Navigating the Transfer of Life Insurance Policies Between ILITs

Understanding Irrevocable Life Insurance Trusts (ILITs)

Irrevocable Life Insurance Trusts (ILITs) are a staple in estate planning, designed to exclude life insurance proceeds from the taxable estate of the insured and their heirs. Once established, an ILIT's terms are set in stone, which can pose challenges if the grantor's circumstances or intentions change. For instance, a grantor may want to adjust beneficiary designations, incorporate their generation-skipping transfer (GST) tax exemption, or alter the trust's distribution terms.

The Dilemma of an Outdated ILIT

When a grantor's wishes evolve, they face a dilemma with their existing ILIT. They could cease contributions, allowing the policy to lapse, and then create a new ILIT with a fresh policy. However, health or financial considerations might make retaining the current policy more advantageous. The ILIT could sell the policy to the grantor, who would then transfer it to a new ILIT, but this triggers a new three-year inclusion period for estate tax purposes under IRC Section 2035(a). Distributing the policy to beneficiaries is another option, but this removes the creditor and estate tax protections afforded by the trust structure.

The Transfer-for-Value Rule

The transfer-for-value rule, as outlined in IRC Section 101(a)(2), limits the tax exclusion of life insurance proceeds if a policy is transferred for valuable consideration. However, exceptions exist, such as transfers to the insured, which can maintain the tax-free status of the death benefit.

IRS Guidance on ILIT Transfers

In Rev. Rul. 2007-13, the IRS examined two scenarios involving ILIT policy transfers. The first scenario involved a new grantor trust purchasing a policy from an old grantor trust. Based on Rev. Rul. 85-13, the IRS concluded that such transactions are disregarded for income tax purposes, meaning the transfer does not constitute a transfer-for-value, and the death proceeds remain tax-free.

In the second scenario, a new grantor trust acquired a policy from an old non-grantor trust. Although this was deemed a transfer for valuable consideration, the exemption for transfers to the insured applied, preserving the tax-free status of the insurance proceeds. However, the old ILIT would need to report income if the policy had appreciated in value at the time of sale.

Strategic Considerations and Precautions

Before transferring a policy from an old ILIT to a new one, several factors must be considered:

1. The old ILIT must allow the trustee to sell the policy, with proceeds remaining within the trust.
2. Any gain from the policy sale by a non-grantor trust is taxable.
3. The grantor must provide funds to the new ILIT, considering gift and GST tax implications.
4. The trustee must act independently to prevent the grantor's estate from being taxed on the insurance proceeds.
5. The policy must be sold for full and adequate consideration to avoid the three-year rule.
6. The trustee must fulfill fiduciary duties, ensuring beneficiaries are treated fairly.
7. The new ILIT must be structured as a grantor trust for income tax purposes but not included in the grantor's estate for estate tax purposes.
8. The use of Crummey powers in the new ILIT should be carefully evaluated.
9. Beneficiaries may need to waive claims against the grantor and trustee following the policy sale.
10. Timing is crucial to prevent the IRS from viewing the transaction as an indirect gift.

Unresolved Tax Questions

Rev. Rul. 2007-13 does not address the tax consequences of transactions involving joint ILITs with survivorship policies. When a joint trust involves two grantors, it is not wholly owned by a single grantor, which complicates the application of the ruling.

Conclusion: Proceed with Caution

Transferring life insurance policies between ILITs is a nuanced process that requires careful planning and consideration of tax and non-tax issues. Grantors and trustees should consult with legal and tax advisors to navigate the potential risks and ensure compliance with all applicable laws and regulations.

Please note that this article is for informational purposes only and should not be construed as legal or tax advice. Taxpayers should seek advice from their own legal and tax advisors for their specific situation.

IRS Rev. Rul. 2007-13 provides guidance on the tax implications of transferring life insurance policies between ILITs. For more information on the generation-skipping transfer tax, visit the IRS GST Tax page. To understand the intricacies of ILITs and estate planning, the American Bar Association offers resources and guidance.