death benefit to income taxation under IRC 101. However, certain transfers are exempted, the primary being that a sale to the insured is not considered a transfer-for-value.

The trust can be drafted so that the grantor is considered the owner of the trust for income tax purposes – a grantor trust. Consequently, the sale of a policy on the life of the grantor by the grantor to the trust will be considered a transfer to the insured, thus protecting the death benefit from income taxation. The IRS recently confirmed this concept’s rationale in Revenue Ruling 2007-13 (a mercifully short and understandable opinion that is well worth reading).

A sales price acceptable to the IRS is important. If the price is later determined to be insufficient the transaction could be deemed a partial gift subjecting the proceeds to the 3-year rule. Others advisors involved will determine the purchase price. The client should be prepared to deposit an amount equal to the purchase price into the trust so that the formalities of the sale and purchase can be accomplished when transferring the policy that was “born out of due time” safely to the trust free from income taxation and estate taxation.

Button, Button – Who’s got the Button

Many carriers will accommodate a procedure that is much simpler. It involves issuing the policy with the insured as owner. When the trust is ready the insured returns the policy as “not taken”. In the twinkling of an eye the carrier issues new coverage under a contract with a) the trust as owner, b) a different policy number, c) a policy date the same as that of the original policy, and d) an issue date after the date of the creation of the trust. Advisors may not be comfortable with the arrangement believing that the IRS might view the two contracts as one for taxable purposes. The practice is not uncommon, but should be done in each case only with advisor approval and close attention to the procedures used by the particular carrier involved.

Under any scenario death prior to the ultimate transfer of the policy into the trust will result in the inclusion of the proceeds in the taxable estate of the insured. The purpose of each stop-gap measure is to avoid the worst possible outcome: death with no coverage at all. Even Ben Franklin, admitting defeat with regard to his “bold and audacious” plan to master the 13 virtues of Moral Perfection, had to concede that sometimes even a speckled axe is best.

Tom Virkler, JD, CLU, is director of advanced markets at CPS Advanced Markets, Los Osos, Calif.

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