Chapter 30 - § 30.3 • ESTATE TAX ISSUES
| Jurisdiction | Colorado |
I.R.C. § 2031(a) provides that the value of the gross estate of the decedent is determined by including, to the extent provided in the Code, the value at the time of death of all property. I.R.C. § 2042 specifically addresses proceeds of life insurance policies on the life of the decedent.
§ 30.3.1—The General Rules of I.R.C. § 2042
I.R.C. § 2042 contains two basic rules regarding inclusion of life insurance proceeds in an insured's gross estate:
1) I.R.C. § 2042(1) requires that proceeds from policies on the life of a decedent be included in the gross estate if they are receivable by the executor; and
2) I.R.C. § 2042(2) requires that the proceeds from policies on the life of a decedent be included in the decedent's gross estate if they are receivable by other beneficiaries and the decedent possessed at his or her death any incidents of ownership, exercisable either alone or in conjunction with any other person.
§ 30.3.2—Receivable by Executor — I.R.C. § 2042(1)
I.R.C. § 2042(1) is not construed literally. Rather, it requires estate tax inclusion when proceeds are either payable to the estate or legally obligated to discharge liabilities of the estate. Treas. Reg. § 20.2042-1(b)(1). It does not matter whether the estate is specifically named as beneficiary under the terms of the policy. Id.
When the terms of the trust instrument require that the trustee pay the debts, taxes, or other expenses of the insured's estate, the policy proceeds are includable in the insured's gross estate to the extent of the obligation to pay the amount of these expenditures. Id. Therefore, an ILIT should never require the trustee to make payments of debts, taxes, or expenses of the insured. Liquid funds from an ILIT can be made available to the estate of an insured by authorizing the trustee to purchase assets from the estate of the insured or loan money to the personal representative of the insured's estate.24
A power (as distinguished from a duty) to pay the taxes, debts, and expenses of the insured's estate will not render the policy proceeds includable in the insured's gross estate under I.R.C. § 2042(1), provided the power is not exercised. See Estate of Wade v. Comm'r, 47 B.T.A. 21 (1942), acq. 1944 C.B. 29, decided under a predecessor statute of § 2042. See also PLR 200147039. The includability of proceeds when actually used pursuant to a discretionary power to pay taxes, debts, and expenses of the insured's estate has not been litigated or ruled upon by the IRS. Thus, including a discretionary provision to pay such items in the trust instrument is an unnecessary temptation and risk for the trustee.
§ 30.3.3—Incidents of Ownership — I.R.C. § 2042(2)
A life insurance policy consists of a number of rights, referred to by the Internal Revenue Code as "incidents of ownership." If the decedent owns at his or her death one or more of these rights, the policy proceeds are includable in the insured's gross estate.
In defining "incidents of ownership," the regulations state that:
the term . . . is not limited in its meaning to ownership of the policy in the technical legal sense. Generally speaking, the term has reference to the right of the insured or his estate to the economic benefits of the policy. Thus, it 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, or to obtain from the insurer a loan against the surrender value of the policy, etc.
Treas. Reg. § 20.2042-1(c)(2).
How much control of a policy by an insured is allowed before incidents of ownership are found to exist? This question cannot be answered with any certainty. One court has held that the insured's right to elect settlement options constituted an incident of ownership, Estate of Lumpkin v. Comm'r, 474 F.2d 1092 (5th Cir. 1973), while other courts have reached the opposite conclusion,25 and neither is binding on Colorado courts. Moreover, the regulations provide that "the effect of the State or other applicable law upon the terms of the policy" must be considered in determining whether the decedent possessed incidents of ownership. Treas. Reg. § 20.2042-1(c)(5).
A discussion of the various interests, powers, and rights that may or may not constitute incidents of ownership is beyond the scope of this discussion.26 Since the primary goal of an ILIT is to avoid estate taxation of the policy proceeds at the death of the insured, the issue of whether the insured possessed an incident of ownership should be avoided to the extent possible and the retention by the insured of an interest that may or may not constitute an incident of ownership should be discouraged.
Drafting Suggestion:
The trust agreement may attempt to prevent an insured from possessing an incident of ownership subsequent to the creation of the ILIT. Consider the following clause:
It is settlor's intent in creating this trust that all gifts made to it be complete and that the assets of the trust estate, including any life insurance proceeds, be excluded from settlor's gross estate for federal estate tax purposes. All provisions of this trust agreement shall be construed in such a manner as best to accomplish these intentions. In furtherance of settlor's intent, settlor shall have the right at any time to release, renounce or disclaim any right, power or interest which might be construed or deemed to defeat such intent. Although settlor has no knowledge of having any right, power, interest or incident of ownership in any insurance policy held as an asset of this trust at this time, settlor hereby conveys to trustee all such right, power, interest or incident of ownership in any policy which may at any time be determined to exist.
Although this type of trust provision may be helpful, the assignment of any rights in a policy must also comply with state law and the terms of the policy.
§ 30.3.4—Fiduciary Powers and Removal Powers as an Incident of Ownership
Fiduciary Power as Incident of Ownership
The regulations specifically address trustee powers as an incident of ownership:
A decedent is considered to have an "incident of ownership" in an insurance policy on his 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, or the time or manner of enjoyment thereof, even though the decedent has no beneficial interest in the trust.
Treas. Reg. § 20.2042-1(c)(4).27
The IRS has ruled that a
decedent will be deemed to have incidents of ownership over an insurance policy on the decedent's life where decedent's powers are held in a fiduciary capacity [as a trustee or trust protector] and the decedent has transferred the policy or any of the consideration for purchasing and maintaining the policy to the trust. Also, where the decedent's powers could have been exercised for the decedent's benefit, they will constitute incidents of ownership in the policy, without regard to how those powers were acquired[, whether they were exercised, or] whether the decedent transferred [the] property to the trust.
Rev. Rul. 84-179, 1984-2 C.B. 195.28
The IRS's position is easily supported when an insured possesses beneficial interests in the trust.29 Whether the IRS's position is correct (that the insured possesses an incident of ownership) when the insured/trustee is a transferor to the trust of which the insured is not a beneficiary and the trust limits distributions to ascertainable standards, is a more difficult question. If the principles of I.R.C. §§ 2036(a)(2) and 2038 apply by analogy,30 it would seem that no incidents of ownership would exist.31 In view of the position of the IRS and the sparse amount of authority, the best practice is to prohibit the insured from serving as trustee of an ILIT or holding any fiduciary or other powers that could be considered incidents of ownership.
Trustee Removal and Replacement Powers
It may be desirable to include a trustee removal and replacement provision in the trust agreement to guard against a trustee who may be performing poorly or charging excessive fees, or an arrangement that has simply become inconvenient for the beneficiaries. The identity of the power-holder and nature and extent of the power will determine whether the existence of the power to remove and appoint trustees creates any adverse transfer tax consequences.
Where the insured possesses an unrestricted power to remove the trustee and appoint anyone (including the insured) to fill the vacancy and serve as trustee, the policy proceeds will be included in the insured's gross estate.32 Even if the settlor does not retain the power to remove the trustee, according to the IRS, the power to name himself or herself as trustee will still cause inclusion in the settlor's gross estate.33
Where the insured may only appoint a successor trustee other than the insured once the original trustee resigns or is removed by another, gross estate inclusion of the policy proceeds in the insured's gross estate will not occur. Rev. Rul. 77-182, 1977-1 C.B. 273.34 Similarly, if the settlor may remove the trustee, but has no power to name a successor trustee, the policy proceeds should not be included in the settlor's gross estate. Where a decedent retained the power to determine the compensation of the trustee, the IRS ruled that the power did not result in gross estate inclusion under I.R.C. § 2036(a)(2). PLR 9809032. This private letter ruling acknowledged that the power provided the decedent "with the ability to encourage the trustees to resign by controlling the compensation," but cannot be relied upon by other taxpayers.
Historic Case Law
Revenue Ruling 79-353, Estate of Wall, and Revenue Ruling 95-58
In Revenue Ruling 79-353, 1979-2 C.B. 325, the IRS ruled that the value of the trust principal was includable in the...
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