Flexibility is not a dominant selling point of Irrevocable Life Insurance Trusts–or the life insurance policies that inhabit them. ILITs usually serve a single purpose, for instance providing a liquid fund to pay estate taxes, but a little creativity and flexibility can go a long way with clients who are on the fence. A recent IRS ruling (Revenue Ruling 2011-28, 2011-49 IRB 830) provides a path for at least one type of ILIT flexibility.
There are not a lot of places to work flexibility into the structure of an irrevocable trust; too much flexibility and the value of the trust’s assets will be included in the grantor’s estate. But one area where flexibility can be introduced is in a power of substitution retained by the grantor.
The power of a grantor to substitute trust property for other property of equivalent value is often drafted into a trust for the purpose of conferring grantor trust status on the trust for income tax purposes. Prior IRS guidance established that the substitution power will not result in trust assets being included in the grantor’s estate for estate tax purposes.
Despite that general rule being clear enough, it was still unclear whether substitution power would result in the value of trust assets being included in the grantor’s estate when the trust is an irrevocable trust and the asset is a life insurance policy.
A grantor’s power to substitute in a life insurance trust could be interpreted as giving the grantor an “incident of ownership” in the life insurance policy held by the trust–thus resulting in estate inclusion of the value of the policy. Revenue Ruling 2011-28 provides a definitive answer to that question.
Prior to issuance of the ruling and its companion, Revenue Ruling 2008-22, there had been some uncertainty surrounding whether a substitution power would cause the trust’s assets to be included in the grantor’s gross estate under Section 2036 (property transferred by a grantor with a retained life interest) or 2038 (revocable transfers).
In Revenue Ruling 2008-22, the IRS came to the general conclusion that a grantor’s substitution power will not cause trust assets to be included in the grantor’s estate. Ruling 2011-28 extends Ruling 2008-22 to include a substitution power over a life insurance policy held in an irrevocable life insurance trust.
Conditions on Substitution