Tax Law

IRS Adds Flexibility to Trusts

As estate planning practitioners are well aware, IRC Section 2042 includes in the gross estate:

  • insurance proceeds on the life of the decedent receivable by the executor; and
  • insurance proceeds on the life of fhe decedent received by others, where the decedent possessed any incident of ownership over the policy

Because life insurance trusts and other types of trusts whose assets include life insurance are common estate planning tools, practitioners must be cautious to avoid the many powers and rights that may result in "incidents of ownership."  See Treas Reg § 20.2042-1(c)(2).

However, in a recent Revenue Ruling the IRS has provided some flexibility for the usage in life insurance in trusts. In Rev Rul 2011-28, the IRS determined that a grantor's retention of the power, exercisable in a non-fiduciary capacity, to acquire an insurance policy held by a trust by substituting other assets of equivalent value will not cause the value of the insurance policy to be includible in the grantor's gross estate under IRC Section 2042. The grantor's retention of the substitution power will not qualify as an incident of ownership so long as the grantor is expressly prohibited from serving as trustee and the grantor's power to substitute assets of equivalent value is held in a non-fiduciary capacity. Additionally, the trustee must have a fiduciary obligation (under local law or the trust instrument) to ensure the grantor complies with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, and that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries.  

When advising clients as to using life insurance to fund a trust, practitioners should keep in mind this added flexibility, and draft trust documents in such a manner as to take advantage of this ability to remove the life insurance policy from the trust through the substitution of other assets.

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