Transfers of Life Insurance Policies Between Grantor Trusts Held Not to Violate Transfer for Value Rule

Under I.R.C. §101, the death benefit proceeds of a life insurance policy are excluded from the gross income of the recipient. An important exception applies if, at any time, the ownership of the policy was transferred from one party to another for a valuable consideration [Code §101(a)(2)]. This is known as the “transfer-for-value” rule. Thus, after the initial issuance of a policy, if it is subsequently transferred for  “valuable consideration,” the income tax exclusion under §101(a) is lost, and the beneficiary will have to include in gross income, the proceeds received, to the extent that they exceed  consideration paid for the policy and any subsequent premiums paid by the transferee [I.R.C. §101(a)(2)].

A recent private letter ruling [Ltr. Rul. 200247006, Nov. 22, 2002] raised the issue as to whether the transfer-for-value rule would apply when a policy owned by the insured’s grantor trust is transferred for consideration to another grantor trust of the same insured.

This ruling involved a married couple, H and W. H established a trust (Trust H1) which acquired a life insurance policy on his life. H and W, together, established a separate trust (Trust HW1), which acquired a life insurance policy on their joint lives. H later established a second trust (H2) and this second trust proposed to acquire, for valuable consideration, the insurance policy owned by Trust H1. Similarly H and W established a second joint trust (Trust HW2), which proposed to acquire, for valuable consideration, the policy owned by Trust HW1. The parties requested rulings that these transfers would not be considered in violation of the transfer-for-value rule. 

All of the trusts involved were  grantor trusts under I.R.C. §675. Section 1.675-1 of the Income Tax Regulations explains that, in effect, section 675 of the Code treats the grantor as the owner of a trust if under the terms of the trust instrument, or the circumstances attendant to its operation, administrative control is exercisable primarily for the benefit of the grantor rather than the beneficiaries of the trust.

In the letter ruling, the IRS refers to Rev. Rul. 85-13 [1985-1 C.B. 184], which concludes that if a grantor is treated as the owner of the entire trust under Code §675, the grantor is considered to be the owner of the trust assets for income tax purposes. 

This leads to the conclusion that “the proposed transfers of life insurance contracts, even though for valuable consideration, will be disregarded for federal income purposes,” and will not affect the tax-free treatment of the eventual death benefit under of Code §101(a)(1). As stated in Rev. Rul. 85-13 "a transaction cannot be recognized as a sale for federal income tax purposes if the same person is treated as owning the purported consideration both before and after the transaction." [See also Ltr. Rul. 200228019.]

Stated another way, since H was deemed the owner of the assets of both Trust H1 and Trust H2 for tax purposes, the shift of title to the policy from H1 to H2 was effectively not a transfer; H was the owner both before and after the shift. The same is true with respect to the policy owned by Trust HW1 that was moved to Trust HW2. H and W, jointly are deemed the owners of the assets of both these trusts, and the shift of policy title from one to the other would not be considered a transfer.>

It should be noted, however, that the favorable result would not apply if the transfer for consideration had been from Trust H1 to Trust HW2 (or from HW1 to H2), since these transfers would not be between grantor trusts having identical ownership.