4B: Estate Tax Issues[Continued]

4B.5 ESTATE TAX CONSEQUENCES OF AN UNLAPSED CRUMMEY WITHDRAWAL RIGHT 

A Crummey withdrawal right is a general power of appointment. IRC sections 2514 and 2041. Its termination during the powerholder’s lifetime may not be a taxable release if the right of withdrawal (or rate of lapse under a hanging right of withdrawal) is limited under the five-by-five safe harbor rules of IRC sections 2514(e) and 2041(b)(2). However, if the powerholder dies before the termination (i.e., lapse) of the (single or hanging) withdrawal right, the amount of the unlapsed right of withdrawal for the year of death will be included in the powerholder’s gross estate. IRC section 2041(a)(2). Additionally, the powerholder will become the (new) transferor of the unlapsed power for GST tax purposes, and the GST tax exemption previously allocated by the grantor will be lost and wasted. Treas. Reg. §26.2652-1(a)(2). However, this is usually of minor concern where the ILIT beneficiaries are younger than the grantor.

4B.6 ESTATE TAX CONSEQUENCES OF WAIVER OR RELEASE OF A CRUMMEY WITHDRAWAL RIGHT

The gross estate of a decedent includes the value of property subject to a general power of appointment that was released or exercised before the decedent’s death if the result of the release or exercise is the creation of a retained interest described in IRC sections 2035, 2036, 2037, or 2038. IRC section 2041(a)(2). If a beneficiary waives his or her Crummey withdrawal right or allows his or her Crummey withdrawal right (which, as previously mentioned, is a general power of appointment under IRC sections 2514 and 2041) to lapse in an amount greater than the five-by-five safe harbor amount described in IRC sections 2514(e) and 2041(b)(2), the waiver or lapse in excess of five-by-five will be treated as a taxable release of a general power of appointment for transfer tax purposes. Additionally, the power- holder will become the (new) transferor of the released power for GST tax purposes. Treas. Reg. §26.2652-1(a)(2).

However, by using a hanging Crummey withdrawal right, you may be able to avoid a taxable release. See, section 3.13, above. If the ILIT provides the beneficiary with a lifetime income interest in the trust, an estate tax problem arises because the beneficiary has made a transfer (i.e., a transfer of the amount of the tax- able release) with a retained life income interest in the ILIT property. IRC section 2036(a). When the beneficiary dies, a percentage of the ILIT will be included in his or her gross estate. The percentage included will be based on a fraction—the numerator is the amount of the release and the denominator is the amount of the value of the ILIT at the time of the release. Treas. Reg. §20.2041-3(d)(4). Multiple or cumulative taxable releases are aggregated. Treas. Reg. §20.2041-3(d)(5).

4B.7 ESTATE TAX CONSEQUENCES OF THE DELAWARE TAX TRAP

 If in exercising a testamentary non-general power of appointment created after October 21, 1942, another power of appointment (general or non-general) is created, which under applicable local law can be validly exercised so as to postpone the vesting of the appointed property or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of the creation of the first power (i.e., extend the original perpetuities period with respect to the appointed property), the exercise of the testamentary non-general power of appointment by the donee will be treated as the exercise of a testamentary general power of appointment, and will result in the appointed property being included in the donee’s gross estate. (The donee will also become the (new) transferor of the appointed property for GST tax purposes.)1 IRC sections 2041(a)(3) and 2514(d). See, Paragraph 8.1(A) of Sample ILIT, which negates the occurrence of the trap.

4B.8 INCLUSION OF LIFE INSURANCE PROCEEDS IN INSURED’S GROSS ESTATE

Inclusion of life insurance proceeds in the decedent’s gross estate under IRC section 2042 applies only if the proceeds are payable to or for the benefit of the insured’s estate, or if the insured possessed any of the incidents of ownership in the policy exercisable alone or in conjunction with any other person. If life insurance policies are transferred to another individual or to an ILIT, the death proceeds may be excluded from the gross estate if the insured lives for more than three years after the transfer. See, IRC section 2035. However, if the decedent is a trustee of an ILIT that holds insurance on the life of the decedent, the life insurance proceeds will be includable in the decedent’s gross estate because the trustee, as the legal owner of the policy, will have incidents of ownership in the policy. IRC section 2042. Thus, an insured should never serve as trustee of an ILIT. See, Paragraphs 1.1(A), 6.1(E), and 7.1(C)(3) of Sample ILIT.

If the non-insured owner of the life insurance policy predeceases the insured, the value of the policy will be includable in the non-insured owner’s gross estate pursuant to IRC section 2033. The amount that is includable is similar to the valuation of a policy for gift tax purposes. See, section 3.1, above.

4B.9 ESTATE TAX CONSEQUENCES OF LIFE INSURANCE PROCEEDS RECEIVABLE BY THE EXECUTOR

Treasury Regulations indicate that life insurance proceeds subject to a legally binding obligation to pay taxes, debts, or other charges of the insured-decedent will be deemed payable to the insured’s estate (to the extent of the obligation) and will be includable in the insured’s gross estate for federal estate tax purposes. Treas. Reg. §20.2042-1(b)(1). If the life insurance proceeds are community property, and under applicable local law one-half of the proceeds belongs to the decedent’s surviving spouse, then only one-half of the proceeds are deemed to be receivable by the decedent’s executor. Treas. Reg. §20.2042-1(b)(2). If the insured purchased an insurance policy payable to another person as collateral security for a loan of the insured (e.g., credit life insurance), the proceeds would be includable in the gross estate. However, the amount of the loan will be deductible in determining the taxable estate. This example in the Regulation appears inconsistent with the statement of inclusion of the life insurance proceeds “to the extent of the…obligation.”

Proceeds from a second-to-die insurance policy transferred to an ILIT are not includable in the gross estate of the surviving spouse if the trustee only has discretionary power to use the life insurance proceeds to pay the federal estate tax of the surviving spouse. As such, the proceeds are not received by the trustee subject to an obligation, legally binding upon the trustee, to pay taxes, debts, or other charges enforceable against the estate of the surviving spouse under Treas. Reg. §20.2042-1(b)(1). Pvt. Letter Rul. 200147039. Cf., Rev. Rul. 77-157, 1977-1 C.B. 279. The private letter ruling does not, however, address the issue of what the estate tax consequences would be if the trustee had in fact used the life insurance proceeds to pay the taxes, claims, and other obligations of the surviving spouse. Presumably the proceeds so used would be includable in the gross estate of the surviving spouse. See also, Estate of Charles Howard Wade v. Commissioner, 47 B.T.A. 21 (1942), acq. 1944 C.B. 29; Old Colony Trust Company v. Commissioner, 39 B.T.A. 871 (1939), acq. 1939-2 C.B. 27 where the court held that the trustee’s mere power to pay taxes, debts and expenses of the insured was not sufficient to result in the life insurance proceeds being includable in the insured’s gross estate, when the power is not so exercised.

Practice Point: Do not direct the ILIT trustee to pay the insured’s death taxes, debts or costs of estate administration. Rather, give the trustee the authority to make loans to the insured’s estate or to purchase assets from the insured’s estate. This is how the ILIT can provide liquidity to the insured’s estate without the ILIT assets being subject to inclusion in the insured’s gross estate. See, Paragraph 5.2 of Sample ILIT.

4B.10 ESTATE TAX CONSEQUENCES OF THE INSURED’S INCIDENTS OF OWNERSHIP IN LIFE INSURANCE

Even if a life insurance policy is transferred more than three years before the insured’s death, the insured’s retention of certain incidents of ownership (exercisable either alone or in conjunction with any other person) will cause inclusion of the life insurance in the insured’s gross estate, regardless of who receives the proceeds upon the insured’s death. IRC section 2042; Treas. Reg. §§20.2042- 1(c)(2), (3), (4). “Incidents of ownership” is not limited in its meaning to ownership of the policy in the technical legal sense. Generally speaking, the “incidents of ownership” refers to the right of the insured or the insured’s estate to the economic benefits of the policy. Thus, “incidents of ownership” includes the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, to obtain from the insurer a loan against the surrender value of the policy, etc.2 In the ILIT context, incidents of ownership problems arise when the insured possess an indirect incident of ownership in the policy that is owned by the ILIT.

4B.10(a) Examples Of Incidents Of Ownership For Estate Tax Purposes

Incidents of ownership in a life insurance policy include the following:

(1) A reversionary interest greater than 5%. IRC section 2042(2) states that the term “incidents of ownership” includes a reversionary interest (if the value of such interest exceeds 5% of the value of the policy immediately before death), which includes a possibility that the policy or the proceeds may return to the decedent or be subject to a power of disposition by him or her. See, section 11.1, below concerning the 5% reversionary rule where a special power holder can appoint the policy to a class of appointees that includes the insured.

Practice Point: The fact that the insured may, at a later date, receive the policy or its proceeds by inheritance through the estate of another person, or as a surviving spouse under a statutory right of election or a similar right does not constitute a reversionary interest in the policy or an incident of ownership in the policy. Treas. Reg. §20.2042-1(c)(3).

(2) Power to change beneficiary (or to veto a change of beneficiary). See, Treas. Reg. §20.2042-1(c)(2); Eleanor M. Schwager v. Commissioner, 64 T.C. 781 (1975) (power of insured to veto a change of beneficiary by the policy owner also constitutes an incident of ownership).

(3) Power to surrender or cancel the policy (or to prevent or veto a cancellation). See, Treas. Reg. §20.2042-1(c)(2).

(4) Power to assign the policy. See, Treas. Reg. §20.2042-1(c)(2).

(5) Power to revoke an assignment of the policy. See, Treas. Reg. §20.20421(c)(2).

(6) Power to pledge the policy for a loan. See, Treas. Reg. §20.2042-1(c)(2).

(7) Power to obtain a loan from the insurer against the policy’s surrender value. See, Treas. Reg. §20.2042-1(c)(2). The term “incidents of ownership” includes legal ownership of the policy, the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, to obtain from the insurer a loan against the surrender value of the policy, etc.

Practice Point: One method of reducing the current value of a life insurance policy for gifting purposes may be to take out a loan against the policy. The burdened policy may then be transferred as a gift in one year. Cash may be transferred to the ILIT in the following year, which is then used to pay off the loan. If attempting this strategy, be careful not to violate the transfer for value rule. If the ILIT is deemed to have relieved the taxpayer of an existing liability (i.e., the loan amount) greater than the taxpayer’s basis in the life insurance policy, then the transfer of the burdened policy may inadvertently trigger the transfer for value rule, causing the proceeds of the policy to be subject to income tax in the hands of the ILIT trustee. See, section 2.5(b)(6), above, for a possible solution to this problem.

(8) Power to change the beneficial ownership (either alone or with another). See, Treas. Reg. §20.2042-1(c)(4). An insured decedent is considered to have an incident of ownership in an insurance policy on his or her life held in trust if, under the terms of the policy, the decedent (either alone or in conjunction with another person or persons) has the power (as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds. Therefore, the insured should not serve as trustee of the ILIT or be permitted to be appointed as a cotrustee or successor trustee. Nor should the insured have a power of appointment (general or limited) over the ILIT

(9) Power to change the time or manner of enjoyment even though decedent has no beneficial interest. See, Treas. Reg. §20.2042-1(c)(4). A deceased grantor-insured is considered to have an incident of ownership in an insurance policy on his or her life held in trust if, under the terms of the policy, the decedent (either alone or in conjunction with another person or persons) has the power (as trustee or otherwise) to change the time or manner of enjoyment of the insurance proceeds, even though the insured decedent has no beneficial interest in the trust. See, Paragraphs 1.1(A), 2.1, 6.1(E) and 7.1(C)(3) of Sample ILIT.

Caution: The insured should not hold the power, whether alone or in conjunction with others, to modify or terminate the ILIT, or to veto or approve decisions concerning the life insurance policy owned by the ILIT on the insured’s life. Rev. Rul. 75-70, 1975-1C.B. 301. Even if the insured cannot initiate the acts associated with the incidents of ownership but can only consent to or veto the exercise of the incidents of ownership by another, the courts and IRS have held that the veto or consent power itself constitutes an incident of owner- ship over the policy. Eleanor M. Schwager v. Commissioner, 64 T.C. 781 (1975) (concerning insured’s power to veto a change in beneficiary designation by the owner of the policy); TAM 7406240100A (concerning insured’s consent to change beneficiaries or to assign the policy). The Second Circuit held that where the insured must consent to the actions of others in altering or amending a revocable trust which included an insurance policy on the insured’s life, the insured had incidents of ownership in the policy. Estate of Miran Karagheusian, 233 F.2d 197 (2d Cir. 1956). Similarly, the Court of Claims held that where the beneficiary/owner of the life insurance policy had the power to change the beneficiary but the power could be exercised only with the consent of the insured, the insured held incidents of ownership in the policy for federal estate tax purposes. Goldstein’s Estate v. United States, 122 F. Supp. 677 (Ct. Cl. 1954). See also, Rev. Rul 79-46, 1979-1 C.B. 303, in which the IRS ruled that the insured had a reversionary interest in the life insurance policy because of his right to purchase the pol- icy owned by his corporate employer (but made payable to the insured’s wife) if the corporation ceased paying premiums or wished to surrender and terminate the policy. The IRS concluded that the insured’s right to purchase the policy was the equivalent of the right to veto the employer’s incident of ownership in surrendering the policy. But see, Estate of John Smith v. Commissioner, 73 T.C. 307 (1979), acq. in result only, AOD 1981-066 (01/12/1981), which involved almost identical facts with those of Rev. Rul. 79-46, except that the corporation was both the owner and beneficiary of the policy. Said the court, “At his death, Smith could neither have initiated changes in the two [key man life insurance] policies [owned by and payable to the publicly traded company that employed Smith] nor consented to them; the company [in which Smith owned only a few shares of stock and was not a controlling shareholder] alone maintained full control over the policies.” The Service’s acquiescence in Smith implies that the IRS will not consider the right to purchase a life insurance policy owned and made payable to a corporation as an incident of ownership (in contrast to a policy owned by a corporation but made payable to a third party, such as the insured’s spouse, as was the case in Rev. Rul 79-46). See also, Priv. Letter Rul. 8049002.

(10) Controlled ownership or control through entity. I fan insurance policy, or any of its benefits, is owned by a corporation or other entity that is controlled by the insured, that control through the entity may cause the life insurance proceeds to be included in the insured’s gross estate. Treas. Reg. §20.2042-1(c)(6) states that life insurance owned by and payable to a corporation in which the insured is a majority shareholder3 will not result in the proceeds being included in the insured’s gross estate (because the proceeds would be taken into account when valuing the insured’s stock holdings). However, if the life insurance proceeds are payable to a third party for non-business purposes, the incidents of ownership held by the insured’s corporation (where the insured is the sole or majority shareholder) will be attributed to the insured through his or her stock ownership and the proceeds will be included in the insured’s gross estate under IRC section 2042. Rev. Rul. 82-145, 1982-2 C.B. 213; Rev. Rul. 76-274, 1976- 2 C.B. 278, situation 1; Estate of Milton Levy v. Commissioner, 70 T.C. 873 (1978).

Life insurance owned by and payable to a partnership or limited liability company in which the insured is a partner or member will not result in the proceeds being included in the insured’s gross estate under IRC section 2042 (because the proceeds would be taken into account when valuing the partner’s/member’s interest in the entity). Estate of Frank H. Knipp v. Commissioner, 25 T.C. 153 (1955), acq. in result, 1959-1 C.B. 4, aff ’d on another issue, 244 F.2d 436 (4th Cir.), cert. denied, 355 U.S. 827 (1957). See, Pvt. Letter Ruls. 200214028 and 200111038. Nevertheless, it is advisable to provide in the partnership agreement or limited liability operating agreement that the insured partner or insured member shall have no rights over a policy insuring his or her life that is owned by the entity. Instead, any such rights should be held exclusively by the other partners or members. See, Priv. Letter Rul. 200017051 (general partner prohibited from participating in decisions regarding insurance on his own life). However, if the life insurance is owned by a general partnership or a limited liability company, and is not pay- able to or for the benefit of the partnership or limited liability company, the insured general partner/member (even if the insured general partner/member does not own a controlling interest in the partnership/limited liability company) will be deemed to possess incidents of ownership in the policy and the proceeds will be includable in the insured general partner/member’s gross estate. Rev. Rul. 83-147, 1983-2 C.B. 158.

Caution: If a majority shareholder permits the corporation to transfer the life insurance policy on his or her life to a third party within three years of the majority share holder’s death, the policy proceeds may be includable in that shareholder’s gross estate under the three-year rule of IRC section 2035, unless: (i) the majority shareholder transfers his or her controlling interest in corporation more than three years before his or her death, or (ii) the transfer of the life insurance policy by the corporation to the third party constitutes a bonafide sale for adequate and full consideration in money or money’s worth. Rev. Rul. 90-21, 1990-1 C.B. 172; Pvt. Letter Rul. 199905- 010. See, section 3.1, above, for a discussion on how to value the policy in such a case.

(11) Power to select settlement option. According to the U.S. Fifth Circuit Court of Appeals, the decedent’s right to select a settlement option is an incident of ownership. Estate of James H. Lumpkin, Jr. v. Commissioner, 474 F.2d 1092 (5th Cir. 1973), rev’g. 56 T.C. 815 (1971). But see, Estate of John J. Connelly, Sr. v. Commissioner, 551 F.2d 545 (3d Cir. 1977), which held that the decedent’s right to select a settlement option was not an incident of ownership.

4B.10(b) What Doesn’t Constitute Incidents Of Ownership For Estate Tax Purposes

Examples of what does not constitute incidents of ownership in a life insurance policy include the following:

(1) Loans To ILIT By The Insured. A grantor’s loan of money to an ILIT trustee to pay life insurance premiums does not, in and of itself, constitute an incident of ownership. Pvt. Letter Rul. 9809032.

(2) Direct Payment Of Premiums By The Insured. Although direct payment of ILIT premiums by the grantor should be avoided (to provide efficacy to the Crummey withdrawal rights granted the ILIT beneficiaries), such action by the grantor will not, in and of itself, constitute an incident of ownership in the ILIT’s life insurance policy. Estate of Frank Martin Perry, Sr. v. Commissioner, 927 F.2d 209 (5th Cir. 1991); Estate of Eddie L. Headrick v. Commissioner, 93 T.C. 171 (1989), aff’d, 918 F.2d 1263 (6th Cir. 1990), AOD 1991-012 (7/3/1991); Estate of Joseph Leder v. Commissioner, 89 T.C. 235 (1987), aff’d, 893 F.2d 237 (10th Cir. 1989). Infrequent direct payments of ILIT premiums by the grantor should not cause the trustee to be treated as an agent of the grantor, with the grantor being a de facto trustee. An occasional (inadvertent) direct payment with proper notice to the beneficiaries who hold withdrawal rights is no different than employer-paid group term or split-dollar premiums. See, sections 1.4(a), above and 10.7, below.

(3) Direct Payment Of Premiums By The Insured’s Employer. Direct payment of premiums by the insured’s employer under a split-dollar plan or under a group term life plan will not, in and of itself, constitute an incident of ownership in the ILIT’s life insurance policy. See, section 3.2 and 3.3, above.

Practice Point: To ensure that direct payment of premiums by the insured or the insured’s employer constitutes a gift of a present interest, the ILIT should contain special language concerning such direct payments, the ILIT should specify how notice is to be given to the Crummey withdrawal right beneficiaries when such premium payments are made, and the ILIT should specify how a Crummey withdrawal right is to be satisfied when premiums are paid directly by the insured or the insured’s employer. See, Paragraphs 3.2(A), (F) and (G) of Sample ILIT.

(4) Use Of Non-Community Property Joint Account To Pay Premiums. A joint tenant’s use of funds from a joint bank account does not, in and of itself, constitute the payment of premiums (and hence a possible incident of ownership) by the non-withdrawing joint tenant who contributed some or all of the funds to the joint bank account. Joint bank accounts are frequently used by husbands and wives. See, Estate of Lee J. Clay v. Commissioner, 86 T.C. 1266 (1986), where the Tax Court held, “[W]e assume, as the parties do, that each tenant to this joint account had the power to withdraw the whole or any part of funds in the account, even though…the funds belonged to them in proportion to their net contributions….The withdrawal of funds with decedent’s knowledge and consent constituted a transfer of those funds by decedent to…[the joint account tenant], terminating…[the decedent’s] interest therein. Therefore, under the circumstances of this case, we reject…[the IRS’] tracing analysis and hold that, in the absence of an agency relationship, the mere payment of premiums with funds withdrawn from a joint account does not constitute payment by the nonwithdrawing tenant.” Id. at 1274.

(5) Insured’s Ability To Convert Group Term Policy To Ordinary Insurance. An insured’s ability to convert a group term policy owned by a third party (such as an ILIT) into individual coverage upon termination of the insured’s employment does not constitute an incident of ownership by the insured. Estate of James Smead v. Commissioner, 78 T.C. 43 (1975); Rev. Rul. 84-130, 1984-2 C.B. 194. Also, where the power to cancel an insurance policy is exercisable only by the insured terminating his or her employment, the insured is not deemed to have an incident of ownership in the policy. Thus, the cancellation of a group term policy upon termination of the insured’s employment does not constitute an incident of ownership by the insured. Rev. Rul. 72-30, 1972-1 C.B. 307. The termination of an insured’s employment is considered to be collateral consequence of an act of independent significance.

(6) Divorce Of Spouse-Beneficiary. The IRS has also ruled that divorcing one’s spouse is an act of independent significance and not a power to change the beneficial enjoyment of insurance proceeds, and therefore is not an incident of owner- ship in a life insurance policy. TAM 8819001. In reaching its decision the IRS quoted the court from the Estate of Edward A. Tully, Sr. v. United States, 528 F. 2d 1401 (Ct. Cl. 1976), “In reality, a man might divorce his wife, but to assume that he would fight through an entire divorce process merely to alter employee death benefits approaches the absurd.” In that same private letter ruling the IRS also ruled that an IRC section 1035 exchange did not trigger a new three-year period under IRC section 2035 where the life insurance policy was owned by an ILIT and the transfer of the policy to the ILIT had occurred more than three years prior to the IRC section 1035 exchange.

(7) Errors Caused By Life Insurance Agent In Processing Of Application. The courts and the IRS have ruled that a life insurance agent’s errors in completing a life insurance application did not result in the insured having incidents of ownership in the policy, where the policy was supposed to be owned by an ILIT. Estate of Bert L. Fuchs v. Commissioner, 47 T.C. 199 (1966), acq., 1967-1 C.B. 2. Priv. Letter Rul. 200603002.

(8) Insured’s Right To Substitute Policy For Property Of Equal Value. In Priv. Letter Rul. 9413045 the IRS ruled that the insured-grantor’s right, in a non-fiduciary capacity, to substitute comparable assets for a trust-owned life insurance policy did not constitute an incident of ownership in the life insurance policy owned by the ILIT. In its ruling, the IRS stated, “[T]he court in Estate of Jordahl held that the ability of an individual to substitute an insurance policy in a trust for assets of equivalent value cannot be seen as a right to the economic benefits of that insurance policy. The court held that in the case of an insurance policy the only asset that should be of equal value would be another insurance policy with ‘equal cash surrender and face value, comparable premiums, and a similar form of policy.’ Estate of Jordahl v. Commissioner, supra at 99. Thus, an insured does not possess incidents of ownership for purposes of section 2042 in an insurance policy held in a trust solely because the insured has the right to substitute assets of similar value for those policies.” See also, Priv. Letter Ruls. 9548013 and 9227013.

Practice Point: Although the Jordhal decision involved the power of substitution held in a fiduciary capacity, that fact should make no difference.4 However, a cautious practitioner may want to consider excluding the insured from having the power to substitute (in a non-fiduciary capacity) any policy that insures his or her life that is owned by the ILIT. Similarly, a cautious practitioner may also want to prohibit a grantor who has contributed IRC section 2036(b) controlled corporation stock to a trust from substituting other property for the stock. See, section 4.2, above. However, if such property is excluded from the power of substitution, the grantor may not have full grantor trust status over the ILIT, and other grantor trust powers will have to be used to obtain full grantor trust status for income tax purposes.

(9) Insured’s Ability To Apply For Life Insurance. An insured’s ability to apply for life insurance does not constitute an incident of ownership. See, section 4.12, below.

(10) Insured’s Ability To Purchase Employer-Owned Policy. If an insured-shareholder or insured-employee has the right to purchase life insurance policies owned by his or her employer upon termination of the insured’s employment or termination of the insured’s ownership interest in the corporation (or such other acts of independent significance), the insured is not deemed to have an incident of ownership in the employer-owned policy. Priv. Letter Rul. 8049002. However, as previously stated above, if the insured’s right to purchase the policy is in his or her sole discretion (i.e., the right to purchase is not subject to a preceding act of independent significance), then the insured will be deemed to have incidents of ownership in the employer-owned policy. See, Rev. Rul 79-46, 1979- 1 C.B. 303.

(11) Insured’s Ability To Expand Class Of ILIT Beneficiaries By Having More Children. The insured’s act of bearing or adopting children is an act of independent significance, the incidental and collateral consequence of which is to add the child as beneficiary to the ILIT. Although the insured’s act of bearing or adopting children will automatically result in adding the child as beneficiary to the ILIT, such result is merely a collateral consequence of the bearing or adopting children. Rev. Rul. 80-255, 1980-2 C.B. 272.

4B.10(c) Estate Tax Consequences Of ILIT Paying Death Taxes And Expenses

A provision within an ILIT or other governing instrument requiring the ILIT trustee to pay the deceased insured’s death taxes (or other expenses) will cause inclusion of the ILIT in the insured’s estate. Treas. Reg. §20.2042-1(b)(1). Instead of directing payment, an authorization in the ILIT permitting the trustee to purchase assets at fair market value from the decedent’s estate or trust or to loan funds to the decedent’s estate (for adequate interest and security) will not cause the proceeds to be includable in the insured’s estate as “proceeds receivable by an executor.” Authorizing the ILIT trustee to make loans and purchase assets will provide the liquidity necessary to pay the insured’s death taxes and expenses. See, Paragraph 5.2 of Sample ILIT.

Proceeds from a second-to-die insurance policy transferred to an ILIT are not includable in the gross estate of the surviving spouse if the trustee only has discretionary power (in contrast to a duty) to use the life insurance proceeds to pay the federal estate tax of the surviving spouse. As such, the proceeds are not received by the trustee subject to an obligation, legally binding upon the trustee, to pay taxes, debts, or other charges enforceable against the estate of the surviving spouse under Treas. Reg. §20.2042-1(b). Pvt. Letter Rul. 200147039. The private letter ruling does not, however, address the issue of what the estate tax consequences would be if the trustee had in fact used the life insurance proceeds to pay the taxes, claims, and other obligations of the surviving spouse. Presumably the proceeds so used would be includable in the gross estate of the surviving spouse. See also, Estate of Charles Howard Wade v. Commissioner, 47 B.T.A. 21 (1942), acq. 1944 C.B. 29; Old Colony Trust Company v. Commissioner,6 B.T.A. 871 (1939), acq. 1939-2 C.B. 27 where the court held that the trustee’s mere power to pay taxes, debts, and expenses of the insured was not sufficient to result in the life insurance proceeds being includable in the insured’s gross estate, when the power is not so exercised.

4B.11 INSURED-TRUSTEE NOT DEEMED TO HOLD INCIDENTS OF OWNERSHIP IN LIFE INSURANCE UNDER LIMITED CIRCUMSTANCES

An insured-trustee will not be deemed to hold incidents of owner- ship in policies of insurance held by the trust on the trustee’s life, if:

  • The insured does not retain any incidents of ownership at the time of the initial transfer, assuming the insured originally owned the policy;
  • The insured did not transfer the policy to the trust;
  • The insured does not provide (directly or indirectly) any assets to purchase or maintain the policy (including permit- ting a trustee to pay premiums from trust income or corpus that is required to be distributed to the insured5);
  • The devolution of the trustee powers on insured was not part of a prearranged plan involving the participation of insured; and
  • The insured can not exercise any powers (including trustee powers) over the policy for the insured’s own personal benefit. Rev. Rul. 84-179, 1984-2 C.B. 195; Priv. Letter Ruls. 200617008, 200518005, and 9748020.

The criteria set forth in this ruling is an exception to the general rule of an insured-trustee possessing “incidents of ownership” under IRC section 2042. However, the ruling will never be applicable to a traditional ILIT, especially when the insured is making annual gifts to the ILIT; and the ruling should not be relied upon as authority for permitting an insured to serve as trustee of his or her ILIT. See also, Estate of Hector R. Skifter v. Commissioner, 468 F.2d 699 (2nd Cir. 1972); Estate of Harry R. Fruehauf v. Commissioner, 427 F.2d 80 (6th Cir. 1970), which describes several situations in which holding powers in a fiduciary capacity over a policy on the trustee’s life will not cause the proceeds to be included in the trustee’s estate upon his death. But if the trustee is also the income beneficiary (the Fruehauf situation), the proceeds are included.

4B.12 INSURED’S NON-BINDING TEST APPLICATION FOR LIFE INSURANCE IS NOT AN INCIDENT OF OWNERSHIP IN THE LIFE INSURANCE POLICY

TAM 9323002 holds that an application for life insurance when the insured did not sign as the policy “owner” but only as the “insured,” and for which no premium payment accompanied the application did not create an incident of ownership in the insured since the application clearly stated that the policy would not be issued until the premium was paid. Thus a non-binding “test” application for life insurance showing “an ILIT to be created” as the potential owner should not result in the insured possessing an incident of ownership in the policy when it is finally issued to the ILIT trustee. Nor, should the non-binding “test” application result in the application of the IRC section 2035 three-year rule to the insured. See, section 4.1, above. Also, an insured’s ability to apply for life insurance coverage does not create an incidents of ownership. Rev. Rul. 76-421, 1976-2 C.B. 280.

4B.13 GENERAL POWER OF APPOINTMENT MARITAL DEDUCTION

If the insured is married and the ILIT does not hold a second to die policy on the insured and his or her spouse, consider including a contingent marital deduction trust in the ILIT. If the ILIT proceeds are includable in the insured’s gross estate, the contingent marital deduction provisions can eliminate any federal estate tax due upon the insured’s death. A marital deduction may be accomplished by requiring the ILIT trustee to distribute the death benefit proceeds to the surviving spouse, either outright or through a marital deduction trust, such as a life estate with a general power of appointment (which is discussed immediately below), or a qualified terminable interest property (“QTIP”) arrangement (which is discussed in section 4.14, below).

For a life estate with a general power of appointment to qualify for the estate tax marital deduction, three requirements must be met (which are in addition to the six preliminary requirements for the marital deduction).7 IRC section 2056(b)(5). These three requirements are:

  • The surviving spouse must have a lifetime right to all of the income from the entire interest, or a specific portion of the entire interest;
  • The income must be payable to the surviving spouse annually or more often; and

(3) The surviving spouse must have the power to appoint the entire interest or the specific portion to him/herself or to his or her estate. IRC section 2056(b)(5); Treas. Reg. §20.2056(b)-5(a).

4B.14 QUALIFIED TERMINABLE INTEREST PROPERTY MARITAL DEDUCTION

The qualified terminable interest property (“QTIP”) devise is a statutory exception to the definition of “nondeductible terminable interest” for federal estate tax marital deduction purposes. Under this exception, the federal estate tax marital deduction is allowed for property given to a QTIP trust for the benefit of the decedent’s surviving spouse, provided:

  • The surviving spouse has a lifetime right to all of the income from the trust;
  • All trust income is payable to the surviving spouse annually or more often;
  • During the lifetime of the surviving spouse, no person, (including the surviving spouse or trustee) may possess the power to appoint QTIP marital deduction trust property to any person other than to the surviving spouse; and

(4) The decedent’s executor makes an election to treat all or a specific portion of the trust property as qualified terminable interest property. IRC section 2056(b)(7).

4B.15 LIABILITY OF ILIT OR BENEFICIARY FOR ESTATE TAX ON LIFE INSURANCE PROCEEDS

The executor of a decedent’s estate is entitled to recover federal estate taxes paid by the estate that are attributable to life insurance proceeds included in the insured’s gross estate. IRC section 2206. If the life insurance proceeds are qualified and elected for the marital deduction, the executor is not entitled to apportionment or recovery under IRC section 2206. This special rule of exoneration is not, however, available for bequests of life insurance proceeds that qualify for the estate tax charitable deduction. Consequently, if life insurance proceeds are to be paid to a charity, the insured’s will must waive the right of apportionment or recovery under IRC section 2206. In the absence of a waiver, the executor’s right of apportionment/recovery for federal estate taxes attributable to life insurance proceeds includable in the insured’s gross estate is on a pro rata basis. An insured can opt out of the recovery/apportionment provisions of IRC section 2206 by stating so in his or her will. A general provision in the insured’s will to pay all taxes from residue will be sufficient to opt out of the Code’s apportionment/recovery scheme. However, if the estate tax on the ILIT proceeds could be substantial, it may not be desirable to waive the right to recovery in all instances, particularly where the residuary beneficiaries and the ILIT beneficiaries differ significantly. Life insurance proceeds received by the ILIT may be included in the insured’s gross estate because of the three-year inclusion rule of IRC section 2035.

4B.16 EXECUTOR’S RIGHT TO RECOVER ESTATE TAX ATTRIBUTABLE TO GENERAL POWER OF APPOINTMENT

The executor of a decedent’s estate is entitled to recover federal estate taxes paid by the estate that are attributable to property over which the decedent held a general power of appointment, and which property is included in the decedent’s gross estate. IRC section 2207. The executor’s right of apportionment/recovery is on a pro rata basis. A decedent can opt out of the recovery/apportionment provisions of IRC section 2207 by stating so in his or her will. A general provision in the decedent’s will to pay all taxes from residue will be sufficient to opt out of the Code’s apportionment/ recovery scheme.

As previously mentioned, a Crummey withdrawal right is a general power of appointment and may be included in a beneficiary’s estate under IRC section 2041. Who should be responsible for the federal estate taxes in such instance? Moreover, is it the drafting attorney’s responsibility to notify the beneficiaries regarding this issue? The ILIT may be illiquid and unable to reimburse the beneficiary’s estate under the recovery rules of IRC section 2207. The ILIT may be illiquid and also unable to reimburse the beneficiary’s estate under the recovery rules of IRC section 2207B.

4B.17 EXECUTOR’S RIGHT TO RECOVER ESTATE TAX ATTRIBUTABLE TO QTIP TRUST PROPERTY

The executor of a decedent’s estate is entitled to recover federal estate taxes paid by the estate that are attributable to QTIP property included in the decedent’s gross estate under IRC section 2044. IRC section 2207A. The executor’s right of apportionment/recovery is on a marginal or incremental basis. A decedent can opt out of the recovery/apportionment provisions of IRC section 2207A by stating so in his or her will or revocable living trust. However, specific reference to IRC section 2207A (or its provisions) in the decedent’s will or revocable living trust is required to opt out of the Code’s apportionment/recovery scheme. If the surviving spouse waives the right to be reimbursed for estate taxes attributable to reverse QTIP property, the waiver (and payment of the estate taxes by the surviving spouse’s estate) does not constitute a constructive addition to the reverse QTIP trust. Treas. Reg. §26.2652-1(a)(5), Example 8. If the ILIT contains a QTIP marital deduction trust to hold proceeds that are determined to be includable in the grantor’s gross estate, should the surviving spouse waive the right to reimbursement? What if the beneficiaries of the surviving spouse’s estate are different from the beneficiaries of the ILIT, which often occurs in a second marriage situation?

4B.18 EXECUTOR’S RIGHT TO RECOVER ESTATE TAX ATTRIBUTABLE TO GRANTOR’S RETAINED INTEREST

The executor of a decedent’s estate is entitled to recover federal estate taxes paid by the estate that are attributable to property or interests in property that are included in the decedent’s gross estate under the retained interest rules of IRC section 2036. IRC section 2207B. The executor’s right of apportionment/recovery is on a marginal or incremental basis. A decedent can opt out of the recovery/apportionment provisions of IRC section 2207B by stating so in his or her will or revocable living trust. However, specific reference to IRC section 2207B (or its provisions) in the decedent’s will or revocable living trust is required to opt out of the Code’s apportionment/recovery scheme.

As previously mentioned, a Crummey withdrawal right is a general power of appointment. If the beneficiary releases the power and retains an interest in the ILIT that is included in the beneficiary’s estate under IRC section 2036, who should be responsible for the federal estate taxes in such instance? The ILIT may be illiquid and unable to reimburse the beneficiary’s estate under the recovery rules of IRC section 2207B.

ILIT property may be included in the grantor’s gross estate because the grantor retained the right to vote shares of stock described in IRC section 2036(b).

Query, which section of the Code applies for apportionment/recovery when the retained interest results in the life insurance proceeds being included in the grantor’s gross estate? IRC section 2206 calls for pro rata reimbursement whereas IRC section 2207B calls for incremental reimbursement. A possible solution may be for the grantor’s will to require all apportionment/reimbursement under IRC sections 2206-2207B to be on an incremental basis.

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