The Internal Revenue Service, in Rev. Rul. 2007-13 (to be published in IRB 2007-11 on March 12, 2007), held that a transfer from an irrevocable life insurance trust to a second irrevocable life insurance trust, where both trusts qualified as grantor trusts for income tax purposes, was not a violation of the transfer for value rule. Perhaps slightly more surprisingly, the Service further held that a transfer from a non-grantor irrevocable life insurance trust to a grantor irrevocable life insurance trust also did not violate the transfer for value rule.
As we all know, generally speaking, all income, from whatever source derived, is taxable. An exception to this general rule of income taxation is provided by IRC § 101(a)(1), which provides that (except as otherwise provided in IRC §§ 101(a)(2), 101(d), and 101(f)) a recipient can exclude from gross income amounts received under a life insurance contract – assuming such amounts are received by reason of the death of the insured. There is, however, a further exception to IRC § 101(a)(1), which provides that if a life insurance contract, or any interest in the policy, is transferred for a “valuable consideration” in money or money’s worth, the exclusion from gross income provided under IRC § 101(a)(1) is limited. The exclusion can’t be greater than the sum of: (1) the actual value of the consideration plus (2) the premiums and other amounts subsequently paid by the transferee. IRC §§ 101(a)(2).
Even if there is a transfer of a policy or an interest in a policy and even if that transfer was made for some valuable consideration, the proceeds will still be income tax free if the transfer is to (among other exceptions): (1) the insured, (2) a partner of the insured, (3) a partnership in which the insured is a partner, or (4) to a corporation in which the insured is a shareholder or officer
The issue the Service examined here is “[i]s the Grantor who is treated for federal income tax purposes as the owner of a trust that owns a life insurance contract on the Grantor’s life treated as the owner of the contract for purposes of determining whether a transfer of the contract (1) is a transfer for a valuable consideration within the meaning of Code Section 101(a)(2) and (2) if so, does a transfer to the insured fall within the safe harbor exception provided for a transfer to the insured? (i.e. Section 101(a)(2)(B))?”
The Service went back to a 1985 Ruling, Rev. Rul. 85-13, 1985-1 C.B. 184. There, a grantor acquired the corpus of a trust in exchange for the grantor’s unsecured promissory note. The ruling concluded that the grantor is considered to have borrowed the corpus of the trust and, as a result, is treated as the owner of the trust under IRC § 675(3). Because the grantor is treated as the owner of the trust, the grantor is deemed the owner of the trust assets for federal income tax purposes. In addition, because the grantor is, therefore, considered to own the purported consideration both before and after the transaction, the exchange of a promissory note for the trust assets is not recognized as a sale for federal income tax purposes.
Here, in Situation 1, the Grantor is considered the owner of both ILITs for federal income tax purposes – and as the owner of all the assets of both trusts, including both the life insurance contract and the cash received for it, both before and after the exchange. Accordingly, in Situation 1, for income tax purposes, there has been no “transfer” of the contract. And without a transfer, there can be no transfer for value. This means the proceeds of the policy have not lost their income tax free nature.
In Situation 2, because the grantor is treated as the owner of all the assets of ILIT 2 but not of ILIT 1 for federal income tax purposes, he is treated as the owner of the cash (but not the life insurance contract) before the exchange, and as the owner of the life insurance contract (but not the cash) after the exchange. Fortunately, even though the IRS finds that there has been a transfer of the life insurance contract and that transfer was clearly in return for a valuable consideration, because the transfer was “to the insured” (since the transferee trust was the grantor’s alter ego), the transaction falls within the IRC § 101(a)(2)(B) safe harbor and therefore the proceeds remain income tax free.
One cautionary note. The IRS has previously ruled that in most circumstances the fair market value of a life insurance policy for gift tax purposes is its interpolated terminal reserve value. The interpolated terminal reserve value is roughly equivalent to the policy’s cash surrender value in most circumstances. In recent years, however, a market has developed for the sale of life insurance policies to viatical and life settlement companies at amounts much greater than the cash surrender value. Will the IRS now take the position that the fair market value of an insurance policy is what it can be sold for in the aftermarket? And what about the beneficiaries of ILIT 1, who will no longer receive the death benefit of the life insurance policy and will instead only receive cash or a note equal to the interpolated terminal reserve value of the policy? Might they bring a law suit claiming that the ILIT trustee breached his fiduciary duty for selling the policy for less than its fair market value? Not a problem where the beneficiaries under ILIT 1 and ILIT 2 are the same, but this could pose a danger of they are different.
Our law firm routinely advises its clients on many estate planning techniques, including the use of life insurance and irrevocable life insurance trusts in advanced estate planning. If you have any clients who are in need of an irrevocable life insurance trust or other advanced estate planning strategy – or if you have a client who would like to modify their existing irrevocable life insurance trust, contacts us to schedule a free consultation with one of our estate planning attorneys.