In Private Letter Ruling 201919002 (released May 10, 2019), the Internal Revenue Service considered the provisions of an irrevocable life insurance trust (ILIT), which had been modified pursuant to state statute before the ILIT held any insurance, in ruling that the ILIT’s subsequent purchase of a policy insuring the life of the settlor’s child wouldn't give rise to any incidents of ownership triggering inclusion in the beneficiary-child’s gross estate under Internal Revenue Code Section 2042(2), provided that: (1) the beneficiary-child wasn’t serving as the trustee vested with all insurance-related powers on his death (insurance trustee); and (2) the ILIT instrument wasn’t subsequently modified in any way that would cause the beneficiary-child to regain any incidents of ownership over the policy.
The ruling serves as a practitioners’ reminder to remain mindful of the potential for inadvertently-created incidents of ownership whenever drafting an irrevocable trust that might be used to hold life insurance. The ruling also re-emphasizes the fact that even inadequately drafted trusts may be fixed pursuant to trust modification procedures recognized under state law.
Incidents of Ownership
Before proceeding further, it may be helpful to explain what “incidents of ownership” are with respect to policies of life insurance held in trust. For purposes of the ruling, one must only know that IRC Section 2042(2) provides that if a decedent-insured possessed certain proscribed powers at death with respect to any policy insuring his life, then he’ll be deemed to have possessed an “incident of ownership” that will trigger the inclusion of that policy’s proceeds within his estate for federal estate tax purposes. In relevant part, incidents of ownership include any powers to: (1) change the policy beneficiary; (2) surrender or cancel the policy; (3) assign the policy to a new owner; (4) revoke a policy assignment; (4) pledge the policy for a loan; or (5) obtain an insurer’s loan against the policy’s surrender value. These incidents of ownership have been defined and interpreted broadly and may be deemed to exist whether a prohibited power is exercisable alone or in conjunction with others.
Before he died, the beneficiary-child’s parent established an ILIT for the benefit of one of his children (Child 1) and such child’s descendants. Under the ILIT instrument, Child 1 was to serve as trustee of the ILIT during Child 1’s lifetime; no co-trustee was named. As trustee and beneficiary, several provisions of the ILIT instrument (instrument) granted Child 1 powers that could’ve been deemed to result in one or more of the above-discussed incidents of ownership; namely:
- to own and acquire life insurance and to pay premiums on policies insuring the life of any person in whom the ILIT or its beneficiaries may have an insurable interest (Section 2.1);
- to have all rights, powers, options, elections, privileges and other incidents of ownership over all ILIT-owned insurance policies (Section 2.4);
- to use all or any part of the ILIT’s net income or principal to pay the premiums and other charges due on all ILIT-owned insurance policies (Section 2.5);
- to distribute the ILIT’s net income and principal to Child 1, as beneficiary, pursuant to an ascertainable standard (i.e. that is, as determined for his own health, education, maintenance and support) (Article 3); and
- to appoint the ILIT assets at Child 1’s death among Child 1’s descendants (power of appointment (POA)) (Section 6.1).
In the initial year of administration, the trustee proposed to purchase a second-to-die life insurance policy insuring the joint lives of Child 1 and Child 1’s spouse (spouse). However, if that policy was purchased, then Child 1’s POA over all ILIT assets would’ve been deemed an incident of ownership, and that would’ve triggered the inclusion of the policy’s proceeds in Child 1’s gross estate under Section 2042(2). Luckily, the policy wasn’t purchased in Year 1, and Child 1 was given some time to pursue ILIT modification options under state law.
ILIT Modification Process
Pursuant to a state statute authorizing the modification of irrevocable trusts, as trustee of the ILIT, Child 1 successfully petitioned the applicable court to modify the instrument’s terms so as to: (1) eliminate Child 1’s POA with respect to any policy insuring Child 1’s life (and the proceeds thereof); (2) add provisions for an “insurance trustee” who would have sole authority over any policies on Child 1’s life that the ILIT aquired; and (3) require that premiums on any policy insuring Child 1’s life could only be paid from principal (and not from taxable income, as determined under Subchapter J of the IRC).
Later that same year, the relevant court approved Child 1’s petition for modification. Specifically, the court approved and confirmed that the instrument was modified in the following ways: (1) Section 2.5 was modified so that if the ILIT owned any policy insuring the life of the settlor, a beneficiary or a trustee of the ILIT, then premium payments could only be made from principal (and not from taxable income);(2) Section 6.1 was modified to provide that the holder of any POA couldn’t exercise that power with respect to any policy insuring the powerholder’s life (or any proceeds therefrom); and (3) Child 1’s sibling (Child 2) was appointed as the insurance trustee, a concept that was fleshed out in new Section 7.12(a). The insurance trustee was essentially a limited purpose third-party trustee who would exercise all fiduciary powers related to any ILIT-held insurance—this effectively eliminated the problems that existed under Sections 2.1, 2.4 and Article III of the instrument before its modification was completed.
Policy Purchase and Ruling
The IRS agreed that the modifications to the instrument eliminated the estate inclusion exposure that would’ve otherwise existed under Section 2042(2). As insurance trustee for the ILIT, Child 2 purchased a second-to-die policy on the lives of Child 1 and spouse (policy) in the year following the court’s ruling. In ruling that the purchase wouldn’t trigger inclusion under Section 2042(2), the IRS noted that the policy wasn’t purchased or held within the ILIT until after all potential “incident-of-ownership” sources were eliminated from the instrument under applicable state law. Accordingly, based on the facts submitted and representations made before it, the IRS concluded that Child 1 didn’t, and wouldn’t, possess any incidents of ownership over any policy insuring Child 1’s life that was acquired by the ILIT, as amended and that the proceeds thereof wouldn’t be includible in Child 1’s gross estate under Section 2042(2).
Stephen Putnoki-Higgins is an attorney in the private client services practice group at Shutts & Bowen LLP, in Tampa, Fla. and is admitted to practice in Connecticut, Florida, and New York.