Are the proceeds of life insurance policies owned first by a taxpayer’s wife and then owned by a family trust, includible in a taxpayer’s gross estate? In Private Letter Ruling 201327010 (July 5, 2013), the Internal Revenue Service held that a taxpayer’s fiduciary powers and individually held powers constituted “incidents of ownership” in insurance policies. However, once that taxpayer relinquished those powers and survived three years beyond that relinquishment, the policies’ proceeds wouldn’t be includible in his gross estate. Here’s why.
Family Trust
The taxpayer’s wife, now deceased, bought multiple life insurance policies that named the taxpayer as the insured and her estate as the beneficiary. The taxpayer never paid any premiums, and no premiums were due.
When the taxpayer’s wife passed away, her will directed that a family trust would own the policies. The family trust provided that trust income and principal would be payable to the taxpayer and the decedent’s descendants, according to the discretion of a trustee. The taxpayer was named trustee and protector of the family trust, with the power to remove and replace trustees as he saw fit. Thus, the taxpayer, as trustee, had incidents of ownership in the life insurance policies.
On a certain date, the family trust was split into two trusts, Trust 1 and Trust 2. The insurance policies funded Trust 1; the remaining assets funded Trust 2. At the time the family trust was divided, the taxpayer stepped down as trustee and protector of Trust 1. He also gave up his power to be reappointed as trustee of Trust 1 and his power of appointment over the assets of Trust 1. He did, however, retain his beneficial interest in Trust 1 as a permissible distributee of Trust 1’s income and principal.
Incidents of Ownership
Under Internal Revenue Code Section 2042(2), the value of a gross estate includes the value of amount receivables from life insurance under policies to which a decedent possesses incidents of ownership at the time of his death. If a decedent transfers an interest in property or gives up power over property during a 3-year period prior to his death, and that property would have otherwise been included in the decedent’s gross estate, the value of that property is still included in a decedent’s gross estate. (IRC Section 2035(a)). However, life insurance proceeds wouldn’t be included in a decedent’s gross estate if a decedent didn’t possess any incidents of ownership at the time of his death. “Incidents of ownership” typically means the right of an insured to the economic benefits of a policy, including a power to pledge the policy for a loan, to change a beneficiary, to surrender/cancel a policy or to assign a policy. Under Treasury Regulations Section 20.2042-1(c)(4), a decedent has an incident of ownership in a policy on his life held in trust if he has the power to change the beneficial ownership in the policy or its proceeds, even though the decedent has no beneficial interest in the trust.
In this PLR, the IRS looked to Revenue Ruling 84-179, 1984-2 C.B. 195, which held that a decedent won’t be deemed to possess incidents of ownership over an insurance policy on his life when the decedent’s powers were held in a fiduciary capacity and weren’t exercisable for his personal benefit; when the decedent didn’t transfer the policy; and when the devolution of the powers on the decedent wasn’t a part of a prearranged plan involving his participation. Rev. Rul. 84-179 also held that a decedent will be deemed to have incidents of ownership when his powers are held in a fiduciary capacity and he transfers the policy (or the consideration) to a trust. And, the revenue ruling stated that when a decedent’s powers could have been exercised for his benefit, they would constitute incidents of ownership in a policy, regardless of how those powers were acquired. Therefore, if a decedent reacquires power over insurance policies in an individual capacity, those powers constitute incidents of ownership.
Under the facts of this PLR, the family trust held insurance policies on the taxpayer’s life. Under the taxpayer’s deceased spouse’s will, he possessed trustee powers over the trust assets, a beneficial interest in the trust and a testamentary power of appointment over the trust assets. He could exercise in his fiduciary capacity his trustee powers over the incidents of ownership in the policies for his own benefit and could exercise in his individual capacity the power of appointment over the policies’ proceeds. As such, both the fiduciary power and the individual power to appoint constitute incidents of ownership in the policies, regardless of how the powers were acquired and regardless of whether the taxpayer transferred property to the family trust. However, after the date the family trust was split and the taxpayer stepped down as trustee and protector of Trust 1, the taxpayer had only a beneficial interest as a permissible distributee, but no powers over the policies or their proceeds and therefore, no incidents of ownership under Section 2042(2). Thus, assuming the taxpayer survives the 3-year period of Section 2035, the policies’ proceeds won’t be includible in his gross estate.