By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
The IRS, in Rev. Rul. 2011-28,1 has ruled that the retention, in a nonfiduciary capacity, by the grantor of a life insurance trust of a §675(4)(C) "power of substitution" over trust assets will not be viewed as the retention of an "incident of ownership" in the policy under §2042. The ruling concludes that the retained substitution power will not cause inclusion of the proceeds of the policy in the grantor's gross estate under §2042 so long as (i) the grantor may not serve as trustee, (ii) the trustee has a fiduciary obligation to insure that the substituted assets are of equivalent value, and (iii) the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.
Section 2042(2) provides that the value of the gross estate includes the value of all property to the extent of the amount receivable as insurance under policies on the life of the decedent by beneficiaries (other than the executor), with respect to which the decedent possessed at decedent's date of death any of the incidents of ownership in the policies, exercisable either alone or in conjunction with any other person. Treasury regulations2 provide that the meaning of the term " incidents of ownership" is not confined to ownership of the policy in the technical legal sense, but refers to the right of the insured or the insured's estate to the economic benefits of the policy. Thus, the term includes without limitation 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.
In Estate of Jordahl v. Comr.,3 the Tax Court held that a power of substitution "was not a power to alter, amend or revoke the trust within the meaning of section 2038(a)(2)," and thus did not cause estate tax inclusion. In Jordahl, the court also determined that because the power of substitution was held in a fiduciary capacity, it could only be exercised in good faith and could not be used to deplete the trust or to shift property among the trust beneficiaries. Thus, the court also held that the power did not cause inclusion under §2042.
Rev. Rul. 2008-224 had previously set forth the specific conditions that must be present in order for a power to substitute assets that is held in a nonfiduciary capacity not to result in estate inclusion under either §2036 (regarding the retention by the grantor of an interest in the income or assets of a trust) or §2038 (regarding "revocable" transfers). Specifically, under that ruling, the grantor must (i) hold the power to substitute assets in a non-fiduciary capacity and be able to exercise the power without the approval or consent of any person acting in a fiduciary capacity; (ii) substitute assets of equivalent value; and (iii) not exercise the power in a manner that can shift benefits among the trust beneficiaries. Additionally, the trustee (but not the grantor) must have a fiduciary obligation, whether under local law or pursuant to the trust instrument, to ensure compliance with the terms of the substitution power by determining that the substituted property is indeed of equivalent value.
This ruling was considered to be of major importance to the estate planning community because many trusts achieve grantor trust status through the intentional granting of one or more administrative powers, which, if held by the grantor or any independent, nonadverse party, will cause the grantor to be taxed as the owner of the trust's assets for Federal income tax purposes.
However, because Rev. Rul. 2008-22 did not address the consequences of the grantor's retention of the power of substitution under §2042, some advisors have been wary of including such power in a life insurance trust, even though its inclusion may facilitate the sale of a policy to the grantor or to another grantor trust with more favorable provisions.5 Rev. Rul. 2011-28 should alleviate that concern, at least where the conditions of the ruling are met.
The facts of the 2011 ruling are similar to those of the 2008 ruling, although posited in the context of a life insurance trust, as follows:The grantor initially funded the trust with cash. Thereafter, the trust, which is an irrevocable trust for the benefit of the grantor's descendants, purchased a life insurance policy on the grantor's life. Trustee is the trustee of trust, and the terms of the trust prohibit the grantor from serving as trustee. The grantor makes gifts every year to the trust, and Trustee pays the premium on the insurance policy. The proceeds of the policy are payable to the trust upon the grantor's death.
The grantor cannot revoke, alter, amend, or terminate the trust. The governing instrument of the trust, however, provides the grantor with the power, exercisable at any time, to acquire any property held in trust by substituting other property of equivalent value. The trust instrument provides that the power is exercisable by the grantor in a nonfiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity. To exercise the power of substitution, the grantor must certify in writing that the substituted property and the trust property for which it is substituted are of equivalent value. In addition, under local law, the trustee has a fiduciary obligation to ensure that the property that the grantor seeks to substitute is equivalent in value to the property distributed to the grantor. Moreover, if a trust has two or more beneficiaries, local law requires 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 has 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.
The grantor has no incidents of ownership in the insurance policy unless his right of substitution is considered an incident of ownership. The grantor dies without having exercised the power to substitute with respect to the life insurance policy.
On these facts, the IRS ruled that the "grantor's retention of the power, exercisable in a nonfiduciary capacity, to acquire an insurance policy held in trust by substituting other assets of equivalent value will not, by itself, cause the value of the insurance policy to be includible in the grantor's gross estate under §2042, provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor's compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, and further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries. A substitution power cannot be exercised in a manner that can shift benefits if: (a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries; or (b) the nature of the trust's investments or the level of income produced by any or all of the trust's investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income."
Thus, Rev. Rul. 2011-28 gives a favorable answer to a long-standing question about the effect of a power of substitution in the context of a life insurance trust. The subject of Rev. Rul. 2011-28 has been included on the list of IRS "priority guidance" projects for many years.6 Its issuance should be a welcome relief to estate planners, some of whom may have been reluctant to rely on the inclusion of this power in a life insurance trust as a "grantor trust" power.7
Planners would be well advised, however, to follow the roadmap laid out in the ruling, including the requirement of a written certification as to value and review of that value by the trustee. While best faith efforts in this regard (including reliance on a statement from the issuing insurance company, where available) should suffice, the prudent course, in cases where it is difficult to establish the value of a policy, may be to obtain an appraisal.
Drafters also would be well advised to include in the trust indenture the power to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries. Administering the insurance trust as a unitrust would appear to be impractical, at least prior to the time that the policy matures (unless there are substantial other assets in the trust), although allowing for discretionary distributions of income and principal during that period may be possible.
For more information, in the Tax Management Portfolios, see Stoneman, 817 T.M., Gross Estate - Section 2033, and in Tax Practice Series, see ¶6240, Life Insurance.
1 2011-49 I.R.B. 830.
2 Regs. §20.2042-1(c)(2).
3 65 T.C. 92 (1975), acq. in result, 1977-1 C.B. 1.
4 2008-16 I.R.B. 796.
5 See, e.g., Rev. Rul. 2007-11, 2007-11 I.R.B. 684.
6 See, e.g., Office of Tax Policy and Internal Revenue Service 2011-2012 Priority Guidance Plan (9/2/11).
7 Note: A trust of which the income of the trust may be applied, without the consent or approval of an adverse party, to the payment of premiums on the life of the grantor or the grantor's spouse may be taxed as a grantor trust under §677(a)(3). However, the interpretation of this provision has been unclear, thus making reliance uncertain.
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