Estate planning with life insurance often involves the transfer of life insurance policies among related parties. In many instances, taxpayers transfer the ownership of existing policies to trusts to prevent the policy proceeds from being included in the gross estate of the insured. When transferring these policies either by purchase or by gift, however, there are many income, gift and estate tax rules that must be satisfied to prevent unintended tax consequences associated with these transfers. Private Letter Ruling (PLR) 2012-35-006 (2/27/12) illustrates a successful navigation of these rules.
In the letter ruling, the taxpayer's parents created an irrevocable, nongrantor trust (Trust A) for the primary benefit of the taxpayer. During the taxpayer's life, the trustee has the discretion to make distributions to the taxpayer and her descendants for their health, education, maintenance and support (HEMS). Trust A will terminate when the taxpayer dies, and the remaining assets are to be distributed to the taxpayer's descendants. The taxpayer created an irrevocable, grantor trust (Trust B) for the benefit of her descendants. During the taxpayer's life, the trustees have the discretion to make distributions to the taxpayer's descendants for their HEMS, and trustees with no interest in the trust have absolute discretion to make distributions from the trust to the taxpayer's descendants. Trust B will terminate when the taxpayer dies, and the remaining assets are to be distributed to the taxpayer's descendants. Regarding additions to Trust B, the trust agreement gave the beneficiaries of the trust the power to withdraw such additions up to the gift tax annual exclusion.
Trust A owns a life insurance policy on the life of the taxpayer. The letter ruling states that Trust A intends to sell its interest in the policy to Trust B for an amount equal to the policy's interpolated terminal reserve value (as described in Reg. Sec. 25.2512-6(a)) on the date of transfer. The taxpayer will fund Trust B with an amount necessary to purchase the policy from Trust B.
The taxpayer first asked the IRS to rule that Trust B is a grantor trust as to the taxpayer and that no part of Trust B is a grantor trust as to the taxpayer's daughter (who is a beneficiary and a trustee of Trust B). The IRS ruled that Trust B's agreement authorized the taxpayer to reacquire trust property by substituting other property of an equivalent value in a nonfiduciary power (a substitution power) — a power that would treat Trust B as grantor trust as to the taxpayer under Sec. 675(4)(C). Consistent with IRS rulings in this area, the IRS declined to rule on whether the power held by the taxpayer was exercised in a nonfiduciary capacity, because such a determination was a question of fact to be determined later. Regarding the withdrawal right held by the taxpayer's daughter, the IRS ruled that under Sec. 678(a), such rights held by the beneficiaries would result in the beneficiaries' treatment as owners of the portions of Trust B subject to their respective withdrawal powers, unless as provided in Sec. 678(b), the grantor is treated as the owner. Noting that if Trust B is a grantor trust under Sec. 675(4) regarding the taxpayer, it is a grantor trust in its entirety regarding the taxpayer notwithstanding the withdrawal rights held by the beneficiaries that would otherwise make them owners under Sec. 678(a).
Second, the taxpayer asked the IRS to rule that the sale of the life insurance policy by Trust A to Trust B would not trigger the "transfer for value" rule in Sec. 101(a)(2), and thus the life insurance proceeds would not be taxable when the taxpayer died. The IRS noted that an exception to the transfer-for-value rule is provided in Sec. 101(a)(2)(B) when the life insurance policy is transferred to the insured, to a partner of the insured, to a partnership in which the insured is a partner or to a corporation in which the insured is a shareholder or an officer. Noting that the taxpayer was the grantor of the Trust B (and thus treated as owned by the taxpayer), the IRS ruled that the transfer of the life insurance policy to Trust B did not trigger the transfer for value, because of the exception in Sec. 101(a)(2)(B).
Third, the taxpayer asked the IRS to rule that the taxpayer's substitution power would not be considered an incidence of ownership under Sec. 2042(2) in the life insurance policy, which would require it to be includable in the taxpayer's estate for estate tax purposes. The IRS noted that in recently released Rev. Rul. 2011-28, 2001-48 C.B. 830, it had ruled that a substitution power under Sec. 675(4)(C) would not be an incidence of ownership under Sec. 2042(2) as long as the substituted property and the trust property were of an equivalent value and under local law the trustee had a fiduciary duty to ensure that the properties were of equivalent value. Noting that facts before it satisfied such requirements, the IRS ruled that the taxpayer's substitution power would not cause inclusion of the life insurance policy in the taxpayer's estate.
Finally, the taxpayer asked the IRS to rule that Trust B would not be includable in the taxpayer's estate under sections 2033 (inclusion in estate of all interests in property), 2036 (inclusion in estate of transfers with a retained life estate) and 2038 (inclusion in estate of revocable transfers) — the focus being on the taxpayer's substitution power. The IRS noted that in Rev. Rul. 2008-22, 2008-16 C.B. 796, it had ruled that a power to substitute would not cause estate tax inclusion under sections 2033, 3036 and 2038 based on the same requirements in Rev. Rul. 2011-28. Having noted that such requirements exist, the IRS ruled that the taxpayer's substitution power would not cause Trust B to be includable in the taxpayer's estate.
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