The facts in PLR 200606027 are as follows:

Irrevocable Life Insurance Trust #1 (“ILIT #1”) owns two life insurance policies, one insuring the life of the grantor and the other insuring the joint lives of the grantor and his spouse. The beneficiaries of ILIT #1 are the children of the grantor and his spouse.

Irrevocable Life Insurance Trust #2 (“ILIT #2) also owns multiple life insurance policies insuring the life of the grantor and the joint lives of the grantor and his spouse. The beneficiaries of ILIT #2 are certain grandchildren of the grantor and his spouse.

The grantor’s spouse is now deceased.

Both ILITs are grantor trusts for income tax purposes. A grantor trust is ignored for income tax purposes. Instead, the income of the trust is reported on the income tax return of the grantor and any taxes are paid by the grantor.

The trustee of ILIT #1 proposes to transfer the life insurance policies owned by ILIT #1 to the trustee of ILIT #2 in exchange for the life insurance policy owned by ILIT #2 plus a promissory note equal to the difference in value of the policies owned by ILIT #1 and ILIT #2. The value used in the exchange of the life insurance policies was determined using the interpolated terminal reserve value (“ITRV”) provided by the insurance company. NOTE: The ITRV of a permanent type life insurance policy is approximately equal to its cash value. The ITRV of a term insurance policy is approximately equal to the amount of pre-paid premium that remains (e.g., a term policy that has an annual premium of $1,000 due January 1 would have a ITRV of approximately $500 on July 1 because approximately half of the prepaid premium already would have been used during the first six months of the year). ITRV cannot be used to value a life insurance policy where the insured is terminally ill. In that case an actuary would have to value the policy and its value would be much closer to the value of the death benefit. The IRS considers a person to be terminally ill where there is a greater than 50% chance that the person will pass away within one year.

The IRS ruled that the exchange between ILIT #1 and ILIT #2 was not a taxable event for income tax purposes because the two ILITs were grantor trusts.

Whenever a life insurance policy is gifted or sold, it is possible that the “transfer for value” rule under IRC § 101(a)(2) is applicable. Normally, death proceeds from a life insurance policy are income tax free to the beneficiaries under the policy. However, this is not always the case. For instance, with viatical settlements where an investor group purchases a life insurance policy insuring a third party, the death benefit is taxable to the extent that the death benefit exceeds the amount paid for the policy. There are exceptions allowing the transferred policy to remain income tax free when the transfer is (a) to the insured, (b) to a partner of the insured, (c) to a partnership in which the insured is a partner, and (d) to a corporation in which the insured is an employee or stockholder. The IRS ruled that this transaction met the exception for a transfer to the insured under IRC § 101(a)(2) and, therefore, the death benefit received by the beneficiaries under the ILITs would remain income tax free. The IRS considered the grantor trusts to be the alter-ego of the grantor and, therefore, the transfer of life insurance policies insuring the grantor of ILIT #1 to a trust created by the same insured was characterized as a transfer from the insured to the insured.

So why was this transaction even entered into? The PLR does not explain the reason behind the transaction, but we can speculate as to one reason why it might have been done. The beneficiaries of ILIT #1 were the children of the grantors. The beneficiaries of ILIT #2 were the grandchildren of the grantors. Unless proper planning was put in place, it is possible that the death benefit received by the grandchildren from ILIT #2 would be subject to generation skipping transfer taxes. If proper planning were put in place, the death benefit received by ILIT #2 would be exempt from estate tax, as well as generation skipping transfer taxes. Assuming that planning was done, it would be in the family’s overall best interest to maximize the death benefit paid to ILIT #2. It is highly likely that the reason for the transfer of the policies between the two ILITs was to maximize the death benefit that would ultimately pass to the grandchildren free of estate tax and generation skipping transfer tax.

Do you have an irrevocable life insurance trust the terms of which your client now wants to change? One option might be to discontinue paying premiums on the life insurance policy in the ILIT, let the existing insurance policy lapse, and then create a new ILIT that purchases a new life insurance policy. Another option, which may be more attractive under most circumstances, is to create a new grantor trust ILIT with the terms desired and then transfer the policy from the first ILIT to the new ILIT. This is often done using a promissory note from the trustee of the new ILIT to the trustee of the old ILIT or by the grantor loaning money to the new ILIT to purchase the policy from the first ILIT for the ITRV of the life insurance policy owned by the first ILIT.

Morris, Hall & Kinghorn is experienced in drafting ILITs and other types of irrevocable trusts for estate planning purposes, as well as in structuring transfers between ILITs in a manner that does not violate the transfer for value rule or cause recognition of gain on the tax deferred gain associated with the cash values of existing policies. Click here to request an appointment and learn more about how we can help you plan to meet your client’s needs.