By Perry Ganz, Esq.
At the time, it seemed an appropriate
estate planning strategy: purchase life insurance; set up an
Irrevocable Life Insurance Trust ("ILIT"); name trusted friends and
advisors, John and Jane, as co-Trustees; and following the insured's
death, authorize the Trustees to make outright distributions of
principal to the children at ages 25, 30 and 35. But that was 1986
and this is 2006. John and Jane are now neither friends nor advisors.
And the outright distributions to the children at ages 25, 30 and 35 -
ages that once seemed far in the future - are now fraught with the
risk that each "hardwired" distribution will chip away at the asset
protection features of the Trust.
The client has many options. The client can simply
start over, cancel the life insurance, have a new ILIT prepared, and
authorize new ILIT to purchase a new policy. But given that the client
is now 20 years older, the client may find replacement life insurance
to be at best too expensive, and at worst unattainable. Reformation
of the Trust through the Court is another avenue, but without a
scrivener's error or an unintended tax consequence, the Court may not
be willing to accept jurisdiction. Another potential strategy is to
pour over - "decant" - into a new ILIT. But without reference to
decanting in either the ILIT or the Massachusetts statutes, the client
may again be forced to live with the status quo – that is, keep the
life insurance and the ILIT in place. A fourth strategy may be to
change the legal situs of the ILIT to a state that expressly permits
the trustee to decant to another trust. For example, Delaware, allows
trustees, under certain conditions, to appoint to a new trust (see 12
Del. C. § 3528). Even if permissible under the statute, the client may
find this to be a cumbersome road.
Enter the purchase and sale strategy between "Old ILIT"
and "New ILIT," discussed in a number of IRS Private Letter Rulings,
most recently Private Letter Ruling 200606027. In the standard purchase
and sale, New ILIT, infused with cash contributed by the Grantor,
transfers the cash to Old ILIT in exchange for the life insurance
policy. This strategy raises a number of potential issues that must be
analyzed prior to "closing."
First, unless New ILIT already has assets in it, the
client must transfer funds to New ILIT for New ILIT to use to purchase
the policy. Assuming annual exclusions are used on part of the
contribution, the balance must either be in the form of a taxable gift
or a loan to New ILIT. A loan should be evidenced by a promissory
note - at the statutorily prescribed interest rate - between New ILIT
and Grantor. The payee on the note should be the client's Revocable
Trust so that the note does not become a probate asset if it is not
repaid prior to the client's death.
Second is the issue of how much cash must be gifted or
loaned by the client to New ILIT. The purchase price for the policy
in Old ILIT should be its fair market value, which, according to Treas.
Reg. 25.2512-6(a), will generally be equal to the policy's
interpolated terminal reserve plus prepaid premiums, though Revenue
Procedure 2005-25 should be reviewed for cases in which the
interpolated terminal reserve does not reflect the value of all of the
relevant features of the policy. In the case of a term policy, the
purchase price would be the policy's unearned premium.
The third issue is the so-called (and infamous)
"transfer for value" rule set forth in Internal Revenue Code §
101(a)(2). The general rule of § 101 (a)(1) is that gross income does
not include amounts received under a life insurance contract, if such
amounts are paid by reason of the death of the insured. Section §
101(a)(2) provides an exception: if the life insurance contract is
the subject of a transfer for a valuable consideration, by assignment
or otherwise, "the amount excluded from gross income... shall not
exceed an amount equal to the sum of the actual value of such
consideration and the premiums and other amounts subsequently paid by
the transferee." This exception, however, itself has a number of
exceptions. One of these exceptions is a transfer for valuable
consideration to the insured. Therefore, if a life insurance policy is
transferred, even for consideration, and the transfer of the policy is
to the insured, the transfer is not deemed to be a transfer for value.
Revenue Ruling 85-13 says that if a grantor is treated as the owner of
an entire trust, the grantor is considered to be the owner of the
trust's assets for federal income tax purposes. Accordingly, if New
ILIT is structured as a grantor trust with respect to its income and
principal, the transfer of the life insurance policy to New ILIT should
be deemed to be a transfer to the insured and within the noted
exception to the transfer for value rule. It is interesting to note,
however, that in the Private Letter Rulings that have addressed the
sale of a life insurance policy, both Old ILIT and New ILIT have been
Fourth is the issue of whether Old ILIT and New ILIT
must have identical beneficiaries with identical interests in both Old
ILIT and New ILIT. According to the private letter rulings, neither
the beneficiaries nor their interests need to be identical. (See
Private Letter Rulings 200514001 and 200514002, where old ILIT was for
the benefit of Taxpayer's descendants, Taxpayer's sibling, and the
sibling's descendants, and New ILIT was for the benefit of Taxpayer's
descendants; and Private Letter Ruling 200228019, where New ILIT,
unlike Old ILIT, provided a fixed dollar amount to certain
individuals). It may be advisable, however, for the trustee to
determine whether he or she should seek indemnification from the
beneficiaries of Old ILIT.
The fifth (and perhaps the most important) issue is to
formally document this purchase and sale with the insurance company.
That is, since New ILIT is now intended to be the owner and beneficiary
of the policy, change of beneficiary and change of ownership forms
must be executed and filed with the life insurance company.
Finally, there is the issue of what to do with Old
ILIT. Whether Old ILIT is, at the end of the transaction, holding
cash, a promissory note, or a combination, there is the question – and
case by case analysis - of whether to distribute the assets of Old ILIT
and thereby terminate the Trust, or keep the assets in the Trust and
continue its administration.
It looked perfect 20 years ago. But times have changed. And perhaps it is time to ask - should your ILIT also change?
Perry Ganz is an associate at Tarlow, Breed, Hart
& Rodgers in Boston. He focuses his practice on estate planning,
taxation and business law. A version of this article appeared in
Massachusetts Lawyers Weekly on September 4, 2006