Fixing Common Problems with
Life Insurance and Life Insurance
Trusts
Scott Gunderson
James B. Hodge
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Overview
• Estate Taxation of Life Insurance Policies
– IRC 2042
• Requires inclusion in the estate of decedent the
amount receivable by the estate as insurance
proceeds on the life of the decedent; and
• Requires inclusion in the estate of decedent the
amount receivable by all beneficiaries as
insurance proceeds on the life of the decedent if
the decedent possessed at his or her death any
“incidents of ownership” in the policy.
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The 3-Year Rule
• IRC Section 2035
– Requires that the value of transfers of
interests in property (in trust or otherwise)
made within 3 years of decedent’s death be
included in decedent’s estate if the property
interest would have been included in the
decedent’s gross estate under IRC Section(s)
… 2042.
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Exception to IRC 2035
• The three year rule of IRC Section 2035
does not apply to transfers (in trust or
otherwise) to any bona fide sale for an
adequate and full consideration in money
or money’s worth.
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Policy Transfers
Case 1:
• 65 year old male owns $2,000,000
insurance policy with his 3 adult children
as beneficiaries
• He has been advised that for estate tax
purposes he should not own the policy.
• What are his options?
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Policy Transfers
Option 1: Gift of existing insurance policy to
children
Issues:
• Gift Tax
• Loss of Control
• 3 Year Estate Inclusion from Date of Gift
• Children’s Creditors & Predators
• Child Predecease Parents
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Policy Transfers
Option 2: Transfer Existing Policy to Trust
Issues:
• Gift Tax
• 3 Year Inclusion
• Loss of Control
• Fixed Creditor/Predator Issue
• Fixed Predeceased Child Issue
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Policy Transfer
Option 3: Sell Policy to a Grantor Trust
• Fixes Gift Tax Issue – no gift
• Fixes 3 Year Inclusion Issue – exception to
2035 and approved in Revenue Ruling
2007-13
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Policy Transfer
• Sale to Grantor Trust raises new issues:
• What is the value of the policy?
• Transfer for value
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Policy Transfer
Valuation (Treas.Reg. 25.2512-6(a))
• For a policy that has been in place for
“some time” and for which further premium
payments are to be made, then:
• Value is the ITR at the date of transfer plus
any unearned premium already paid
• Insurance Companies issue 712s
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Policy Transfer
• Valuation
– How is valuation affected as the client ages?
– Is the real value of the policy the replacement
cost? The death benefit?
– How will the life settlement market affect
valuation?
– As this market matures – assume IRS will
want to use “comparable sales” to determine
policy value in these circumstances
– What if client is ill, maybe terminally ill?
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Policy Transfer
Transfer for value (IRC 101(a)(2))
• Income tax on policy proceeds if acquired
for value
• If transferee trust is a grantor trust:
exception to transfer for value rule applies
under Rev.Rul. 2007-13
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Policy Transfers
Case 2
• Same facts except policy is owned by an
irrevocable life insurance trust (ILIT); client does
not like terms of existing trust and wants to
change the terms of the trust.
• Solution 1: Amend trust if possible under state law
• Solution 2: Petition court for reformation
• Solution 3: Create new trust and transfer policy to new
trust.
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Policy Transfers
• Create New Trust & Transfer Policy:
• Issues:
– Gift Tax
– Transfer for Value
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Policy Transfer
Solution:
• Sell to a grantor trust (Rev Rul. 2007-13).
• If grantor trust to grantor trust transfer
deemed not to be a transfer (Rev.
Rul.2007-13)
• If non-grantor trust to grantor trust transfer
then an exception to the transfer for value
rule applies (Rev. Rul. 2007-13)
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Cash or Note?
• On Sale of Policy to New Grantor Trust can the
policy be sold for a note?
– Potential Issues if Using a Note (No Rulings on Point)
• Does the Transfer for Value rule apply at death of Grantor if
ILIT holds note, since it is no longer a Grantor Trust?
• If the note exceeds the ILIT’s basis in the policy, at Grantor’s
death, potential gain recognition to the extent that the debt
exceeds the trust’s basis. It’s possible that “negative basis”
disappears once trust is entitled to insurance proceeds (date
of death).
• Should probably use cash if possible for sale
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New Policy
Old policy
• Life settlement
• Surrender
• 1035 exchange
• Loan from Trust 1 to Trust 2
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New Policy
• Advisor duty/liability to investigate new
insurance
• Increased life expectancies; lower
mortality cost; better guarantees available
today if client is still insurable.
• May be able to obtain more insurance at
same or lower cost, or same insurance at
lower cost, even though client is older
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Common ILIT Problems
• No Crummey notices sent
– Does not result in estate inclusion of life
insurance
– Only limits the use of annual exclusion gifts to
ILIT and erodes Lifetime exemption amount
– Not required to be in writing
– Actual notice is required
– Affidavits from beneficiaries
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Common ILIT Problems
• Payment of premium by insured
– Not an issue so long as insured has no
incidents of ownership over the policy
– Either direct or indirect payments
– Headrick v. Comm’r 93 TC 171 (1989), aff’d
918 F2d 1263 (6thCir. 1990)
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Common ILIT Problems
• Client wants to have adult child purchase
insurance rather than ILIT
– No Estate Tax Inclusion Issues
– No Gift Taxes (unless client is paying
premium)
– No Control Over Policy Proceeds
– No Creditor/Predator Protection for Child
– May Not be Used for Intended Purpose
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Common ILIT Problems
• Trustee Issues
– Uncooperative
– No Successor Named
– Trust Protector
– Professional Fiduciaries
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Summary
• Rev. Rul. 2007-13 Approves Tax-Efficient
Methods of Dealing with Bad ILITs
• New Insurance May Be Better than
Keeping the Old Policy
• Insurance Belongs in a Trust
• Questions?
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