4 Estate Tax Issues 1

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1 4 Estate Tax Issues 1 CHAPTER OVERVIEW One of the primary reasons for creating an ILIT is to keep life insurance proceeds out of the insured s gross estate for federal estate tax purposes. See, section 1.1, above. This chapter discusses the many ways an ILIT can fail to accomplish that purpose, and how to avoid those types of issues. The chapter also discusses selected key estate tax issues concerning life insurance. 2 There are numerous estate tax retained interest traps, as well as incidents of ownership and general powers of appointment issues that must be examined when drafting an ILIT. 3 If the grantor- 1 The author gratefully acknowledges the contribution of Mary Ann Mancini, Esq. of Bryan Cave, LLP of Washington, DC in the writing of this chapter. The chapter does not discuss all of the estate tax aspects of life insurance, only selected aspects. For example, if the decedent owns an insurance policy on the life of another person, the value of the policy is includable in the decedent s gross estate under IRC section See, Chapter 3 of Howard M. Zaritsky & Stephan R. Leimberg, Tax Planning With Life Insurance: Analysis With Forms 2d Edition, Warren, Gorham & Lamont, Boston, Massachusetts (Supp. 2007) for an overview of the estate taxation of life insurance. 3 See, Dodge, 50-5th T.M., Transfers with Retained Interests and Powers, Bureau of National Affairs, Washington, DC, for a detailed discussion of retained interests under IRC section IRC sections 2036 and 2038 are valuation sections and do not physically return the asset to the grantor s estate. Thus, the grantor s estate cannot claim a marital deduction for the increased value unless the interest subject to IRC sections 2036 or 2038 went to the surviving spouse in a manner that qualifies for the marital deduction. 157

2 158 Irrevocable Life Insurance Trusts 4.1 insured is married and is the sole insured, certain safety nets can be placed in the ILIT to minimize adverse estate tax consequences, particularly if the grantor dies within three years of transferring an existing policy to the ILIT. Also, gifts made to an ILIT by the grantor can create income, estate, gift, and GST tax problems for the trust beneficiary if the beneficiary dies or if the right of withdrawal is not properly drafted. This chapter discusses the estate tax implications of these issues. 4.1 ESTATE TAX CONSEQUENCES OF INSURED S TRANSFER OF LIFE INSURANCE WITHIN THREE YEARS OF DEATH Although the deemed transfer rule 4 and the three-year transfer in contemplation of death rule 5 has, since 1981, been eliminated with respect to most gifts, the insured s transfer of an incident of ownership in a life insurance policy within three years of the insured s death for less than full and adequate consideration will result in some or all 6 of the life insurance policy being includable in the 4 See, section 1.4(a), above, concerning the abolition of the deemed transfer rule. 5 See, Brody, Althauser, and English, 818 T.M., Section 2035 Transfers, Bureau of National Affairs, Washington, DC for a detailed discussion of IRC section Prior to 1977, gifts made within three years of death were includible in the gross estate if they were made in contemplation of death. This resulted in the grantor s estate and the IRS having to ascertain the (now deceased) grantor s subjective intent at the time of the gift. 6 See, Estate of Morris R. Silverman v. Commissioner, 61 T.C. 338 (1973), aff d on other grounds, 521 F.2d 574 (2d Cir. 1975), acq., C.B. 2 for determining the percentage of policy proceeds that are includable in the insured s gross estate after a policy has been transferred and the transferee pays the premiums with his or her own money (and not with money supplied by the insured). See also, TAM ; Priv. Letter Rul ; Estate of Sidney M. Friedberg v. Commissioner, T.C. Memo ; GCM (9/25/79); GCM (9/27/78) (concerning transfer of policy subject to Texas community property law). Under the Silverman rule, a cautious insured will have the transferee of the policy pay the premiums for the first three years after the insured transfers the policy (for less than full and adequate consideration) to the transferee. This will minimize the amount of the life insurance proceeds that are includable in the insured s gross estate if the insured dies within three years of the policy s transfer.

3 4.1 Estate Tax Issues 159 insured s gross estate. 7 IRC section 2035(a); Priv. Letter Rul See also, IRC section If a grantor gratuitously transfers an interest in property or relinquishes a power in property (including the relinquishment of a general power of appointment) for less than full and adequate consideration within three years of his or her death, (which power or interest would have been included in the grantor s gross estate under IRC sections 2036, 2037, 2038 or 2042 but for the grantor s disposition or relinquishment of that interest or power), IRC section 2035 will cause the federal estate tax value of the property (or interest therein) to be includable in the grantor s gross estate. 8 Estate of Helen Ward DeWitt, T.C. Memo 7 If the insured gratuitously transfers the policy and lives for more than three years, the policy proceeds will not be includable in the insured s gross estate under IRC section Therefore, when transferring an existing policy, the insured should make sure that the life insurance company actually transfers the policy and follows the insured s instructions. There have been several instances where it was discovered shortly before the insured s death (but more than three years after the initial request for the policy transfer) that the carrier had not completed the paperwork and still showed the insured as the owner. To successfully avoid the application of IRC section 2042 (incidents of ownership) and IRC section 2035 to the insured s estate, the insured s estate s (or the IRS) have requested private rulings, which have been granted. See, TAM where the IRS ruled that the provisions of the life insurance policy (the policy facts ) were rebutted by documentary evidence that corroborated the insured s intent (the intent facts ) to transfer the policy s ownership and change the beneficiary designation more than three years prior to the insured s death. In Priv. Letter Rul the IRS ruled that the intent facts rebutted the policy facts, and recognized the insureds reformation of a second to die life insurance policy to reflect their ILIT as the policy owner. The IRS ruled that the reformation and assignment would not be a transfer subject to gift tax, and that if the insureds died within three years of the policy s reformation and assignment to their ILIT, the life insurance proceeds would not be includable in their gross estates under IRC section In Priv. Letter Rul the IRS ruled that the intent facts showed that the decedent s corporation (and not the decedent) was supposed to be the named beneficiary of the policy, and therefore the proceeds were not includable in the decedent s gross estate under IRC section See, section I,C,4 of Budin, 826 T.M., Life Insurance, Bureau of National Affairs, Washington, DC for a discussion of the policy facts doctrine and its exceptions. 8 The three-year rule of IRC section 2035(a) concerning the grantor s disposition of an interest under IRC section 2036, 2037, and 2038 is not applicable to the grantor s original retained interest per se (since the grantor s retention of an interest in the property is already subject to inclusion in the grantor s gross estate under IRC sections 2036, 2037, 2038). Rather, IRC section 2035(a) is applicable to the

4 160 Irrevocable Life Insurance Trusts (1994). See, also, Treas. Reg (d). Also, any gift taxes paid by the grantor (or by the donee under the terms of a net gift) within three years of death are includable in the grantor s gross estate. IRC section 2035(b). Estate of Samuel C. Sach v. Commissioner of Internal Revenue, 88 T.C.769 (1987), aff d on this issue, 856 F.2d 1158 (8th Cir. 1988). See, TAM (which held that the three-year rule starts on the date of the transfer, rather than the first day after the transfer). If the life insurance policy is initially acquired directly by a third party (such as an ILIT), without any incidents of ownership in the insured, the proceeds will not be included in the insured s estate, even if the insured pays all of the premiums and dies within three years of the acquisition of the policy. 9 IRC section 2035(d) provides that life insurance transferred for full and adequate consideration in money or money s worth is not includable under the three-year rule. If new insurance cannot be obtained, the transfer of cash to an ILIT that contains grantor trust provisions and the purchase of the existing policy by that ILIT for grantor s subsequent divestment or relinquishment of the retained interest within three years prior to the grantor s death for less than full and adequate consideration. Thus, a lapse or cessation of the grantor s retained interest, such as the expiration of the grantor s interest in a grantor retained annuity trust (GRAT) or a qualified personal residence trust (QPRT) at the end of the GRAT or QPRT s term (as specified in the trust agreement), is not subject to the three-year rule of IRC section 2035(a). Note, however, that IRC section 2036(b)(3) has its own special threeyear rule concerning the termination of the grantor s retained voting rights in a controlled corporation, including voting rights held by the grantor as a trustee. Under IRC section 2036(b)(3) a lapse, cessation, or expiration of the grantor s voting rights in a controlled corporation is subject to the three-year rule of IRC section 2035(a). Therefore, to avoid inclusion under IRC section 2035(a) and 2036(b), any voting rights retained by the grantor in a controlled corporation must be relinquished more than three years prior to the grantor s death. Thus, if the grantor of a GRAT has the right, as a trustee or co-trustee, to vote IRC section 2036(b) stock held by the GRAT, the grantor would have to cease serving as trustee at least three years before his or her death to avoid the value of the stock s inclusion in his or her gross estate. The termination of the GRAT s term does not in and of itself cause the special three-year rule of IRC section 2036(b)(3) to cease. 9 See, section 12.9, below, for a discussion of whether a trust can have an insurable interest in the life of the another person, such as the grantor of the ILIT, and the unresolved issues created by Chawla v. Transamerica Occidental Life Ins. Co., 440 F.3d 639 (4th Cir. 2006), aff g in part, vac g in part, 2005 WL (E.D. Va. Feb. 3, 2005).

5 4.1 Estate Tax Issues 161 the policy s fair market value should avoid the three-year rule and transfer for value rule. 10 Pvt. Letter Rul (See, transfer for value discussion under section 2.1(a)(2), above.) Transfer of a life insurance policy to an ILIT may be a completed gift for gift tax purposes, even though the policy ultimately is included in the grantor s gross estate under IRC section Furthermore, the possibility that the policy proceeds might be payable to the deceased grantor s revocable trust if the proceeds are determined to be includable in the grantor s gross estate is not sufficient retention of dominion and control by the grantor such that the initial gift of the life insurance policy to the ILIT will be considered as incomplete for gift tax purposes. TAM Practice Point: If the insured transfers a policy to an ILIT, the consequences of IRC section 2035 can be mitigated by having the ILIT buy term insurance for a three-year period in an amount equal to the potential federal estate tax liability. Once the IRC section 2035 period has ended, the ILIT can cancel the term insurance. Practice Point: If the ILIT insures only the grantor (and not the grantor s spouse) and the grantor s spouse is a beneficiary of the ILIT, a contingent marital deduction trust contained in the ILIT can also be used to mitigate the effects of IRC section See, section 11.3, below. Practice Point: The gratuitous transfer of an employer provided group term life insurance policy to an ILIT is subject to IRC section Rev. Rul , C.B Practice Point: The gratuitous transfer of a life insurance policy to an insured s limited liability company is subject to IRC section TAM Practice Point: The gratuitous transfer of a life insurance policy by an insured s closely held corporation may be subject to IRC section Treas. Reg (c)(6); Rev. Rul , C.B See, Lawrence I. Richman, Sidestepping 2035, 146 Trusts & Estates 32 (April 2007). The author recommends that the ILIT purchase the existing policy for cash. If a promissory note is used to purchase the policy, the author suggests that the note be paid in full prior to the insured s death. Id. at 34.