By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
PLR 201235006 illustrates how to sell a trust-held life insurance policy to a new trust with different terms without triggering adverse estate or income tax consequences.
Facts: Grantors established Trust A, an irrevocable life insurance trust for the primary benefit of Taxpayer (who appears to have been the insured). During Taxpayer's lifetime, the trustee, who was Taxpayer's brother, could distribute the trust assets to Taxpayer and Taxpayer's descendants for their health, education, maintenance and support (HEMS). Upon the death of Taxpayer, Trust A will terminate and its assets will be distributed, presumably outright, to Taxpayer's descendants. There was no representation in the ruling that Trust A was a "grantor" trust with respect to any individual.
Taxpayer (not the original grantors of Trust A) established Trust B, an irrevocable life insurance trust, for the benefit of Taxpayer's descendants, including one daughter and one granddaughter. Daughter is the named trustee of Trust B. Taxpayer is prohibited from serving as a trustee. The most relevant terms of Trust B - which were considerably different from those of Trust A - may be briefly summarized as follows:
Trust A intends to sell its interest in the life insurance policy on the life of Taxpayer to Trust B for an amount equal to the value of Trust A's interest in the policy as determined under applicable Treasury regulations,2 that is the interpolated terminal insurance reserve value for the policy as of the date of sale and use that amount, plus the proportionate amount of premium last paid before the sale that covers the premium extending beyond the date of sale as the purchase price. Taxpayer will fund Trust B with a gift of the amount necessary to purchase the policy.
1. Trust B will be treated as a grantor trust with respect to Taxpayer as a result of the application of either/both §674 (Power to Control Beneficial Enjoyment)and/or §675 (Powers of Administration).
The IRS observed that Taxpayer's "power of substitution" would make Trust B a grantor trust under §675(4) only if the power is exercisable in a "nonfiduciary capacity." If a power that is not exercisable by a person acting as a trustee, the determination of whether the power is exercisable in a fiduciary or a nonfiduciary capacity depends on "all the terms of the trust and the circumstances surrounding its creation and administration."3 Because this is a factual determination that cannot be made in advance, the IRS ruled only that "[p]rovided that the circumstances indicate that the grantor holds a power of administration exercisable in a nonfiduciary capacity, the grantor will be treated as the owner of Trust B under §675(4)."
The IRS did not rule on the grantor trust status of Trust B under §674, perhaps because that section requires that the grantor or a non-adverse party (which would not include Taxpayer's daughter, the trustee of Trust B) be able to control beneficial enjoyment, except in certain tightly defined circumstances.
2. Taxpayer's daughter and granddaughter will not be treated as grantors of Trust B during the life of Taxpayer as a result of any withdrawal right they may have with respect to contributions made to Trust B.
Section 678(a) provides that a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which (1) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or (2) the person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would cause a grantor to be treated as the owner of such portion of the trust within the principles of §§671 through 677 (the "grantor trust provisions").
Section 678(b) provides, however, that §678(a) shall not apply with respect to a power over income, as originally granted or thereafter modified, if the grantor of the trust is otherwise treated as the owner under the grantor trust provisions, other than §678.
Under §678(a), the withdrawal rights granted to the beneficiaries of Trust B result in the treatment of the beneficiaries as owners of the portions of Trust B subject to their respective withdrawal powers, unless the grantor is treated as the owner. The IRS reasoned that, if it is (eventually) determined that Trust B is a grantor trust with respect to Taxpayer, then it is a grantor trust in its entirety with respect to Taxpayer, notwithstanding the withdrawal rights held by the beneficiaries that would otherwise make them owners under §678(a).
3. & 4. The proposed sale to Trust B of the policy is either not a transfer for valuable consideration under §101(a)(2) or, in the alternative, will satisfy the requirements of §101(a)(2)(B) (exception for a transfer to the insured), and therefore, will not subject the policy proceeds that Trust B will receive to income taxation.
Gross income generally does not include amounts received under a life insurance contract if such amounts are paid by reason of the death of the insured.4 If the insurance contract is sold for a valuable consideration, however, §101(a)(2) provides that the insurance proceeds will be subject to income tax to the extent that the proceeds exceed the consideration paid (and premiums paid subsequent to the sale). An exception to the general rule of §101(a)(2) is provided in §101(a)(2)(B) when the contract 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 officer. In these cases, the general rule of §101(a)(2) will not affect exclusion.
In discussing the application of these rules to the situation in PLR 201235006, the IRS referenced Rev. Rul. 2007-13,5 addresses two different factual situations in which a life insurance contract is transferred between trusts. Situation 1 describes a sale of a life insurance contract between two grantor trusts established by the same grantor. The ruling holds that, in Situation 1, the grantor is treated for federal income tax purposes as the owner of the contract for applying the transfer for value limitations. Therefore, the transfer of the life insurance contract between the two grantor trusts that are treated as owned by the same grantor is not a transfer for valuable consideration under §101(a)(2).
Situation 2 describes a transfer for value of a life insurance contract from a non-grantor trust to a grantor trust. Grantor was the insured under the life insurance policy subject to the transfer. Accordingly, although the transfer of the life insurance contract was made for valuable consideration within the meaning of §101(a)(2), the transfer for value limitations nevertheless do not apply because the transfer to a grantor trust that is treated as wholly owned by the insured is a transfer to the insured, and therefore is excepted from the transfer for value limitations.
In PLR 201235006, Situation 1 does not apply because Trust A and Trust B had different grantors. However, Situation 2 is apposite because the transfer of the policy will be a transfer to the insured, who is treated as the owner of Trust B for income tax purposes.
In addition, the IRS ruled that the death of Taxpayer will not be considered as a transfer that could result in a transfer for valuable consideration, and therefore that the proceeds of the life insurance contract (which will be receivable by reason of the death of the insured) will not be included in the gross income of Trust B even if the life insurance contract is subject to debt or policy loans at the death of Taxpayer.
5. The power to reacquire the corpus of Trust B by substituting other property of an equivalent value will not result in Taxpayer possessing incidents of ownership under §2042(2) in the policy.
Section 2042(2) provides that the value of the decedent's gross estate includes the proceeds of all life insurance policies on the decedent's life receivable by beneficiaries other than the decedent's executor to the extent that the decedent possessed at death any "incidents of ownership," exercisable either alone or in conjunction with any other person. The term "incidents of ownership" is broadly defined to reference all rights of the insured or the insured's estate to the economic benefits of the policy, including the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy.6
For a number of years, it was unclear whether a grantor's retained right to substitute assets, exercisable in a nonfiduciary capacity, would be regarded as an "incident of ownership" in a life insurance policy held in trust. However, Rev. Rul. 2011-28,7 held that this power, if truly exercisable in a nonfiduciary capacity, without the approval or consent of anyone serving in a fiduciary capacity, will not cause estate tax inclusion under §2042. To demonstrate that the power is held in a nonfiduciary capacity the grantor in Rev. Rul. 2011-28 was required by the terms of the trust indenture to certify in writing that the substituted property and the trust property for which it was substituted are of equivalent value. Local law imposed a similar obligation on the trustee to insure that the property is of equivalent value. Moreover, if a trust has two or more beneficiaries, local law required the trustee to act impartially in investing and managing the trust assets, taking into account any differing interests of the beneficiaries. Finally, under local law and without restriction in the trust instrument, the trustee had the discretionary power to acquire, invest, reinvest, exchange, sell, convey, control, divide, partition, and manage the trust property in accordance with the standards provided by law.8
The IRS therefore concluded, based on similar representations made in PLR 201235006, that Taxpayer's power to reacquire the corpus of Trust B by substituting other property of an equivalent value will not result in Taxpayer possessing incidents of ownership in the policy under §2042(2).
6. In a sixth and final ruling, the IRS also ruled, based on the same considerations underlying its ruling #5, that no portion of the principal of Trust B will be included in Taxpayer's gross estate under §§2033 (Property in Which the Decedent Had an Interest), 2036 (Transfers With Retained Life Estate), and 2038 (Revocable Transfers) at the death of Taxpayer.9
While PLR 201235006 does not address the gift or generation-skipping transfer tax implications of the sale of the policy by Trust A to Trust B, it provides a good roadmap for avoiding any adverse income or estate tax implications of such transfers on facts similar to those posited in the PLR.
This commentary also will appear in the January 2013 issue of the Tax Management Estates, Gifts and Trusts Journal. For more information, in the Tax Management Portfolios, see Danforth and Zaritsky, 819 T.M., Grantor Trusts: Income Taxation Under Subpart E, and in Tax Practice Series, see ¶6120, Estate and Trust Income Taxation - General Rules.
1 2008-1 C.B. 796.
2 Regs. §25.2512-6(a).
3 Regs. §1.675-1(b)(4)(iii).
5 2007-11 C.B. 684.
6 Regs. §20.2042-1(c)(2).
7 2011-48 C.B. 830.
8 See also Rev. Rul. 2008-22, 2008-16 C.B. 796.
9 See Rev. Rul. 2008-22.