Power to substitute insurance policy in trust
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
Intentionally defective grantor trusts are one of the most effective wealth transfer planning techniques available to high net worth individuals.
Since the income in a grantor trust is taxable to the grantor, the trust is essentially compounding tax free. In other words, the grantor's payment of the trust's income taxes is a tax-free gift to the beneficiaries of the trust.
As a result of Rev. Rul. 2004-64, one of the most popular grantor trust triggers is IRC Section 675(4) – the power of substitution. That code section creates a grantor trust if the grantor has the power in a non-fiduciary capacity, without the approval or consent of any person in a fiduciary capacity, to reacquire trust corpus by substituting other property of an equivalent value.
However, if the trust is an irrevocable life insurance trust or an IDGT that owns a life insurance policy, the use of a power of substitution has raised the issue whether the insurance proceeds will be subject to estate taxes because the power of substitution constitutes an incident of ownership at death under IRC Section 2042.
The Internal Revenue Service, in Rev. Rul. 2011-28, has ruled that the retention by the grantor of a trust owning a life insurance policy on the grantor's life, in a non-fiduciary capacity, of a power of substitution over trust assets will not be viewed as the retention of an incident of ownership in the policy under IRC Section 2042 – provided (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.
That said, the question becomes "what is the value of a life insurance policy?"
There is no simple answer to this question, since there are a number of factors that impact the value of a life insurance policy. The starting point would be the policy's interpolated terminal reserve value that can be obtained from the carrier on IRS Form 712. However, for an insured who is in poor health, you may have to look to the life settlement market to determine the policy's fair market value.
Many life insurance trusts do not earn income, so grantor trust status may not be that useful. However, many IDGTs use trust income to pay premiums on life insurance policies. For example, in connection with an installment sale to an IDGT, the trust income (in excess of the interest payment to the grantor) could be used to pay premiums on a life insurance policy insuring the grantor's life. Such planning was given a boost by Rev. Rul. 2008-22.