The revocable, irrevocable life insurance trust. .

• Author: Packard, Pamela

Life insurance trusts are among the most commonly used estate planning tools. If used correctly, they enable large sums of money to pass to lower generations without the imposition of estate tax and, in many circumstances, without any gift tax. The largest drawback to their efficacy has always been that if they are to accomplish the desired goals, they must be irrevocable. However, life insurance trusts set up at the beginning of a marriage or created when children were very young, may no longer meet the insured's planning objectives, but cannot be amended to reflect current testamentary intentions, because they are irrevocable.

Although taxpayers cannot amend an irrevocable trust, the Service has recently sanctioned a different form of relief, in Letter Ruling 200247006. Using the concept of the defective grantor trust, taxpayers can now possibly create a new trust, which reflects the insured's current intentions and purchases the policy from the old trust.

The Facts

Two trusts were grantor trusts for income tax purposes as to H (H1 trust and H2 trust), and two trusts were grantor trusts as to both H and W (HW1 trust and HW2 trust). In the ruling, the H1 trustees and the HW1 trustees would sell the life insurance policies held in each trust to the H2 trustees and HW2 trustees, respectively. The ruling merely stated that each of the trusts were grantor trusts for income tax purposes as to "all the assets of the trusts" to either H or to H and W; it did not state a basis for the grantor-trust status. The Service ruled that because the trusts were grantor trusts and were to be ignored for Federal income tax purposes, the proposed life-insurance policy transfers, even though for valuable consideration, were disregarded for Federal income tax purposes; the trusts will receive the insurance proceeds income tax free on the death of the respective insureds.

Discussion

As stated above, the ruling has raised some very important questions that need to be addressed before relying on this type of sale and purchase. Confirmation of grantor-trust status as to both trusts is crucial; without this classification, the transfer of the policies will be a transfer for value. One of the exceptions to the transfer-for-value rule is a transfer to the insured. Because the trusts in the ruling qualified as grantor trusts, the Service was ruling that the transfer amounted to a transfer to the insured. Second, to avoid any further gift tax, a proper value for the...