On Dec. 1, 2011, the Internal Revenue Service issued Revenue Ruling 2011-28,1 which finally clarified that a life insurance policy in an irrevocable trust isn't included in the grantor's estate if the grantor retains the right to substitute the policy with assets of equivalent value.

Background

Grantor trusts are popular and useful estate-planning devices. Practitioners use techniques such as grantor retained annuity trusts and sales to intentionally defective grantor trusts. Most irrevocable life insurance trusts (ILITs) are also grantor trusts, because trust income can be used to pay premiums. However, many practitioners are wary of allowing a substitution of assets when there's life insurance involved, because they fear that the proceeds of the life insurance might be included in the grantor's estate under Internal Revenue Code Section 2042. To avoid this result, some practitioners include a clause in the trust instrument stipulating that the grantor can't substitute assets of equivalent value for a life insurance policy in the trust.

Until the court's ruling in Estate of Jordahl v. Commissioner,2 there were no positive developments allowing a grantor to substitute for a life insurance policy without the proceeds being includible in his estate.3 While the case covered other issues, the IRS argued that the ability to substitute policies of equal value allowed the decedent to reacquire full ownership of the policies in the trust and, therefore, should be included in the estate under IRC Section 2042. The court decided otherwise.

After Jordahl, the IRS issued Rev. Rul. 2008-22.4 That ruling involved a grantor who retained the right, exercisable in a non-fiduciary capacity, to substitute any trust property with other property of equivalent value. The trustee had a fiduciary obligation, either under local law or the trust instrument. The ruling concluded that the grantor's power to substitute assets of equivalent value wouldn't, by itself, cause estate tax inclusion under IRC Sections 2036 or 2038. It also provided that the grantor can't exercise the power in a manner that would cause shifting of benefits among the beneficiaries. However, the ruling didn't reference IRC Section 2042, so practitioners were still leery.

IRC Section 2042

Section 2042(2) states:

In determining the value of the possibility that the policy or proceeds thereof may be subject to a power of disposition by the decedent, such possibility shall be valued as if it were a possibility that such policy or proceeds may return to the decedent or his estate.

Treasury Regulations Section 20.2042-1(b) delineates the circumstances in which a policy would be included:

  • If the beneficiary must use the proceeds to pay taxes, debts or other obligations of the estate.
  • If the policy is used as collateral security for a loan or other accommodation.

Under Treas. Regs. Section 20.2042-1(c)(2), these include the powers to:

  • Change the beneficiary;
  • Surrender or cancel the policy;
  • Assign the policy;
  • Revoke an assignment; and
  • Pledge the policy for a loan.

Subsection (c)(4) says that if the decedent, either alone or in conjunction with another person or persons, has the power to change the beneficial ownership in the policy, its proceeds or the time or manner of enjoyment thereof, the policy would be includible in the estate.

Rev. Rul. 2011-28

Rev. Rul. 2011-28 specifically addresses whether a grantor's power to change the beneficial ownership in the policy or the proceeds creates inclusion in the estate under IRC Section 2042. The ruling offers a set of facts. D establishes and funds a trust with cash. The trust purchases a life insurance policy on D's life. The trust specifically prohibits D from being a trustee of the trust. Further, the trust pays yearly premiums from annual gifts to the trust made by D. D can't revoke, amend or terminate the trust. However, D has the power to acquire any property in the trust by substituting property of equivalent value, exercisable in a nonfiduciary capacity. The trustee has the fiduciary obligation to ensure that any property D offers in substitution of property in the trust is equivalent in value. D must certify in writing that the property being used to substitute is of equivalent value.

In the ruling, the IRS looks at IRC Section 2042(2), Treas. Regs. Section 20.2042-1(c)(2), (4), Jordahl and Rev. Rul. 2008-22. The IRS also discusses Rev. Rul. 84-179,5 in which an insured-decedent transferred ownership of a policy to his wife. She predeceased him and, when she died, the policy went into a trust of which the insured-decedent was a trustee. The insured-decedent couldn't exercise any powers for his own benefit. The ruling states that, for purposes of IRC Section 2042(2), the insured-decedent wouldn't have an incident of ownership if he couldn't have exercised the power for his own benefit. However, if the insured-decedent reacquired the policy in an independent capacity, it would be includible in his estate.

Rev. Rul. 2011-28 holds that D has no incidents of ownership, since he couldn't be a trustee of the trust, and the power to substitute is held in a nonfiduciary capacity. While D can transfer assets in exchange for the life insurance policy, they must be of equivalent value. D, according to the ruling, “… cannot exercise the power to substitute assets in a manner that will reduce the value of the trust corpus or increased D's net worth.” Finally, because the trustee has a fiduciary responsibility to the beneficiaries of the trust and must ensure that the assets substituted are of equivalent value, under these facts, there wouldn't be any incidents of ownership under Section 2042 and, therefore, the power itself or the proper exercise of the power won't cause estate tax inclusion.

Determining Proper Value

While there are many rules and regulations for valuing life insurance policies,6 the most appropriate would be the “willing buyer-willing seller” method of valuing the policy and the assets being substituted for the policy. Practitioners can do this by getting an appraisal from a qualified appraisal company that does such valuations.

Roadmap Provided

Rev. Rul. 2011-28 provides a roadmap to safely allow a grantor-insured to substitute assets of equivalent value for life insurance owned by a trust without running afoul of IRC Section 2042. Since the power to substitute is often considered in creating a grantor trust, knowing that this can be done for a trust that owns life insurance should give comfort to practitioners and provide an important tool for estate planning. Since many grantor trusts may ultimately, if not initially, own life insurance, it makes sense to draft the trust to satisfy this revenue ruling. Unless grantor trust status is specifically unwanted, any ILITs being set up today should include such a provision to increase flexibility.

Endnotes

  1. Revenue Ruling 2011-28, 2011-49 IRB 830 (Dec. 1, 2011).
  2. Estate of Jordahl v. Commissioner, 65 T.C. 92 (1975), acq. in result, 1977-2 C.B. 1.
  3. See Estate of Fruehauf v. Comm'r, 427 F.2d 80 (6th Cir. 1970) and Estate of Skifter v. Comm'r, 468 F.2d 699 (2d Cir. 1972).
  4. Rev. Rul. 2008-22, 2008-16 I.R.B. 796.
  5. Rev. Rul. 84-179, 1984-2 C.B. 195.
  6. See Richard L. Harris, “Transferring a Life Insurance Policy by Gift or Sale,” Trusts & Estates (April 2011) at p. 37, for a complete discussion of the methods and issues.

Richard L. Harris is the managing member of Richard L. Harris LLC in Clifton, N.J.