"Switching" ILITs

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.


Irrevocable life insurance trusts (ILITs) are commonly used to keep insurance proceeds outside the estates of the grantor-insured, the grantor's spouse, and the grantor's descendants (if a generation-skipping trust is used). As the name indicates, an ILIT is irrevocable and its terms cannot be amended after it is created. The irrevocability of an ILIT can create problems for grantors and their attorneys alike. For example, perhaps the ILIT is not a generation-skipping trust and the grantor now wishes to leverage his/her GST exemption with the policy or policies owned by the trust. Or maybe the grantor no longer wishes to provide for one or more of the beneficiaries of the ILIT, or desires to change the dispositive terms of the trust. So what can the grantor of an ILIT do if he/she is no longer happy with the terms of an ILIT?

The grantor can always stop making gifts to the ILIT, let the existing policy lapse, and start over with a new ILIT and a new policy. But, retaining the current policy may be preferable for health or economic reasons. The ILIT can sell the policy back to the grantor-insured, who then assigns it to a new ILIT, but that will start the running of a new three-year rule (under IRC Section 2035(a)). Finally, if the ILIT permits, the policy can be distributed to one or more of the beneficiaries. However, without a trust, the policy beneficiaries will not be protected from creditors, ex-spouses, or estate taxes.

Transfer-for-Value Rule

IRC Section 101(a)(1) generally excludes life insurance proceeds from gross income. IRC Section 101(a)(2) limits the exclusion to the consideration paid by the purchaser for the policy (plus subsequent premiums) where there has been a transfer for valuable consideration. But, there are several exceptions to this limitation, including a transfer to the insured.

Rev. Rul. 2007-13

Rev. Rul. 2007-13 considered two situations. In the first, a new grantor trust purchased a life insurance policy on the grantor's life from an old grantor trust. Citing Rev. Rul. 85-13, which provides that transactions between a grantor and his/her grantor trust are disregarded for income tax purposes, the IRS ruled that the transfer between the two grantor trusts was not a transfer for valuable consideration under IRC Section 101(a)(2) because the entire transaction is disregarded. In other words, there was no transfer of the insurance policy within the meaning of IRC Section 101(a)(2). As such, the death proceeds remain income tax free.

In the second situation, a new grantor trust purchased a policy from an old non-grantor trust. The IRS ruled that there was a transfer for valuable consideration under those facts, but the transfer was exempt because the transfer to the new ILIT is treated as a transfer to the grantor, who is the insured. Thus, as in the first situation, the insurance proceeds remain income tax free. But, unlike the first situation, the old ILIT will have reportable income on the sale if there was any gain in the policy at the time of sale.

Precautions

Accordingly, based on Rev. Rul. 2007-13, it is possible for the grantor of an existing ILIT to create a new ILIT (with the desired beneficiaries and provisions), and then gift or loan the new ILIT sufficient cash to purchase the policy from the old ILIT. But, before doing so, there are a number of issues to be resolved, including the following:
    1. The old ILIT must permit the trustee to sell the policy, and the sale proceeds still remain in the old ILIT to be administered.

    2. If the old ILIT is a non-grantor trust, any gain in the policy sold will be subject to income taxes.

    3. The grantor has to expend monies (whether by gift and/or loan) to fund the new ILIT, and has to deal with the attendant gift and GST tax consequences if gifts are used.

    4. The trustee must act independently of the grantor. Too much involvement in the transaction by the grantor could result in the trustee's incidents of ownership over the policy being imputed to the grantor, possibly resulting in the insurance proceeds being taxable in the grantor's estate under IRC Section 2042.

    5. To avoid the three-year rule, the policy must be sold for full and adequate consideration. Generally, the value of a policy is its interpolated terminal reserve value, plus the unearned premium. Treas. Reg. Sec. 25.2512-6(a), Example 4. But, it might not be safe to ignore the higher price the policy might garner in the life settlement market.

    6. The trustee of the old ILIT must consider his/her fiduciary duties to the beneficiaries of the old ILIT, particularly if the policy is not sold for its highest price and/or the sale results in some beneficiaries being left out of the new ILIT. In any event, prior to implementing the Rev. Rul. 2007-13 technique, the grantor should notify the trustee of the old ILIT that the grantor intends to make no further gifts to the old ILIT. Thereby, the trustee of the old ILIT may be justified in selling the policy to avoid the policy lapsing.

    7. Care must be taken to assure that the new ILIT is a grantor trust for income tax purposes, but not included in the grantor's estate for estate tax purposes. For the ILIT to be deemed "wholly owned by the grantor" for income tax purposes, intentional violations of the grantor trust rules of IRC Sections 671-678 must occur.

    8. The use of Crummey powers in a grantor trust raises the question of whether the beneficiaries become co-owners of the ILIT when they allow their withdrawal powers to lapse. IRC Section 678(a). If so, the new ILIT will not be deemed to be "wholly owned" by the grantor for income tax purposes and the exception to the transfer-for-value rule will be put in jeopardy. In PLRs 200729005 through 200729016, the IRS ruled that a grantor trust is wholly owned by the grantor, despite the existence of the withdrawal powers held by the Crummey beneficiaries. But, since PLRs cannot be relied upon as precedent, it might be advisable to not use Crummey powers in the new ILIT.

    9. Consideration should be given to having the beneficiaries waive any claims they may have against the grantor and the trustee resulting from the sale of the policy. But, disinherited beneficiaries may have little reason to cooperate.

    10. To avoid a step-transaction argument from the IRS, some time should elapse between funding the new ILIT and purchasing the policy from the old ILIT. Otherwise, the IRS might argue that the transaction is essentially an indirect gift of the policy to the new ILIT, triggering a new three-year rule under IRC Section 2035(a).
Left unanswered by Rev. Rul. 2007-13 are the tax consequences when a joint ILIT is either the seller and/or purchaser of a survivorship policy. In that situation, there are two grantors (husband and wife) and, therefore, the joint trust is not wholly owned by a single grantor. But, Rev. Rul. 2007-13 does provide guidance and authority for "switching" ILITs that are wholly-owned by a single grantor. However, a number of tax and non-tax issues must be carefully examined before implementing this technique. Grantors and trustees should proceed with caution, and should consider with their advisors all of the potential risks and liabilities in this area.

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