Structuring of life insurance trusts: impact of recent cases.by Englebrecht, Ted D.
In a typical life insurance trust, the taxpayer sets up an irrevocable trust and provides it with funds to purchase a life insurance policy on the taxpayer's life. Upon the taxpayer's death, the trust collects the proceeds from the insurance policy and distributes them to the beneficiaries of the trust.
A recent Appeals Court decision, Estate of Eddie L. Headrick, 1 and a Tax Court case, Estate of Leder, 2 have held that insurance proceeds from such policies, even though purchased within three years of the date of death of the decedent, are not includable in the gross estate of the decedent. In so ruling, the court rejected the position of the IRS that such proceeds are includable under Sec. 2035.
PROVISIONS OF SEC. 2035
Sec. 2035(a) generally requires that the gross estate of a decedent must include the value of any property in which the decedent has held an interest within three years of death. This includes property that the decedent has transferred by trust or any other means. 3
For persons dying after December 31, 1981, Sec. 2035(d)(1) provides an exception to the inclusion rule of Sec. 2035(a). However, Sec. 2035(d)(2) states that the exception does not apply to a transfer of an interest in property that is included in the value of the gross estate under Sec. 2036, 2037, 2038, or 2042, or would have been included under any of these sections if such interest had been retained by the decedent.
Secs. 2036, 2037, and 2038 deal with transfers with a retained life, transfers taking effect at death, and revocable transfers, respectively. Because these types of transfers have no beaing on the issues in Headrick and Leder, they will not be discussed further.
PROVISIONS OF SEC. 2042
Under Sec. 2042, the gross estate of a decedent must include: 1) the amount receivable by the executor from insurance policies on the life of the decedent, and 2) amoutns receivable by beneficiaries from insurance policies on the life of the decedent if the decedent possessed incidents of ownership of the policy at his or her death. 4 The term "incidents of ownership" includes a reversionary interest exceeding 5% of the value of the policy. Through such an interest, the policy or the proceeds of the policy could revert to the decedent or his or her estate. Also included is the right of the decedent to dispose of the policy, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to change beneficiaries, to borrow from the insurer against the policy, or to pledge it as security for a loan.
It is clear from SEc. 2042(2) that proceeds from a life insurance policy on the life of a decedent may be includable in the decedent's gross estate if the decedent maintained any control over the disposition of the funds from such a policy. An example of such control would be the act of reserving the right to name or change the beneficiary of such a policy.
THE LEDER DECISION
In Leder, Joseph Leder's wife, Jeanne, within three years of her husband's death, purchased a life insurance policy on his life and signed the original application as owner. Mrs. Leder transferred the policy to an irrevocable trust and named herself as trustee. The named beneficiaries of the trust were herself and her three children. Premiums on the policy were paid directly to the insurance company by Mr. Leder's wholly-owned corporation.
Upon the husband's death in 1983, the $1,000,000 proceeds of the policy were distributed outright to the beneficiaries. No part of the proceeds was included in the decedent's gross estate on the federal estate tax return.
Position of the IRS
The IRS maintained that the proceeds from the policy were includable in Leder's gross estate pursuant to Sec. 2035. It argued, notwithstanding Sec. 2035(d)(1), that Congress intended for the three- year rule to continue to apply to gifts of life insurance. Language in the legislative history accompanying Sec. 2035(d) was cited as support for this position.
The Position of the Taxpayer
Leder's estate countered that: 1) Sec. 2035 applies only if the insurance proceeds are includable in the gross estate due to the provisions of Sec. 2042; 2) in this case, Sec. 2042 was inapplicable because Leder never possessed any of the incidents of ownership in the policy; and 3) the proceeds were not includable in the value of the gross estate under Sec. 2035 because no transfer of incidents of ownership under Sec. 2042 took place.
Ruling of the Tax Court
The court noted that pursuant to Sec. 2035(a) a decedent's gross estate must include the value of property transferred by the decedent within three years of death for less than adequate and full consideration. It further noted that Sec. 2035(d)(1), added by ERTA in 1981, generally nullifies Sec. 2035(a) for estates of decedents dying after 1981. An exception to Sec. 2035(d)(1) exists for certain transfer described in Sec. 2035(d)(2).
Sec. 2035(d) was looked upon by the court as an "added sieve" through which transactions must pass before being tested under the three-year rule. The three-year rule is generally repealed by Sec. 2035(d)(1). However, "perforations" in the sieve are found in Sec. 2035(d)(2). These perforations allow the three-year rule to be applied to a transfer of an interest in property which either 1) is included in the value of the gross estate under Sec. 2042, (5) or 2) would have been included under Sec. 2042 had such an interest been retained by the decedent.
The first issue to be settled, then, was whether the decedent retained any incidents of ownership on the life insurance policy pursuant to Sec. 2042. The court ruled that state law must be looked to for the answer to this question. Under Oklahoma law, if an insurance policy does not grant the insured the express right to change the beneficiary of the policy, the insured has no power to transfer to any person the beneficial interest in such a policy. The Leder policy specifically stated that only the owner was entitled to the rights granted under the policy. Thus, until the policy was transferred to the trust, the wife, and not the decedent, had the sole authority to exercise powers under the insurance contract.
The court concluded that, under Oklahoma law, the decedent never possessed any contractual rights under the contract. He never possessed any incidents of ownership in the policy pursuant to Sec. 2042. Because Sec. 2042 was not applicable in this case, Sec. 2035(d)(2), including the three-year rule, also did not apply, and the insurance proceeds were excludable from the gross estate of the decedent under Sec. 2035(d)(1).
THE HEADRICK DECISION
Eddie Headrick was a tax attorney living in Cleveland, Tennessee. He had a wife and three young daughters. Headrick wanted to provide for his family in the event of his untimely death, and as a result, established an irrevocable trust. The trust agreement designated Headrick's wife and daughters as primary beneficiaries and reserved to Headrick the right to remove any trustee at will and appoint a bank as successor trustee. The trust beneficiaries were granted a limited power to withdraw trust property within 30 days of the contribution of such property.
On December 18, 1979, Headrick met with James C. Brewer, president of the Cleveland Bank and Trust Company (CBT), to discuss setting up the trust. Brewer later stated that he believed Headrick intended the trust to function as an "insurance trust for Headrick's family." Headrick, however, did not require CBT, as a condition of establishing the trust, to commit to acquire life insurance with the trust corpus.
The trust agreement authorized the trustee to accept the contribution of a life insurance policy or to purchase such a policy, as trust principal, on the life of:
* A beneficiary; or
* A person in whom Headrick or a beneficiary had an insurable interest.
Furthermore, the agreement provided that each insurance policy purchased or contributed to the trust must be owned exclusively by the trustee. Only the trustee was to exercise incidents of ownership over each policy.
Upon executing the trust agreement, Headrick paid $5,900 to CBT as trust principal. Also on that date, Headrick's wife, Lucille, executed on behalf of herself and her minor children a waiver of the right of the beneficiaries to withdraw any portion of the $5,900 contribution to the trust.
On December 19, 1979, CBT executed an application with Massachusetts Mutual Life Insurance Co. to obtain a $375,000 insurance policy on the life of Eddie Headrick. CBT was named in the application as owner of the policy. Headrick signed the application as the insured. Monthly premium payments of $435.76 were to be remitted by the bank. The first premium check was dated December 20, 1979.
CBT's application was approved, and the policy was issued on January 8, 1980. No ownership rights were conferred by the policy on Headrick. Furthermore, Headrick acquired no ownership rights in the policy indirectly through a reserved power in the trust agreement.
Subsequently, Headrick made two additional contributions to the trust corpus: $5,500 on December 30, 1980, and $2,000 on December 22, 1981. No beneficiary elected to withdraw any portion of these contributions. The total contributions of $13,400 covered all premium payments made by the trust.
Approximately three months after establishing the trust, Headrick joined CBT's board of directors and became chairman of CBT's trust committee. One of the responsibilities of the trust committee was to regularly review and discuss new trust accounts and the investments in those trusts. Along with other trusts Headrick's trust was reviewed every three or four months by the trust committee. In addition, CBT's trust department was regularly audited by the FDIC and Tennessee bank auditors. Neither the CBT trust committee nor the bank auditors determined that CBT had improperly administered Headrick's trust.
Headrick died in an automobile accident on June 19, 1982 at the age of 33. He was survived by his wife and three minor daughters. As owner of the life insurance policy, the trustee was paid $378,701.93 in death benefits by Massachusetts Mutual Life Insurance Co. The estate tax return filed by the executors of Headrick's estate did not include the life insurance proceeds. The IRS determined that the transfer of the life insurance proceeds to the trustee constituted a transfer pursuant to Sec. 2035(a). Accordingly, the amount of the taxable estate was increased by $378,701.93. This resulted in a deficiency in the estate tax liability of $192,881.15.
Headrick's estate maintained that Headrick never possessed any incidents of ownership in the policy within the meaning of Sec. 2042. Consequently, the exception specified in Sec. 2035(d)(2) to Sec. 2035(d)(1) did not apply. Therefore, the insurance proceeds should not have been included in the taxable estate.
The IRS conceded that the trust was structured so that the incidents of ownership were not legally or technically held by Headrick. However, it declared that Headrick
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so dominated the trust arrangement that the trustee was essentially acting as Headrick's agent in acquiring insurance on his life. The fact that Headrick, through the trust arrangement, indirectly paid the premiums on the insurance policy was offered as evidence of his control.
The IRS relied on the pre-ERTA cases, Bel, (6) Detroit Bank and Trust, (7) and Kurihara (8) in maintaining that Headrick had made a constructive transfer of the insurance policy to the trust. In a typical constructive transfer, the decedent purchases a life insurance policy on him- or herself, pays all premiums, and designates children or spouse as owners and beneficiaries. Under Sec. 2035(a), the courts have considered such transactions as transfers because the decedent "beamed" the policy proceeds to the children or spouse. This was accomplished by paying the policy premiums and vesting in the children or spouse all contractual rights to the insurance benefits. Applying this reasoning, the IRS determined that Headrick had acquired a transferable interest in the policy pursuant to Sec. 2042.
Accordingly, the requirement of Sec. 2035(d)(2) was satisfied, and the insurance proceeds did not qualify for exclusion from Headrick's gross estate under the three-year rule of Sec. 2035(d)(1).
Tax Court. Headrick was first heard by the Tax Court, which determined that the issue to be decided was whether the proceeds of a life insurance policy purchased by a trust within three years of the insured grantor's death must be included in the trustor's gross estate under Sec. 2035(a). The court noted that the IRS conceded that the incidents of ownership were not legally or technically held by Eddie Headrick. Consequently, the court's inquiry was limited to whether Eddie Headrick, under Sec. 2042, ever owned the policy acquired by the trustee. If he did, the exception in Sec. 2035(d)(2) would apply and the proceeds would be includable in his estate. If not, Sec. 2035(d)(2) would not apply and the proceeds would be excluded under Sec. 2035(d)(1).
In reaching its decision, the Court felt that the facts in Headrick were similar to those of Leder and ruled that its decision in Leder was controlling. In Headrick, the Tax Court applied the same line of reasoning it did in Leder. First, it addressed the question of whether under Sec. 2042, Eddie Headrick had possessed any incidents of ownership in the policy on his life.
The court ruled that it was immaterial that the trust paid the policy premiums out of trust corpus contributed by Headrick. As support for this conclusion, the court cited the Senate Report from 1954 when Sec. 2042 was amended. The report stated that Sec. 2042 "revises existing law so that payment of premiums is no longer a factor in determining the taxability under this section of insurance proceeds." The Tax Court noted that since Congress changed Sec. 2042 in 1954 courts have consistently held that the so called "premium payment test" is now abandoned under Sec. 2042. As a result, the court concluded, as in Leder, that the beamed transfer approach was not relevant to whether Headrick ever controlled the insurance policy pursuant to Sec. 2042.
The next issue examined was whether, under Tennessee law, Headrick would have a beneficial interest in the insurance policy. As in Leder, the Court determined that the decedent would not have had such an interest.
The court concluded that Headrick never owned or controlled the insurance policy, and consequently, never possessed any incidents of ownership in the policy under the provisions of Sec. 2042. Accordingly, the exception of Sec. 2035(d)(2) did not apply, and the insurance proceeds were excludable from his gross estate under Sec. 2035(d)(1).
The Sixth Circuit. The Sixth Circuit likewise rejected the position of the IRS. The court upheld the conclusion of the Tax Court that a literal reading of the statutory language of Sec. 2035(d)(2) first requires analysis of the life insurance transaction under Sec. 2042 so as to ascertain the existence of any incidents of ownership.
Furthermore, the court refused to apply the constructive transfer doctrine to Sec. 2035(d)(2). It felt that to do so would resurrect, under Sec. 2042, the premium payment test. Application of the constructive transfer doctrine to Sec. 2035(d)(2) would be counter to the express language of that subsection and the undisputed intent of Sec. 2042.
Applying the "incidents of ownership" test of Sec. 2042, the court found that Headrick never possessed any incidents of ownership in the policy. The policy conferred no ownership rights on Headrick. CBT, as trustee, was the owner of the policy from the time of application for the policy until the proceeds were paid to the trust. The fact that Headrick made payments to the trust corpus for the payment of the life insurance premiums was determined to be irrelevant because the payment of premiums is not an incident of ownership under Sec. 2042.
Because Headrick was determined not to possess any incidents of ownership in the policy under Sec. 2042, he did not transfer an interest in the policy that would have been included in the value of his gross estate under Sec. 2042. It follows that the policy proceeds were not includable under Sec. 2035(d)(2), and the proceeds were excludable from Headrick's estate under the general rule of Sec. 2035(d)(1).
The results in Headrick and Leder have significant tax implications for persons establishing life insurance trusts. If the Appeals Court had not upheld the decision of the Tax Court, the proceeds of Headrick's life insurance policy, almost $400,000, would have been included in his gross estate. The resulting increase in estate tax liability would have been nearly $200,000. In the case of Leder, the taxable estate would have increased by about $1 million. This would have caused the estate tax liability to increase by more than $250,000.
Factors affecting the includability of life insurance proceeds in the gross estate of the decedent are listed in Figure 1.
Most irrevocable insurance trust instruments are drafted to include a Crummey power, which is the right to withdraw a specified amount of property within a limited period. Absent the use of a Crummey power by the beneficiary, most gifts to the trust will not constitute a present interest and, therefore, will not qualify for the annual gift tax exclusion. The term "Crummey power" can be traced to the Crummey decision. In Crummey, the parents established an irrevocable trust for each of their four children, some of whom were under the age of 21 at the time the transfer was made to the trust. Each child was given the power to withdraw a portion of the transfers to the trust each year. To the extent the power was unexercised at the end of the year, the power lapsed.
The issue resolved by the court in Crummey (9) was whether gifts to the minor children, who could only exercise their withdrawal powers through a reluctant guardian, qualified for the annual exclusion. The court held that the present interest requirement is satisfied and the annual exclusion available as long as the demand for withdrawal could not be legally resisted.
A Crummey power is a general power of appointment, and the lapse of this power is generally a taxable gift under Sec. 2514(b). Sec. 2514(e) provides that the lapse of a power is a release and, therefore, a taxable gift, except to the extent of the greater of $5,000 or 5% of the assets from which the power could have been exercised.
One technique available to eliminate the gift tax consequences of a lapsed Crummey power is to limit the amount of the contribution to the amount imposed by the five and five limit. However, the amount of the power which may lapse each year tax-free ($5,000 or 5%) is less than the amount of the annual gift tax exclusion of $10,000. This disparity creates several problems. First of all, the insurance premiums may be greater than the five and five limit, and while the grantor desires his or her entire contribution to escape gift taxation, he or she does not wish the beneficiaries to incur a gift tax liability on the amount of the excess lapse.
If the grantor is attempting to maximize the amount that can be paid in premiums each year without paying gift taxes, the number of beneficiaries who are granted Crummey powers of withdrawal powers should be maximized.
An alternative solution to the gift tax problem would be to transfer policies with high cash values to the trust. Because of high accumulation values in these policies, annual premiums are reduced significantly because policy dividends offset premium payments. The advantage of transferring such a policy to a trust is that the grantor may commit smaller annual outlays and still take advantage of the annual gift tax exclusion.
A technique to avoid the five and five limitation on lapsed powers and maximize the annual gift exclusion is the use of a hanging power. The hanging power delays the lapse of the power tot he extent that the lapse would exceed the five and five limit of Sec. 2514. When a hanging power is used, the annual lapse is limited to the greater of $5,000 or 5%. Withdrawals in excess of this limit do not lapse but are subject to the beneficiary's right of withdrawal and are reduced in future years against the $5,000 or 5% in those future years.
The use of hanging powers is an aggressive technique of which the IRS strongly disapproves. So far, the IRS has not been successful in its battle, but its position, as expressed in PLR 8901004, is that it will not sanction the hanging nature of a power of withdrawal if the lapse is expressed in terms of general tax consequences.
In PLR 8901004, the IRS has detailed a trap for the unwary. That is, to the extent that a grandchild or more remote descendent of the grantor holds a Crummey power, a gift made to the trust is treated as an immediate direct skip transfer for generation-skipping transfer taxation only if that skip person is the sole beneficiary of the trust. Of course, the effect of this private letter ruling makes all transfers to trusts in which a skip person holds a power of withdrawal subject to generation skipping transfer tax (GSTT) as a direct skip if there are other beneficiaries of the trust. To avoid immediate assessment of the GSTT, the grantor would have to use a portion of his or her $1 million GSTT exemption.
THE LIFE INSURANCE TRUST
CAN WORK TO AVOID ESTATE
A life insurance trust can be used to provide for one's family in the event of one's untimely death. The taxpayer simply establishes an irrevocable trust, funds the trust with cash, and names his or her family members as trust beneficiaries. The trustee uses the cash to purchase insurance on the life of the taxpayer. Upon the death of the taxpayer, the insurance proceeds are paid to the trust and then distributed to the trust beneficiaries.
Headrick seems to have resolved the issue of whether life insurance proceeds paid to such trusts are includable in the gross estate of the decedent. Both courts followed Leder in that the appropriate test is whether the decedent, under Sec. 2042, held incidents of ownership (e.g., the right to change beneficiaries, exercise policy options, etc.) over the policy or transferred the policy, within three years of the date of death. If so, the exception of Sec. 2035(d)(2) to Sec. 2035(d)(1) applies, and the proceeds are includable under Sec. 2035(a). Otherwise, they are excludable from the gross estate.
In reaching this decision, the Sixth Circuit upheld the ruling of the Tax Court that:
* The constructive transfer rule no longer applies; and
* Premium payments are irrelevant to the determination of policy ownership.
In establishing such trusts, taxpayers should be careful not to own or control the policy before it is acquired by the trust. To avoid the appearance of ownership by the insured, the trust agreement should state that only the trust has ownership rights in the policy. That is, the insured should not have the right to change beneficiaries or exercise any other control over the policy. Furthermore, the policy should be acquired by the trust and not by the insured. If the policy is acquired by the insured and then transferred to the trust, the insured will be deemed to have had ownership rights in the policy. If such ownership rights are held by the insured within three years of death, the insurance proceeds will be includable in the gross estate under Sec. 2042.
A life insurance trust can be a very effective way to provide for loved ones at death. A careful structuring of the trust agreement to avoid ownership or control of the policy by the insured will help to assure that the proceeds are not taxable in one's gross estate. Lastly, a properly drafted trust may incorporate Crummey and hanging powers, but the generation-skipping issue must be addressed by the grantor to avoid adverse tax consequences.
Steven C. Colburn, PhD, is an Assistant Professor of Accounting at Georgia State University, Atlanta. He has published articles in Taxation for Lawyers, Journal of Taxation of Investments, and Journal of Real Estate Taxation, among others.
Ted D. Englebrech, PhD, is the KPMG Peat Marwick's Professor of Accounting at Georgia State University, Atlanta. He has published articles in many academic and practitioner journals and is nationally recognized in the area of estate planning.
(1) USCA 6, No. 90-1150, aff'g 93 TC 171 (1989).
(2) 89 TC 235 (1987).
(3) Subsec. (b) provides an exception to Sec. 2035(a). While not relevant to this case, Subsec. (b) is included here for clarification: it provides that Subsec. (a) shall not apply: (1) to any bona fide sale for an adequate and full consideration in money or money's worth, and, (2) to any gift to a donee made during a calendar year if the decedent was not required by Sec. 6019 (other than by reason of Sec. 6019(2)) to file any gift tax return for such a year with respect to gifts to such donee.
(4) Such incidents of ownership could have been exercisable either by the decedent or in conjunction with someone else.
(5) As noted earlier, under Sec. 2035(d)(2) similar treatment may apply to transfers made pursuant to Secs. 2036, 2037, or 2038, which do not apply in this case.
(6) Bel v. United States, 452 F.2d 683 (5th Cir. 1971), cert. denied, 406 U.S. 919 (1972).
(7) Detroit Bank & Trust Co. v. United States, 467 F.2d 964 (6th Cir. 1972), cert. denied, 410 U.S. 929 (1973).
(8) Estate of Kurihara v. Commissioner, 82 T.C. 51 (1984).
(9) Crummey 397 F. 2d 82.
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