Whether doomed from the start or a victim of changed circumstances, it's not unusual to find that a client's irrevocable life insurance trust (ILIT) doesn't work anymore.
Sometimes it makes sense to retain the insurance policy even when the trust itself is a problem. In these cases, you can often sell the policy to a new trust, an option that is sometimes overlooked. As long as you structure the sale to avoid negative estate, gift and income tax consequences, a sale can be a home run for the client and an indirect score for the insurance professional, who retains an attractive insurance policy while replacing the obsolete trust that holds it.
Terms of the sale
First and foremost, as with any transaction that could be scrutinized by the IRS as a disguised gift, the sale transaction terms must be commercially reasonable. This means they must be what you would reasonably expect to see in an arms-length transaction between unrelated parties.
You should first consider whether the selling trust and the purchasing trust should have separate counsel, which is standard in a typical arms-length purchase transaction. Next, consider how the new ILIT will pay for the policy. Will someone make a taxable gift to the new ILIT? Will it be funded with gifts that qualify for the donor's annual exclusion from gift taxes, i.e., so-called Crummey gifts? Will the new ILIT pay for the policy over time (and, if so, do you need to secure the debt with the insurance policy as collateral)? Should someone guarantee the purchase price?
Whatever terms are ultimately agreed upon, both the sale and financing terms (if applicable) should reflect what an unrelated seller, buyer and lender would agree to in an arms-length transaction and be formally documented with a written asset purchase agreement and financing documents.
Tax issues and obstacles
After determining the financial terms of the transaction, the real fun begins -- guiding your client through the tax issues. Here are some of the major ones and how to deal with them.
Avoiding a transfer for value
Among the best-recognized tax issues is the "transfer for value" rule. Under the general rule of the Internal Revenue Code, amounts received under a life insurance contract when the insured dies are excluded from gross income. However, under the transfer for value rule, this exclusion is not available if the life insurance contract is transferred for a "valuable consideration" (i.e., sold).
Luckily, a transfer (including a sale) of an insurance policy to the insured is an exception to the transfer for value rule. If the transaction is structured so that it is viewed for federal income tax purposes as a sale from the old trust to the insured, the policy proceeds will remain exempt from income taxes. This can be done by designing the new ILIT so that it is a "grantor trust" with respect to the insured.
With a grantor trust, federal income tax laws ignore the trust as a separate tax entity and view the grantor of the trust as the owner of the property in the trust for income tax purposes. When the new ILIT is a grantor trust, the sale of the insurance policy from the old trust to the new ILIT is treated as a transfer of the policy to the insured/grantor and does not trigger the transfer for value rule. If the old trust also happens to be a grantor trust, there is an additional income tax benefit in that no gain will be realized by the old trust when it sells the policy.
There are several ways to make the new ILIT a "grantor trust." One is to give the grantor/insured the power, exercisable in a non-fiduciary capacity, to acquire property held in the new ILIT (subject to certain important restrictions on what property may be acquired) by substituting other property of equal value. Retaining rights in the new ILIT typically raises concerns that the new ILIT's assets will be included in the grantor's estate; however, a recent IRS revenue ruling effectively avoids this undesirable result so long as the trustee is obligated to ensure that any substituted property is, in fact, equal in value to the trust property that is reacquired by the grantor.
Can I still use Crummey powers?
You can rarely have it all with any estate planning technique, and this one is no different. To avoid the transfer for value rule, you may need to give up, to some degree, the use of Crummey withdrawal powers to qualify gifts to the new ILIT for the gift tax annual exclusion.
This is because the grantor trust rules also make the holder of a Crummey withdrawal power the federal income tax owner of a portion of the trust's assets. When the insured and a Crummey beneficiary are both federal income tax owners, whose rights prevail? If it is the holder of the Crummey power, you will violate the transfer for value rule. Although a series of IRS private letter rulings state that when such a conflict exists, the insured's power prevails, only the person to whom the ruling is issued can rely on it. The result is that giving Crummey withdrawal rights over the initial gift may create uncertainty about whether a transfer for value occurred.
One possible solution is to design the new ILIT so that there are no Crummey withdrawal rights for the initial gift to the trust of the purchase price for the policy. This makes the initial gift a taxable one, but the sale would clearly be treated as a transfer to the insured. Once the sale is complete, you could then provide that all future gifts to the new ILIT are subject to Crummey withdrawal rights. This would qualify these gifts for the annual exclusion going forward. While not perfect, this solution may be less risky than relying solely on the IRS private letter rulings to avoid the transfer for value rule.
The three-year rule
Whenever a life insurance policy is transferred to an ILIT, the three-year rule is a concern. This estate tax rule would include the policy proceeds in the taxable estate of the transferor, unless the policy is transferred for adequate and full consideration or the insured survives the transfer by more than three years.
When the policy is transferred from an ILIT to which the three-year rule already applies (because the policy was transferred from the insured to the original ILIT via gift), make sure to transfer the policy for "adequate and full consideration," which will prevent the extension of this three-year rule to the new trust.
The measure of adequate and full consideration depends on the cost to replace the policy on the transfer date. This value is usually approximated by the sum of: (1) the interpolated terminal reserve value; plus (2) any unearned portion of the current year's premium; plus (3) any prepaid premiums; plus (4) any dividend accumulations; less any policy loans. If you are concerned that the insured's poor health makes the insurance policy worth more than this measure of value, consider obtaining a quote for the policy's value from a company that purchases life insurance policies on the secondary market.
Summary
If your client's trust doesn't fit the bill anymore but you want to maintain the insurance policy held by the trust, a sales transaction may be the perfect way to rescue the policy from the obsolete trust. Although there are a number of tax issues that require expert guidance and advice, you can use this technique to achieve a positive long-term financial and estate planning result.
For both you and your client, the result is often well worth the effort.
Michael J. Maransky is a partner in the Tax & Estates Department of Fox Rothschild LLP, resident in the Montgomery County office. Maransky's practice involves a broad range of matters, many of which are tax related, and also counsels businesses and business owners on commercial matters. He can be contacted at mmaransky@foxrothschild.com or (610)397-6502.
