Life insurance trusts are an extremely popular estate planning tool. Since the proceeds of life insurance policies are generally included in the taxable estate of the insured-owner, many individuals transfer policies to an irrevocable trust during life to remove the death benefit from later federal estate tax. One significant downside to the use of an irrevocable life insurance trust is; however, the fact that such trusts cannot be changed by the insured-owner. As changes in family circumstances occur over time (marriages, deaths, births, divorce, etc.), the irrevocable dispositive provisions of the trust may become less suitable.
A strategy that is often employed to effect a “change” in the terms of an irrevocable life insurance trust is to establish an entirely new trust and have the new trust purchase the life insurance policy from the old trust for the policy’s fair market value (usually, its interpolated terminal reserve value plus unearned premiums). Following the sale, instead of owning a life insurance policy with substantial death benefit, the “selling” trust owns an asset (a promissory note or cash equal to the interpolated terminal reserve value of the policy) that is worth substantially less than the death benefit that will be realized from the insurance policy on the insured’s death. The result is that the death benefit (except that portion, if any, that will be required to pay off a promissory note used in the purchase transaction) will pass to the trust beneficiaries in accordance with the new trust’s terms (rather than the old trust’s less suitable terms).
One significant impediment to the “sale” of any life insurance policy is the so-called transfer for value rule. Although life insurance proceeds generally enjoy income tax free treatment upon the death of the insured, under Code Section 101(a)(2), if a life insurance contract is transferred during the life of the insured for valuable consideration, the gross income exclusion is limited to an amount equal to the consideration paid for the policy and the premiums subsequently paid by the transferee. As a result, if a sale of a life insurance policy between two trusts resulted in a “transfer for value” under Code Section 101(a)(2), the majority of the death benefit would be subject to income tax on the death of the insured.
Notwithstanding the general transfer for value rule, the IRS has ruled on multiple occasions that if the buying trust is a “grantor trust” for income tax purposes (meaning that the person who established the trust, the insured in this case, is treated as the owner of the trust for income tax purposes) the sale will not be considered a “transfer for value.” This is because one notable exception to the transfer for value rule is a transfer of the insurance policy to the insured. Since the buying trust is considered the “insured” for income tax purposes, no transfer for value results. Similarly, any transfer that is in the nature of a gift is also not a transfer for value.
A recent private letter ruling demonstrates that in some situations it will be very important that the “selling” trust (as opposed to just the buying trust) be characterized as a grantor trust. In Private Letter Ruling 2014-26-005, the IRS recently considered a situation in which a husband and wife established an irrevocable life insurance trust that owned a joint and survivor life insurance policy. The selling trust was a “grantor trust” for income tax purposes as to the husband and wife jointly. The buying trust, however, was a grantor trust only as to the husband (since the wife did not participate in creating the buying trust). The IRS ruled that the transfer from the selling trust to the buying trust had two components for income tax purposes. First, since the husband was a grantor of both trusts, his portion of the ownership of the policy (through the selling trust) was not a transfer for value under the exception for transfers to the insured. Second, although the wife was not a grantor of the buying trust, the sale of the policy between the two trusts was, in effect, a sale of the wife’s interest from wife (as a partial grantor and partial deemed owner of the assets of selling trust) to the husband (as the sole grantor and sole deemed owner of the assets of buying trust). The IRS cited Code Section 1041 which generally deems any sale between a husband and wife as a gift between the spouses for income tax purposes. As a result, the sale of the wife’s portion of the policy to the husband (through the grantor trusts) was a deemed gift under Section 1041 and not a transfer for value under the gift exception in Section 101(a). If the selling trust had been a “complex” trust and not a “grantor” trust deemed owned partially by the wife, the transfer for value rule would have been implicated. This ruling demonstrates that life insurance sale transactions must be carefully analyzed to insure the transaction properly falls within an exception to the transfer for value rule, to avoid subjecting the death benefit to later income tax.