The Revocable, Irrevocable Life Insurance Trust

Life insurance trusts are among the most commonly used estate planning tools. If used correctly, they enable large sums of money to pass to lower generations without the imposition of estate tax and, in many circumstances, without any gift tax. The largest drawback to their efficacy has always been that if they are to accomplish the desired goals, they must be irrevocable. However, life insurance trusts set up at the beginning of a marriage or created when children were very young, may no longer meet the insureds planning objectives, but cannot be amended to reflect current testamentary intentions, because they are irrevocable.

Although taxpayers cannot amend an irrevocable trust, the Service has recently sanctioned a different form of relief, in Letter Ruling 200247006. Using the concept of the defective grantor trust, taxpayers can now possibly create a new trust, which reflects the insureds current intentions and purchases the policy from the old trust.

The Facts

Two trusts were grantor trusts for income tax purposes as to H (H1 trust and H2 trust), and two trusts were grantor trusts as to both H and W (HW1 trust and HW2 trust). In the ruling, the H1 trustees and the HW1 trustees would sell the life insurance policies held in each trust to the H2 trustees and HW2 trustees, respectively. The ruling merely stated that each of the trusts were grantor trusts for income tax purposes as to all the assets of the trusts to either H or to H and W; it did not state a basis for the grantor-trust status. The Service ruled that because the trusts were grantor trusts and were to be ignored for Federal income tax purposes, the proposed life-insurance policy transfers, even though for valuable consideration, were disregarded for Federal income tax purposes; the trusts will receive the insurance proceeds income tax free on the death of the respective insureds.

Discussion

As stated above, the ruling has raised some very important questions that need to be addressed before relying on this type of sale and purchase. Confirmation of grantor-trust status as to both trusts is crucial; without this classification, the transfer of the policies will be a transfer for value. One of the exceptions to the transfer-for-value rule is a transfer to the insured. Because the trusts in the ruling qualified as grantor trusts, the Service was ruling that the transfer amounted to a transfer to the insured. Second, to avoid any further gift tax, a proper value for the sales price of the insurance policy must be established.

Sec. 677(a)(3) provides that a trust whose income may be applied to the payment of insurance premiums on the life of the grantor or the grantors spouse is a grantor trust. Case law has stated that merely providing that income may be applied to the payment of insurance premiums is insufficient to create a grantor trust; there must actually be payments of insurance premiums. Sec. 677(a)(3) would probably cause the original trust to be considered a grantor trust, but because the second (new) trust has not paid any insurance premiums, it cannot rely on this section for grantor-trust status. Extra care must be exercised in choosing a defective power for this new trust. The trust must be a grantor trust as to both income and principal, and the power should probably not be one that gives the grantor the right to substitute property of equivalent value. In the case of an insurance policy, the right of substitution may be viewed as an impermissible retention of rights under the policy for Sec. 2036 purposes.

Establishing the insurance policys value should not prove a daunting task. The insurance company should be able to provide a current value of the worth of any policy.

The only gift in the transaction is the transfer of funds to the new trust to purchase the policy from the old trust. This gift can be quite substantial, depending on the insurance policys value. Practitioners may want to consider the possibility of funding the purchase price through a loan rather than a gift, but funds will still be needed to pay off the purchase of the policy, so future gifts may still be needed above and beyond the annual premiums. Additionally, interest will have to be charged on any loan; interest costs may eliminate or reduce some of the benefit. An alternative would be the use of a note between the two trusts, but this might have the added complication of creating a split-dollar arrangement. Using a sale or a note rather than a distribution and recontribution of the policy to another trust has the additional benefit of avoiding the three-year rule, which would otherwise include the insurance proceeds in the estate of an insured who died within three years of the transfer of an insurance policy.

Conclusion

With proper planning and research prior to implementing a new trust, it may now be possible to revoke an irrevocable insurance trust without adverse income or gift tax effects. Because funds still remain with the original trust, not all value has been transferred to the new one. The insured has managed to freeze the value of the original trust and transfer the excess over the fair market value at the time of the transfer to the new trust according to a different donative scheme.

From Randi A. Schuster, J.D., LL.M, New York, NY