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.
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.1 If the grantor-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.
4A.1 ESTATE TAX CONSEQUENCES OF INSURED’S TRANSFER OF LIFE INSURANCE WITHIN THREE YEARS OF DEATH
Although the “deemed transfer” rule2 and the three-year “transfer in contemplation of death” rule3 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 all4 of the life insurance policy being includable in the insured’s gross estate.5 IRC section 2035(a); Priv. Letter Rul. 200432015. See also, IRC section 2043. 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.6 Estate of Helen Ward DeWitt, T.C. Memo 1994-552 (1994). See, also, Treas. Reg. §20.2041-3(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 200432106 (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.
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 the policy’s fair market value should avoid the three-year rule and transfer for value rule.7 Pvt. Letter Rul. 9413045. (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 2035. 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 9533001.
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 2035. 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 2035. Rev. Rul. 82-15, 1982-1 C.B. 132.
Practice Point: The gratuitous transfer of a life insurance policy to an insured’s limited liability company is subject to IRC section 2035. TAM 200432015.
Practice Point: The gratuitous transfer of a life insurance policy by an insured’s closely held corporation may be subject to IRC section 2035. Treas. Reg. §20.2042- 1(c)(6); Rev. Rul. 82-141, 1982-2 C.B. 209.
Practice Point: IRC section 2042 (and thus the three- year rule of IRC section 2035) applies only to “proceeds of insurance on the decedent’s life.” Treas. Reg. §20.2042-1(a)(1). Thus, if an insured transfers a second to die policy to an ILIT within three years of his or her death and the other insured is still living and does not die within three years of the transfer, the three-year rule of IRC section 2035 does not apply with regard to the transferred policy and no value attributable to the second to die policy should be includable in the insured’s gross estate under IRC section 2035.8 However, if the surviving insured dies within three years of the policy’s transfer to the ILIT and the surviving insured had an incident of ownership in the policy at the time of the transfer, then IRC section 2035 would apply as to the surviving insured.
Practice Point: If an insured dies within three years of the transfer of a second to die life insurance policy and the other insured under the policy dies within six months after the first insured’s death, do not elect alternate valuation under IRC section 2032 with regard to the first insured’s estate. Alternate valuation will result in the full amount of the life insurance proceeds being included in the first insured’s estate due to the death of the second insured within the six month alternate valuation period.
Practice Point: Life insurance transferred by a decedent who is not the insured does not come within the purview of IRC section 2035 vis-à-vis IRC section 2042. Treas. Reg. §20.2042-2(a)(2).
Practice Point: If the insured has incidents of ownership in a life insurance policy and wants to avoid the three- year rule of IRC section 2035, the insured should sell (rather than gift) the policy for its fair market value to an ILIT that is structured as a grantor trust (to avoid the transfer for value rule under IRC section 101(a)(2) and to avoid the recognition of any gain on the sale of the policy). IRC section 2035 does not apply to bonafide sales of life insurance policies for full and adequate consideration in money or money’s worth. See, Priv. Letter Rul 9413045. If the new ILIT, is structured as a grantor trust with respect to the insured and the new ILIT issues (an unsecured) promissory note for the purchase of the life insurance policy, the insured will not be taxable on any interest paid under the note; nor will the insured be required to recognize any imputed income under IRC section 7872 if the promissory note does not pay an adequate rate of interest. Rev. Rul 85-13, 1985-1 C.B. 184.9 See, sections 2.5 (transfers for value) and 3.1 (valuation of life insurance policies), above.
4A.1(a) Gift Splitting Does Not Invoke IRC Section 2035
Merely consenting to split gifts made in trust with the donor spouse does not make the donee (consenting) spouse, who is also a trust beneficiary, a transferor for purposes of the three-year rule of IRC sections 2035. IRC section 2513(a)(1); Pvt. Letter Rul. 200130030. See, Rev. Rul. 82-198, 1982-2 C.B. 206; Rev. Rul. 74- 556,1974-2 C.B. 300; Rev. Rul. 54-246, 1954-1 C.B. 179. However, gift splitting does make the donee spouse a transferor for GST tax purposes as to the one-half of the entire gift amount without regard to the consenting spouse’s ascertainable interest in the gift, and the consenting spouse must allocate his or GST tax exemption to the gift amount. See, section 5.22, below.
4A.2 ESTATE TAX CONSEQUENCES OF TRANSFER OF PROPERTY TO ILIT WITH A RETAINED INTEREST BY GRANTOR
The grantor’s retained interest in property gifted to an ILIT may result in that property being included in his or her gross estate. IRC section 2036; Treas. Reg. §20.2036-1(a)(1). IRC section 2036(a)(1) includes in a decedent’s gross estate the date of death (or the alternate valuation date) value of property previously transferred (for less than full and adequate consideration in money or money’s worth) during the decedent’s lifetime in which the decedent retains the use, possession, right to income, or other enjoyment of the gratuitously transferred property10 (i) for his or her lifetime, or (ii) for a period of time ascertainable without reference to the decedent’s death (such as a retained beneficial interest in a trust (e.g., a grantor retained annuity trust, a grantor retained unitrust or a qualified personal residence trust) for a specified period of time and the decedent dies prior to the expiration of the retained beneficial interest11), or (iii) for a period of time measured from the decedent’s death, such as “the grantor’s right to income from this trust shall expire 60 days before the grantor’s death”). Therefore, the grantor of the ILIT should not be a beneficiary of the ILIT. The rules of IRC section 2036 apply both to the grantor and the ILIT beneficiaries. For example, if there is a taxable release of a Crummey withdrawal right (such as a lapse of a Crummey withdrawal right in excess of the five- by-five safe harbor amount) and the beneficiary causing the release retains an income interest for life in the ILIT (or an interest in the ILIT that is otherwise ascertainable), the beneficiary has transferred property to the ILIT (to wit, the property subject to the taxable release) and has retained an interest in the released property for purposes of IRC section 2036(a). In this instance, the beneficiary is also a “grantor” of the ILIT and a portion (if not all) of the trust estate may be included in the beneficiary’s gross estate. See, Treas. Reg. §20.2041-3(d)(4). If the grantor’s spouse is a beneficiary of the ILIT, it is important that the spouse not make gift contributions to the ILIT (other than consenting to the splitting of gifts made by the grantor). See, Paragraph 1.3 of Sample ILIT, which defines “donor” to include not only the grantor but other persons who make certain types of gift contributions to the ILIT.
Caution: If an existing ILIT distributes a life insurance policy to the non-insured spouse, who is a beneficiary of the ILIT, the non-insured spouse can contribute the life insurance policy to a new trust (assuming there is no transfer for value issue (see, section 2.5, above)). Although IRC section 2035 will not apply to the transfer by the non-insured spouse to the new ILIT (since IRC section 2035 applies to an insured), IRC section 2036 may apply to the non-insured spouse if he or she is a beneficiary of the new ILIT. IRC sections 2038 and 2041 may also apply to the spouse’s retained beneficial interest in the new ILIT.
4A.2(a) Discharging Grantor’s Legal Obligations
Another form of a grantor’s retained interest in gifted property is the trustee’s use of ILIT property to discharge the grantor’s legal obligations (e.g., support of a spouse or a dependent, or trustee’s use of ILIT property for the grantor’s pecuniary benefit, such as the payment of the grantor’s debts or living expenses). Treas. Reg. §20.2036-1(b)(2). Therefore, trust distributions to beneficiaries during the grantor’s lifetime should be made on a discretionary basis limited to an ascertainable standard for health, education, support, and maintenance, rather than as mandatory distributions (which may have the effect of discharging the grantor’s legal obligation of support to his or her spouse or minor children). Causing discretionary distributions to be capped by an ascertainable standard should not be construed as creating a floor that mandates distribution. See, Paragraph 8.3(G) of Sample ILIT. Furthermore, when making a discretionary distribution limited to matters pertaining to an ascertainable standard, the trustee should be required to consider all other resources available to the beneficiary, including any legal obligation of support that another person (such as the grantor) may owe to such beneficiary; and the trustee should also be prohibited from making a distribution that would have the effect of discharging the grantor’s legal obligations, including the obligation of support. See, Paragraphs 1.1(B) and 7.11 of Sample ILIT. These two requirements should negate the application of IRC section 2036(a)(1). Pvt. Letter Rul. 8504011; Restatement Third (Trusts) section 50 (comment e (3)). See, Paragraphs 4.1(A), (B) and 4.2 of Sample ILIT.
4A.2(b) Reimbursement Of Grantor For Income Taxes Attributable To Trust Property
If the ILIT is a defective grantor trust created on or after October 4, 2004, the grantor’s right (under state law or the governing instrument) to be reimbursed by the trustee for income taxes borne by the grantor is a retained interest in the transferred property under IRC section 2036, and the ILIT property will be included in the grantor’s gross estate. The right of reimbursement constitutes a discharge of the grantor’s legal obligation to pay income taxes. If neither state law nor the governing instrument requires the trustee to reimburse the grantor, there is no retained interest. However, if the trustee has the discretion (under state law or the governing instrument) to reimburse the grantor and the trustee exercises that discretion, the grantor may have a retained interest in the ILIT under IRC section 2036 if there is an express or implied “understanding” or “arrangement’ between the trustee and the grantor concerning the exercise of the trustee’s discretion.12 Specifically negating the grantor’s right to be reimbursed by the ILIT trustee for any income and capital gains tax imposed on the grantor (because of defective grantor trust status) should be sufficient to avoid the application of IRC section 2036. Therefore, consider including the following language in the defective grantor trust: “The grantor hereby waives any right that the grantor would or might otherwise have to be reimbursed from the trust (or its beneficiaries) for any income tax (including capital gains tax) concerning trust property (or a transaction by the trust) that is taxable to the grantor under the IRC sections 671-679 and/or applicable local law.”
ILIT assets could also be included in the grantor’s estate under IRC section 2036 if the trustee has the discretion to reimburse the grantor and the grantor has the right to remove the trustee and appoint him or herself as successor trustee (or to remove a trustee and appoint a successor who is related or subordinate to the grantor within the meaning of IRC section 672(c)), or if state law subjects the trust’s assets to the claims of the grantor’s creditors. Furthermore, if the grantor dies before the gift becomes a completed gift, the date of death value of the trust corpus will be includible in the grantor’s gross estate, for federal estate tax purposes, under IRC section 2038 because of the grantor’s retained power to, in effect, terminate the trust by relegating the grantor’s creditors to the entire property of the trust. Rev. Rul. 76-103, 1976-1 C.B. 293.13 Consequently, caution dictates that any discretionary right to reimbursement should be vested exclusively in an independent trustee who is not related or subordinate to the grantor within the meaning of IRC section 672(c),14 provided the discretionary right to reimbursement will not subject the trust assets to the claims of the grantor’s creditors, as is the case under the laws of certain jurisdictions (e.g., Alaska, Delaware, Nevada, Missouri, Rhode Island, Utah, Oklahoma, and South Dakota) that permit a grantor to retain a discretionary beneficial interest in a self-settled irrevocable trust (which is also commonly referred to as a “domestic asset protection trust”). In any event, the grantor’s payment of the incomes taxes attributable to defective grantor trust status (whether the grantor receives reimbursement from the ILIT or not) does not constitute a gift being made by the grantor to the ILIT beneficiaries, because the grantor is legally liable for the income taxes. Rev. Rul. 2004-64, 2004-27 I.R.B. 7.
Practice Point: According to Rev. Rul. 2004-64, pre-October 4, 2004 defective grantor trusts that require reimbursement of the grantor’s income tax liability do not constitute a retained interest under IRC section 2036, and the trusts are grandfathered from the rules set forth in the Revenue Ruling. However, to not disturb the grandfathered status of these grantor trust, it may be advisable to not make any additions to the trusts after October 3, 2004.
Caution: Pre-October 4, 2004 defective grantor trusts that contain discretionary reimbursement clauses are subject to the rules set forth in Rev. Rul. 2004-64; such trusts are not grandfathered from Rev. Rul. 2004-64.
4A.2(c) Danger Of Using Illiquid Assets
A grantor’s retained interest in property transferred to an irrevocable trust will be included in the grantor’s gross estate. In Estate of Eleanor T.R. Trotter v. Commissioner, T.C. Memo 2001-250 (2001), the Tax Court held that Crummey withdrawal rights held by the trust beneficiaries were not sufficient to negate the grantor’s retained power over the transferred property, and that the transferred property (a condominium that the grantor continued to live in without paying rent after transferring it to the trust) was includable in the grantor’s gross estate under IRC section 2036(a)(1). The grantor’s estate argued that IRC section 2036(a)(1) did not apply because the beneficiaries’ Crummey withdrawal rights defeated all other rights. The disturbing part of the Tax Court’s opinion is not the IRC section 2036 retained interest holding, but how it disposed of the estate’s argument that the beneficiaries’ Crummey withdrawal rights precluded application of IRC section 2036(a)(1). In that regard, the Tax Court stated:
“Moreover, we are satisfied that the logical conclusion to be drawn [from the terms of the trust itself ] is not negated by the withdrawal provisions upon which the estate so heavily relies. The numerous indicia discussed above [concerning the terms of the trust itself, section 2036, and the retained interest in the transferred condominium] are equally supportive of an implied understanding that the withdrawal rights would not be exercised, an interpretation buttressed by the awareness that the beneficiaries were the decedent’s grandchildren (and three of the five were minors). We cannot blind ourselves to the reality of the family relationships involved, and the estate has failed to show that the withdrawal rights were anything more than a paper formality without intended economic substance. In addition, such construction is strengthened still further by the fact that the trust’s having been funded solely with a single piece of real estate would have made any attempt to effectuate a withdrawal complex and burden- some at best. While it is not entirely clear from the document how the [withdrawal] provision would operate in this circumstance, we doubt that any beneficiary would have seriously contemplated forcing the trustee to sell the home so that he or she could collect $10,000.” Id. at 637 (emphasis added).
This comment by the Tax Court emphasizes the need to try to fund the ILIT with liquid assets (such as premium contributions or liquid seed money), if possible, and that the beneficiaries need to be granted sufficient time to exercise their right of withdrawal over the liquid assets.15 This comment should not cause concern regarding group term life insurance policies held by an ILIT where the premiums are paid by the grantor’s employer, provided the beneficiaries receive timely notice from the donor or trustee of the schedule of premium payments by the employer, and have a right to withdraw the value of the premium payments, usually in the form of a fractional interest in the life insurance policy itself or from a side fund of cash or liquid assets. See, section 12.3, below. Furthermore, the Tax Court’s concern about the difficulty of dividing a house into $10,000 parcels is less problematic for an ILIT when the trustee has the power to borrow funds or can transfer the policy to the beneficiaries.
4A.2(d) Other IRC Section 2036 Issues
The retained interest rule of IRC section 2036 also includes (1) the value of transferred property that is subject to the claims of the grantor’s creditors16 (Commissioner v. Sarah Gilkey Vander Weele, 254 F.2d 895 (6th Cir. 1958); Estate of Estelle E. German v. United States, 7 CL. Ct. 641(1985); Estate of Floyd G. Paxton, 86 T.C. 785 (1986); Mary M. Outwin v. Commissioner, 76 T.C. 153 (1981) acq. 1981-2 C.B. 2; Alice S. Paolozzi v. Commissioner, 23 T.C. 182 (1954) aff ’d in an unpublished decision, acq. 1962-1 C.B. 421; Estate of Edgar M. Uhl v. Commissioner, 25 T.C. 22 (1955), rev’d in part 241 F.2d 867 (7th Cir. 1957); Rev. Rul. 77-378, 1977-2 C.B. 347; Rev. Rul. 76-103, 1976-1 CB 293; Pvt. Letter. Ruls. 200223013, 200223014, 200123002, 199917001, 9332006, and 8752064; G.C.M. 35112 (11/13/1972)), (2) the grantor’s right to remove a trustee and replace a trustee (Treas. Reg. §20.2036-1(b)(3)), (3) the grantor’s right to vote (directly or indirectly, as a trustee, general partner, manager, or otherwise) shares of a controlled corporation that the grantor has gifted to a trust or transferred to a partnership or limited liability company17 (IRC section 2036(b)), (4) the grantor’s power to distribute trust income or principal, where the power is not limited by an ascertainable standard, and (5) the grantor’s right, either alone or in conjunction with another person (including a co-trustee, beneficiary, or a person having an adverse interest in the exercise of the grantor’s right/power) to designate which beneficiaries shall possess or enjoy the trust property or its income, including the ability to control the timing and manner of a beneficiary’s enjoyment of the trust property, (IRC section 2036(a)(2); Treas. Reg. §20.2036-1(b)(3)). If the grantor serves as a trustee or co-trustee of the gifted property, IRC section 2036(a)(2) could cause that property to be included in the grantor’s gross estate.23 Therefore, the grantor of an ILIT should not serve as a trustee of the gifted property.
Caution: Powers retained by the grantor that are subject to a contingency may also result in the property’s inclusion in the grantor’s gross estate under IRC section 2036(a)(2), even though the contingency is outside of the grantor’s control or did not in fact occur prior to the grantor’s death. Treas. Reg. §20.2036-1(b)(3).
4A.2(e) Family And Entity Attribution Rules Apply For Controlled Corporations
Unlike IRC section 672 of the grantor trust rules, IRC section 2036(a) does not contain a spousal attribution rule. However, the attribution rules of IRC section 318 do apply to controlled corporations. IRC section 2036(b). A “controlled corporation is one in which the grantor and related parties (using the IRC section 318 attribution rules) own 20% or more of the voting stock. Even where there is no application of the attribution rule, if the reciprocal trust doctrine applies to the grantor, the uncrossing of the reciprocal trusts or reciprocal powers of appointment could result in the grantor holding a retained interest under IRC section 2036. See, Chapter 10, below, for a discussion of the reciprocal trust and reciprocal power of appointment doctrines.
4A.2(f) Non-Gratuitous Transfers Or Ascertainable Standards
IRC section 2036 does not apply to transfers made for full and adequate consideration in money or money’s worth. IRC section 2036(a). See also, IRC section 2043. Also, IRC section 2036(a)(2) does not apply to non-discretionary powers held by the grantor that are limited by an enforceable ascertainable standard, such as the beneficiary’s health, education, support, and maintenance. Oliver Gould Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Estate of Walter E. Frew v. Commissioner, 8 T.C. 1240 (1947), acq. 1947-2 C.B. 2; Estate of Ralph Budd, Petitioner v. Commissioner, 49 T.C. 468 (1968), acq. 1973-2 C.B. 1; Estate of Marvin L. Pardee v. Commissioner, 49 T.C. 140 (1967) (applying Michigan law), acq. 1973-2 C.B. 3; Rev. Rul. 73-143, 1973-1 C.B. 407; Pvt. Letter Ruls. 200419011, 200213013, 200123034, 199903025, and 8916032. Cf., Treas. Reg. §25.2511-2(g).
4A.2(g) Gift Splitting Does Not Invoke IRC Section 2036
Merely consenting to split gifts made in trust with the donor spouse does not make the donee (consenting) spouse, who is also a trust beneficiary, a transferor for purposes of the retained interest rules of IRC section 2036. IRC section 2513(a)(1); Pvt. Letter Rul. 200130030. See, Rev. Rul. 82-198, 1982-2 C.B. 206; Rev. Rul. 74- 556,1974-2 C.B. 300; Rev. Rul. 54-246, 1954-1 C.B. 179.
Practice Point: To avoid the IRC section 2036 trap inherent when an ILIT income beneficiary transfers assets to an ILIT (such as transfers by the grantor and the grantor’s spouse, where the spouse is also an ILIT beneficiary), only the grantor should make gifts to the ILIT, and any gifts of the grantor in excess of the IRC section 2503(b) amount should be split with the spouse under IRC section 2513. Accordingly, where the grantor’s spouse is a beneficiary of the ILIT, it is preferable for the grantor to use his or her separate property when making contributions to the ILIT; and, to avoid using joint assets. See, section 12.7, below for a discussion of using a joint bank account to pay life insurance premiums.
4A.3 ESTATE TAX CONSEQUENCES OF TRANSFER OF PROPERTY TO ILIT WITH GRANTOR’S POWER TO CONTROL BENEFICIAL ENJOYMENT OF ILIT PROPERTY (INCLUDING POWER TO REMOVE A TRUSTEE)
The rules of IRC section 2038 (concerning the power (held by the grantor at his or her death) to control the beneficial enjoyment of trust property that has been gratuitously transferred by the grantor during his or her lifetime) are similar to the rules of IRC section 2036(a)(2), and apply both to the grantor and the ILIT beneficiaries.25 For example, if there is a taxable release of a Crummey withdrawal right (such as a lapse in excess of the five-by-five safe harbor amount) and the beneficiary causing the release has discretionary power over the released property (either as a beneficiary or as a trustee), the beneficiary is deemed to be a “grantor” of the released property and a portion (if not all) of the value of the trust estate may be included in the beneficiary’s gross estate because of the beneficiary’s power to control the distribution or devolution of the released property. IRC section 2038(a); Treas. Reg. §20.2038-1(a). A grantor does not retain the power to control the beneficial enjoyment of ILIT property if the grantor subsequently gets divorced, has more children, or adopts children. These are acts of in- dependent significance and are considered beyond the grantor’s control. TAM 8819001. Similarly, such acts do not constitute an incident of ownership over the life insurance held by an ILIT.
4A.3(a) Removing The Trustee
Both IRC sections 2036 and 2038 include the grantor’s ability to remove and replace a trustee. Treas. Reg. §§20.2036-1(b)(3) and 20.2038-1(a)(3). Fortunately, in 1995, the IRS reversed its position taken in Rev. Rul. 79-353, and held that a grantor’s reservation of an unqualified power to remove an existing trustee and appoint a replacement trustee who is not related or subordinate to the grantor (within the meaning of IRC section 672(c)) is not a reservation of the trustee’s discretionary powers of distribution that might cause trust corpus to be included in the grantor’s estate under IRC sections 2036(a) and 2038(a)(1). Rev. Rul. 95-58, 1995-2 C.B. 191. The holding of Rev. Rul. 95-58 is as follows:
Rev. Rul. 77-182 concludes that a decedent’s power to appoint a successor corporate trustee only in the event of the resignation or removal by judicial process of the original trustee did not amount to a power to remove the original trustee that would have endowed the decedent with the trustee’s discretionary control over trust income….Rev. Rul. 79-353 and Rev. Rul. 81-51 are revoked. Rev. Rul. 77-182 is modified to hold that even if the decedent had possessed the power to remove the trustee and appoint an individual or corporate successor trustee that was not related or subordinate to the decedent (within the meaning of IRC section 672(c)), the decedent would not have retained a trustee’s discretionary control over trust income. (Emphasis added.)
In Pvt. Letter Ruls. 9746007, 9735025, and 9607008, the IRS extended its holding in Rev. Rul. 95-58 to beneficiaries who were given the unqualified power to remove an existing trustee and appoint a replacement trustee who is not related or subordinate to the beneficiaries (within the meaning of IRC section 672(c)). Pvt. Letter Rul. 9832039 clarifies Rev. Rul. 95-58 by holding that the removal and replacement of a trustee by a grantor does not have to be limited to “cause,” as long as the replacement trustee is not related or subordinate to the grantor (within the meaning of IRC section 672(c)). Pvt. Letter Rul. 9832039 also clarifies Rev. Rul. 95-58 by holding that the insured’s ability to remove a trustee for “cause” and replace that trustee with someone other than the insured does not constitute the insured holding an incident of ownership over the insurance policy held by the ILIT on the insured’s life. Thus, a grantor can remove an ILIT trustee at anytime for no cause as long as the grantor cannot name a replacement trustee (in contrast to a successor trustee already named in the ILIT) who is the grantor, an insured, or a person who is “related or subordinate” to the grantor within the meaning of IRC section 672(c).
In Pvt. Letter Rul. 200314009, the IRS extended its holding in Rev. Rul. 95-58 to the insured. In Pvt. Letter Rul. 200314009 the IRS permitted the reformation of an ILIT to correct a scrivener’s error concerning a patent ambiguity concerning the office of trustee and Rev. Rul. 95-58. The reformation added a provision to the ILIT that precluded the grantor and any person related or sub- ordinate to the grantor (within the meaning of IRC section 672(c)) from serving as a trustee of the ILIT. Prior to the reformation, the grantor could, as a result of the ambiguity, have been appointed as a successor trustee. The ruling held that the reformation (which clarified the trustee ambiguity) did not result in a release or transfer of the trust property under the three-year rule of IRC section 2035, nor would the proceeds of the life insurance policies be includable in the grantor’s gross estate under IRC section 2042(2).
A grantor or beneficiary who has the unrestricted right to remove a trustee and appoint a related or subordinate person as successor trustee is deemed to hold the powers of the removed trustee. Treas. Reg. §20.2041-1(b). Depending on the powers and assets held by the removed trustee, this generally means that the removing party will hold a general power of appointment over the trust assets (or possibly an incident of ownership with regard to life insurance policies held by the trustee insuring the life of the removing party), which will result in the trust property being included in the removing party’s gross estate under IRC section 2041 (or IRC section 2042 with regard to any life insurance policies). If a beneficiary ends up holding a general power of appointment, he or she will be the (new) transferor for GST purposes and any GST tax exemption previously allocated by the grantor will be wasted. Limiting a beneficiary’s right to remove a trustee for reasonable cause will obviate this problem and provide flexibility concerning the choice of the successor trustee (which of course should never be the grantor). See, Paragraph 6.21 of Sample ILIT.
4A.3(b) Other IRC Section 2038 Issues
A grantor’s right or power to alter, amend, revoke,18 or terminate a gratuitous transfer previously made by the grantor, constitutes a prohibited power under IRC section 2038, and could cause the gratuitous transfer to be partially or wholly incomplete for gift tax purposes. Treas. Reg. §§25.2511-2(b) and (c).19 If the grantor relinquishes the prohibited power within three years of his or her death or holds the prohibited power at his or her death, the value of the property over which the grantor held (or holds) the prohibited power is included in the grantor’s gross estate. IRC section 2038(a); Treas. Reg. §20.2038-1(a). Consequently, the grantor’s right under state law or the trust instrument to amend or terminate an ILIT (in conjunction with the ILIT beneficiaries or the trustee) should be expressly negated by stating in the ILIT that the trust agreement is irrevocable and that the grantor retains no rights under IRC sections 2036(a) or 2038. But see, Treas. Reg. §20.2038-1(a)(2), which states that “[i]f the decedent’s power [to terminate the trust] could be exercised only with the consent of all parties having an interest (vested or contingent) in the transferred property, and if the power [to terminate the trust] adds nothing to the rights of the parties under local law” then IRC section 2038 does not apply.20 See, Paragraphs 1.1(A) and 2.1 of Sample ILIT.
Other examples of powers held by the grantor that could cause the transferred property to be included in the grantor’s gross estate under IRC section 2038, include (1) the power to change or add beneficiaries21; (2) the power to accumulate or distribute income or corpus to a beneficiary (even if the accumulated income and corpus is vested in the beneficiary or the beneficiary’s estate and no other person has a beneficial interest in the trust)22; (3) the power to appoint the gratuitously transferred property by will or to subsequently affect a beneficiary’s interest by will; (4) the power to man age the gratuitously transferred property in a manner that will affect a beneficiary’s rights, including the power to control the timing and manner of a beneficiary’s enjoyment of the trust property; (6) the power to change beneficial interests that are not subject to an ascertainable standard; (7) the power to revest title to the trust property in the grantor; (8) the power to purchase, sell, or reacquire trust property for less than full and adequate consideration (this is tantamount to having the power to revoke the trust); and (9) the power to distribute trust income or principal, where the power is not limited by an ascertainable standard. None of these powers should be retained by the grantor of an ILIT.
Practice Point: Unlike IRC section 2036(a)(2), IRC section 2038 does not require the grantor to have retained the prohibited power at the time of the gratuitous transfer. IRC section 2038 applies to a grantor’s right or power regardless of how the power was acquired (whether expressly stated in the governing instrument, granted by state law, held as a fiduciary or as an individual, or given to the grantor through a person exercising a power of appointment) and regardless of whether the power to alter, amend, revoke, or terminate is exercisable alone or in conjunction with someone else.23 If the grantor holds the prohibited power at the time of the grantor’s death (or has relinquished the power within three years of the grantor’s death), IRC section 2038 applies.
4A.3(c) No Family Attribution Rule
Unlike IRC section 672 of the grantor trust rules, IRC section 2038 does not contain a spousal attribution rule. However, if the reciprocal trust doctrine applies to the grantor, the uncrossing of the reciprocal trusts or reciprocal powers of appointment could result in the grantor holding a retained interest under IRC section 2038. See, Chapter 10 for a discussion of the reciprocal trust and reciprocal power of appointment doctrines.
4A.3(d) Non-Gratuitous Transfers Or Ascertainable Standards
IRC section 2038 does not apply to transfers made for full and adequate consideration in money or money’s worth. IRC sections 2038(a)(1) and (2). See also, IRC section 2043. Also, IRC sections 2038 does not apply to non-discretionary powers held by the grantor that are limited by an enforceable ascertainable standard, such as the beneficiary’s health, education, support, and maintenance. Oliver Gould Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Estate of Walter E. Frew v. Commissioner, 8 T.C. 1240 (1947), acq. 1947-2 C.B. 2; Estate of Ralph Budd, Petitioner v. Commissioner, 49 T.C. 468 (1968), acq. 1973-2 C.B. 1; Estate of Marvin L. Pardee v. Commissioner, 49 T.C. 140 (1967) (applying Michigan law), acq. 1973-2 C.B. 3; Rev. Rul. 73-143, 1973-1 C.B. 407; Pvt. Letter Ruls. 200419011, 200213013, 200123034, 199903025, and 8916032. Cf., Treas. Reg. §25.2511-2(g).
4A.3(e) Gift Splitting Does Not Invoke IRC Section 2038
Merely consenting to split gifts made in trust with the donor spouse does not make the donee (consenting) spouse, who is also a trust beneficiary, a transferor for purposes of the retained interest rules of IRC section 2038. IRC section 2513(a)(1); Pvt. Letter Rul. 200130030. See, Rev. Rul. 82-198, 1982-2 C.B. 206; Rev. Rul. 74- 556,1974-2 C.B. 300; Rev. Rul. 54-246, 1954-1 C.B. 179.
4A.4 ESTATE TAX CONSEQUENCES OF LAPSE OF A CRUMMEY WITHDRAWAL RIGHT
If a beneficiary dies after his or her Crummey withdrawal right has lapsed within the five-by-five limits imposed by IRC sections 2514(e) and 2041(b)(2), the lapsed amount is not included in the beneficiary’s gross estate because the lapse does not constitute a tax- able release of the power. IRC section 2041(a)(2), (b)(2).
Footnotes:
1. [Add Footnotes Here]
2. [Add Footnotes Here]
3. [Add Footnotes Here]
4. [Add Footnotes Here]
5. [Add Footnotes Here]
6. [Add Footnotes Here]
7. [Add Footnotes Here]
8. [Add Footnotes Here]
9. [Add Footnotes Here]
10. [Add Footnotes Here]
11. [Add Footnotes Here]
12. [Add Footnotes Here]
13. [Add Footnotes Here]
14. [Add Footnotes Here]
15. [Add Footnotes Here]
16. [Add Footnotes Here]
17. [Add Footnotes Here]
18. [Add Footnotes Here]
19. [Add Footnotes Here]
20. [Add Footnotes Here]
21. [Add Footnotes Here]
22. [Add Footnotes Here]
23. [Add Footnotes Here]