On February 16, 2007, the IRS issued a formal ruling approving a sale of a life insurance policy to a grantor trust. This ruling is a rare formal ruling by the IRS in the grantor trust area. Grantor trusts, or intentionally defective grantor trusts, are used often in a variety of estate planning situations. Grantor trusts are typically used in estate planning situations where the parties want the income of the trust to be taxed to the grantor of the trust (the person who set up the trust) or where they want the grantor to be deemed to be the owner of the trust property for income tax purposes.
One situation where grantor trusts have been utilized is in restructuring the ownership of a life insurance policy to cure problems which may exist in an existing irrevocable life insurance trust. For example, a person may set up an irrevocable life insurance trust for estate planning purposes. However, if the person’s family or financial situation changes and necessitates a change in the trust, the trust is irrevocable and cannot be modified. A sale of the insurance policy from the old trust to a new trust with the needed modifications allows the grantor/insured to maintain the existing insurance policy, but in the new trust with the desired changes.
However, a sale of a life insurance policy can trigger adverse income tax consequences under the so called “transfer for value rule” which makes the death benefit taxable for income tax purposes. An exception to this rule exists for sales to the insured. Revenue Ruling 2007-13 approves the sale of a life insurance policy from one trust to another trust and indicates that the transfer for value rule does not apply when the purchasing trust is a grantor trust. The Revenue Ruling concludes that the sale to the grantor trust is treated as a sale to the grantor/insured and therefore the exception to the transfer for value rule applies.
There has been some concern that the IRS might begin rethinking its policy on grantor trusts, but this ruling would appear to indicate that the IRS is not doing so. Furthermore, this ruling will be helpful for any grantor trusts transfers involving life insurance policies.