Presenting a live 90‐minute webinar with interactive Q&A

Estate Planning and Life InsuranceCrafting ILITs for Tax Benefits, Navigating the Transfer for Value Rule and Addressing Beneficiary Designations

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

TUESDAY, JANUARY 17, 2012

Today s faculty features:

James A. Soressi, Law Office of James A. Soressi, New York

Diana S.C. Zeydel, Shareholder, Greenberg Traurig, Miami, Fla.

Scott K. Tippett, Special Counsel, Carruthers & Roth, Greensboro, N.C.

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A Complete ILIT Tax Guide—Just About Everything You Need to Know to Create and Administer a Successful Irrevocable Life Insurance Trust

Diana S.C. Zeydel

© 2006. Diana S.C. Zeydel

All Rights Reserved.

An irrevocable life insurance trust (ILIT) is probably the most frequently used irrevocable trust in estate planning. One reason is that life insurance continues to be a highly tax favored asset. However, the tax aspects of forming and administering an ILIT are often misunderstood. Drafting for flexibility while minimizing transfer and income taxation of the policy proceeds requires a thorough understanding of the complex tax rules affecting ILITs. Successful navigation of the tax pitfalls provides a substantial opportunity for leverage by delivering the policy proceeds to the ILIT beneficiaries with minimum tax.

Purposes of Forming an ILIT

An irrevocable life insurance trust is typically established to achieve one or more of the following basic objectives: (1) to pass the life insurance proceeds down to the next generation free of transfer tax in the estate of the insured and, if married, also the estate of the insured’s spouse; (2) to avoid gift tax on payments of premiums by the insured to fund the insurance; (3) to retain income tax free receipt of the policy proceeds; (4) to provide liquidity at the insured’s death to pay any debts, expenses and/or taxes due, to support any business assets, to fund cash bequests, and to support the intended beneficiaries of the decedent’s estate; and (5) to control the timing of receipt of the proceeds by individual beneficiaries.

There are other possible benefits as well. Life insurance proceeds may not be subject to creditors claims under applicable local law. There may be a general exclusion from creditor claims, but a transfer of the policy to an irrevocable trust will enhance the protection of the proceeds. Life insurance proceeds payable to an irrevocable life insurance trust may also be excludible in determining a surviving spouse’s elective share of the decedent’s estate.1 It should be noted that estate planning that involves irrevocable trusts created with both spouses’ knowledge and consent may also have the collateral consequence of removing the trust assets from the marital estate for equitable distribution purposes.2 A life insurance trust can also be used to transfer property estate tax free to a non-citizen spouse without the

1 See, e.g., N.Y. E.P.T.L. 5-l.1(b)(2) and Sections 732.2035(6) and 732.2045(1)(d), Florida Statutes (insurance proceeds generally excluded from the elective estate, but, if payable to the surviving spouse, will satisfy the elective share). 2 Query whether the estate planner has a duty to so advise the spouses in the context of a joint representation for estate planning purposes. Compare Schneider v. Schneider, 864 So.2d 1193 (Fla. 4th D.C.A. 2004) (irrevocable life insurance trust created by husband for parties’ children without the wife’s knowledge and consent was part of the marital estate and wife was entitled to be compensated out of other assets) with Hedendal v. Hedendal, 695 So.2d 391 (Fla. 4th D.C.A. 1997) (irrevocable education trust created by husband for parties’ son was not a marital asset for equitable distribution purposes).

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need satisfy the special marital deduction rules applicable to such a transfer.3 Section 2056A4 contains additional requirements to qualify a trust for the marital deduction in the case of a non-citizen surviving spouse beyond the requirements contained in Section 2056. These include that at least one trustee must be a U.S. trustee and that no distribution (other than income or distributions for hardship) may be made unless the U.S. trustee has the right to withhold estate tax. A life insurance trust can avoid the requirements of Section 2056A in the case of a non-citizen spouse by removing assets from the insured’s gross estate (thus avoiding the need for marital deduction qualification), while nevertheless giving the non-citizen spouse a beneficial interest.

Basic Provisions of Section 2042 In general, Section 2042 of the Code provides that the proceeds of an insurance

policy on the life of a decedent are includible in the decedent’s gross estate for estate tax purposes if the proceeds are receivable by the decedent’s executor or if the decedent’s possessed any incidents of ownership over the policy.

Payable to the Decedent’s Executor. Section 2042(1) provides that the proceeds of

an insurance policy on the decedent’s life are included in the decedent’s gross estate if the proceeds are receivable by the decedent’s executor as insurance under policies on the life of the decedent. The term “executor” is defined under Section 2203 to include an administrator or, if there is none within the U.S., any person in actual or constructive possession of any property of the decedent. Treasury Regulation §20.2042-1(b) provides that proceeds payable to the decedent’s estate or payable to a beneficiary subject to contribution to defray legal obligations of the decedent’s estate (such as taxes, debts or expenses) are includible under Section 2042(1), in the latter case, to the extent of such obligations. On the other hand, where the beneficiary may, but is not legally obligated to, make payments to the estate, the power to volunteer should not cause inclusion of the proceeds under Section 2042(1).5

Incidents of Ownership. Section 2042(2) provides that the proceeds of an insurance policy are also includible in the decedent’s gross estate if the decedent, at the time of the decedent’s death, possessed any of the incidents of ownership over the policy. The decedent is deemed to possess incidents of ownership exercisable either alone or in conjunction with any other person.6 “Incidents of ownership” include the power, individually or as trustee, to change the beneficiary, to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment thereof, to surrender or cancel the policy, to assign the

3 Under Section 2056(d), no estate tax marital deduction is allowed for transfers to or for the decedent’s surviving spouse except for a transfer to a qualified domestic trust described in Section 2056A. 4 All references to a “Section” or “§” unless otherwise indicated are to a section of the Internal Revenue Code of 1986, as amended. 5 See, e.g., Rev. Rul. 77-157, 1977-1 C.B. 279. 6 I.R.C. §2042(2).

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policy, to revoke an assignment, to pledge the policy for a loan, and to obtain from the insurer a loan against the surrender value of the policy.7

Power to Remove and Replace the Trustee. Although there used to be a concern that the power to remove and replace a trustee always causes the powers of the trustee to be attributed to an insured/trustee,8 Revenue Ruling 95-589 clarifies that no powers of a trustee will be attributed to a grantor for purposes of Section 2036 or Section 2038 so long as a power to remove trustees is not coupled with a power to appoint related and subordinate trustees within the meaning of Section 672(c). In PLR 200314009, the IRS extended the rational of Revenue Ruling 95-58 to Section 2042(2) and ruled that a grantor’s power to appoint trustees of an insurance trust would not cause inclusion of policy proceeds under Section 2042(2).10

Grantor as Trustee. Treas. Reg. §20.2042-1(c)(4) provides that a decedent is considered to have an incident of ownership in an insurance policy on the decedent’s life held in trust if, under the terms of the policy, the decedent, either alone or in conjunction with any 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. The regulation also warns that if the decedent created the trust, such a power may result in Section 2036 or Section 2038 inclusion if, for example, the decedent has the power to surrender the policy, and if the income otherwise used to pay policy premiums would become currently payable to a beneficiary of the trust. In other words, the regulations view the ability to surrender the policy, in such a case, as control over the beneficial enjoyment of the trust property or its income, triggering Section 2036 and/or Section 2038.

The case law diverges on the question of whether the insured as trustee must have the right to economic benefits under the policy in order to have an incident of ownership, causing estate tax inclusion under Section 2042.11 Revenue Ruling 84-17912 states that the insured as trustee has an incident of ownership only if either (1) the insured has transferred the policy or any consideration for purchasing and maintaining the policy to the trust, or (2) the insured as trustee can exercise the trustee’s powers for the insured’s individual benefit. Even if the insured cannot exercise the insured’s powers as trustee for the insured’s individual benefit, the insured might be deemed to have incidents of ownership if there is some prearranged plan to benefit the insured in which the insured participated. In an expansion of the position taken in Revenue Ruling 84-179, the IRS ruled in PLR 200123024 that the grantor may act as trustee of a trust owning insurance on the grantor’s life

7 Treas. Reg. §20.2042-l(c)(2) and (4). For a more thorough discussion of the “incidents of ownership” test see C. McCaffrey, Estate, Gift and Generation-Skipping Transfer Tax Aspects of the Life Insurance Trust, 49th Annual N.Y.U. Institute (1991). 8 Rev. Rul. 79-353, 1979-2 C.B. 325, revoked by, Rev. Rul. 95-58, 1995-2 C.B. 191. 9 1995-2 C.B. 191. 10 Note that neither a private letter ruling nor a technical advice memorandum may be cited as precedent under Section 6110(k)(3). 11 See Terriberry v. U.S., 517 F.2d 286, cert. denied, 424 U.S. 977 (1976); Skifter Est. v. Commissioner, 468 F. 2d 699 (2d Cir. 1972). 12 1984-2 C.B. 195.

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transferred to the trust by the insured, and nevertheless avoid estate tax inclusion, if the grantor, as trustee, has no powers with respect to the policy and the grantor’s authority over trust distributions are limited by an ascertainable standard so that Section 2036 and Section 2038 (relating to retained income in and control over property transferred by the decedent) do not apply. Nevertheless, if would appear prudent to discourage the grantor from acting as trustee of his or her own ILIT. It will certainly raise inquiry by an examining IRS agent, and will require a most carefully drafted ILIT to avoid a direct or indirect incident of ownership in the policy and to avoid any interest, power or authority that would attract Section 2036 or 2038 inclusion.

Beneficiary as Trustee of a Trust Owning Insurance on the Beneficiary’s Life. In PLR 200617008, the IRS considered the following facts. Husband created a discretionary trust for Wife and descendants. After Husband’s death, the trustees were to set aside a percentage of the trust in a marital type trust for Wife and the balance of the trust was payable to descendants. The trust provided that a beneficiary acting as trustee was prohibited from participating in making decisions affecting the disposition of trust property to himself of herself. Husband died and the trust for Wife was created with Wife and Father as trustees. The taxpayers proposed to have Wife resign as co-trustee and thereafter invest a portion of the trust estate in a policy on Wife’s life. Wife would receive all the income from the trust, but taxpayers represented that only principal would be used to pay policy premiums and Wife would not pay any policy premiums personally. The IRS concluded that Wife would not be deemed to have any incidents of ownership in the policy nor to have transferred any incidents of ownership in the policy under Section 2042(2). In addition, the proceeds would not be includible in the Wife’s estate under Section 2035(a)13 if the Wife were to die within three years of her resignation as trustee. The taxpayer’s position in the ruling appears to have been very conservative. It would seem, given the prohibition on participating in distribution decisions by a beneficiary who is also a trustee, that it would have been sufficient for the Wife, as trustee, to renounce the ability to participate in any decisions concerning the investment in a policy on her own life. Perhaps, the taxpayers believed that such a renunciation of fiduciary authority would not be effective, and therefore opted for a complete resignation prior to investment in the policy. Payment of policy premiums by the Wife should not have caused her to be deemed to have an incident of ownership in the policy, and payment out of her income interest should have been treated similarly, although perhaps the concern was that she would have an interest in the policy by reason of her income interest in the trust if premiums were paid out of income.

Other Powers and Interests. Other powers and interests can give rise to incidents of ownership. A greater than 5% reversionary interest (valued immediately before the decedent’s death) in a trust owning a policy on the grantor’s life is an incident of ownership.14 On the other hand, an ILIT that eliminates the insured’s spouse as a trust beneficiary in the event of divorce should not cause incidents of ownership to be attributed

13 Under Section 2035(a)(2), property that would have been included in the decedent’s gross estate under Section 2036, 2037, 2038 or 2042 is still included if the decedent made a transfer, for less than full and adequate consideration in money and money’s worth, of the interest or power that would have caused the inclusion if held at death during the 3-year period ending on the date of the decedent’s death. 14 Treas. Reg. §20.2042-l(c)(3).

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to the insured, but rather should be considered a fact of independent significance with no estate tax inclusion consequence.15 The power to convert a group term policy to an individual policy may not be an incident of ownership.16

An issue does arise if a surviving spouse can exercise elective share rights over an ILIT. Revenue Procedure 2005-2417 states that if a transfer to a charitable remainder trust can be reached by a surviving spouse for elective share purposes, the charitable remainder trust is disqualified unless the spouse waives the spouse’s elective share rights as to the trust. The application of Revenue Procedure 2005-24 was deferred and the grandfather provisions extended by Notice 2006-15.18 Nevertheless, query whether potential application of a surviving spouse’s right of election to an ILIT, for example because the trust was created within one year of death, could cause Sections 2042(1) or (2) to apply to the proceeds upon the death of the insured who created the trust unless a spousal waiver of the right of election is obtained because the trust estate is available to satisfy an obligation of the insured’s estate.

Incidents of Ownership Through a Corporation. In general, incidents of ownership in a policy owned by a corporation on the life of a controlling shareholder (owning more than 50% of the total combined voting power) are attributed to the shareholder through the shareholder’s stock ownership. Treas. Reg. §20.2042-1(c)(6) provides that in the case of economic benefits of a life insurance policy on the decedent’s life that are reserved to a corporation of which the decedent is the sole or controlling shareholder, the corporation’s incidents of ownership will not be attributed to the decedent through the decedent’s stock ownership to the extent the proceeds of the policy are payable to the corporation. This is an important exception to the attribution of incidents of ownership rule. Proceeds payable to a creditor of the corporation for a valid business purpose so that the net worth of the corporation is increased by the amount of the proceeds are considered payable to the corporation. The decedent will not be deemed to be the controlling stockholder unless, at the time of the decedent’s death, the decedent owned stock possessing more than 50% of the total combined voting power of the corporation. The decedent is considered to own (i) the stock to which the decedent had legal title, (ii) the stock in which the decedent had a beneficial interest through a voting trust and (iii) the stock held in any other trust with respect to which the decedent was treated as the owner under the income tax grantor trust rules immediately prior to the decedent’s death. Thus, if estate planning with the stock of a closely held corporation using grantor trusts has been implemented, and the proceeds of an insurance policy owned by the corporation are not payable to the corporation, stock ownership must be carefully tallied. Jointly owned stock is counted to the extent of the proportionate consideration furnished by the decedent. However, in the case of group term insurance under Section 79, the power to surrender or cancel the policy by a corporation is not attributed to any decedent through the decedent’s stock ownership.

15 See Estate of Tully v. U.S., 528 F.2d 1401 (Ct.Cl. 1976); Rev. Rul. 80-255, 1980-2 C.B. 272 (provision in trust instrument to include after-born or after-adopted children is not retention of a power to change beneficial interests within the meaning of Sections 2036(a)(2) and 2038(a)(1)). 16 See Estate of Smead v. Commissioner, 78 T.C. 43 (1982), acq., 1985-1 I.R.B. 4. 17 2005-16 I.R.B. 909. 18 2006-8, I.R.B. 501.

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Incidents of Ownership Through a Partnership. Revenue Ruling 83-14719 concludes that the proceeds of an insurance policy owned by a general partnership in which the decedent was a one-third partner should be included in the decedent’s gross estate under Section 2042(2) because the policy proceeds were payable to the decedent’s child for a purpose unrelated to the business of the partnership. On the other hand in Estate of Knipp v. Commissioner,20 the decedent was a 50% general partner in a partnership that owned 10 insurance policies on the decedent’s life payable to the partnership. The Tax Court held that the decedent, in his individual capacity, had no incidents of ownership in the policies under Section 2042(2), acknowledging that to hold otherwise would cause double inclusion of the proceeds, once under Section 2042 and once under Section 2031 as part the value of the decedent’s partnership interest. Thus, so long as the proceeds of a policy owned by a partnership are payable to the partnership, estate tax inclusion results only in proportion to the partnership interest retained by the decedent, which is similar to the rule described above with respect to corporations

Gift Tax Issues

Gifts of Policies and Premium Payments. A transfer, to the extent made for less than full and adequate consideration in money or money’s worth, is a gift for federal gift tax purposes. Hence, the gratuitous transfer of a policy to an ILIT, a transfer of cash to an ILIT and the payment of a premium on a policy owned by an ILIT are gifts. The gift is equal to the fair market value of the property transferred.

Valuation of an Existing Policy Transferred to an ILIT. In general, the gift tax value of an existing policy, depending on the type of life insurance, has been determined using such concepts as replacement cost,21 interpolated terminal reserve plus a proportionate part of the premium covering the post-gift period,22 or for group term, the unearned premium.23 However, different valuation principles for life insurance have recently been articulated in other areas of the law. For example, consideration might be given to Revenue Procedure 2005-2524 which, although addressed specifically to the employee benefits area, could become applicable to a gift of a life insurance policy because the gift tax regulations provide only that value may be approximated by interpolated terminal reserve plus unexpired premiums, but do not abandon the general rule that the value of a gift is its fair market value at the time of transfer. Revenue Procedure 2005-25 provides safe harbors for determining the fair market value of a life insurance policy distributed from a qualified retirement plan requiring the use of the greater of (i) interpolated terminal reserve plus unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for the policy year based upon company performance (a new requirement) and (ii) a more complex formula based on premiums, earnings, reasonable charges and a surrender factor. Query

19 1983-2 C.B. 158. 20 25 T.C. 153 (1955). 21 Gugenheim v. Rasquin, 312 U.S. 254 (1941). 22 Treas. Reg. §25.2512-6(a). 23 See, generally, ABA Section of Real Property, Probate and Trust Law, The Insurance Counselor: Federal Gift, Estate and Generation-Skipping Transfer Taxation of Life Insurance at 8 (1991). 24 2005-17 I.R.B. 962.

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also whether the current activity in the life settlement market has bearing on the valuation of an insurance policy contributed to an ILIT. If the test is what a willing buyer would pay a willing seller for the policy,25 perhaps the opportunity for life settlement is relevant to the determination of value for gift tax purposes.

Funding an ILIT Using the Annual Exclusion.

Requirement of a Present Interest. Section 2503(b) permits a donor to exclude as a taxable gift annual transfers of property not exceeding $10,000 (indexed for inflation) per donee. Section 2503(b) requires, in order for a transfer to qualify for the annual exclusion for gift tax purposes, that the transfer be a gift of a present interest, and not a future interest. Treas. Reg. §25.2503-3(a) defines a future interest to include reversions, remainders and other estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession or enjoyment at some future date or time. Thus, a transfer in trust, because enjoyment does not generally commence until a future time such as when the trustee determines to make distributions, does not typically qualify for annual exclusion treatment. The Supreme Court in Fondren v. Commissioner26 held that it is not enough to bring the exclusion into force that the donee has vested rights. The court stated:

In addition, he must have the right presently to use, possess or enjoy the property. . . . The question is of time, not when title vests, but when enjoyment begins. Whatever puts the barrier of a substantial period between the will of the beneficiary or donee now to enjoy what has been given him and that enjoyment makes the gift one of a future interest within the meaning of the regulation.27

In Fondren, the trustee was authorized to distribute income and corpus of the trust for support, maintenance and education, but only in the event of need (which was not contemplated at the time the trust was created).28 Accordingly, the donee was held not to have a present interest in the assets contributed to the trust.

On the other hand, an income interest in a trust will constitute a present interest if the income must be paid.

An outright gift of a life insurance policy qualifies as a present interest.29 However, a requirement that the beneficiary receive all the net income of a trust holding a life insurance policy at least annually will be treated in its entirety as a “future interest” because

25 As a general rule, the value of property for gift tax purposes is the price at which the property would change hands between a willing buyer and a willing seller, neither being under a compulsion to buy or sell, and both having reasonable knowledge of the relevant facts. Treas. Reg. §25.2512-1(a). 26 324 U.S. 18 (1945). 27 Id. at 20-21. 28 See also Commissioner v. Disston, 325 U.S. 442 (1945) (discretion to apply income for maintenance and support as necessary did not create a present interest). 29 Treas. Reg. §25.2503-3(a) confirms that an insurance policy is not per se a “future interest”.

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the policy is a non-income producing asset.30 In contrast, the payment of premiums by the insured on a policy owned by someone else will be treated as gifts of a present interest.31

Section 2503(c) Trust. Section 2503(c) provides an exception to the present interest requirement for a trust satisfying the specific requirements of the Section. Thus, contributions to a life insurance trust for the benefit of a beneficiary under the age of 21 structured to satisfy the requirements of Section 2503(c) should qualify for the annual exclusion until the beneficiary attains age 21.32 Section 2503(c) provides that no part of a gift to an individual who has not attained the age of 21 years on the date of such transfer shall be considered a gift of a future interest in property for purposes of Section 2503(b) if the property and the income therefrom (a) may be expended by, or for the benefit of, the donee before attaining the age of 21 years, and (b) will to the extent not so expended either pass to the donee upon attaining age 21 or, in the event the donee dies before attaining age 21, be payable to the estate of the donee or as the donee may appoint under a general power of appointment as defined in Section 2514(c).33 Typically, a Section 2503(c) trust confers on its beneficiary the right, upon attaining age 21 and for a limited period of time, to withdraw all the assets of the trust. If the Section 2503(c) trust were an ILIT, this would mean that the beneficiary would have the right to withdraw and retain the insurance policy. In addition, unless the beneficiary’s power of withdrawal continues after age 21, subsequent contributions to the trust may not qualify for the annual exclusion because the beneficiary may have no present right to receive those contributions. Although it might not often be the case, a Section 2503(c) trust should not be ruled out as a possible form of ILIT because it will avoid an annual power of withdrawal and the need for the annual notices required in a so-called Crummey power ILIT, discussed below. And if the policy becomes paid up during the period prior to the beneficiary attaining age 21, no further contributions to pay premiums would be required.

30 See Phillips v. Commissioner, 12 T.C. 216 (1949); see also Treas. Reg. §25.2503-3(c) Example (2) (income distributions that begin only after an insurance policy matures is a gift of a future interest). 31 Treas. Reg. §25.2503-3(c) Example (6). 32 See Duncan v. U.S., 368 F.2d 98 (5th Cir. 1966). 33 Note that if the beneficiary is a skip person for generation-skipping tax purposes, a Section 2503(c) trust may be sufficient to obtain a zero inclusion ratio under §2642(c). Section 2642(c) provides that a transfer that is not treated as a taxable gift by reason of Section 2503(b) is a direct skip that has an inclusion ratio of zero. A transfer to a trust for the benefit of an individual qualifies as a non-taxable gift if during the life of such individual no portion of the trust may be distributed to or for the benefit of any other person and if the trust does not terminate before the individual dies, the assets of such trust will be includible in the gross estate of such individual. Until age 21, a Section 2503(c) trust is also solely for the benefit of a single beneficiary, and is fully includible in the beneficiary’s gross estate if the beneficiary dies. However, typically, in a Section 2503(c) trust, the donee is given a power to withdraw all the assets of the trust at age 21 for a limited period of time, after which the power of withdrawal typically lapses, but the trust continues. However, if the general power of appointment lapses as to any portion of the trust in a manner that avoids estate tax inclusion, for example because the lapse is not treated as a release under Section 2514(e) to the extent it is equal to the greater of $5,000 or 5% of the trust corpus, the trust may no longer qualify as a good Section 2642(c) trust. That is because Section 2642(c) requires that the entire trust corpus either be distributable to the beneficiary or be includible in the beneficiary’s gross estate until the beneficiary’s death. Thus, it may be that the beneficiary’s power of withdrawal cannot lapse if the trust is intended also to qualify for Section 2642(c) treatment. See, e.g., PLR 200633015.

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Completed Gift Requires Surrendering Dominion and Control. A transfer will not qualify for the annual exclusion unless the transfer is complete for gift tax purposes. Treas. Reg. §25.2511-2 provides that a gift of property is complete when the donor has so parted with dominion and control as to leave the donor no power to change its disposition, whether for the donor’s own benefit or for the benefit of another. A transfer of an existing policy to an irrevocable trust is usually a completed gift for gift tax purposes. The irrevocable designation of a beneficiary of a policy is also a completed gift. However, a gift is incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves. But a gift is not considered incomplete merely because the donor reserved the power to change the manner or time of enjoyment by, for example, delaying or accelerating the time when the donee’s enjoyment is realized. Note that a retained power to affect the timing of enjoyment, even if the gift is complete, may cause the property subject to the power to be included in the donor’s estate under Section 2038, unless the power is limited by an ascertainable standard.34 The foregoing rules again weigh in favor of avoiding the designation of the insured as the trustee of his or her own ILIT so as to ensure a complete gift to the ILIT and avoid potential estate tax inclusion.

Transfers by Cash or by Check. A gift of cash to a trust is complete when the transferor relinquishes dominion and control.35 If the gift is made by check and state law permits the transferor to stop payment, the gift is not complete until payment of the check by the transferor’s bank when the trustee cashes it.36 More recently, however, courts have been willing to apply the doctrine of relation back in a non-charitable context where checks were delivered to the donee and presented for payment within a short time and within the tax year, even though not honored until the following year.37 On the other hand, if a check is delivered to the donor’s agent, no completed gift occurs.38 Accordingly, if trust contributions are made by check, the best practice will be for the trustee to negotiate the checks within the taxable year to ensure that the gifts by the transferor are complete in that year.

Crummey Powers of Withdrawal. In order to qualify contributions to an ILIT for the annual exclusion, the beneficiaries of the trust are usually given what is known as a “Crummey” power of withdrawal, named after the case Crummey v. Commissioner.39 In Crummey, each of four children, two of whom were minors, were given the power from the time of the addition to the trust until December 31 of the year in which the transfer to the child’s trust was made to demand in writing, in cash, the lesser of $4,000 or the amount of the transfer. The court held that whether a present interest exists turns on whether the donee is legally and technically capable of immediately enjoying the property. The court found 34 See Treas. Reg. §20.2038-1(a) (Section 2038 is applicable to a power reserved by the grantor of a trust to accumulate income or distribute it to A, and to distribute corpus of A, even though the remainder is vested in A or A’s estate, and no other person has any beneficial interest in the trust). 35 Treas. Reg. §25.2511-2(b). 36 See Dillingham v. Commissioner, 88 T.C. 1569 (1987), aff’d, 903 F.2d 706 (10th Cir. 1990) (court refused to extend the relation back doctrine applicable to charitable gifts to non-charitable gifts). 37 See Metzger v. Commissioner, 38 F.3d 118 (4th Cir. 1994). 38 See Estate of Holland v. Commissioner, 32 T.C.M. (CCH) 3236 (1997). 39 397 F.2d 82 (9th Cir. 1968), rev’g on this issue T.C. Memo 1966-144 (1966).

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that the parent could make a demand on behalf of the minor, and that it would be up to the trustee to petition the court for a legal guardian to receive the funds. The court declined to establish a test based upon the likelihood that the demand right would be exercised.40

As most frequently used, a Crummey power is a power, for a limited period, to withdraw an amount of the contribution not in excess of the annual exclusion available (generally, $10,000, indexed, or $20,000, indexed, if the transferor and the transferor’s spouse elect split-gift treatment under Section 2513 and the powerholder is not the transferor’s spouse) legally exercisable by a beneficiary or his or her guardian, whether or not a guardian has been appointed. Although IRS rulings indicate at least 30 days notice is required, the IRS has acquiesced in the result in the Estate of Cristofani v. Commissioner,41 which held that a right of withdrawal not in excess of the annual exclusion exercisable by the decedent’s children and five contingent remainder grandchildren for a period of 15 days following a transfer to the trust to constitute gifts of a present interest in each case within the meaning of Section 2503(b). In Cristofani, all trust income was payable equally to decedent’s two children and upon the decedent’s death, the trust was divided into two equal trusts for the benefit of the decedent’s children and payable to them upon surviving the decedent by 120 days. The court found that the decedent intended to benefit his grandchildren based upon the trust provisions, and that there was no agreement or understanding among the decedent, the trustees and the beneficiaries that the decedent’s grandchildren would not exercise their withdrawal rights, even though the rights were not exercised and the grandchildren never received trust distributions.42 On the other hand, where the facts and circumstances indicate a prearranged understanding that the withdrawal right would not be exercised, the annual exclusion may be denied especially in the case where the powerholders have no other interest in the trust.43

The beneficiary must have not only prompt notice but also a reasonable opportunity to exercise the right of withdrawal.44 Caution dictates notifying the beneficiary of the exact amount of the contribution and the amount that can be withdrawn.

In TAM 9532001, the IRS ruled that a waiver of contemporaneous notice as to future gifts to a trust disqualified those gifts as present interests because “[w]ithout the current notice that a gift is being transferred, it is not possible for a donee to have the real and

40 See Rev. Rul. 73-405, 1973-2 C.B. 321 (gift in trust for the benefit of a minor should not be classified as a future interest merely because no guardian was in fact appointed, if there is no impediment under the trust or local law to the appointment of a guardian and the minor donee has a right to demand distribution); Rev. Rul. 85-24, 1985-1 C.B. 329 (when a trust instrument gives a beneficiary the power to demand immediate possession of corpus, the beneficiary has received a present interest). 41 97 T.C. 74 (1991), acq. in result only, 1992-12 I.R.B. 4. 42 See also Estate of Kohlsaat, T.C. Memo 1997-212 (1997) (sixteen contingent remainder beneficiaries with 30 day demand rights held to qualify transfers for the annual exclusion; court refused to infer an implied understanding that the beneficiaries had agreed with the decedent not to exercise their withdrawal rights). 43 See, e.g., PLR 9731004. 44 Rev. Rul. 81-7, 1981-1 C.B. 474 (right to withdraw corpus qualifies as a present interest if the beneficiary has notice of the withdrawal right and a reasonable opportunity to exercise the power). See, e.g., PLR 199912016 (if the trustee gives prompt notice of the contribution to the beneficiary or the beneficiary’s custodian and there is no express or implied agreement that the withdrawal right will not be exercised, contributions to the trust will qualify for the annual exclusion).

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immediate benefit of the gift.” Accordingly, contemporaneous notice (within a reasonably short time of the transfers to the trust) coupled with proof that notice was given is the best practice to establish qualification for the annual exclusion. It may also be possible to satisfy the notice requirement by providing a schedule of contributions, such as, for example, in the case of a group term policy where the employer pays premiums directly, with an undertaking to notify the beneficiaries if the amount or timing of the contributions changes.45 Actual notice will also suffice, but the difficulty will be proving that the notice took place. However, in “clean-up” mode a written acknowledgment of actual notice by the beneficiaries may save the day. If the parent of a minor trust beneficiary with a withdrawal right is the trustee of the trust, there is no need to record written notice from the trustee to the parent.46

Potential Gift and Estate Tax Consequences to Holders of Crummey Powers. A Crummey withdrawal right is a general power of appointment within the meaning of Section 2514(c). The lapse of a Crummey power of withdrawal will be considered a release of the power, and consequently a taxable transfer by the powerholder to the extent the value of the property subject to the power exceeds of the greater of $5,000 or 5% of the then value of the trust.47 Revenue Ruling 85-8848 describes the application of this “5 and 5” exemption to multiple transfers to a single trust and transfers to multiple trusts and the requirement of aggregation and adopts an annual approach so that the 5% limitation is measured by the value of the trust on the date of each lapse of a power of withdrawal during a given calendar year, and the highest value may be used. However, having multiple lapse dates, which may have appeal from the standpoint of limiting the opportunity that the beneficiaries will have actually to withdraw trust funds, can be a record-keeping nightmare. Accordingly, many practitioners adopt the method originally articulated in the Crummey case, which is to extend all withdrawal rights to December 31 of each calendar year or, to the extent of contributions made during December, to extend those to December 31 of the following year.

Whether the lapse of a withdrawal right in excess of the $5,000/5% amount under Section 2514(e) is a current gift by the powerholder for gift tax purposes will depend on the terms of the trust instrument. If the property subject to the right of withdrawal is held in a trust for the exclusive benefit of the powerholder and the powerholder has a testamentary nongeneral or general power of appointment, no completed gift will occur because the powerholder has not relinquished dominion and control over the property.49

If Crummey powers of withdrawal in excess of the amount under Section 2514(e) are permitted to lapse creating a current taxable gift by the powerholder, a portion of the trust may nevertheless be includible in the gross estate of the powerholder under Section 2041(a)(2). Section 2041(a)(2) requires inclusion in the gross estate of a proportionate share of the trust with respect to which there has been a release of a general power of appointment to the extent that the post-lapse interests in the property, if the powerholder had owned and

45 See TAM 9045002 (authorizing an annual notice). 46 See Estate of Holland v. Commissioner, 32 T.C.M. (CCH) 3236 (1997). 47 Sections 2514(b) and (e). 48 1985-2 C.B. 201. 49 See Sanford’s Estate v. Commissioner, 308 U.S. 39, reh. den., 308 U.S. 637 (1939).

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transferred such property to the trust, would have caused inclusion under Sections 2035, 2036, 2037 or 2038. This is another example of the application of both gift and estate tax to the same transfer. Thus, even if a completed gift occurs by reason of the lapse of a power of withdrawal, there could be estate tax inclusion. Here’s why. The lapse of a power of withdrawal treated as a taxable gift will cause the powerholder to be treated as the settler of any continuing trust. If the powerholder has a continuing interest in the trust (for example, as a discretionary beneficiary), the trust will be treated as a self-settled trust. And a discretionary interest in a self-settled trust that can be reached by the settlor’s creditors under applicable State law will cause the trust to be included in the powerholder’s gross estate.50 In addition, the amount over which the powerholder has a current Crummey power of withdrawal at his or her death will be includible under Section 2041(a)(2). As previously stated, a completed gift as a result of the lapse of a power of withdrawal may be avoided if the powerholder has a testamentary power of appointment over the property with respect to which the lapse occurred.51 Even if no taxable lapse has occurred because the powerholder has a power of appointment over the continuing trust making the powerholder’s deemed transfer to the trust an incomplete gift, a portion of the trust will be includible in the powerholder’s gross estate under Sections 2041(a)(2) and 2038 because the powerholder has retained the right to determine who will receive the property.

Hanging Powers. One solution to both the gift and estate tax exposure described above is to avoid a taxable lapse (that would constitute a release) of the power of withdrawal through the use of a “hanging power”. A hanging power is a power to withdraw all of each addition up to the maximum amount permitted under the annual exclusion, that lapses only to the extent of $5,000 or 5% of the trust principal. The balance “hangs” into future calendar years until the lapse of the power will not be treated as a release under Section 2514(e).52

The amount subject to a hanging power of withdrawal can build up rapidly in the early years of the trust in view of the $5,000 or 5% maximum lapse permitted under Section 2514(e). Although it may not be the intention that any beneficiary actually exercise the power (no implied understanding, please), the occasional beneficiary will give it a whirl. One suggested way to cope with this possibility is to require the consent of another person (such as the trustee) with respect to the portion that hangs beyond the original Crummey 50 See Outwin v. Commissioner, 76 T.C. 153 (1981) (transfer to a trust that could be reached by the settlor’s creditors was incomplete for gift tax purposes). Treasury Regulations §20.2041-3(d)(4) and §20.204l-3(d)(5) explain how to calculate the includible portion of the trust, and indicate that lapses in multiple years will cause an ever increasing fraction of the trust to be includible because the fractions for each year are added to create a cumulative total, not to exceed the total assets over which the powers could have been exercised. 51 Whether a testamentary special power of appointment is sufficient to avoid a completed gift is not entirely clear. The examples under Treas. Reg. §2511-2(b) state that a gift is incomplete with respect to a transfer to a trust for the exclusive benefit of the transferor and over which the transferor has retained a testamentary special power of appointment. Thus, it is possible that a trust which includes other current beneficiaries is not within the foregoing exception. 52 Care should be taken to draft the hanging power in such a way that it will not be characterized as a condition subsequent. See TAM 8901004. In addition, one commentator has expressed the view that a hanging power may not be effective if the trust is funded with term insurance, even if the policy can be withdrawn by exercise of the power, because the value of the policy reaches zero by the end of the term; hence, the value of the trust is less than the value of the hanging power.

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withdrawal period. If the consentor is a person who is not the creator of the trust and who has no substantial interest in the trust adverse to the exercise of the hanging power, the power should continue to be a general power of appointment with respect to the powerholder.53 Accordingly, no lapse of a general power of appointment should occur by requiring consent to the exercise of the hanging power. Note that consent may not be required for purposes of exercising the original Crummey power without violating the present interest rule.54 However, after the initial withdrawal period, the continuing withdrawal right that avoids the lapse of a general power could require consent for its exercise.

One commentator has suggested a form of hanging power that specifically provides for a pro rata termination, taking account of the current Crummey power and all unlapsed hanging powers from prior years, but acknowledges that, alternatively, the powers could lapse in the order of created.55 The pro rata termination method requires allocating the permissible lapse amount among the current and hanging powers proportionately and carrying over the balance. In all events, the manner in which the successive lapses are to occur should be made clear in the instrument to avoid a construction that because it cannot be determined what lapses when, the powers hang indefinitely. The simplest method is to have a single lapse date each year and require the earliest withdrawal right to lapse first.

Gift-Splitting Considerations. Section 2513(a)(1) provides that a gift made by one spouse to any person other than his or her spouse shall, for gift tax purposes, be considered made one-half by each spouse. Gift splitting is permitted only if the following conditions are met: (1) at the time of the gift, both spouses are either citizens or residents of the United States so that each is fully subject to U.S. gift tax under Section 2502; (2) the spouses are married at the time of the gift, and if they subsequently divorce during the taxable year neither remarries prior to the end of the calendar year; and (3) both spouses consent to gift-splitting. However, gifts with respect to which the consenting spouse has an interest, unless the interest of third parties is ascertainable at the time of the gift and hence severable from the interest transferred to the spouse, may not be split.56 This rule will affect most ILITs which usually create an interest in the consenting spouse.

In PLR 200130030, Wife created a trust for Husband and three children. Husband was the trustee of the trust. Husband’s authority to distribute property to himself was limited by an ascertainable standard. The trust provided that upon each transfer by gift to the trust, each descendant of Wife could withdraw an amount from the trust equal to the lesser of the annual exclusion or a pro rata share of the contribution based upon the number of beneficiaries at that time. The taxpayer represented that contributions to the trust would not exceed twice the available annual exclusion multiplied by the number of Wife’s descendants who possessed a power of withdrawal. The powers of withdrawal would lapse, but only as to $5,000 or 5% of the assets subject to withdrawal in each year. The ruling

53 Section 2041(b)(1)(C); see Rev. Rul. 82-156, 1982-2 C.B. 216. 54 See Treas. Reg. §25.2503-3(b) (only an unrestricted right to immediate use, possession or enjoyment of property is a present interest). 55 Practical Drafting at 1812, R. B. Covey ed. July 1989. 56 Treas. Reg. §25.2513-1(b)(4).

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concludes that split gift treatment was available because “[t]he right of the trustee to make discretionary distributions to either Husband or the descendants is subordinate to the right of the descendants to exercise their withdrawal right.” Thus, the gifts were deemed made to the holders of the powers of withdrawal, not to the trust of which the Husband was a beneficiary, for purposes of analyzing whether split gift treatment was available.

However, a more recent PLR cast doubt on the foregoing treatment of powers of withdrawal. In PLR 200616022, Husband established an irrevocable trust for the primary benefit of Husband and Wife’s children. The Husband’s descendants had a noncumulative right to withdraw all or part of each contribution to the trust. The trust contained a qualified terminable interest property (QTIP) marital trust for Wife in the event Husband died within three years from the date of funding and a substantial portion of the trust estate were included in Husband’s gross estate for federal estate tax purposes. No gift tax returns were filed in the first two years that contributions were made to the trust. In the following three years, gift tax returns were filed and Husband signified Wife’s consent to split gifts on his gift tax return, but Wife never signed the return. The IRS concluded that split gift treatment was available for all five years because Wife’s interest is susceptible of determination and therefore severable from the gifts to the other beneficiaries. Thus, to the extent the value of the transfers to the trust exceeded the actuarial value of Wife’s interest as determined under Section 7520, split gift treatment was available. The IRS also concluded that since no returns were filed for years 1 and 2, split gift treatment would be available under Section 2513(b)(2)(A) which permits consent to split-gift treatment to be signified on the first filed return for the year. Because Husband and Wife evidenced their intention to elect split gift treatment for years 3, 4 and 5 on Husband’s return, and Wife did not file her own return, the consent to split gift treatment was effective for those years as well. Unfortunately, the effect of the Crummey powers on split gift treatment was not analyzed. But to the extent contributions to the trust did not exceed the amount subject to the powers of withdrawal, the existence of Wife’s QTIP trust should have been irrelevant to the analysis of whether split-gift treatment was available.

The IRS has also ruled that a spouse who consents to split gift treatment under Section 2513 with respect to transfers made by the other spouse will not become a transferor to the trust for purposes of Section 2036 or 2038.57 In addition, the consenting spouse acting as trustee of the trust will not be deemed to have a general power of appointment so long as distributions may not be made to satisfy the spouse’s support obligations and distributions to the spouse are limited by an ascertainable standard. However, the consenting spouse will become a transferor of one-half the property transferred to the ILIT for GST purposes.58

Use of Loans to Pay Premiums.. In PLR 200603002, Husband was the owner and insured of a life insurance policy having an interpolated terminal reserve value of $X. Wife was owner and insured of a life insurance policy having an interpolated terminal reserve value of $Y. Both policies were transferred to a Trust created by Husband and Wife and by their four children with Child as trustee. The Trust was revocable by any of the four children, in which case the trust estate would be distributed equally to those children. The 57 See, e.g., PLR 200130030. 58 Treas. Reg. §26.2652-1(b)(1) Example 9.

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Trust issued a deferred obligation to Husband and Wife represented by a note with a face value of $X + $Y less the amount of anticipated available annual exclusions. The intent was to exchange the two policies for a single “second to die” policy insuring the lives of Husband and Wife having a face amount of $Z that would be the property of the Trust. Each beneficiary acknowledged the gift to the Trust and the intent to contribute sufficient funds to the Trust to satisfy the deferred obligation and to pay ongoing premiums on the policy. Husband and Wife acknowledged that a split gift was made to the four children equal to the allowable annual exclusions. The life insurance agent presented documents and Husband and Wife assumed they were properly done, but the new policy was issued to Husband and Wife as the owners rather than to the Trust. All premium notices were sent to Child as trustee and Child paid the premiums. Husband and Wife did not file United States Gift (and Generation-Skipping Transfer) Tax Returns, Forms 709, in year 1. A few months later on January 1 of year 2, Husband and Wife executed a Declaration of Gift and Forgiveness of Note. Taxpayers requested rulings that the policy could be reformed and assigned to the Trust as owner without gift tax consequences, and that the proceeds of the policy would not be included in the gross estate of either Husband or Wife under 2035 if one or both were to die within 3 years of the reformation and assignment. The IRS ruled that there would be no taxable gift as a result of the reformation and assignment and that 2035 did not apply.

Nevertheless, spontaneously “for purposes of sound tax administration”, the IRS ruled that the deferred obligation was part of a prearranged plan with an intent to forgive the note. Facts cited in support were forgiveness a few months later, in a different tax year, and the fact that no payments on the note were ever made. Accordingly, the ruling concludes the note was part of prearranged plan to avoid gift tax. Thus the note did not constitute adequate and full consideration in money or money’s worth resulting in a gift in year 1 equal to the principal of the note, rather than a gift in year 2 eligible for a second round of annual exclusions.

The use of notes to fund an ILIT may be viewed as problematic because the ILIT may not be able to satisfy the criteria to support the note as bona fide debt. A number of factors have been identified by the courts as indicative of bona fide debt, which include the ability to pay interest currently and to have assets sufficient to satisfy the debt, perhaps independent of the asset acquired with the proceeds of the loan.59 However, because an ILIT is typically a grantor trust, the issue of interest income and the deductibility of the

59 See Miller v. Comm'r., 71 T.C.M. 1674 (1996), aff’d, 113 F.3d 1241 (9th Cir. 1997) (“The mere promise to pay a sum of money in the future accompanied by an implied understanding that such promise would not be enforced is not afforded significance for Federal tax purposes, is not deemed to have value, and does not represent adequate and full consideration in money or money’s worth. . . . The determination of whether a transfer was made with a real expectation of repayment and an intention to enforce the debt depends on all the facts and circumstances, including whether: (1) There was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was any security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) any actual payment was made, (7) the transferee had the ability to repay, (8) records maintained by the transferor and/or the transferee reflected the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax purposes is consistent with a loan”). See, also, Santa Monica Pictures, LLC v. Comm'r, TC Memo 2005-104. But see, Estate of Rosen v. Commissioner, T.C. Memo 2006-115.

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interest expense does not arise.60 Thus, perhaps an accrual of interest until the policy matures can be justified without raising other tax issues.

Additional Estate Tax Issues

Section 2035 provides that life insurance proceeds are includible in the decedent’s gross estate even if the decedent has no incidents of ownership at death, if the decedent transfers within three years of the decedent’s death an interest in the policy that would have caused the proceeds to be includible in the decedent’s gross estate had the decedent retained the interest (Sections 2035(a)). Section 2035(d) provides an exception for transfers for full and adequate consideration.

Deemed Transfer Rule. Under the “deemed” transfer rule articulated in Bel v. United States,61 the proceeds of an insurance policy acquired by a trust within 3 years of death may be includible in the decedent’s gross estate even if the decedent never actually possessed any incidents of ownership. Under the rule, a decedent may be held responsible for the existence of the policy at death (and thus treated as if he or she had owned the policy), either because the decedent paid premiums or otherwise controlled the actual owner, and is therefore “deemed” to have made a transfer creating the contractual rights in the policy beneficiary. The “deemed” transfer within three years of death causes the entire proceeds to be includible in the decedent’s gross estate. The “deemed transfer” rule, if applied, in effect resurrects the old “payment of premiums” test for inclusion of life insurance proceeds when the policy is acquired within three years of death. However, subsequent cases have discredited the “deemed” transfer rule.

In Estate of Headrick v. Commissioner,62 the Commissioner sought to include the proceeds of an insurance policy purchased within three years of death by the trustee of an ILIT created by the decedent. The decedent alone made contributions to the trust. The Tax Court, in a unanimous reviewed decision, held that the proceeds were not includible in the decedent’s gross estate following its decision in Estate of Leder v. Commissioner.63 The court found that the bank/trustee was not acting as the decedent’s agent, and rejected applying the constructive transfer theory articulated in Bel.64 An interesting point is that the Commissioner apparently conceded that the decedent’s “right to remove any trustee at will and appoint a successor bank trustee” was not an incident of ownership.65

In Estate of Perry v. Commissioner,66 the court held that proceeds from life insurance policies purchased within three years of the decedent’s death were not includible in his gross estate, despite the fact that he had signed an application for insurance as proposed insured,

60 Under Rev. Rul. 85-13, 1985-1 C.B. 184, a loan between a grantor and a grantor trust is not recognized for federal income tax purposes. 61 452 F.2d 683 (5th Cir. 1971), cert. denied, 406 U.S. 919 (1972). 62 93 T.C. 171 (1989), aff’d, 918 F.2d 1263 (6th Cir. 1990). 63 89 T.C. 235 (1987), aff’d, 893 F.2d 237 (10th Cir. 1989). 64 Note Action on Decision CC-1991-012 (July 3, 1991) announcing that the Service will no longer litigate this issue and recommending acquiescence. 65 Cf. Rev. Rul. 79-353, supra. 66 59 T.C.M. (CCH) 65 (1990), aff’d, 927 F.2d 209 (5th Cir. 1991).

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and had paid the premiums. The application designated the decedent’s three sons as co-owners, and the court found that the decedent never held any ownership, economic, or other contractual rights in the policies. In light of Perry, the insured should be careful not to sign the application as the owner, but only consent to the application as the insured.

Note that even if a transfer of the policy is made within three years of death, a portion of the proceeds may nevertheless be excludible. In Estate of Silverman v. Commissioner,67 the court held that the portion of the proceeds of a life insurance policy includible in the decedent’s gross estate under Section 2035, if the assignee paid the premiums during the three year inclusion period, should be calculated by multiplying the entire proceeds by a fraction, the numerator of which is the amount of premiums paid by the decedent, and the denominator of which is the entire amount of premiums paid since the inception of the policy.

Use of a Protective Marital Deduction Trust. If existing policies are transferred to an ILIT by a married individual, the ILIT should contain a provision creating a trust that qualifies for the marital deduction in the event of the insured’s death within the three-year inclusion period (or if estate tax inclusion occurs for any other reason). Because an insurance trust is irrevocable, any provisions for the benefit of the surviving spouse should be thought through carefully in light of the realities of possible divorce and second family circumstances. A so-called QTIP trust within the meaning of Section 2056(b)(7) is preferable because the settlor will control the ultimate disposition of the proceeds upon the spouse’s death and the amount of marital deduction used.68 In addition, if the definition of surviving spouse is modified either to exclude an existing spouse in identified situations or include a future spouse, care should be taken to make sure tax sensitive powers (such as powers to maintain grantor trust status discussed below) take account of any modified definition of “spouse”.

Transfers for Full and Adequate Consideration. Section 2035(d) creates an exception to the application of the transfer within three years of death rule for transfers for adequate and full consideration in money or money’s worth. To the extent a policy is owned by the insured and would thus be includible under Section 2042(2), a transfer to an ILIT for full and adequate consideration should avoid estate tax inclusion of the policy proceeds.69 Caution should be exercised in establishing the appropriate value of the policy.

A transfer for full and adequate consideration can potentially avoid the application of all of Sections 2036, 2038 and 2035. Section 2036 could apply if the insured’s spouse has at any time been the owner of the policy and is intended to be a beneficiary of the ILIT. Section 2038 could apply if the transferor is intended to be a trustee of the ILIT. A transfer for consideration also raises the issue of whether full and adequate consideration is

67 61 T.C. 338 (1973), aff’d, 521 F.2d 574 (2d Cir. 1975), acq., 1978-1 C.B. 2. 68 A QTIP trust qualifies for the marital deduction only to the extent elected. If the insured’s spouse may not be a U.S. citizen when the insured dies, the trust should be in the form of a QDOT. 69 For a more comprehensive discussion of the topic, see M. Gans & J. Blattmachr, Life Insurance and Some Common 2035/2036 Problems, 139 Trusts & Estates 58 (May 2000), reprinted in 26 ACTEC Notes 39 (Summer 2000).

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measured by the value of what would have been included in the estate (the policy proceeds) or the fair market value of the policy at the time of transfer. The better view is that it should be the latter based upon the principle of arms length dealing articulated in Treas. Reg. §25.2512-8 since no arms length purchaser would pay more than current value for the policy.70 Some argue that under the Allen71 case involving the sale of an income interest in a trust, fair market value is measured by what would have been included in the gross estate at death, which in the case of a life insurance policy would be the policy proceeds. But that analysis would seem flawed because in the case of a purchase of a policy, the entire asset is transferred. In Allen, only the income interest was sold in order to exclude the underlying principal of the trust from the gross estate. That result should be distinguished from the case where the remainder interest is sold for its actuarial value, a result that has been upheld because the remainder interest over the life expectancy of the beneficiary would grow to equal the value of the trust.72 Moreover, the ILIT will likely have a continuing obligation to pay premiums in order to receive the policy proceeds. The payment of those premiums, in the view of the insurer, is actuarially appropriate consideration for the right to receive the death benefit. Accordingly, payment of an amount equal to the current fair market value of the policy, plus payment of future premiums, is economically equal to the value of the death benefit, and there is no windfall to the taxpayer in the transaction.

So long as the trust is a wholly grantor trust for income tax purposes, a sale of assets to the trust by the grantor is disregarded. If the non-contributing spouse has a discretionary interest as to both income and principal, the trust should be wholly grantor under Section 677(a)(1) as to the contributing spouse. Accordingly, no income tax realization event occurs and the policy proceeds should be excluded from both estates.73

Application of the Reciprocal Trust Doctrine. If both husband and wife contemplate creating an ILIT, consideration should be given to the potential application of the reciprocal trust doctrine. The U.S. Supreme Court set forth the doctrine in its current form in the seminal case U.S. v. Grace.74 In Grace, husband and wife created virtually identical trusts for one another. The decedent’s trust was created within 15 days of the wife’s trust. The wife’s trust, at issue in Grace, provided that the trustees were to pay all the income to the husband, with principal payable in the discretion of the trustees. The husband also had a testamentary special power of appointment in favor of the wife and their descendants. The wife used funds given to her by the decedent to create the trust. The Supreme Court held that the two trusts were interrelated and, to the extent of mutual value, left the settlors in approximately the same position as they would have been in had they created trusts naming themselves as life beneficiaries. Accordingly, to the extent of the mutual value, the wife’s trust was includible in the husband’s estate under the predecessor to Section 2036(a)(1). Importantly, the Court ruled that the reciprocal trust doctrine is dependent neither upon a finding that each trust was created as a quid pro quo for the other nor upon the existence of a tax-avoidance motive.

70 Compare U.S. v. Allen, 293 F.2d 916 (10th Cir. 1961). 71 Id. 72 See, e.g., Estate of D’Ambrosio v. Comm’r, 101 F.3d 309 (3rd Cir. 1996). 73 See, e.g., PLR 9413045. 74 395 U.S. 316 (1969).

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In Estate of Bischoff v. Commissioner,75 the Tax Court extended the application of the reciprocal trust doctrine to trusts created by a husband and wife in which neither had any beneficial interest. Each of Bruno and Bertha Bischoff created four trusts, one for each of their four grandchildren, naming each other as sole trustee. The trustee was authorized to apply income and principal for the benefit of the grandchild, and to accumulate income not so applied. The trusts were created within 2 days of each other. Bruno died approximately 2 years before Bertha. The Tax Court refused to limit the application of the reciprocal trust doctrine to crossed economic interests, and held that the trusts created by Bruno and Bertha were includible in their respective estates under Section 2036(a)(2) and Section 2038(a)(1). Note that this is not exactly what the Grace court did. The Grace court would have included the trusts created by Bruno in Bertha’s estate and vice versa.

In Sather v. Commissioner,76 each of three brothers and their wives attempted to make annual exclusion gifts to their own children and to each others’ children. The court denied the annual exclusion for the gifts to nieces and nephews under the reciprocal trust doctrine, treating those gifts as if made by the parents. All gifts were of family stock and were made on the same day and in the same amounts.

On the other hand, in Estate of Levy v. Commissioner,77 the Tax Court held that the reciprocal trust doctrine did not apply to two similar trusts created by decedent and his wife. The two trusts were identical, except that the husband’s trust conferred on the wife, individually and not as trustee, a special power of appointment entitling her to appoint income and corpus of the husband’s trust at any time during her lifetime to any person or persons other than herself, her creditors, her estate or the creditors of her estate. The trusts were created on the same day. Each trust appointed the other spouse as sole trustee. It appears that the spouses had no other interests in the trusts.

Moreover, in Estate of Green v. U.S.,78 the Sixth Circuit refused to apply the reciprocal trust doctrine based solely on fiduciary powers (expressly discrediting the Bischoff decision) where husband created a trust for the benefit of one granddaughter, naming wife as trustee, and wife created a trust for the benefit of a different granddaughter, naming husband as trustee. The trustee had the power to accumulate income and time the distribution of income and corpus until the beneficiary reached age 21. The trusts were created on the same day. The court held that the fiduciary powers “do not constitute a retained economic benefit that satisfies the core mandate of Grace ‘that the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries.’”

In PLR 200426008, each of husband and wife created an irrevocable life insurance trust naming the other spouse as sole trustee. Each trust was to own insurance of the life of the settlor. During the lives of the settlor and the settlor’s spouse, the trustee was required to distribute to or for the benefit of the spouse and/or the son any amounts of income or

75 69 T.C. 32 (1977). 76 251 F.3d 1168 (8th Cir. 2001). 77 46 T.C.M. (CCH) 910 (1983). 78 68 F.3d 151 (6th Cir. 1995).

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principal as are necessary or advisable for their health, support, maintenance and education. The husband’s trust contained the following provisions not in the wife’s trust: (i) with respect to the trust administered during the husband’s lifetime, if son predeceased wife, a “5 and 5” power and a lifetime special power of appointment over principal, (ii) with respect to the protective Marital Trust, a 5% withdrawal right and a testamentary special power of appointment, and (iii) with respect to the trust administered after the husband’s death, if the son predeceased wife, a “5 and 5” power and lifetime and testamentary special powers of appointment. The wife’s trust eliminated the husband’s beneficial interest in the trust in the event his net worth and compensation exceeded certain dollar amounts. The IRS, after discussing Grace and Levy, ruled that neither trust would be includible in the gross estate of the spouses by application of the reciprocal trust doctrine.

In view of the foregoing authorities, if husband and wife will each create an irrevocable life insurance trust and, in particular, if each will have a beneficial interest in the other’s trust, those interests should be drafted as substantively differently as possible. Giving one spouse but not the other a special power of appointment should be considered. In addition, husband and wife should probably not serve as trustee of each other’s trust, and the trusts should not appoint the same third party trustee. It would be preferable if the trusts were not created on the same date. Six months or a year apart should help to demonstrate that the trusts were not interrelated.

Income Tax Issues

Transfer for Value. To avoid loss of income tax exclusion of the policy proceeds, the transfer for value rule of Section 101(a)(2) must be taken into account. Section 101(a)(2) provides that if an insurance policy is transferred for valuable consideration then, unless an exception applies, the general rule that the policy proceeds are not includible in gross income does not apply. Under Revenue Ruling 85-13,79 a transfer between a grantor and his wholly grantor trust is not an income tax realization event. Under Section 1041, transfers between spouses, provided neither is a nonresident alien, also do not result in income tax realization, rather the transferee spouse takes a “carry over” income tax basis. Section 101(a)(2)(A) specifically excepts transfers where the transferee takes a carry over basis from application of the transfer for value rule. Section 101(a)(2)(B) also excepts from the transfer for value rule transfers to the insured, a partner of the insured, a partnership in which the insured is a partner and a corporation in which the insured is a shareholder or officer. It has always been a question whether a transfer to a wholly grantor trust with respect to the insured would qualify as a transfer “to the insured” for purposes of the transfer for value rule. Happily, Rev. Rul. 2007-1380 answers that question in the affirmative. The ruling considers the situation of a transfer of a policy from one wholly grantor trust to another, as well as a transfer of a policy from a non-grantor trust to a wholly grantor trust. The ruling concludes that a grantor who is treated for Federal income tax purposes as the owner of a trust that owns a life insurance contract on the grantor’s life is treated as the owner of the contract for purposes of applying the transfer for value limitations under Section 101(a)(2). 79 1985-1 C.B. 184. 80 2007-11 I.R.B. 684.

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Maintaining Grantor Trust Status. To avoid application of the transfer for value rule described above, it may become necessary to establish who is the grantor of a particular trust. Treas. Reg. §1.671-2(e)(1) provides that the grantor includes any person to the extent such person either creates a trust or directly or indirectly makes a gratuitous transfer of property to a trust. The regulation then draws a distinction between a grantor and one who can be treated as an owner of any portion of the trust for purposes of Sections 671 through 677. Only a person who makes a gratuitous transfer to a trust can be treated as an “owner” for purposes of those Sections, and being an owner is necessary in order to engage in disregarded transactions with the trust. Thus, if A makes a gratuitous transfer to a trust but is thereafter reimbursed by B, both A and B are grantors, but only B can be treated as an owner.

If property is transferred from one spouse to another shortly before the funding of a trust, both spouses may be treated as grantors, but if the recipient spouse who created the trust is treated as contributing property to the trust as part of a prearranged plan with the donor spouse, it will be the donor spouse who is treated as the “owner” for grantor trust purposes.81

Making sure that every irrevocable life insurance trust is a wholly grantor trust as to only one person is very useful in anticipation of a potential need to exit the trust. Given the IRS’s willingness to disregard transfers between wholly grantor trusts with respect to the grantor or the grantor’s spouse, trusts with undesirable provisions can be terminated in favor of new trusts that reflect the revised dispositive intent of the grantor. It might be unwise to rely solely on Section 677(a)(3) (which provides for the trust to be a grantor trust to the extent the income of the trust may be used to pay premiums on policies on the life of the grantor or the grantor’s spouse) for grantor trust status. Grantor trust status may apply only to the portion of the trust the income from which is currently used to pay premiums. The power held in a non-fiduciary capacity, to substitute property of equivalent value under Section 675(4)(C) should cause a trust to be a wholly grantor trust, although the IRS has refused to rule on its effectiveness. Where the assets of the trust consist of an insurance policy on the life of the grantor, a substitution power may raise a concern about estate tax inclusion under Section 2042(2). The court in Estate of Jordahl v. Commissioner,82 held that a power of substitution did not result in Section 2042(2) inclusion, but also concluded that the grantor held the power in a fiduciary capacity. Private letter rulings have extended the rule even where the power is not held in a fiduciary capacity. However, it is reported that the IRS recently refused to issue a favorable ruling that trust property was not includible in the gross estate under any of Sections 2033, 2036, 2038 and 2039 without a representation that the power of substitution was held in a fiduciary capacity.83 Some suggest giving the power to someone else, such as a spouse or other party. The word “reacquire” in Section 675(4)(C) does give one pause, although the spousal unity rule under Section 672(e)

81 Cf., e.g., Brown v. U.S. 329 F.3d 664 (9th Cir. 2003) (spouse who paid gift tax with funds received from the other spouse the previous day was treated as a “mere conduit”, and when the other spouse died, the gift taxes paid were included in the decedent’s gross estate under Section 2035(b) notwithstanding the lack of a binding legal obligation on the part of the decedent’s spouse to make the gift tax payment). 82 65 T.C. 92 (1975), acq. 1977-1 C.B. 1. 83 See, e.g., PLR 200603040.

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of the grantor trust rules makes giving the spouse the power a seemingly viable choice. Alternatively, a related and subordinate party could be named as trustee with the power to make discretionary distributions not on an ascertainable standard in order to make the ILIT a wholly grantor trust, although the trustee named must be related and subordinate as a matter of fact in order for the rule to apply. So long as the grantor cannot remove and replace the trustee, the initial appointment of a related and subordinate party trustee should not cause the powers of the trustee to be attributed back to the grantor for estate tax purposes.84 Another possibility is to give a person who is not a contributor to or beneficiary of the trust the power to add to the class of beneficiaries (for example, charity or other descendants).85

Crummey Powerholders Treated as Grantors. As previously mentioned, maintaining an irrevocable life insurance trust as a wholly grantor trust can provide opportunities for tax efficient exit strategies should the trust provisions no longer be desirable. So long as the grantor is treated as the owner under the grantor trust rules, no other person will be treated as the owner. Note, however, that for income tax purposes, the IRS takes the position that under Section 678(a)(2), a Crummey powerholder who fails to exercise the power will be treated as the owner, for grantor trust purposes, of the portion of the trust not only as to which a Crummey power is outstanding, but also as to which a Crummey power lapsed, and that the lapses in successive years are cumulative.86 Thus, for example, if a spousal beneficial interest or power of substitution were the means of maintaining grantor trust status, death of the spouse prior to the insured, may cause the trust to become a grantor trust not as to the “true” grantor, but instead as to the Crummey powerholders. Accordingly, thought should be given to a back-up mechanism to maintain grantor trust status in the grantor to preserve flexibility.

It may not be entirely clear whether grantor trust status as to the grantor trumps grantor trust status as to the holder of a power of withdrawal over trust principal. Section 678(a) says that a person other than the grantor will be treated as the owner of any portion of a trust with respect to which such person has a power exercisable solely by himself to vest corpus or income therefrom in himself or has partially released such a power and thereafter retained such control within the principles of Sections 671 to 677 as would subject the grantor to treatment as the owner. Thus, a Crummey powerholder with a beneficial interest in the trust would be caught by this rule and treated as the owner of the trust for grantor trust purposes. Section 678(b) creates an exception to the foregoing rule, and states that the rule does not apply with respect to a power over “income” if the grantor is otherwise treated as the owner. This raises the question of whether the exception applies if the power is over “corpus”. Treas. Reg. §1.671-2(b) provides, however, that when the regulations state that “income” is to be attributed to the grantor or another person, unless specifically limited, the reference is to income determined for tax purposes and not to income for trust accounting purposes. Treas. Reg. §1.678(b)-1 repeats the exception in the Code for a power over “income” if the grantor is treated as the owner. If the word “income” in Section 678(b) is read (consistent with the regulations) to mean “taxable income”, then a Crummey power over trust principal (which would include capital gains allocable to corpus) would be 84 See, e.g., PLR 9636033. 85 See Section 674(b)(5) and (6). 86 See, e.g., PLRs 9034004, 8701007, 8521060 and 8517052.

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excepted under Section 678(b), and the grantor would continue to be treated as the owner of the entire trust for grantor trust purposes. The IRS has issued private letter rulings consistent with this interpretation.87

Generation-Skipping Transfer Tax Issues

If an irrevocable life insurance trust owns a policy that is certain to be maintained as a permanent feature of the grantor’s estate plan (which is probably a rare case), consideration should be given to allocating GST exemption to transfers to the trust. In the case of a policy which at any time will have a value lower than premiums paid, late allocation may be considered; however, Treas. Reg. §26.2642-2(a)(2) provides that the rule permitting valuation as of the first day of the month during which the late allocation occurs may not be used with respect to a trust owning a life insurance policy if the insured has died. Query whether the rule applies if the trust owns an interest in an entity that in turn owns the insurance.

In order to cause an irrevocable life insurance trust to have a zero inclusion ratio for GST purposes by means of timely GST exemption allocations, allocation must be made to all transfers to the trust. Crummey rights of withdrawal granted to grandchildren of the transferor will not generally permit those transfers to qualify for the special rule under Section 2642 that affords non-taxable gifts a zero inclusion ratio. This is because the transfers are deemed made to the trust for GST purposes, rather than being treated as direct skip transfers to the grandchildren. And an ILIT with powers of withdrawal does not typically satisfy the requirements of Section 2642(c) because it usually has multiple beneficiaries.

Treas. Reg. §26.2652-1(a)(5) Example 5 confirms that the lapse of a withdrawal right in the hands of someone other than the grantor’s spouse after 60 days that does not result in a taxable gift by the powerholder will not cause the powerholder to be treated as a transferor to the trust for GST purposes. Therefore, to the extent that the amount with respect to which the power of withdrawal lapses does not exceed $5,000 of 5% of the value of the trust estate, the original transferor to the trust will remain the transferor for GST purposes and may effectively allocate GST exemption to the trust. Treas. Reg. §26.2632-1(c)(2)(ii)(B) states that the value of transferred property is not considered as being subject to inclusion in the gross estate of the spouse of the transferor (the so-called ETIP rule that generally prevents current allocation of GST exemption), if the spouse possesses with respect to any transfer to the trust, a right to withdraw no more than $5,000 or 5% of the trust corpus, and such withdrawal right terminates no later than 60 days after the transfer to the trust. Accordingly, all withdrawal rights in an ILIT to which GST exemption will be allocated should conform to the foregoing limitations so that GST exemption allocations by the grantor will be effective.

Section 2632(c) defines a GST trust as a trust that could have a generation skipping transfer at sometime in the future. An ILIT will typically satisfy this definition. Section 2632(c) provides a number of exceptions to the default designation of a trust as a GST trust,

87 See, e.g., PLRs 200011054, 9812006, 9810006, 9809004, 9745010, 9321050 and PLR 9309023.

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but the application of the exceptions is not entirely clear. If an ILIT is determined to be a GST trust, the deemed allocation rules of Section 2632(c) will apply to cause automatic allocation of the grantor’s GST exemption. Therefore, if GST exemption allocation is not desired, the transferor (and the transferor’s spouse in the case of split gifts under Section 2513) will need to elect out of deemed allocation. The IRS has recently published final regulations on the election out of deemed allocation of GST exemption under Section 2632(c).88

If any portion of a trust would be includible in the gross estate of a non-skip person if the non-skip person died immediately after the transfer, the trust is excluded from the definition of a GST trust. An ILIT where a child has an outstanding Crummey power would be partly includible in the child’s gross estate if the child were to die. However, Section 2632(c) provides an exception to the estate tax inclusion rule for rights of withdrawal that do not exceed the amount referred to in Section 2503(b). Thus, Crummey powers within the annual exclusion will not cause a trust to fail to be a GST trust, and deemed allocation would apply. Unfortunately, an ILIT with a hanging power is likely to exceed this limitation in the second or third year of the ILIT, if contributions are made each year, thus causing the ILIT to cease being a GST trust.

Exceptions to the definition of a GST trust also exist for trusts that terminate in favor of non-skip persons prior to age 46 or upon the death of a person more than 10 years older than a non-skip person. Unfortunately, the typical ILIT falls between these two exceptions. A trust that has the grantor’s spouse as a beneficiary and, following the spouse’s death, is divided into continuing trusts for children until age 35 would satisfy neither of the foregoing exceptions to a GST trust and be subject to deemed allocations of GST exemption. Likewise a trust that continues as a pot trust until the death of the insured, followed by trusts to stated ages under 46, would fall outside the exceptions.

In view of the complex application of the deemed allocation rules, the practitioner would be well advised to elect out of the application of the deemed allocation rules with respect to all transfers to the ILIT in the year it is created and for all future years. This may be done on a timely filed gift tax return for the year the ILIT is initially funded. Electing out of the deemed allocation rules will not prevent the affirmative allocation of GST exemption, if desired.

It may also be possible to minimize the application of GST tax to an ILIT through the use of the so-called “Cascading Crummy PowersSM” technique.89 This technique involves having the powerholders’ powers of withdrawal actually lapse in their entirety so as to cause the excess over the $5,000 and 5% amount to be treated as a taxable gift to the ILIT by the powerholders. But then to avoid current gift tax, further Crummey powers are conferred as to the taxable gifts made by the powerholders. Of course, the trust must be drafted so that a taxable gift in fact occurs as a result of the lapse of the first tier of Crummey powers. If the ILIT is held, at least initially, as a single discretionary trust for the benefit of

88 26 CFR Parts 26 and 602 [TD 9208]. 89 See J. Blattmachr & G. Slade, Life Insurance Trusts: How to Avoid Estate and GST Taxes, 22 Est. Plan. 259 (September/October 1995).

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the grantor’s spouse and descendants over which no powers of appointment are granted, this would in fact be the case. The GST consequences of a taxable lapse of a Crummey power will be that the powerholders will become transferors to the ILIT for GST purposes, thus potentially deferring GST tax to the extent the powerholders are in a generation lower than that of the grantor of the ILIT. Each portion of the ILIT that is treated as having a separate transferor should be treated as a separate trust for GST purposes. This technique of course involves even more complex administration by requiring several tiers of Crummey notices to be issued by the trustee as well as necessitating separate accounting for the portions of the trust having different transferors for GST purposes.

Alternatives to an ILIT

It can many times be the case that the annual premium on a given life insurance policy is so large that the grantor does not have a sufficient number of beneficiaries who can be granted Crummey powers so as to avoid entirely a taxable gift to the trust when the premium is paid. Since it may not be known whether the life insurance will be maintained until death, it would seem inefficient for the lifetime gift tax exclusion to be used to shelter the premium payments from gift tax. In such a case, combining ownership of the life insurance with other estate planning strategies can produce the most tax efficient results. If, for example, a family partnership were an appropriate structure to own family assets, and those assets produce sufficient cash flow to support the insurance policy, it may be most appropriate to permit the family partnership to acquire the insurance. Transfers of interests in the family partnership to trusts for the benefit of family members, either by gift or by sale, should cause a proportionate part of the proceeds to be excluded from the insured’s estate, even if the insured is a partner.90 Moreover, because the trust would not require annual contributions to maintain the policy, it will be more straightforward effectively to allocate GST exemption to the trust and produce a zero inclusion ratio.91

A family partnership can also provide an exit strategy for an insurance policy that is improperly owned because transfers for value to a partnership in which the insured is a partner or to a partner of the insured are both exceptions to the transfer for value rule.92 Therefore, using a partnership as an exit strategy will preserve income tax exclusion of the policy proceeds.

Conclusion

Structuring an effective irrevocable life insurance trust is important to the estate plan of many clients. Maximizing the after-tax value of the insurance proceeds, while maintaining the opportunity to deal flexibly with the disposition of the policy, requires

90 See Estate of Knipp v. Commissioner, supra. 91 Nevertheless, in light of Estate of Strangi v. C.I.R., 115 T.C. 478 (2000), aff’d in part, rev’d in part, 293 F.3d 279 (5th Cir. 2002), reh’g denied, 48 Fed.Appx. 108 (5th Cir. 2002), on remand, T.C. Memo. 2003-145, aff’d by, 417 F.3d 468 (5th Cir. 2005), reh’g granted, 429 F.3d 1154 (5th Cir. 2005), where the Tax Court attributed powers causing estate tax inclusion to the decedent through the decedent’s non-controlling interest in the general partner of a family partnership, it may be appropriate to avoid having the insured ever control distributions or investments in the family partnership that owns the insurance. 92 I.R.C. §101(a)(2).

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careful navigation of both the transfer tax and the income tax rules. The attached checklist will assist the practitioner to avoid the pitfalls and preserve the tax benefits in creating and administering this complex, but extremely common, estate planning tool.

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CHECKLIST FOR PREPARING AND ADMINISTERING AN ILIT

1. Make sure your ILIT permits distributions during the life of the insured (subject to the Crummey powers). An ILIT is not a “naked” trust; it has an asset in the form of the policy that needs to be administered and potentially distributed to one or more of the beneficiaries.

2. Do not allow the insured/grantor to be appointed as a trustee. You are asking for trouble.

3. If you are dealing with a new policy, make sure the ILIT is in place first and the trustee applies for the policy. Make sure the ILIT is designated as owner and beneficiary of all policies.

4. If contributions to the ILIT are made by check, make sure the trustee opens a bank account in the name of the trust and negotiates checks promptly, but in all events within the calendar year.

5. Make the ILIT a wholly grantor trust with respect to one and only one grantor. Remember, in general, only the person who gratuitously contributes assets can be treated as an “owner” for grantor trust purposes. Splitting gifts should not affect the identity of the grantor. Make sure grantor trust status is maintained until the death of the insured (otherwise 678 may shift grantor trust status to the Crummey powerholders).

6. Make sure your Crummey powers comply with the case law. Use at least a 30-day notice period, require written notice and keep records. Give Crummey powerholders an interest in the trust by making them discretionary beneficiaries during the life of the insured to avoid an IRS challenge that the powers are illusory. Do not engage in any written or oral communications to the effect that the powers are “technical and not to be exercised.”

7. Do not allow Crummey powers to be exercised on behalf of a minor beneficiary by a contributor to the trust.

8. Consider giving contributors to the trust the power to eliminate powerholders or change the duration of the powers of withdrawal with respect to any new transfer to the trust. This should not cause a contributor who is the insured to be deemed to have incidents of ownership with respect to the policy, even if the powers of withdrawal are exercisable with respect to the policy itself.

9. If the rights of withdrawal will exceed $5,000 or 5% annually, use hanging powers to avoid taxable gifts by the powerholders. Consider an annual lapse on December 31 for ease of administration.

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10. Consider carefully whether allocating GST exemption is worthwhile. As your ILIT is unlikely to qualify for 2642(c), you will need to allocate exemption to all transfers to the trust, or make effective late allocations. Remember no late allocations after the insured’s death are permitted, so don’t wait too long. If GST exemption is allocated, the Crummey powers need to comply with the GST Regs. (no more than 60 days, and only $5,000 or 5% for the spouse). Elect out of automatic allocation for current and all future transfers to the trust on a timely 709 for the first year of the trust. Then make your own allocations by Notice of Allocation, if desired. Note that if you are splitting gifts with the spouse, the spouse is a GST transferor and must elect out of automatic allocation and allocate as well. Remember for the trust to be exempt, you must allocate to all transfers, even if the spouse and children have powers of withdrawal because each transfer is to the trust for GST purposes, not to the Crummey powerholders.

11. Consider whether using a family entity ownership structure combined with more comprehensive estate planning is more tax efficient and flexible for insurance with larger premium payments than a simple ILIT.

12. Make sure the trustees have adequate powers to administer the policy, including potentially entering into split dollar arrangements, selling the policy, exchanging it and so forth. If there is a need to exit the trust altogether, do not forget about the transfer for value rule.

13. Maintain your sense of humor. This stuff is absurdly technical for a fairly simple objective.

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RESHUFFLING YOUR LIFE INSURANCE WITHOUT GIVING THE IRS YOUR CHIPS* © 2005 Diana S.C. Zeydel. All Rights Reserved.

Diana S.C. Zeydel

Greenberg Traurig, P.A. Miami, Florida

THIS WRITING IS NOT TAX ADVICE.

TO THE EXTENT THE WRITTEN MATERIAL CONTAINED HEREIN IS NEVERTHELESS CONSTRUED TO BE TAX ADVICE, WE ADVISE YOU AS FOLLOWS: PURSUANT TO FEDERAL REGULATIONS IMPOSED ON PRACTITIONERS WHO RENDER TAX ADVICE (“CIRCULAR 230”), WE ARE REQUIRED TO ADVISE YOU THAT ANY TAX ADVICE CONTAINED HEREIN IS NOT INTENDED OR WRITTEN TO BE USED FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE. IF THIS ADVICE IS OR IS INTENDED TO BE USED OR REFERRED TO IN PROMOTING, MARKETING OR RECOMMENDING A PARTNERSHIP OR OTHER ENTITY, INVESTMENT PLAN OR ARRANGEMENT, THE REGULATIONS UNDER CIRCULAR 230 REQUIRE THAT WE ADVISE YOU AS FOLLOWS: (1) THIS WRITING IS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED ON A TAXPAYER; (2) THE ADVICE WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTION(S) OR MATTER(S) ADDRESSED BY THE WRITTEN ADVICE; AND (3) THE TAXPAYER SHOULD SEEK ADVICE BASED ON THE TAXPAYER’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.

*Updated and reprinted with the permission of Trusts & Estates magazine and American College of Trust & Estate Counsel

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Life insurance continues to provide clients unique economic and estate planning opportunities. For that reason, life insurance is frequently an integral component of a well-conceived estate plan. Section 101(a)(1) of the Code1 provides that amounts paid by reason of the death of the insured under a life insurance contract are excluded from gross income. In effect, life insurance has its own basis “step-up” rule upon the death of the insured, independent of Section 1014.

Unfortunately, Section 1014 will not rescue the taxpayer who stumbles over the “transfer for value” rule contained in Section 101(a)(2). If the rule is violated, most of the benefits of the exclusion are lost and the insurance proceeds constitute gross income for income tax purposes. Thus, understanding the operation of the transfer for value rule is critical to effective estate planning using life insurance. This article provides an overview of the exclusion under Section 101(a)(1) and the limitation imposed by the transfer for value rule, focusing on the most recent developments and clarifications.

General Exclusion of Proceeds from Income

As a threshold matter, the exclusion from gross income applies only to “life insurance contracts”. Effective as of January 1, 1985, the term “life insurance contract” acquired a statutory definition contained in Section 7702. Although an analysis of the definition is beyond the scope of this article, it is worthwhile to bear in mind that a life insurance contract in which the investment component is too large relative to the insurance element will fail the definition. In addition, certain nonstatutory requirements must be met. One of the most significant is the requirement that the policy be obtained by one having an insurable interest in the life of the insured under state law.2

In a recent, and alarming, interpretation of the law on insurable interest the Eastern District Court of Virginia asserted in Chawla v. Transamerica Occidental Life Insurance Company3 that an irrevocable life insurance trust had no insurable interest in the life of the settlor, not because the trust beneficiary had no insurable interest (which she did not), but because the trust was viewed as having no “lawful and substantial economic interest in the continuation of the life, health, [and] bodily safety of the [decedent].” Instead, the trust was viewed as standing only to gain by the decedent’s death. Taken literally, the court’s interpretation would invalidate all irrevocable life insurance trusts. Moreover, because the insurance contract in Chawla was procured by fraud on the application, the court did not need to reach the insurable interest issue. Accordingly, the holding in Chawla should probably be viewed as an overbroad statement of the rule. There is little on the subject, however, although it would seem that the appropriate rule should be to look through to the trust beneficiaries to determine whether an insurable interest exists.

A second requirement under Section 101(a)(1) is that the insurance proceeds be payable “by reason of the death of the insured.” If the proceeds are payable to a creditor in satisfaction of an outstanding debt, for example, Section 101(a)(1) does not apply. Thus, in Landfield Finance Co. v. United States,4 the Seventh Circuit held that proceeds payable to a creditor, pursuant to an irrevocable designation of the creditor as beneficiary of a policy on the life of the company’s sole stockholder, constituted gross income to the creditor. The creditor was obligated to pay any proceeds in excess of the unsatisfied debt to the secondary

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beneficiaries designated by the insured. The court concluded that Section 101(a)(1) was not intended to apply to “life insurance proceeds received and retained in lieu of other income due the beneficiary which, but for the death of the insured, would clearly have been includible in the gross income of the beneficiary.”5

On the other hand, if there is no condition on the creditor’s right to receive the entire proceeds of the policy, then the proceeds will qualify for the exclusion under Section 101(a)(1), even if the decedent’s indebtedness is nearly equal to the amount of the proceeds.6 In addition, the proceeds of key man insurance acquired in a business context by a company having an insurable interest in the life of the insured (including an insured who is not an employee, officer, director, shareholder or partner of the company) are excludable under Section 101(a)(1) as payable “by reason of the death of the insured.”7

The IRS has also carved out certain instances when payment of insurance proceeds prior to death of the insured nevertheless qualifies for the exclusion. In Revenue Ruling 78-372, the Service ruled that payment upon the declaration of a person as “Missing in Action” constitutes payment by reason of the death of the insured.8 In addition, under Proposed Regulations § 1.101-8 and § 1.7702-2(c), qualified accelerated death benefits are treated as payable by reason of the death of the insured. A qualified accelerated death benefit under a life insurance contract is a benefit that meets certain economic criteria9 and is payable prior to the death of the insured if the insured has become terminally ill. Terminal illness is defined as an illness or physical condition that, notwithstanding appropriate medical care, is reasonably expected to result in death within 12 months.10

What is a Transfer for Value

Having satisfied the criteria of Section 101(a)(1), a taxpayer qualifies for income tax free receipt of the insurance proceeds provided the transfer for value rule has not been violated. The penalty for violating the rule is harsh. Section 101(a)(2)11 provides that the exclusion under paragraph (1) following a transfer for value is limited to the actual value of the consideration and premiums or other amounts paid by the transferee. Thus, if a transferee acquires a policy with a face value of $300,000 and a market value of $10,000 for $10,000, the proceeds will be excluded from gross income only to the extent of $10,000 plus the sum of all premiums subsequently paid by the transferee. That result is in sharp contrast to a $300,000 exclusion under the general rule.

A transfer for value occurs upon any transfer of an insurance contract or an interest therein for valuable consideration.12 Treasury Regulation §1.101-1(b)(4) states that a transfer for value includes “any absolute transfer for value of a right to receive all or a part of the proceeds of a life insurance policy.” The consideration may be direct or indirect. For example, in Monroe v. Patterson,13 the court found that insurance policies assigned in trust pursuant to a buy/sell agreement for the benefit of taxpayers, to facilitate their purchase of the insured’s stock, were transferred for value because taxpayers agreed to pay a portion of the premiums. Consequently, upon payment of the proceeds from the trust in exchange for the stock, the taxpayers had to include in gross income the difference between the premiums they paid and the proceeds. Monroe highlights the difficulty in restructuring corporate owned key man insurance because a transfer to a shareholder (other than the insured) in

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exchange for the shareholder’s promise to pay premiums is a transfer for value not excepted from the transfer for value rule.

Pledges and assignments of a policy as collateral security do not constitute transfers for purposes of the rule.14 But a transfer for value can occur even though the policy transferred has no cash surrender value.15

Why Make a Transfer for Value; Avoiding the Application of Section 2035(a) or Exiting an Undesirable Ownership Arrangement

Section 2035(a) provides that if a decedent makes a transfer (by trust or otherwise) of an interest in an insurance policy on the decedent’s life or relinquishes an incident of ownership with respect to such a policy that would otherwise have been included in the decedent’s gross estate under Section 2042, and does so within three years of the date of the decedent’s death, the policy proceeds will continue to be estate tax includible.

Section 2035(d) provides an exception for a bona fide sale for full and adequate consideration. Thus, transferring a life insurance policy in a manner that satisfies 2035(d) and avoids application of the transfer for value rule will achieve both estate tax and income tax exclusion of the proceeds.

Another reason to make a transfer for value is to exit an undesirable ownership arrangement of a policy without transfer tax consequences. In that case, the original owner must be paid full and adequate consideration for the policy, yet the new owner wants to preserve income tax, and possibly estate tax, exclusion of the proceeds.

Two Exceptions to the Rule

1. Part Sale/Part Gift

Section 101(a)(2)(A) provides one of two exceptions to the transfer for value rule. Transfers following which the transferee determines his or her basis in the insurance contract, in whole or in part, by reference to the transferor’s basis are not subject to the rule. Section 101(a)(2)(A) is frequently referred to as the “part sale/part gift” exception; however, the exception is broad enough to cover other instances when the transferee receives a carryover basis, such as tax-free reorganizations.16 Of particular interest is the application of the rule in the gift context.

In the absence of a gift, the transferee of property in an arms length transaction takes a cost basis.17 This includes sales or exchanges for inadequate consideration made in the ordinary course of business, if the transaction is bona fide, at arm’s length, and free from donative intent.18 Thus, in Rath v. United States,19 the Sixth Circuit held that the transfer of an insurance policy from a corporation in which the insured was the largest individual shareholder to the insured’s wife was a transfer for value even though the wife paid less than fair market value for the policy.

On the other hand, a gift not within the business exception will be part sale and part gift whenever the consideration given by the transferee is less than the fair market value of

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the policy (or interest therein) transferred. (Note that inadequate consideration may also trigger application of Section 2035, which includes the proceeds of an insurance policy in the gross estate of an insured/transferor who dies within three years of a transfer of the policy for less than adequate and full consideration.20) In general, the fair market value of an insurance policy for gift tax purposes is its replacement cost,21 or if the policy is not paid-up, its interpolated terminal reserve value plus unexpired premiums.22 Treasury Regulation §25.2512-6(a) states

As valuation of an insurance policy through sale of comparable contracts is not readily ascertainable when the gift is of a contract which has been in force for some time and on which further premium payments are to be made, the value may be approximated by adding to the interpolated terminal reserve at the date of gift the proportionate part of the gross premium last paid before the date of the gift which covers the period extending beyond that date.

Treasury Regulation §25.2512-6(a) also states, “If, however, because of the unusual nature of the contract such approximation is not reasonably close to full value, this method may not be used.” Thus, if death is imminent, that fact will be taken into account in determining value.23 Moreover, it may be relevant that in Revenue Procedure 2005-25,24 the IRS takes the position that for purposes of valuing a life insurance policy distributed from a qualified retirement plan, fair market value must be used, and establishes safe harbors requiring the use of the greater of (i) interpolated terminal reserve plus unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for the policy year based upon company performance (a new requirement) and (ii) a more complex formula based on premiums, earnings, reasonable charges and a surrender factor.

In order for a gift of an insurance policy to qualify for the part sale/part gift exception, not only must the consideration given be less than fair market value, but it must also be less than the transferor’s basis. Under Treas. Reg. §1.1015-4(a), if a transfer is in part a sale and in part a gift, the transferee’s basis is the sum of (a) the greater of (i) the transferee’s cost, or (ii) the transferor’s adjusted basis, plus (b) the basis increase for gift tax paid under Section 1015(d). Thus, if the transferee’s cost is greater than the transferor’s basis, the transferee’s basis is not determined by reference to the transferor’s basis and the exception does not apply. On the other hand, if cost is less than the transferor’s basis, the exception applies, and the proceeds continue to be fully excludable.

Determining Basis

What is the transferor’s basis in an insurance contract? The transferor’s basis is determined by reference to the investment in the contract within the meaning of Sections 72(c)(1) and 72(e)(6). In general, the investment in the contract is equal to the aggregate amount of premiums or other consideration paid for the contract reduced by dividends received.25 Dividends received include any cash distributions of dividends and dividends used to reduce premiums, but should not include dividends used to purchase additional paid-up additions, as is frequently the case in so-called participating whole life policies. The IRS ruled in PLR 9443020, however, that to arrive at a taxpayer’s adjusted basis for purposes of determining gain upon the sale of an insurance policy, the investment

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in the contract must be reduced by the cost of insurance protection provided through the date of transfer. In so doing, the IRS relied on two cases, Century Wood Preserving Co. v. Commissioner26 and London Shoe Co. v. Commissioner,27 which held that for purposes of determining a taxpayer’s loss upon the transfer of an insurance policy, the taxpayer must deduct that part of the premiums representing annual insurance protection. The IRS apparently ignored the court’s acknowledgment in London Shoe that basis for purposes of determining gain is different from basis for purposes of determining loss as follows:

[T]he computation of taxable gains somewhat favors the taxpayer at the expense of the government, because it allows the deduction of the full amount of the premiums paid from the total amount received, though the premiums are in excess of what would normally be required for insurance protection, and thus lessens the amount of the taxable gain. It does not necessarily result that such statutory indulgence will be given the taxpayer in computing losses, especially where there is no statutory provision that contains language that will justify it.28

Whether or not the IRS is correct in its position, caution dictates making the additional subtraction for cost of insurance protection to determine whether a transferor has received consideration in excess of basis for purposes of the part sale/part gift exception. In the absence of proof to the contrary, the cost of insurance protection may be approximated by using the difference between (i) the aggregate premiums paid, and (ii) the cash value of the contract with regard to surrender charges.29

Effect of Policy Loans

After determining the transferor’s basis, the transferee’s consideration must be quantified. In this connection, particular attention must be given to policy loans. Prior to a gratuitous transfer of an insurance policy, it is frequently desirable to borrow out the cash value in order to reduce the value of the gift. Loans taken against the cash value of an insurance policy are non-recourse in nature because they are secured only by the policy itself. Unlike in other contexts, the policy owner receives no basis increase in respect of this non-recourse debt, even if the debt is funded in part with investment returns within the policy. Nevertheless, upon the transfer of a policy with outstanding loans, the transferor realizes value equal to the full outstanding indebtedness.30

In Revenue Ruling 69-187,31 the IRS considered the application of the part sale/part gift exception to the gratuitous transfer of a policy with an outstanding loan. The IRS concluded that the transferee’s interest in the policy was acquired in part for a valuable consideration. Because the loan did not exceed the transferor’s basis, upon the death of the insured, the transferee nevertheless receives the proceeds income tax-free. Similarly, in PLR 8951056, the IRS ruled that the transfer of policies subject to indebtedness incurred as a result of outstanding policy loans was a transfer for value, but within the part sale/part gift exception.32 In PLR 8951056, the insured was apparently unhappy with the provisions of his life insurance trust. He therefore purchased the policies back from the trustee for their net cash surrender value (the aggregate cash surrender value, including the cash value of additions and accumulations, less the amount of the policy loans). The IRS ruled that the

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insured acquired a cost basis in the policies equal to the amount realized by the trustee (which would include the debt). Hence, the IRS found the taxpayer’s transfer of the policies to the new trust, subject to the loans, eligible for the part sale/part gift exception because the loans were less than the insured’s cost basis. The rationale of this ruling on its particular facts is questionable as the ruling did not analyze whether the trust was a grantor trust for income tax purposes. If the trust were a grantor trust, the grantor would not have been able to realize a cost basis as a result of a “purchase” of assets from the trust under Revenue Ruling 85-13.33

The examples in Treasury Regulation §1.101-1(b)(5) illustrate the operation of the part sale/part gift exception in the context of a series of transfers. Example (4), in particular, makes clear that if any transfer in a series of transfers does not qualify for the part sale/part gift exception, then unless another exception applies (see text below), the proceeds will not be fully excludable. This is true even if the final transferee determines its basis in the policy by reference to its transferor’s basis. Example (4) provides that if X Corp. purchases a policy on an employee’s life, transfers it to Y Corp. in a tax-free reorganization, and then Y Corp. transfers it to Z Corp. for value, after which Z Corp. transfers it to M Corp. in a tax-free reorganization, the proceeds are taxable to M Corp. to the extent of the excess over the consideration paid by Z Corp plus aggregate premiums paid by Z Corp. and M Corp. In contrast, multiple gratuitous transfers of a policy with outstanding loans that do not exceed the original transferor’s basis will preserve full exclusion of the proceeds.

The part sale/part gift exception is also useful in the context of transfers between spouses. Section 1041(b) provides that property transferred to a spouse or former spouse incident to a divorce receives a carryover basis. Accordingly, property transferred between spouses always has a basis determined by reference to the basis of the transferor (unless the transferee spouse is a nonresident alien). That being the case, intraspousal transfers cannot disqualify an insurance policy from the part gift/part sale exception. In this respect, Example (6)34 of the Regulations appears to be obsolete. Example (6) provides that a transfer to a spouse for full consideration followed by a gratuitous transfer to a child violates the transfer for value rule. Under current law, the spouse, notwithstanding the consideration, would take a carryover basis under Section 1041. Accordingly, the part sale/part gift exception should apply.

2. Excepted Transferees

Section 101(a)(2)(B) excepts from the application of the transfer for value rule transfers to the insured, a partner of the insured, a partnership in which the insured is a partner and a corporation in which the insured is a shareholder or officer (hereinafter referred to as “exempt persons”). An obvious omission from the class of exempt persons is shareholders and officers of a corporation in which the insured is a shareholder or officer. Thus, the transfer of insurance policies from an insured shareholder to another shareholder in the same corporation to fund a cross purchase agreement constitutes a transfer for value not within the exception.35 Significantly, unlike the part sale/part gift exception, a transfer to an exempt person cleanses an insurance policy from the taint of all prior transfers for value. Thus, Example (5) of the Regulations provides that a transfer to a corporation in which the insured is a shareholder, following a prior transfer for value to a non-exempt

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corporation, reinstates the exclusion of the proceeds from gross income. Example (7) confirms the same result for a final transfer to the insured.

Use of Partnerships in Business

In light of the foregoing, partnerships are commonly used to receive existing life insurance policies intended to fund corporate cross purchase agreements. So long as the partnership has a bona fide business purpose, there is no requirement that the partnership have any connection to the business of the corporation transferring the insurance.36 In PLR 9309021, the IRS even blessed the formation of a new partnership for the purpose of acquiring life insurance policies from a corporation in which the taxpayers were shareholders. A more conservative approach would require the use of a partnership that has at least one business purpose independent of purchasing and managing life insurance policies on the lives of its partners. This is particularly true in light of the IRS’s continued “no rule” position with respect to whether the transfer of a life insurance policy to a partnership substantially all the assets of which consist or will consist of life insurance policies on the lives of its partners will be exempt from the transfer for value rule.37 Indeed, in several rulings involving transfers for value to a partnership to restructure the interests in one or more policies, the facts recite that, following the transfer, the cash value of the life insurance policies would constitute less than 50% of the value of the assets held in the partnership.38

Attribution of Incidents of Ownership in Partnerships

Although the approach in PLR 9309021 avoids the application of the transfer for value rule, it raises the concern of whether it avoids estate tax inclusion in the estate of the deceased partner. One commentator has cautioned that there may be double inclusion, once because the decedent has incidents of ownership (under Section 2042) in the policy as a partner of the partnership and once because the value of his partnership interest is increased by the amount of the proceeds payable at death.39 This would appear to be an incorrect interpretation of current law. Recent private letter rulings40 acknowledge the continued viability of the analysis in Estate of Knipp v. Commissioner.41 In Knipp, the decedent was a 50% general partner in a partnership that owned 10 insurance policies on the decedent’s life at the time of his death. The partnership paid the premiums on the policies, and the insurance proceeds were payable to the partnership. The court held that the decedent, in his individual capacity, had no incidents of ownership in the policies; therefore, the proceeds were not includible in the decedent’s gross estate under the predecessor to Section 2042(2). Knipp is consistent with the example in Treasury Regulation §20.2042-1(c)(6), which concludes that incidents of ownership will not be attributed to the controlling shareholder of a corporation through his stock ownership where the proceeds of the policy on the shareholder’s life owned by a corporation are payable to the corporation. Any proceeds payable to a third party for a valid business purpose of the corporation, such as in satisfaction of a business debt, will be deemed payable to the corporation. Knipp should be contrasted with the outcome in Revenue Ruling 83-14742 which concludes that the insurance proceeds of a policy owned by a general partnership of which the decedent was a one-third general partner should be included in the decedent’s gross estate under Section 2042(2)

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because the policy proceeds were payable to the decedent’s child for a purpose unrelated to the partnership business.

Many taxpayers have adopted a more conservative approach. Private letter rulings frequently recite that not only is the insured a limited (rather than a general) partner without management rights, but the partnership agreement expressly precludes the insured from having any incidents of ownership with respect to a policy on the insured’s life.

Various alternatives to the approach in PLR 9309021 have emerged. One possibility is a direct transfer from the corporation to the individual shareholders who are also partners.43 Another, more attractive solution, is outlined in a series of virtually identical rulings, PLRs 9328010, 9328012, 9328017, 9328019 and 9328020. In those rulings, five individuals were the sole shareholders of a corporation and the sole partners of a partnership. The corporation owned insurance on the lives of each of them. The corporation transferred all policies to the partnership and the partnership in turn distributed each of the policies to the four partners other than the insured. (The rulings do not state whether there was an income tax reason that the policies were not transferred directly from the corporation to the partners.) Then, the group of four partners jointly transferred the policy to a grantor trust whose only asset was the insurance policy on the life of the fifth partner, who was not a grantor. Upon the death of a partner, the grantor trust owning the policy on the deceased partner’s life would distribute the proceeds to the grantors/partners for purposes of purchasing the deceased partner’s interests in the corporation and the partnership. In addition, under the trust agreements, the deceased partner’s interest in each of the remaining trusts would be transferred to the other grantors of the trust in return for cash equal to the deceased partner’s beneficial interest in the unmatured policies.

Because the deceased partner had no interest in the trust holding the policy on his life, no portion of the proceeds should be includible in his gross estate. Moreover, the IRS ruled that there were no transfers for value under the foregoing arrangement. The transfers to the trusts did not constitute a change in beneficial ownership of the policies because the grantors were the trust beneficiaries; therefore, under Revenue Ruling 74-7644 no transfer for value occurred. The balance of the transfers were to exempt persons (either to a partnership or to partners of the insured) within Section 101(a)(2)(B).

Dealing with Irrevocable Trusts

The exception for transfers to exempt persons can also be used to unwind an otherwise undesirable trust arrangement. One method is to transfer insurance policies held in trust back to the insured/grantor who can then transfer the policies to a new trust. If the existing trust is a grantor trust, the sale by the trustee to the grantor should not be recognized for income tax purposes under Revenue Ruling 85-13.45 Rather, the grantor will receive a carryover basis in the assets purchased from the trust, thus satisfying the part sale/part gift exception as well as the exception for a transfer to the insured. As discussed above, care should be taken in a subsequent transfer of the policy to a new trust if there are outstanding policy loans.

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Use of Partnerships with Trusts

The disadvantage of using a purchase by the insured to undo a life insurance trust with undesirable provisions is that for purposes of Section 2035, a new three-year period will begin to run upon the transfer of the policy to the new trust. One should bear in mind that it is apparently the IRS’s position that Section 2035 can cause estate tax inclusion of policy proceeds that were not includible in the insured’s gross estate prior to a transfer within 3 years of death. In PLR 199905010, taxpayer was a majority shareholder of Corporation that owned a life insurance contract on taxpayer’s life of which Corporation was designated the beneficiary. Taxpayer and his spouse were also general and limited partners in Partnership which held investment assets. Taxpayer proposed to transfer portions of his limited partnership interests in Partnership to his children by means of annual exclusion gifts. Taxpayer represented that he intended to continue a pattern of gifts over the next several years and also planned to give stock of Corporation to the children in order to divest himself of control. Subsequent to the initial gifts of limited partnership interests to the children, the children proposed to purchase the life insurance policy from Corporation for the greater of its interpolated terminal reserve value or its cash value. The purchase price would be paid by a demand promissory note with interest at the Section 7520 rate. At closing, the children proposed to obtain a policy loan against its cash value to repay the demand note to the Corporation to the extent possible. Immediately after the sale, the children would designate themselves as beneficiaries of the policy.

The IRS ruled that the proposed purchase of the policy would satisfy the exception to the transfer for value rule for transfers to a partner of the insured. Significantly, the IRS also concludes that the taxpayer must de-control Corporation within three years of death if the purchase of the policy by the children turns out not to be for full and adequate consideration. Extending beyond its facts the holdings of Revenue Ruling 90-21,46 the IRS’s concluded that for purposes of determining whether taxpayer would have had attribution of incidents of ownership in the policy through Corporation, the payment of policy proceeds on the date of death, not at the time of the transfer, must be considered. Thus, under this analysis, the exception under Treasury Regulation §20.2042-1(c)(6) would not apply to exclude the proceeds payable to a third party on a policy transferred by a controlled Corporation (for less than full and adequate consideration) within three years of death, even though, at the time the Corporation owned the policy, the proceeds were not includible in taxpayer’s gross estate under Section 2042(2). In other words, the test for whether the policy proceeds would have been included in the decedent’s gross estate under Section 2035(a)(2) takes account of the ownership by the controlled corporation within three years of death, but looks at the actual disposition of the proceeds at death.

Given the favorable transfer for value results available through the use of partnerships, taxpayers have continued to rely on partnerships as an intermediary to accomplish reshuffling of the economic interests in life insurance policies. In PLR 200111038, the grantor and his wife created an irrevocable life insurance trust that owned 3 second to die polices on their lives as well as interests in real estate ventures and marketable securities. Thereafter, they created a second trust designed to be exempt from GST tax. The two trusts and the grantors formed a limited partnership. The GST exempt trust contributed cash in exchange for a general partnership interest. The ILIT contributed 2 of the insurance

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policies in exchange for a limited partnership interest. The grantors contributed cash in exchange for limited partnership interests. The ILIT and GST Exempt trust each had general language permitting the trustees to invest in any property including a business. The limited partners had no right to participate in management or investment decisions or to withdraw from the partnership and taxpayers represented that the partnership would not elect for tax purposes to be treated other than as its default classification as a limited partnership. The ruling recites that the ILIT’s incidents of ownership in the policies following the contribution to the partnership would be extinguished and that the partnership would designate itself as the beneficiary under the policies. The ruling also recites that the aggregate net cash surrender value of the policies will at times be less than 50% of the partnership’s assets. Following its formation, the partnership planned to continue the real estate investment activities of the ILIT by investing in an LLC engaged in developing residential apartments and in a mobile home park. The IRS ruled that the partnership would be treated as a partnership for federal tax purposes and that the transfer of the policies by the ILIT to the partnership is a transfer for value within the exception under Section 101(a)(2)(B). Following an analysis of Knipp and Rev. Rul. 83-147, the IRS also ruled that the grantors will not possess any incidents of ownership under Section 2042 with respect to the policies contributed to the partnership by the ILIT by reason of their limited partnership interests. The restructuring likely achieved GST exemption for at least a portion of the policy proceeds and eliminated the need for additional gifts by the taxpayers to finance policy premiums.

In PLR 200017051, taxpayers sought to unwind a series of loans previously used to finance policy premiums on various policies held in trust and to solve the cash shortfall going forward. Husband had created three trusts. Trust 1 owned a policy on husband’s life. Trust 2 owned 3 second to die policies on husband’s and wife’s lives. Trust 3 owned cash and marketable securities, real estate subject to a mortgage and promissory notes evidencing loans to Trust 1 and Trust 2 to pay premiums on their policies. Husband had also loaned money to Trust 1 personally. Trust 3, husband and wife formed an LLC. Trust 3 contributed cash and marketable securities and the real estate, and restructured the mortgage to substitute the cash and securities as collateral. Husband and wife contributed cash to the LLC in exchange for managing member interests. Trust 3, H and W also formed a limited partnership. Trust 3 contributed its interest in the LLC, cash and marketable securities and the promissory notes from Trust 1 and Trust 2. Husband and wife contributed cash to the partnership and husband also contributed his promissory note from Trust 1. Husband and wife where the general partners of the partnership. The partnership agreement expressly prohibited husband and wife from exercising any incidents of ownership with respect to any insurance policy on their lives. The partnership planned to demand payment on the promissory notes. Trust 1 and Trust 2 planned to satisfy the notes by transferring their respective insurance policies to the partnership. The policies would be valued as provided in Treasury Regulation §25.2512-6(a). If the value of the policies were greater than the outstanding indebtedness, the trusts would borrow against the cash value as needed. The taxpayers recited as business purposes for the proposed transactions the cash flow shortage of the trusts, the repayment of the debt and the diversification of the partnership assets. The taxpayers represented that the cash value of the policies would be less than 50% of the partnership assets. The IRS ruled that immediately after the proposed transfers the real estate owned by the partnership would represent more than 20% of the partnership assets, so

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the partnership would not be subject to the investment company rules. The transfers of the policies to the partnership were transfers for value within the exception under Section 101(a)(2)(B). Finally, the insureds would not be treated as possessing any incidents of ownership in the policies under Section 2042(2).

Transfers to the Insured

Notwithstanding taxpayers’ success in using partnerships as a trust intermediary in order to restructure the economic interests in a life insurance policy that is already excluded from the gross estate, in many cases it would be preferable simply to be able to move a policy directly from one trust to another trust. The question raised by such a maneuver is whether a transfer to a trust that is a wholly grantor trust with respect to the insured will be treated as a transfer to the insured for purposes of the exception to the transfer for value rule under Section 101(a)(2)(B).

Grantor Trust as the Insured

Swanson v. Commissioner,47 is the leading case supporting the conclusion that a transfer to a wholly grantor trust is, for transfer for value purposes, equivalent to a transfer to the grantor. In Swanson, the taxpayer attempted to form a partnership with his grantor trusts as managing partner, following which the trusts purchased insurance policies on his life from his foundation. The Eighth Circuit upheld the Tax Court’s determination that the partnership was not viable for tax purposes. The taxpayer was successful in his second argument, however, that the transfers to the trusts were transfers to the insured for purposes of Section 101(a)(2)(B) in that the trusts were grantor for income tax purposes. The grantor had an almost unlimited power to amend the trusts and change the beneficiaries, provided that he could not make himself a beneficiary. Thus, he had a Section 674 power.

The IRS initially expressed unwillingness to accept the Swanson holding on its broadest terms. In its Action on Decision, the IRS called the Eighth Circuit’s holding erroneous because the exempt persons exception does not specifically enumerate trusts. Accordingly, the IRS found the Swanson decision to be an improper broadening of the exception. Thereafter, G.C.M. 37228 was issued indicating a reversal of position. G.C.M. 37228 states that the earlier response to Swanson should be modified to indicate that the grantor/insured was also the owner of the policies by virtue of his ownership of the trusts.

Transfers among Grantor Trusts

Notwithstanding Swanson, the IRS has refused to rule on whether a transfer to a wholly grantor trust would fall within the exception to the transfer for value rule for transfers to the insured.48 However, a series of more recent rulings have found a way to circumvent that analysis. Rather than analyzing whether a transfer to a wholly grantor trust constitutes a transfer for value within the exception for a transfer to the insured, taxpayers have rather focused on whether there has been a transfer within the part sale/part gift exception. Under Revenue Ruling 85-13,49 any transfers among wholly grantor trusts would qualify, including, by reason of Section 1041, trusts that are wholly grantor with respect to either the husband or the wife.

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This new found approach has created a viable exit strategy for undesirable life insurance trusts. Bear in mind that in the typical completed gift trust where grantor trust status is based on an administrative power, the IRS will not rule on whether a trust is a wholly grantor trust because the IRS believes this to be a fact based determination. However, the IRS will rule as to the balance of the tax consequences relying upon the taxpayer’s representation that the trusts are wholly grantor.

In PLR 200120007, taxpayers were not only able to restructure the ownership of various insurance contracts, but to preserve GST exempt status of the proceeds. Husband and wife created a series of 5 trusts. The beneficial interests in the trusts were not the same. Husband was the grantor of Trust 1 and Trust 2, each of which owned 2 second to die policies on the lives of husband and wife. Husband created Trust 3 which was a grantor trust with respect to husband. Wife created Trust 4 which was a grantor trust with respect to wife. One of the policies in each of Trust 1 and Trust 2 were proposed to be transferred for value to Trusts 3 and 4, respectively. The polices were subject to a pre-2001 equity split dollar arrangement with a corporation controlled by husband and wife. The IRS ruled that the transfer of the policy from Trust 1 to Trust 3 is disregarded under Revenue Ruling 85-13 because husband is the grantor of both trusts. The transfer of the policy from Trust 2 to Trust 4 is not disregarded because husband is the grantor of Trust 2 and wife is the grantor of Trust 4. Nevertheless, the IRS ruled that for income tax purposes the transaction is treated as a transfer by husband to wife to which Section 1041(b)(1) applies. Thus, the transfer is treated as made by gift, not for value, avoiding the application of Section 101(a)(2). Trust 5 was a grandfathered GST exempt trust but not a grantor trust. Trust 5 was a partner in a partnership owned by husband, wife, Trust 3, Trust 4 and Trust 5. Trust 5 proposed to purchase, for the interpolated terminal reserve value adjusted for last paid premiums and outstanding indebtedness, the other 2 policies. The IRS ruled the payment to be for “full value”. The IRS further ruled that the proposed transfer would fall within the exception to the transfer for value rule under Section 101(a)(2)(B) and that neither the investment in the policies nor the death benefit would constitute additions to Trust 5 for GST purposes.

The IRS reached the same result in PLR 200247006 in connection with the purchase of single life and second to die policies from one trust to another. The single life policies were transferred between trusts of which husband was the grantor and the second to die policies were transferred between trusts of which both husband and wife were grantors. Although the IRS mentions Section 1041(a)(1), the ruling states that both sets of transfers will be “disregarded” for income tax purposes and thus are not transfers for value.

In PLR 200228019, the taxpayer wished to adjust the disposition of the proceeds of various insurance policies held in trust. Husband had created 3 trusts. Trust 2 had purchased 3 variable life insurance policies insuring the “joint lives” of husband and wife. Trust 2 provided that the trust income and principal could be used for the best interests of husband’s lineal descendants. Upon the death of the second to die of husband and wife, subject to certain limitations, the trust estate would be distributed to husband’s lineal descendants, per stirpes. Trust 3 provided instead that upon the second to die of husband and wife, a pecuniary distribution would be made to certain relatives and friends followed by a distribution of the balance of the trust estate to husband’s lineal descendants, per

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stirpes. However, Trust 2 also empowered the trustee to restrict distributions to husband’s lineal descendants upon the failure to enter into a prenuptial or postnuptial agreement. Trust 3 proposed to purchase the insurance policies from Trust 2 for value as determined under Treasury Regulation §25.2512-6(a). Taxpayer represented that both Trust 2 and Trust 3 were wholly grantor trusts with respect to husband under Section 677(a)(3). Accordingly, the IRS ruled that the proposed purchase of policies by Trust 3 from Trust 2 would be disregarded for federal income tax purposes and would not affect the application of Section 101(a)(1) to the policy proceeds.50

In the case of transfers of polices where the taxpayer is uncertain of grantor trust status, a partnership can be interposed. Note that if the trust holding a partnership interest is a grantor trust (which may be the case under Section 677(a)(3) by reason of the ownership of insurance on the grantor’s life51), the insured, rather than the trust, is considered a partner in the partnership with respect to the trust’s interest.52 Hence, a partnership solely between a grantor and his grantor trust may not be a true partnership for income tax purposes. In addition, the termination of grantor trust status constitutes a transfer of a partnership interest for income tax purposes potentially triggering an income tax.53

Given the IRS’s willingness to uphold the identity of the grantor and the grantor’s grantor trust for income tax purposes in a variety of other contexts, it is disappointing that the rule of the Swanson case has not been extended beyond its facts. Of particular note is the IRS’s continuing adherence to Revenue Ruling 85-13,54 which permits transactions between a grantor and the grantor’s grantor trust without gain recognition. Revenue Ruling 85-13 expressly states that the grantor of a wholly grantor trust is “considered to be the owner of the trust assets for federal income tax purposes.” A series of recent private letter rulings, PLRs 200518061, 200514001 and 200514002, conclude that a transfer of an insurance policy between two grantor trusts is “disregarded” for Federal income tax purposes under Revenue Ruling 85-13; and therefore, the transfer for value rule does not apply. Section 101(a) is an income tax provision. In searching for the owner of an insurance policy held by a grantor trust, Revenue Ruling 85-13 clearly points to the grantor. Hence, it is consistent to treat the transfer of an insurance policy to the insured’s grantor trust as a transfer to the insured for purposes of the transfer for value rule. This would be important where it is unclear whether the existing trust owning a policy is a wholly grantor trust.

An additional complication in relying on the exception for a transfer to the insured is identifying the insured in a policy on more than one life. Who is the insured for purposes of the transfer for value rule in the case of a second-to-die policy? Or a first-to-die policy? Clearly, each policy insures both lives, but actuarial calculations that support the pricing of these policies involve multiplying the probabilities of death for each of the two lives. Accordingly, the value of the contract cannot readily be allocated between the insureds. If the insureds are partners, a transfer to either of the insureds should qualify. In the absence of a partnership, a simple approach would be to permit a transfer to either of the insureds to fall within the exception. But such an approach may compromise the integrity of the transfer for value rule. For example, suppose a corporation has two shareholders. The corporation purchases two first-to-die policies on the two lives. Under the simple approach, each shareholder is an insured and could purchase one of the policies for value without

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violating the transfer for value rule. If the shareholders do that, observe what has happened. For a somewhat higher price, one of the shareholders will have accomplished what would otherwise be impermissible under the rule: tax-free receipt of death benefits on the death of a fellow shareholder, following a transfer for value, without the use of a partnership.

One cure would be to adopt a wait-and-see approach. The insured could be defined as the person whose death triggers payment of the proceeds. That would probably force taxpayers to seek a means other than a transfer to the insured to preserve the exclusion. Guidance in this area is needed even outside the context of trusts.

Splitting Policies Without Trusts

The IRS has also ruled favorably in the context of splitting policies between joint owners. In PLR 9852041, the taxpayers successfully split policies owned jointly into separate, equal polices. The taxpayers represented that one of the purposes of splitting the policies was to facilitate the making of unilateral decisions regarding whether to exchange or surrender the policy or to obtain a policy loan. The IRS stated that the test for determining whether there has been a “transfer for valuable consideration” turns on who has the right to receive policy proceeds, not on who has the right to make investment decisions with regard to the policy. Accordingly, a split of the policies into separate, equal policies on the same life with one-half the death benefit, cash value and indebtedness was viewed as in the nature of a partition of joint property, and not a transfer for value.

In PLR 199940028, one sister decided to purchase a second to die policy on her parents. After the payment of an initial premium, however, she contracted buyer’s remorse. The policy lapsed, but provided various options including the option to convert to a single premium paid up policy without additional payment. Subsequently, the first sister decided to purchase an alternate policy and convinced her sister to participate by paying half the premiums. Sister 1 and Sister 2 represented that there was no binding legal obligation to pay premiums between them. The IRS ruled that if the second policy were somehow a continuation other of the first, the transfer of an interest in the first policy to Sister 2 was by gift. If, on the hand, the first policy truly lapsed, the payment of premiums on the second policy was nothing more than an agreement to purchase a one-half interest in the policy and did not constitute a transfer of valuable consideration between the sisters.

Conclusion

As an individual’s estate plan evolves over time, the need to transfer a life insurance policy may arise. The exceptions to the transfer for value rule offer opportunities to change the beneficial interests in a life insurance policy while preserving income tax and estate tax exclusion of the proceeds. Recent developments in the IRS’s position in this area confirm that a carefully planned exit strategy from an undesirable ownership and disposition structure can be achieved without undue complexity or loss of tax benefits.

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1 All references to a provision or section of the Internal Revenue Code are to the Internal Revenue Code of 1986, as amended. Private letter rulings are cited throughout this Article as illustrative of the position of the Internal Revenue Service on the issues, but may not be cited or used as precedent under Section 6110(j)(3) of the Code.

2 See Atlantic Oil Co. v. Patterson, 63-1 U.S.T.C. ¶ 9445 (N.D. Ala. 1963), aff’d, 331 F.2d 516 (5th Cir. 1964); Ducros v. Commissioner, 272 F.2d 49 (6th Cir. 1959), rev’g, 30 T.C. 1337 (1958).

3 2005 WL 405405 (E.D. Va. 2005).

4 418 F.2d 172 (7th Cir. 1969).

5 Id. at 176.

6 See L.C. Thomsen & Sons, Inc. v. United States, 484 F.2d 954 (7th Cir. 1973), A.O.D. 1977-103.

7 See Harrison v. Commissioner, 59 T.C. 578 (1973), acq., 1973-2 C.B. 2 (creditor-beneficiary who has insurable interest in key man beyond debtor-creditor relationship may exclude insurance proceeds from gross income).

8 Rev. Rul. 78-372, 1978-2 C.B. 93 (1973).

9 The accelerated benefit must equal or exceed the present value of the reduction in death benefits otherwise payable (calculated assuming the death benefit will be payable 12 months after the payment of the accelerated benefit) and the cash surrender value must be reduced proportionately to the reduction in death benefits upon payment of the accelerated benefit. Prop. Reg. §1.7702-2(d) and (e).

10 Prop. Reg. §1.7702-2(e).

11 (2) TRANSFER FOR VALUABLE CONSIDERATION. -- In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by paragraph (1) shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee. The preceding sentence shall not apply in the case of such a transfer –

(A) if such contract or interest therein has a basis for determining gain or loss in the hands of the transferee determined in whole or in part by reference to such basis of such contract or interest in the hands of the transferor, or

(B) if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.

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12 For an excellent discussion of all the tax implications of transfers of life insurance policies, see John R. Price, Transfers of Life Insurance: Opportunities and Pitfalls, The Twenty-Seventh Annual Philip E. Heckerling Inst. on Estate Planning, Ch. 3.

13 197 F. Supp. 146 (N.D. Ala. 1961).

14 Treas. Reg. §1.101-1(b)(4); PLR 8628007 (March 21, 1986).

15 PLR 7734048 (May 26, 1977), citing James F. Waters, Inc. v. Commissioner, 160 F.2d 596 (9th Cir. 1947), cert. denied, 332 U.S. 767 (1947).

16 Treas. Reg. §1.101-1(b)(5), Example (2).

17 I.R.C. §1012.

18 Thus, property transferred by a donor in the ordinary course of business that exceeds the value, in money or money’s worth, of the consideration given therefor is not subject to gift tax. Treas. Reg. §25.2512-8.

19 608 F.2d 254 (6th Cir. 1979).

20 See Estate of Pritchard v. Commissioner, 4 T.C. 204 (1944), appeal dismissed, unpublished op. (6th Cir. 1945).

21 See United States v. Ryerson, 312 U.S. 260 (1941), rev’d on other grounds, 114 F.2d 150 (7th Cir. 1940).

22 Treas. Reg. §25.2512-6.

23 See Pritchard, supra note 21.

24 2005-17 I.R.B. 962.

25 See Treas. Reg. §1.72-6.

26 69 F.2d 967 (3d Cir. 1934).

27 80 F.2d 230 (2d Cir. 1935), cert. denied, 298 U.S. 663 (1936).

28 Id. at 232. The statutory provision referred to is Section 22(b)(2) of the Revenue Act of 1928, the relevant language of which is now contained in Section 72.

29 See PLR 9443020 at footnote 4.

30 See Crane v. Commissioner, 331 U.S. 1 (1947); Treas. Reg. §§ 1.1001-2(a)(1) and 1.1001-2(a)(4).

31 1969-1 C.B. 45 (1969).

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32 For an excellent discussion of the effects of loans on the transfer of insurance policies, see Joe B. Cox, Gift of Life Insurance Policy with an Outstanding Loan Can Result in Two Taxes, 17 Est. Planning 298 (September/October 1990).

33 1985-1 C.B. 184.

34 Treas. Reg. §1.101-1(b)(5).

35 See, e.g., PLR 7734048 (May 26, 1970) (shareholders sought to exchange insurance policies originally purchased on their own lives).

36 See, e.g., PLR 9045004 (July 31, 1990) (the corporation was in the business of selling musical instruments; the partnership was involved in rental real estate activities and oil and gas production).

37 Rev. Proc. 2005-3, 2005-1 I.R.B. 118, Section 3.01(6).

38 See, e.g., PLR 200017051 (January 24, 2000) and PLRs 9725007, 9725008 and 9725009 (March 18, 1997).

39 Alan Kupferberg and Robert M. Wolf, Transferring Life Insurance Policies to a New Partnership, 20 Est. Planning 340 (November/December 1993).

40 See, e.g. PLR 200111038 (December 15, 2000).

41 25 T.C. 153 (1955), aff’d on another issue, 244 F.2d 436 (4th Cir. 1957), cert. denied, 355 U.S. 827 (1957), acq. in result, 1959-1 C.B. 4.

42 1983-2 C.B. 158.

43 See, e.g., PLR 9347016 (August 24, 1993).

44 1974-1 C.B. 30 (1974).

45 1985-1 C.B. 184 (1985). But see Rothstein v. United States, 735 F.2d 704 (2d Cir. 1984) (taxpayer obtained a new cost basis in assets purchased from a grantor trust).

46 1990-1 C.B. 172.

47 518 F.2d 59 (8th Cir. 1975); Action on Decision (July 23, 1975).

48 See PLR 9413045. Note that in PLR 9413045, the taxpayers incorporated a tax reimbursement clause that the IRS concluded would not cause estate tax inclusion. The result would presumably be to contrary under current law following the issuance of Revenue Ruling 2004-64, 2004-27 I.R.B. 7.

49 1985-1 C.B. 184.

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50 See also PLR 200338023 (June 25, 2003) (transfer of policies that does not result in a realization event under Section 1001 will not result in a transfer for value).

51 See PLR 8839008 (June 23, 1988).

52 See Rev. Rul. 77-402, 1977-2 C.B. 222 (1977); Mandorin v. Commissioner, 84 T.C. 667 (1985).

53 In Mandorin v. Commissioner, supra note 51, the court expressly upheld . Reg. §1.1001-2(c), Example (5), which states that when a trust holding a partnership interest ceases to be a grantor trust, the grantor is considered to have transferred ownership of a partnership interest; whereupon, the grantor’s share of partnership liabilities are treated as money received.

54 1985-1 C.B. 184.