TRANSFER FOR VALUE – SAFE HARBOR
The IRS issued Rev Rul 2007-13, 2007-11 IRB on February 16, 2007. This ruling is important in that it provides a safe harbor for transfers for value (cash, in this ruling) of life insurance policies from one trust to another trust, so long as the transferee is a grantor trust.
Section 101 of the Internal Revenue Code provides that amounts received under a life insurance contract are excluded from income. There is an exception in Section 101(a)(2) where the life insurance policy, prior to death, is transferred for some valuable consideration. In those cases, the sum of the amount paid for the policy plus whatever premiums are paid is still excluded from income. All amounts over that are included in income.
But Section 101(a)(2) provides for two exceptions: (i) first, if the basis of the policy in the hands of the transferee is the same as the basis of the transferor; and (ii) if the transfer is to the insured, a partner of the insured, to a partnership in which the insured is a partner and to a corporation in which the insured is a shareholder or officer.
The ruling addresses the second of those two exceptions, and does so in the context of a grantor trust as the trustee.
“Grantor trust” is not a technical term, but is a moniker given to trusts wherein a person, typically the grantor (hence the name), is treated as owning some portion of the trust, which results under Section 671 in the taxation to that owner-grantor of some or all of the income tax consequences of the trust. The types of trusts or trust provisions that make a trust a “grantor trust” are found in Sections 673 through 677, with definitions in 672 and provisions related to someone other than the grantor being the owner found in Section 678. Foreign trusts are addressed in Section 679.
In Rev.Rul. 85-13 , the IRS, in response to the decision in the Rothstein case, clearly stated the rule that a grantor who deals with a trust with respect to which he is treated as the owner cannot create a taxable transaction in dealing with that trust. Other similar rulings followed.
Then, in 2002 and 2006, in two private letter rulings , the IRS ruled that the transfers of life insurance policies to grantor trusts were, in essence, a transfer to the insured. As a result, they were exceptions to the transfer for value rule, and, thus, the death benefits paid by the life insurance would be excluded from taxable income.
But those were private letter rulings which cannot be cited as authority (except by the taxpayer to whom they were addressed). The newly issued revenue ruling settles the matter for the rest of us.
The ruling addresses two fact situations. In the first fact situation, Trust 1 and Trust 2 are both "grantor trusts" for income tax purposes and the insured is the grantor, and, thus, under the grantor trust rules, is treated as the owner of all assets in both trusts. Trust 2 owns life insurance on the insured and sells the insurance to Trust 1 for cash. In the second fact situation, Trust 2 is not a grantor trust.
In the first fact scenario, the IRS reasoned that tax law does not recognize any tax consequences of a transaction with oneself, and, as a result, dealings between Trust 1 and Trust 2 are considered as dealing with oneself, and no tax consequence can flow from that. The IRS therefore concluded that no transfer at all occurs in this fact scenario.
In the second fact scenario, because Trust 2 is not a grantor trust, there is a transfer, and, moreover, it is a transfer for value. Here, the transferee is Trust 1, which is a grantor trust, and, therefore, the transfer is treated as a transfer to the insured-grantor. The transfer is thus within the exception and the death benefits are not taxable under the income tax system.
Note that the ruling does not address what the value of a life insurance policy is (a matter of some debate in this context notwithstanding Reg. §25.2512-6 on valuation of a life insurance contract - see Rev. Proc. 2005-25, 2005-17 IRB 962, 04/08/2005, IRC Sec(s). 402 and Reg §1.402(a)-1(a)(2)). And clearly, that regulation does not apply in the context of a state law examination of the actions of the trustees of Trust 2 when the question is asked whether the trustee obtained the appropriate amount of cash (or other value) for the policies.
Note also that this ruling does not mean that the life insurance remains outside of the insured’s-grantor’s estate. Clearly, Trust 1 must have all of the provisions that would keep the life insurance out of the estate.