The most common strategy that wealthy and healthy taxpayers use to fund against unavoidable anticipated estate tax liability is to purchase life insurance in an irrevocable trust; funding the trust with gifts so the trustee can pay the premiums.
Transfers to the trust can be protected from gift taxation by using either available annual exclusions or the grantor/donor’s lifetime exemption. At the death of the insured the proceeds are not included in the taxable estate, but the funds are available to buy assets out of the estate to provide liquidity necessary to pay estate taxes. All is right with the world!
But what happens if the insurance is later needed for other purposes outside the trust and back inside the taxable estate?
Careful advisors take the precaution of having the policy in a grantor (or defective) trust that by its terms allows the grantor/insured to purchase the contract out of the trust.
The practice is common and allows for broad future planning options. In the past no one was quite sure if reserving the power to repurchase the coverage didn’t constitute an “incident of ownership” in the policy that would draw the death benefit back into the insured’s taxable estate, even if they didn’t buy the policy back.
Not to worry!
If your clients are concerned then suggest that they ask their legal or tax advisor about Rev. Rul. 2011-28 which determined that the right to repurchase does not create an incident of ownership so long as:
- The trustee was obligated to assure that the purchase price paid was adequate.
- The transaction didn’t shift benefits among trust beneficiaries.
With these provisions in place a trustee can buy life insurance inside the trust without fear of using up a grantor’s insurability that might be needed outside the trust at a later date.
Take the planning flexibility one step further.
Assume a policy was purchased back from the trust because the grantor/insured needed it for collateral on a business loan (and couldn’t get additional coverage because of medical issues that arose subsequent to the original purchase date). Once the need has passed (i.e. repayment of the loan) the grantor can sell the policy back to the trust without fear, if properly done, of either:
- The 3-year look-back rule for purposes of estate taxation, because the policy was sold and not gifted to the trust
- A transfer-for-value for income tax purposes, because the sale to a grantor trust by the grantor is deemed a transfer to himself.
Call if your client has concerns about the flexibility he or she may have getting proposed trust-owned life insurance back out if needed down the road or, for that matter, the sale of an existing policy to a trust. Call, too, if you want a copy of Rev. Rul. 2011-28 to read or to pass on the client’s legal or tax advisor.