To prevent any adverse tax consequences under the transfer for value rule of IRC Section 101 and to be sure that any miscellaneous trust income is taxed to the grantor of an ILIT rather than to the trust at it’s significantly compressed tax rates, it is often best to design a trust holding life insurance (often called “irrevocable life insurance trusts” or ILITs) as “grantor” trusts. This means that the income tax obligation always falls on the creator, or grantor, of the trust while living rather than on the trust itself. If structured correctly, the income tax attributes remain with the grantor but the trust assets (e.g. life insurance proceeds) will not be subject to estate tax on the grantor’s death. This bifurcated treatment is often referred to as a “defective” trust, meaning that it “works” for estate tax planning, but doesn’t “work” to transfer the income tax burden (defective is a misnomer, however, because keeping the income tax obligation with the grantor can be an extremely powerful estate and GST tax planning tool).
To make an ILIT defective, the trust must be designed around the “grantor trust” sections of the Internal Revenue Code (Sections 671-677) with careful attention so as not to also cause the trust assets to otherwise be included for estate tax under the estate tax provisions of the IRC. One popular method to do this is to allow the grantor to have a power to substitute, or swap, assets of the trust with assets of equivalent value. A conflict arises however, under IRC Section 2042 dealing with inclusion of life insurance proceeds for estate tax. Section 2042(2) includes any life insurance proceeds for estate tax if the decedent possessed at his or her death any “incidents of ownership” in the policies,(my emphasis). Corresponding Estate Tax Regulations provide that the meaning of the term “incidents of ownership” is not confined to ownership of the policy in the technical legal sense. Generally speaking, the term “incident of ownership” refers to the right of the insured or the insured’s estate to the economic benefits of the policy.
The question, then, is whether or not retaining a power to substitute assets of equivalent value is also retaining an “incidents of ownership” that would cause the trust assets to be included for estate tax and destroying one of the primary purposes of an ILIT.
Both the Estate of Jordahl and Rev. Rul. 2008-22 gave planners some guidance and comfort to design grantor trusts holding life insurance with substitution powers but just released Rev. Rul. 2011-28 enhance that comfort level and provides further guidance for designing effective trusts.
Both the Estate of Jordahl and Rev. Rul. 2008-22 gave planners some guidance and comfort to design grantor trusts holding life insurance with substitution powers but just released Rev. Rul. 2011-28 enhance that comfort level and provides further guidance for designing effective trusts. Rev. Rul. 2011-28 is not a blanket endorsement of this technique, however. Instead, it lays out some very precise rules that must be followed in order for the trust to be successful and these rules require some careful drafting to be sure that the IRS endorsed strategy will be successful.