Application of the Transfer For Value Rule to the Sale of Life Insurance

Remember that Internal Revenue Code (“Code”) Section 2042 causes inclusion of the proceeds of a policy on the decedent’s life if an estate receives the proceeds or if the decedent retained significant control over the policy, for example, by retaining the right to change beneficiaries of the policy or to pledge the policy. The Code refers to these rights as “incidents of ownership” and includes the policy proceeds in the estate of the decedent if the decedent dies holding any.

Setting up an Irrevocable Life Insurance Trust (“ILIT”) provides an effective way to remove the value of the policy proceeds from the decedent’s estate. By owning the policy in the ILIT and naming the ILIT as the beneficiary of the policy and including restrictions disallowing the insured to serve as or name a trustee, the insured releases all incidents of ownership. Of course, removing the policy proceeds from the insured’s estate requires advance planning and sometimes the insured obtains a policy without consulting an attorney first.

If the insured did not create an ILIT to own the policy prior to purchasing the policy, the insured has two options:  gift the policy to the ILIT or sell the policy to an ILIT. If the insured gifts the policy, then the insured has gifted the current value of the policy, likely far less than the death benefit of the policy. This may not matter to the insured; however, there’s another issue. Code Section 2035 will include the policy proceeds in the decedent’s estate if the decedent dies within three years of the transfer. For some clients the three-year rule poses a significant hurdle to Estate Planning with life insurance.

Selling the policy to an ILIT for fair market value allows the insured to remove the policy proceeds from their estate immediately, without gift tax consequences thereby avoiding the application of the three-year rule. However, the sale to an improperly structured ILIT could cause income tax consequences because of the “Transfer for Value” Rule. Generally, Code section 101(a) excludes the life insurance death benefit from taxable income. If the policy was transferred for valuable consideration, which would be the case if the policy were sold, then the Code includes the policy proceeds in the policy owner’s income, otherwise known as the “Transfer for Value Rule.”  Unless an exception to the Transfer for Value Rule applies, the proceeds are taxable, except to the extent of the amount paid by the purchaser.

The Transfer for Value Rule contains the following safe-harbors:  (1) a transfer in which the transferee derives their basis from the transferor (gift); (2) a transfer to the insured, (3) a transfer to a partner of the insured, (4) a transfer to a partnership in which the insured is a partner, or (5) a transfer to a corporation in which the insured holds office or is a shareholder. Creating a trust that qualifies as a grantor trust as to the insured removes the sale from the application of the Transfer for Value Rule because it’s treated as a transfer to the insured. Let’s review an illustrative example.

Let’s assume that Grace owned a life insurance policy with a $5 million death benefit. On the advice of Ami Tuer Atty, Esq., she sold the policy for $100,000 (its fair market value) to an irrevocable trust that Ami set up for her. Ami made a critical mistake and failed to ensure that the trust was a grantor trust as to Grace. Grace died a month later and the Trustee of such trust received the $5 million death benefit but was shocked to learn that resulted in $4,900,000 in taxable income to the trust. At the trust’s tax rate, that’s over $1.8 million in tax liability leaving only $3 million for distribution to the trust’s beneficiaries.

Now let’s change the facts a bit. Assume that Grace went to Gray T. Atty, Esq., who created a grantor trust as to Grace to purchase the policy. Again, the Trustee sold the policy to the trust for its $100,000 fair market value; however, under this scenario, because Gray structured the trust as a grantor trust as to Grace, the sale fell into the safe-harbor of the Transfer for Value Rule of a transfer to the insured. When Grace died a month later, the receipt of the death benefit was not taxable income and the Trustee was delighted to distribute the entire $5 million death benefit to Grace’s beneficiaries.

The above example demonstrate the complexities that arise when Estate Planning with life insurance. The example makes understanding the resulting consequences easy; however, it’s important to understand the underlying rules and reasons for the structure to properly advise an insured. There are numerous traps out there for the unwary, this is but one.

What Estate of Marion Levine Means for Life Insurance

Life insurance!! Years ago, when the exemption amount was lower, I suggested the purchase of life insurance to provide liquidity for an estate if the individual expected to have an estate tax liability at death. With the current exemption amount of $12.06 million, far fewer individuals need to purchase life insurance solely for this reason. Far more individuals purchase life insurance as an investment and use sophisticated techniques to achieve the desired tax results. A recent Tax Court case that resulted in a huge win for the taxpayer demonstrates the effective use of one of those techniques.

The taxpayer, Marion Levine, used an ILIT to purchase life insurance on her son and daughter-in-law and structured the transaction to avoid estate tax inclusion under Internal Revenue Code (“Code”) Sections 2036 and 2038. The following example contains facts based upon the Estate of Marion Levine v. Commissioner (158 T.C. No. 2). Marion’s attorneys-in-fact created an ILIT to own two life insurance policies. The provisions of the ILIT named a trust company as an independent trustee and named a business associate of Marion’s as the sole member of the investment committee. Of note, the investment committee possessed the power to terminate the arrangement and controlled all investment decisions for the ILIT. The ILIT borrowed $6.5 million from Marion’s revocable trust to pay upfront premiums to purchase the insurance policies insuring Marion’s son and daughter-in-law. The ILIT assigned the policies to the revocable trust as collateral for the amount borrowed and agreed to repay the revocable trust its investment: the greater of the premiums paid or the cash surrender value of the policies either on the death of the insureds or at the date of termination of the policies. The ILIT retained the right to terminate the arrangement and surrender the policies. Upon Marion’s death, her executor was unclear about what to include in Marion’s estate: her revocable trust’s right of repayment in the future valued at $2,282,195 or the cash-surrender value of the life insurance policies at the time Marion died valued at approximately $6,500,000.

The Tax Court determined that the split-dollar arrangement met the requirements set forth in Treasury Regulation Section 1.61-22 and concluded that neither Code Sections 2036(a)(2) or 2038 required inclusion of the cash-surrender value in Marion’s Estate. Marion retained no right to terminate the policies, either alone or in conjunction with someone else. Remember, that right remained with the ILIT alone. Marion’s revocable trust possessed a receivable created by the split-dollar arrangement which was the right to receive the greater of the premiums paid or the cash-surrender value of the policies upon termination and nothing more. Although the Commissioner argued that the transaction was a façade that did not match the reality, the Tax Court disagreed and found that state law imposed fiduciary duties on the sole member of the investment committee with respect to the trust and its beneficiaries, none of whom were Marion. The Tax Court concluded that the only asset from the split-dollar arrangement includible in Marion’s estate was the receivable owned by her revocable trust at death.

While the above example seems straightforward in many ways, the taxpayer scored a huge victory because the estate included only the discounted value ($2,282,195) of what it gave to the ILIT, rather than the full value ($6,500,000) which was a 65% discount. Further, although Marion’s attorneys-in-fact created both the ILIT and the revocable trust, and served as Trustees of the ILIT, the Tax Court did not collapse the transaction. Because the ILIT named an independent trustee and contained instructions that the investment committee direct the Trustee, that preserved the transaction and kept the assets out of Marion’s estate, even though it seemed she stood on both sides of the transaction. As this article demonstrates, understanding life insurance and the use of ILITs presents an opportunity for us to work together and add value by being well-versed in the myriad ways to use and structure life insurance.

Let’s Talk about Trusts…and Taxation

I build estate plans around trusts. Trusts offer great flexibility both during life, for example during a period of disability, and after the death of the grantor by providing asset protection, remarriage protection, asset management, and other benefits which might not be otherwise available.

The income tax consequences of a trust depend upon whether the trust contains provisions that make it a “grantor” trust or a “nongrantor” trust. Generally, the tax attributes of a grantor trust flow through to the grantor of the trust, pursuant to Sections 671 through 678 of the Internal Revenue Code (the “Code”). Many refer to these Code Sections as the “Grantor Trust Rules” and these sections determine the income tax status of a trust. If the trust qualifies as a grantor trust under the Grantor Trust Rules, then the Internal Revenue Service disregards the trust as a separate tax paying entity.

If the grantor retains the power to revoke the trust, that’s a grantor trust according to Section 676 of the Code. The grantor reports the income from the trust on their United States Individual Income Tax Return (“Form 1040”). The trust typically uses the grantor’s social security number when establishing an account at a bank or other financial institution in the name of the revocable trust. Alternatively, the trust could use a separate taxpayer identification number for the trust. Either way, the income would flow through to the grantor’s tax return. See Treas. Reg. Section 1.671-4. Assuming the trust uses the grantor’s social security number for tax reporting, when the financial institution issues a Form 1099 or any other tax document, it would do so using the grantor’s social security number.

Revocability alone does not determine grantor trust status. In fact, the grantor need not have a direct benefit from the trust and the trust may be classified as a grantor trust. If the grantor creates an irrevocable trust but retains certain benefits or powers under that trust, then the trust may be a grantor trust. In general terms, if the grantor retains a reversionary interest of more than five percent of the value of the trust, controls the beneficial enjoyment of the income or principal of the trust without the consent of an adverse party, retains certain administrative powers, such as the power to substitute property of equivalent value for the property in the trust, or receives income from the trust, then that’s a grantor trust. Grantor trust status may be beneficial because it allows the grantor to benefit another individual, such as a child or grandchild, while maintaining the tax liability without the payment of the tax being considered an additional gift by the grantor.

The Code classifies any trust that is not a grantor trust under the Grantor Trust Rules as a nongrantor trust and considers such trust its own taxpaying entity. The trustee files a separate income tax return detailing the income, deductions, credits, and tax liability for the trust on the United States Income Tax Return for Estates and Trusts (“Form 1041”). The nongrantor trust obtains a taxpayer identification number for use in reporting items of income and filing its tax returns. If the trustee distributes income to beneficiaries, those distributions may carry out the taxable income of the trust. The trustee provides the beneficiaries with a Schedule K-1 detailing the trust income attributable to that beneficiary which the beneficiary includes in income on their Form 1040. The trust receives an offsetting distribution deduction on its Form 1041. The trust pays tax on any income for which it did not have an offsetting distribution deduction.

The trust reaches the top federal tax rate of 37% on income that exceeds $13,450 in 2022. Contrast that with a single individual taxpayer who reaches the top tax rate of 37% on income that exceeds $539,900 in 2022. Clearly, grantor trust status provides, among other things, tax benefits to a grantor by lowering the tax rate for income. Let’s review a quick example that illustrates that difference in real numbers.

Assume that Mila established the Mila Kunis Revocable Trust. During her lifetime, the trust incurs income of $550,000 annually. Mila includes her only source of income, the trust income, on her Form 1040 for the tax year 2022. Mila has $550,000 of taxable income. Her Form 1040 shows a liability of $166,456 after the application of the tax brackets for a single taxpayer in 2022.

Assume instead that Mila establishes the Kunis Family Trust as a nongrantor trust and names her adult children, Wyatt and Dimitri, as beneficiaries of the Trust. The trust again has taxable income of $550,000 for the year 2022. Thus, Form 1041 would show a tax liability of $201,762. This number alone demonstrates the importance of a trust distributing its income and the important distinction between grantor trust and nongrantor trust status. If the trustee distributes all the income to the beneficiaries, who have no other income, then the trust should receive a distribution deduction for the $550,000 distributed. Each of Wyatt and Dimitri would include $275,000 on their individual Forms 1040. If neither receives income from another source, then assuming each files using single taxpayer status for 2022, each child would have a tax liability of $70,021 after application of the applicable tax brackets.

As the examples above demonstrate, grantor trusts provide an opportunity to lower a trust’s total tax liability, a powerful tool in the Estate Planning arsenal. As we approach the deadline for filing our 2021 income tax returns, it’s important to review your estate plan, paying close attention to any trusts that are part of your plan. Remember that grantor trust income flows through to the grantor, whether or not the trust makes distributions to beneficiaries of the trust. Conversely, non-grantor trust income flows out to the beneficiaries, if they received appropriate distributions during the year, and the trust receives a corresponding distribution deduction. If you have questions about the operation of your trusts or the resulting tax consequences, I can guide you through this complex area of the law.

Just When You Thought You Understood the 10-Year Rule, Think Again

As many of us remember, the Setting Every Community Up for Retirement Enhancement Act of 2019 (“SECURE Act”) sent shockwaves with its significant changes to the rules regarding distributions from Individual Retirement Accounts (“IRAs”). To recap, the SECURE Act repealed the maximum age at which a taxpayer could contribute to their IRA, increased the age at which the taxpayer needs to begin withdrawing funds from the IRA, and eliminated the lifetime stretch benefit for any beneficiary other than the newly created category of beneficiary called the Eligible Designated Beneficiary (“EDB”). EDBs consist of surviving spouses, children who have not yet reached the age of majority, chronically ill or disabled individuals, and any other individual not more than ten years younger than the participant, or appropriately structured trusts for the benefit of those individuals. Any beneficiary other than an EDB was subject to the newly created 10-year rule. The 10-year rule would operate like the 5-year rule that existed prior to the SECURE Act. This meant that the non-EDB need not worry about RMDs and only needed to withdraw all funds by December 31st of the year of the tenth anniversary of the participant’s death. Sounds simple and easy enough to understand and implement, right?  Not so fast…

The ink was barely dry on the SECURE Act when the Internal Revenue Service (“IRS”) took a position that changed the perceived operation of the 10-year rule. In the 2020 updated version of Publication 590-B, the IRS included an example that required a beneficiary subject to the 10-year rule to take annual withdrawals for nine years and then exhaust the IRA fully by December 31st of the year of the tenth anniversary of the participant’s death. This pronouncement meant that the 10-year rule operated completely unlike the 5-year rule. Even though we cannot rely upon Publication 590-B as “official IRS guidance,” the inclusion of this example understandably caused concern. Shortly thereafter, the IRS corrected Publication 590-B by removing that example and confirming that no withdrawals were necessary prior to December 31st of the year of the tenth anniversary of the participant’s death. Considering the proposed Treasury Regulations issued last week, that earlier “mistake” may have been foreshadowing at its finest.

On February 23, the United States Treasury released much-anticipated proposed regulations updating, among other things, the rules regarding RMDs from IRAs. These proposed regulations backtrack on some of the guidance published since the passage of the SECURE Act in 2019. The proposed regulations revert a bit to the incorrect example previously espoused in Publication 590-B and take a nuanced approach to distributions under the 10-year rule. Now, any non-EDB needs to take annual distributions based upon the participant’s life expectancy over the next nine years and exhaust the IRA by December 31st of the year of the 10th anniversary of the participant’s death if the participant reached their Required Beginning Date prior to death. This represents a sharp departure from the operation of the 10-year rule and the advice that most professionals have given their clients since the passage of the SECURE Act in 2019.

Instead of simplifying the IRA Rules, this explanation of the 10-year rule adds another layer of complexity to an already confusing area of the law. Earlier this year, the IRS updated the life expectancy tables which requires recalculation of RMDs for anyone taking distributions from an IRA subject to their life expectancy. Prior to these proposed regulations, only participants, EDBs, and designated beneficiaries who inherited IRAs prior to the SECURE Act used the lifetime stretch. Now, by extension, the tables will apply for non-EDBs who will take under the deceased participant’s life expectancy as well. These changes will undoubtedly confuse many taxpayers and many of their advisors. You can best protect yourself from unintended consequences by consulting with me about the impact that these proposed regulations will have on your IRA and your obligation to take RMDs.

While these Treasury Regulations are only proposed regulations, clients have good reason to be concerned. This area continues to grow in complexity with changed positions and conflicting guidance. Beginning in 2022, any non-EDB subject to the 10-year rule needs to take annual distributions. This author suspects that we have more to learn on this topic and recommends that the brave read the 275 pages of these Treasury Regulations at This article focuses solely on the most drastic change contained in the proposed regulations, although plenty of other changes were made as well. The final Treasury Regulations may revert the 10-year rule to its prior version that existed from 2019 through 2021, and many commentators believe that these regulations improperly interpret provisions of the Internal Revenue Code that set forth the 10-year rule. Until we have final regulations, taxpayers have three options:  follow the Just, file a Form 8275-R noting the contrary position to the regulations or initiate a lawsuit. Stay tuned for additional changes and updates, but in the meantime, follow one of the three options noted herein.

Estate Planning – Something You Shouldn’t Do Yourself

The advent of websites like “Legal Zoom” may lead you to believe that you can create your own estate plan without the assistance of a qualified Estate Planning attorney. You may believe or have heard that writing your intentions on a piece of paper might suffice as a Will. When you write your testamentary intentions on a piece of paper entirely in your own handwriting and sign and date it, that’s called a holographic Will. While creating your own estate plan without the assistance of a qualified Estate Planning attorney may tempt you, using a holographic Will or any other documents that were not drafted by an attorney to dispose of your estate upon your death will likely cause more problems than it solves. Let’s look at an example based upon a recent North Dakota case that highlights just some of the issues that holographic Wills create.

Assume that Bill died survived by several siblings, including Joel, and one son, Luke. Upon Bill’s death, Luke sought informal probate and was appointed as co-personal representative along with his cousin. A few months later, Joel submitted Bill’s purported holographic Will for formal probate. The purported holographic Will read as follows:

My Last Will and Testament
Bill Murray
I leave to Joel Murray
Everything I own
P.S. Bury me in Malibu

The court heard the petition for formal probate and Joel introduced testimony from seven witnesses, most of whom testified that the signature and all portions of the document were in Bill’s handwriting. The court found that Bill’s signature was his signature based upon the evidence offered. The court also held that the clause “everything I own” was not in Bill’s handwriting because the ink appeared lighter, the handwriting slanted differently, and that clause was smaller in text and printed when the remainder of the document was a mix of cursive and print. According to the court, “everything I own” was a material clause, required under North Dakota law. Without the material clause, the document failed to express the donative and testamentary intent necessary for a valid holographic Will. Joel appealed the lower court’s findings, but the higher court ultimately agreed with the lower court findings.

The example above demonstrates just a few of the myriad issues that arise with a holographic Will. Some states like Florida, Illinois, Missouri, New Hampshire, and Wisconsin may accept a holographic Will if the document otherwise meets the statutory requirements for a valid Will, including witness and notary requirements. Maryland and New York recognize holographic Wills made by members of the Armed Forces, but only for the year immediately following the service member’s discharge. A handful of states such as Alabama, Connecticut, Iowa, Washington, and Wisconsin do not recognize a holographic Will made within the state but will honor those made in other states if the instrument is valid in that state. Finally, about half of all states, including California, Kentucky, Louisiana, Texas, and Virginia recognize a holographic Will.

Even in those states that recognize holographic Wills, uncertainty looms when folks create do-it-yourself estate plans. For example, consider the estate of the Queen of Soul, Aretha Franklin. Aretha died in 2018, presumably intestate. Under the laws of Michigan, that meant the distribution of her estate equally among her four children, one of whom has special needs. A few months later, while clearing out Aretha’s home, her niece found three handwritten documents expressing conflicting testamentary directions. All three contained illegible portions, and Aretha failed to execute any of those documents with the requisite formalities for a Will. Although an expert confirmed that all documents were in Aretha’s handwriting, much remains unclear, including whether the documents were simply drafts or her do-it-yourself final estate plan. Sometime later, one of her sons obtained a fourth will along with Aretha’s handwritten notes from a law firm Aretha allegedly had engaged to help her complete her Estate Planning. That son submitted these documents to the probate court and requested that the court admit the documents as his mother’s Will. Although a trial was set to occur in August 2021, no formal opinion has yet been issued. Aretha’s family has waited over three and a half years for distribution from the estate. Are they a “Chain of Fools?” Perhaps it’s time to “R-E-S-P-E-C-T” Aretha’s written instructions; determining those instructions remains the problem.

As the North Dakota case and Aretha’s estate illustrate, holographic Wills and do-it-yourself plans create ambiguities in many situations. Lack of clearly defined beneficiaries, too many beneficiaries, and failing to account for the death of a beneficiary all exacerbate the issue. Legibility and authenticity pose problems as well. Finally, although not discussed in the above examples, consider what happens if the holographic Will or self-created plan disposes of only part of the estate or disposes of assets that the testator does not own. Holographic Wills and other do-it-yourself plans often fail to account for unique circumstances because the author lacks the specialized knowledge of an experienced Estate Planning attorney. Leaving something as important as the distribution of assets upon death to a holographic Will or self-created plan leaves the testator’s family vulnerable to in-fighting, wastes time, and causes significant expense.

Holographic Wills and self-created documents complicate, rather than simplify, an estate. It’s important to speak with a qualified Estate Planning attorney regarding your estate plan and your unique circumstances. I recommend only the use of Revocable Living Trusts as Will substitutes to avoid probate and to provide certain other protections during life, including simplified asset management during periods of disability. If you have a holographic Will, a self-created estate plan, or have considered writing one, don’t! Instead, consult with me and I can ensure that the documents you sign are legally valid, distribute your assets in accordance with your wishes, and account for your distinct circumstances. Save your loved ones that time and expense.