TRANSFER FOR VALUE RULES
The irrevocable life insurance trust (“ILIT”), can provide a means to make transfers to heirs free of both estate and income tax. Ideally, the trust is drafted prior to application for and purchase of the life insurance policy that it will eventually hold as its primary asset. However, circumstances may arise which result in a need to transfer an existing policy into a trust. In this event, special measures must be taken to preserve the income and estate tax benefits of the ILIT.
Generally, §2035 of the Internal Revenue Code (“Code”) provides that a transfer of a policy by an insured within three years of death will result in estate inclusion of all policy proceeds. However, under Code §2035(d), the three-year inclusion rule does not apply to a bona fide sale for adequate and full consideration. A sale of a policy to a trust, however, gives rise to its own set of issues, namely policy valuation, trust funding, and the transfer for value rule under §101(a) of the Code.
The three-year rule does not apply to a bona fide sale for adequate and full consideration, it is crucial that the policy be appropriately valued-otherwise, a policy transferred for less than full value will be treated as a part gift/part sale. A policy should be sold for its fair market value. Generally speaking, the fair market value of a permanent policy will be equal to its interpolated terminal reserve plus unearned premiums. (However, in the first year of a policy's issue, the value typically will be premiums paid.) The value of a term policy will generally be equivalent to unearned premium. This information can be obtained by requesting Form 712 from the insurance carrier.
To effect a sale of a policy to an irrevocable trust, the trust will need to obtain the funds to purchase the policy by some method. Typically, this can be accomplished through annual exclusion gifts to the trust, or perhaps through a single lifetime applicable exclusion gift, while a more aggressive planner might employ a promissory note.
Under §101(a)(1) of the Code, transfer of a life insurance policy for valuable consideration results in the loss of the otherwise tax-free treatment of death proceeds. However, an exception to this transfer for value rule is where the policy is transferred to the insured. The sale of a policy to a grantor trust (in which the insured is the grantor) would fall under this exception to the transfer for value rule. Rev. Rul. 85-13 suggests that an existing life insurance policy can be sold by a grantor to a grantor trust without transfer for value issues, and Rev. Rul. 2007-13 specifically provides that a non-grantor trust's sale of an existing policy to the insured's grantor trust also falls into the exception.