• Rulings regarding “incidents of ownership” of life insurance under Internal Revenue Code Section 2042—Two recent rulings analyzed whether a decedent had incidents of ownership over life insurance policies, which would cause inclusion of the policy death proceeds in his estate for estate tax purposes.
In the first, Private Letter Ruling 201327010 (July 5, 2013), the taxpayer’s spouse owned a policy on the taxpayer’s life, and when the spouse died, the policy was transferred to a family trust for the benefit of the taxpayer and the descendants of the taxpayer and the spouse. The taxpayer had a limited power of appointment (POA), was named as trustee and trust protector and could remove and replace trustees.
The family trust was severed into two trusts: one held the insurance policy and the other held all remaining assets. With respect to the trust that held the insurance policy on his life, the taxpayer relinquished his roles as trustee and trust protector and his POA over the trust that held the insurance policy, but retained his beneficial interest in the trust.
Under IRC Section 2042, insurance proceeds on the life of a decedent, to the extent received by all beneficiaries, are includible in a decedent’s estate if a decedent possessed “incidents of ownership” in the policy on his death. An incident of ownership is generally defined to mean some right to the economic benefits of the policy (for example, the right to change the beneficiary, surrender or cancel the policy, assign the policy, revoke the assignment or pledge the policy for a loan). Applying the Treasury regulations under Section 2042, the ruling held that the taxpayer no longer held any incidents of ownership in the policy after making the disclaimers. Therefore, as long as the taxpayer survived for three years (such that IRC Section 2035 wouldn’t apply to include the proceeds due to the taxpayer’s relinquishment within three years of death of his powers as trustee and trust protector and the POA), the policy proceeds wouldn’t be includible in the taxpayer’s estate.
In the second ruling, Chief Counsel Advice 201328030, the decedent maintained a life insurance policy for the benefit of his ex-spouse pursuant to a property settlement agreement that was incorporated into the state court’s judgment of divorce. The decedent paid all premiums and received the dividends, but couldn’t borrow against or pledge the policy (it’s not clear, but we assume he wasn’t the policy owner). The ruling held that the right to receive dividends isn’t an incident of ownership, because, according to prior case law, the purpose of the dividends is to, in effect, reduce premiums, but the right to receive them isn’t a right to the economic benefits of the policy.
• CCA 20133003 determines gift relating to self-cancelling installment notes—In a cryptic and vague CCA, the Internal Revenue Service showed its suspicion of self-cancelling installment notes (SCINs). In the ruling, the taxpayer funded grantor trusts with gifts of stock. Later, the taxpayer transferred additional stock to the trusts in exchange for promissory notes. Some of the promissory notes were SCINs, meaning that the notes, by their terms, were cancelled if the taxpayer died before the end of the term (and therefore nothing more was owed to the taxpayer’s estate, and no amount was includible in the estate). The term of such a note generally can’t exceed the taxpayer’s life expectancy. The SCINs only required annual interest payments with a balloon payment of principal at maturity. Some of these SCINS had a face amount that was almost double the value of the stock transferred in exchange for the SCIN. This risk premium was designed to compensate the taxpayer for the risk that he (and his estate) wouldn’t be fully repaid if he died before the end of the term. The other SCINs had higher interest rates instead of higher face amounts, as a different type of risk premium. Generally, the life expectancy and the risk premium of SCINs should be determined using term/life annuity factors under a mortality table, such as Table 2000CM. The ruling doesn’t describe how the taxpayer determined the risk premiums.
The taxpayer filed gift tax returns disclosing the SCIN transactions, but didn’t report them as taxable gifts. The gift tax return valued the SCINs “based upon the Section 7520 tables” and took the position that the SCINs were adequate consideration for the stock transferred. Shortly after the SCIN transactions, the taxpayer was diagnosed with a health condition, and he died less than six months after the diagnosis, having received no payments from the trusts. There was no information in the ruling regarding his health at the time of the SCIN transactions.
The ruling noted that the SCINs were interest-only with a balloon payment and that it wasn’t clear that the trusts had the ability to repay the notes that had a principal premium that made the debt nearly double the stock value. The IRS held that the value of the SCINs shouldn’t be determined under the IRC Section 7520 rate tables, explaining that:
[W]e do not believe that the Section 7520 tables apply to value the notes in this situation. By its terms, Section 7520 applies only to value an annuity, any interest for life or term of years, or any remainder.
The ruling doesn’t specifically explain how the SCINs should be valued, other than using the willing-buyer/willing-seller test, taking into consideration the taxpayer’s life expectancy and medical history. It concluded that the SCINs were worth less than their stated amounts, and the difference between the fair market value and the stated amount of each SCIN was a taxable gift.
Next, in assessing the estate tax consequences of the self-cancellation of the notes, the ruling concluded that the SCINs weren’t bona fide. The ruling: (1) distinguished the taxpayer’s situation from a case in which a 72-year-old taxpayer in average health sold stock and other property to a company in exchange for SCINs that called for equal payments of interest and presumably principal (the ruling isn’t clear); and (2) analogized the taxpayer’s situation to a case in which an 84-year-old taxpayer with medical conditions transferred property to his son in exchange for an interest-free SCIN, when the taxpayer had no expectation of being repaid, and the son had no expectation or ability to pay. The ruling noted that the taxpayer was in very poor health and died shortly after the SCINs were executed and then held that “in this case, we believe that there is no estate tax consequence associated with the cancellation of the notes with the self-cancelling feature upon the decedent’s death.”
The CCA shows a distrust of SCINs, particularly those that are interest-only. While it’s not clear what constitutes “poor health,” the CCA shows that the IRS is clearly leery of transactions in which a taxpayer dies shortly after executing SCINs.
• Massachusetts Supreme Judicial Court approves common law decanting—In Morse v. Kraft et al., 466 Mass. 92 (July 29, 2013), the Massachusetts Supreme Judicial Court approved common law trust decanting. Robert and Myra Kraft funded four trusts in 1982, one for the benefit of each of their four sons. By the terms of the trusts, the four sons were prohibited from serving as trustee, because, at the time the trusts were established, the sons were minors and Robert and Myra weren’t sure that their sons would possess the requisite skills and judgment to serve as trustees. Moreover, as the trust only allowed non-beneficiary trustees, it wasn’t possible to appoint the sons later as trustees under the trust instrument. The current trustee, who had been serving since the trusts were established, was now 82. He wished to transfer the property of each trust to a similar new trust for the benefit of each son and his descendants, which would allow the sons to serve as trustees.
The original 1982 trusts were grandfathered from the generation-skipping transfer (GST) tax. Under the Treasury regulations, modifications of a grandfathered trust may be considered a constructive addition that would cause the trust property to lose its GST tax-exempt status. However, there’s an exception under Treasury Regulations Section 26.2601-1(b)(4)(i)(A) for discretionary distributions to new trusts if:
the terms of the governing instrument of the exempt trust authorize distributions to the new trust or the retention of trust principal in a continuing trust, without the consent or approval of any beneficiary or court.
The new trust also can’t extend the rule against perpetuities applicable to the original trust property.
The trust instrument establishing the 1982 trusts authorized the trustee to distribute principal or income to a beneficiary and further noted that: (1) a payment of principal or income to a beneficiary also allowed the same to be applied for his benefit, and (2) the trustees had full power to take any steps and perform any act that they deem necessary or proper without order or license of court. The question, therefore, was whether the authority to make discretionary distributions to or for a beneficiary included the authority to make a distribution to another trust for the benefit of the beneficiary.
In the absence of any statute permitting decanting, the court held that the terms of the trust authorized the distribution to another trust without the consent or approval of any beneficiary or court, considering the terms of the trust and the donors’ intent, which was attested to by affidavit. The court didn’t go so far as to recognize an inherent power in trustees to decant irrevocable trusts, regardless of the trust language. So, for now, decanting is permitted in Massachusetts only if the language of the trust instrument specifically authorizes it or shows sufficient intent to authorize it.