The use of an irrevocable trust to hold one or more life insurance policies, with the main purpose of keeping the life insurance proceeds out of the grantor’s estate, is an established estate tax planning technique. There are circumstances where a grantor may become unhappy with the terms of the irrevocable trust that holds a life insurance policy. If the grantor is currently insurable and can obtain a new comparable life insurance policy, it may make sense to let the current policy lapse and create a new irrevocable trust with the desired terms. 

However, if the grantor has become uninsurable or the insurance policy has considerable value, the grantor (and beneficiaries) may be looking for a way to transfer the insurance policy to another (new or existing) trust with the desired terms. A trustee with the authority to make principal distributions during the grantor’s lifetime may be able to transfer the insurance policy to another trust for the same beneficiaries. But if the trustee is not authorized to make distributions of principal during the grantor’s lifetime, which may be the case, the only option may be to sell the policy to another trust. 

While Rev. Rul. 2007-13 provided important guidance for tax advisors and their clients who are unhappy with the terms of an irrevocable trust and who desire to sell an insurance policy owned by that trust to a grantor trust that is treated as wholly owned by the insured, it did not provide guidance on the income tax consequences to the non-grantor trust seller of the insurance policy.  Recent Rev. Rul. 2009-13 provides guidance on the income tax consequences of the sale of an insurance policy to unrelated persons. Based on these rulings, there may be more clarity as to the income tax consequences when a non-grantor trust sells an insurance policy to a grantor trust that is treated as wholly owned by the insured.

Gross income generally does not include amounts received under a life insurance contract if such amounts are paid by reason of the death of the insured. However, Internal Revenue Code § 101(a)(2) provides that in the case of an insurance contract transferred for valuable consideration, the exclusion is limited to the consideration paid for the insurance contract plus the premiums and other amounts subsequently paid by the transferee. An exception to the “transfer for value” rule applies if the insurance contract is transferred to the insured. See IRC § 101(a)(2)(B). 

In Rev. Rul. 2007-13, the IRS provided binding guidance regarding the treatment of life insurance sales involving grantor trusts. It ruled that the sale of a life insurance contract between two wholly owned grantor trusts created by the same grantor is not a transfer for valuable consideration within the meaning of § 101(a)(2). The IRS found that because the grantor is treated as the owner of both trusts for federal income tax purposes, the grantor is considered the owner of both the life insurance contract and the cash received for it, both before and after the exchange; therefore, there had been no transfer of the contract within the meaning of § 101(a)(2). In addition, the IRS ruled that while the sale of a life insurance contract from a non-grantor trust to a grantor trust is a transfer of the life insurance contract for valuable consideration within the meaning of § 101(a)(2), if the grantor trust is treated as wholly owned by the insured, the sale will be considered a transfer to the insured under § 101(a)(2)(B) and thus qualify for the exception to the transfer for value limitation under § 101(a)(2).

While Rev. Rul. 2007-13 provided a good outcome for the grantor trust, the sale of an insurance policy from a non-grantor trust to a grantor trust will cause the non-grantor trust to recognize gain, if any, upon the transfer. Rev. Rul. 2007-13 did not provide guidance as to how to determine the non-grantor trust’s basis in the life insurance contract. However, Rev. Rul. 2009-13 provides some, but not conclusive, guidance on the tax consequences to the non-grantor trust as the seller of an insurance policy.

In Rev. Rul. 2009-13 the IRS determined that if the original holder of a life insurance policy surrenders the policy to the insurance company for its cash surrender value, the amount received is included in gross income to the extent the amount exceeds the “investment in the contract.”  For a holder who has neither received distributions nor borrowed against the cash surrender value, the investment in the contract will generally be the total amount of premiums paid.  The IRS ruled that the income on surrender will be ordinary income, despite the enactment of Section 1234A, which generally provides that gain or loss on the termination of a right or obligation with respect to a capital asset will be treated as gain or loss from the sale of the asset.

If the holder sells the policy to an unrelated person instead of surrendering it to the insurance company, the IRS, citing old case law, takes the position that the holder’s basis in the policy does not include the total amount paid as premiums, since some part of those premiums was paid for continuing insurance protection, and that part was earned and used. Thus, the policy holder will recognize a greater gain (or smaller loss) on the sale of a policy because of the inability to include in basis the full amount of the premiums paid.  Moreover, on the sale of a policy with a cash surrender value, under what the IRS refers to as the “substitute for ordinary income doctrine,” a portion of the gain will be ordinary income equal to the amount that would be ordinary income if the contract were surrendered, i.e., the inside build-up under the contract. Thus, the gain is bifurcated between ordinary income and capital gain, even though the ruling assumes that the policy is a capital asset in the hands of the holder. 

In the case of term policies, where the holder has paid for insurance protection without an investment component, the insured is likely to have little or no basis in the policy, and the IRS states that for a level premium term contract with no cash surrender value, absent other proof, the cost of the insurance is presumed to equal the monthly premium under the contract.  Presumably, the only basis available will be for premiums paid for coverage not yet provided.  However, because there is no cash surrender value and no inside build-up, there will be no ordinary income on the sale under the “substitute for ordinary income doctrine” according to the ruling.  Therefore, all of the gain would be capital gain.

Rev. Rul. 2009-13 assumes that the purchaser of the insurance policy is a person unrelated to the insured and who would suffer no economic loss upon the insured’s death. The income tax consequences to a non-grantor trust that sells a life insurance policy to a grantor trust of which the insured is the grantor, a related person, will presumably be the same as where the sale is to an unrelated person. Therefore, the non-grantor trust would recognize ordinary income and/or capital gain as a result of the sale of the insurance policy to the grantor trust. However, so long as the grantor trust is treated as wholly owned by the insured, the sale of the insurance policy to the grantor trust would not trigger the transfer for value rule, and the life insurance proceeds should remain exempt from income tax.

The income tax consequences to the non-grantor trust is only one issue that should be examined before the trustee sells a life insurance policy to a grantor trust that is treated as wholly owned by the insured.  As with the sale of any trust asset, a trustee should consider its fiduciary obligation to administer the trust pursuant to its terms for the sole benefit of the beneficiaries. Because an active secondary market exists for life insurance policies, the price the non-grantor trust could obtain for an insurance policy in such a market may far exceed the standard measures used for policy valuation (cash surrender value or interpolated terminal reserve). It may be necessary to engage a qualified appraiser or obtain an opinion from a life settlement broker to determine the fair market value of the insurance policy. If the non-grantor trust sold the policy to the grantor trust for less than its fair market value, the trustee may be deemed to be making a distribution of principal to the grantor trust, which the trust document may or may not authorize. 

While Rev. Rul. 2007-13 provided important guidance for tax advisors and their clients who were unhappy with the terms of an irrevocable insurance trust, it did not provide guidance as to how to determine a non-grantor trust’s basis in the life insurance policy. Recent Rev. Rul. 2009-13 provides guidance to sellers of an insurance policy for sales to unrelated persons. Based on these rulings, there may be more clarity as to the income tax consequences when a non-grantor trust sells an insurance policy to a grantor trust the assets of which are treated as wholly owned by the insured. However, the income tax consequences to the grantor trust purchaser and the non-grantor trust seller are not the only issues that should be examined before an insurance policy is sold.

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Morrison & Foerster’s Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients. If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6296 or PMcCabe@mofo.com.

© Copyright 2009 Morrison & Foerster LLP.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.