A recent Revenue Ruling issued by the Internal Revenue Service (IRS) providing guidance on the income tax treatment of assets owned by an irrevocable grantor trust (IGT) at the grantor’s death, as well as a scathing letter sent by four U.S. Senators to the Treasury Department urging
for regulatory and sub-regulatory action on IGTs, may indirectly reinforce the value of owning life insurance in trust, which is explained below after discussing these two recent developments.
IRS Issues Revenue Ruling Addressing the Income Tax Effect on Basis of IGT Assets at the Grantor's Death
In March 2023, the IRS issued Revenue Ruling 2023-2 addressing the issue of whether there is a basis adjustment under Internal Revenue Code (IRC) § 1014(b) to the assets of an IGT upon the death of the grantor if the trust assets are not includible in the grantor’s gross estate for estate tax purposes? The full text of this ruling can be found here.
Ruling Confirms No Basis Step-Up for Gifted Assets Held by an IGT at Grantor’s Death:
This ruling confirmed a widely-held view that an asset owned by an IGT that was funded through a completed-gift transaction, and is not includible in the grantor’s gross estate for estate tax purposes, does not receive a basis adjustment to its fair market value at the grantor’s death because it is not “acquired or passed from a decedent” as defined in § 1014(b). The basis of such asset remains unchanged immediately before and after the grantor’s death.
Irrevocable Grantor Trusts, in General:
An IGT is one where certain administrative powers are retained by the grantor or beneficiary designations are made that cause the grantor to be treated as the owner of the principal and income of the trust, in whole or in part, for income tax purposes but not for estate and gift tax purposes. In other words, the trust is the grantor for income tax purposes, but it is not the grantor for estate and gift tax purposes. Accordingly, all items of income, deduction, and credit against the tax of the trust attributable to that portion for which the grantor is treated as the owner are included in computing the grantor’s taxable income and credits.1 Moreover, any transactions between the grantor and the trust, whether by gift, sale, or otherwise, are ignored (treated as though they never happened) for income tax purposes.2
IGTs are commonly used by wealthy individuals to tax-efficiently transfer wealth to their beneficiaries, often over multiple generations. Most commonly, these wealth transfer benefits include the obligation for the grantor to pay the tax attributable to the trust income but not having to report such payment as a taxable gift to the trust.3 Additionally, the grantor can engage in transactions with the trust without income tax consequences, such as substituting (“swapping”) assets with the trust of equal value, or selling assets to the trust in exchange for note under the installment method as an estate freeze strategy. Essentially, no taxable gain on these transactions is recognized nor taxable income for any interest paid, if applicable, as would normally be the case with such transactions if between separate taxpayers.
Potential Purpose of this Revenue Ruling:
Property owned by an individual which are includible in her estate for estate tax purposes may be eligible for abasis adjustment to fair market value as of the date of the individual’s death under § 1014, with certain exceptions.4 Because IGT assets may be treated as owned by the grantor for income tax purposes, in whole or in part, there has been uncertainty and debate regarding whether such assets are eligible for the same basis adjustment. Some aggressive practitioners have been advising clients that trustees and beneficiaries can claim a basis step-up under § 1014 at the grantor’s death to eliminate capital gains tax liability. It appears the purpose may have been to clarify this issue, at least in part as discussed below, and curtail this potentially abusive, although uncommon, tax reporting practice for IGT assets.
What this Revenue Ruling Does Not Address:
The ruling only referenced assets held by an irrevocable grantor trust that were specifically funded through a transaction that is treated as a completed gift for gift tax purposes. For example, it did not address assets that were transferred in trust in other forms, such through an installment sale.
A commonly held view suggests that assets acquired by trusts in transfers such as installment sales are also not eligible for a § 1014 basis adjustment, by reference to various tax laws and guidance. For example, there should be no basis credit equal to the consideration paid by the trust (note issuance) to acquire the asset under § 1012 because the transaction is ignored and no realization event occurred for income tax purposes. Various cases, rulings and informal guidance have been decided or issued concluding that a grantor’s death is not an income tax realization event.5 Furthermore, IRC § 1015(b) states that assets transferred to a trust (other than by gift, bequest or devise) shall have a basis equal to that of the grantor’s, increased by the amount of gain or decreased by the amount of loss recognized by the grantor on the transfer.6 Additionally, by analogy, if gift tax is paid on a completed gift of an asset to an IGT, there is generally no retroactive basis adjustment in the asset at the grantor’s death for the gift tax paid on the transfer during life under § 1015(d) because, again, the transaction was ignored for gift tax purposes.
Due to the lack of reference to trust assets funded in transactions other than completed gifts, perhaps it might indicate that this Revenue Ruling is the first in a series that addresses these other unresolved situations?
Note: This Revenue Ruling does not impact the general efficacy of IGTs as they are commonly used in estate planning under current law, but only clarifies a previously unresolved and related income tax concern. However, the letter written by four U.S. Senators discussed below suggested several actions that, if taken, could have a negatively impact on IGTs.
U.S Sentators Write Letter to the Treasury Secretary Urging Regulatory and Sub-Regulatory Action on IGTs
Also in March 2023, U.S. Senators, Elizabeth Warren, Bernie Sanders, Chris Van Hollen and Sheldon Whitehouse, sent a strongly-worded letter to the Secretary of the U.S. Department of the Treasury, Janet Yellen, urging certain actions be taken with respect to IGTs to curtail what they claim to be abusive use of such trusts by multi-millionaires and billionaires to avoid taxes and shift wealth to their heirs tax free. The full text of this letter can be found here.
The letter urges the Treasury Department to exercise its authority to take the following regulatory and sub- regulatory actions on IGTs, which could doom IGTs into extinction as estate planning vehicles as they are commonly used today:
• Revoke Revenue Ruling 85-13 and follow Rothstein v. US
– Impact: Transactions between a grantor and IGT could be taxable events for income tax purposes.7
• Revoke Revenue Ruling 2004-64
– Impact: Payment of the income tax by the grantor attributable to IGT income would be treated as a gift and possibly incur gift tax.8 The ultimate outcome of this action may be uncertain because there could be unconstitutionality arguments raised regarding imposing an additional tax on a taxpayer’s satisfaction of a tax obligation, but this issue may have to be decided by the courts.
• Clarify that IGTs are not entitled to stepped-up basis
– Impact: Confirm the consensus view that IGT assets that are not included in an estate for estate tax purposes are not entitled to a basis adjustment under § 1014, which the IRS just confirmed, in part, with Revenue Ruling 2023-2 as mentioned above.
Note: This letter suggested additional actions not referenced above.9 It may only be a matter of time before the above or similar actions are taken, whether regulatorily by the Treasury or legislatively by Congress and the President, because the grantor trust rules are antiquated and currently provide loopholes that allow legal exploitation for estate planning that effectively only benefits the ultra-wealthy, which may be an indefensible position as a matter of public tax policy.10
The Value of Trust-Owned Life Insurance Reinforced
Permanent life insurance is constructed with two fundamental components, the protection and investment components. The protection component consists of the death benefit proceeds payable on the insured’s death. The investment component consists of the internal build-up of cash value which is increased by premiums and interest credits and decreased by cost of insurance charges which are the consideration paid to the insurer for the death benefit.11
Because of the financial security it provides to the general public, life insurance is availed of codified tax benefits:
• Income earned in the cash value is tax deferred and excluded from gross income.12
• Cash value can be accessed income tax free through withdrawals up to basis and/or policy loans up to the cash surrender value, if done properly.13
• Death benefit proceeds can be paid income tax free and excluded from gross income if paid by reason of the insured’s death.14
Revenue Ruling 2023-2 and the letter to the Treasury may have indirectly affirmed the economic value of life insurance when owned by an irrevocable trust, whether an IGT or a traditional complex (non-grantor) trust:
• Death benefit proceeds received by an IGT, or a non-grantor trust, are generally income tax free in the form of cash and can be reinvested thereafter. Cash equals basis, so life insurance with the grantor as insured effectively may be the only asset that can effectively receive an upward basis adjustment at the grantor’s death when owned in trust and not included in the grantor’s estate for estate tax purposes. The same effect could ensue for trust-owned policies insuring the trust beneficiaries.
– That is, the basis in the policy before the insured’s death is generally the total premiums paid reduced, but not below zero, by withdrawals and partial surrenders. After the insured’s death, the basis is effectively adjusted to the death benefit proceeds received and that were excluded from gross income even though the proceeds were not included in the insured’s gross estate for estate tax purposes.
– Thus, because of the favorable income tax treatment and economic attributes, death benefits proceeds can provide valuable protection for estate planning as well as a way to help mitigate unrealized capital gains taxes in other trust assets and potentially increase wealth transfer over multiple generations.
• The build-up of cash value is tax deferred and can be accessed tax free, so life insurance on the life of the grantor and/or trust beneficiaries can also help reduce or avoid taxable income otherwise realized by a trust.
– In the case of an IGT, assuming no change to current grantor trust laws, tax paid by the grantor attributed to the trust’s income, which is income personally recognized but not personally received, can be reduced while still yielding favorable accumulation potential and wealth transfer benefits for trust beneficiaries.
– Should grantor trust laws change, as what was suggested in the letter to the Treasury by treating the payment of tax attributable to trust income as a gift, trust income and corresponding taxes paid by the grantor can be reduced or avoided, thus reducing or avoiding gift tax exposure. Moreover, in a non-grantor trust setting, trust income that is subject to the highest federal income tax rates almost immediately can be reduced or avoided, thus reducing onerous trust income tax liability.
Summary
There may be gift tax and various funding strategies to consider regarding transferring money to a trust to pay policy premiums but these are beyond the scope of this commentary and should be addressed by the individual’s financial, tax and legal professionals. Although the outcome of the grantor trust laws and various corresponding estate planning strategies as they exist today remains uncertain, it may be unlikely that Congress would act to change the laws related to the tax attributes of life insurance.15 Accordingly, life insurance has been and will likely continue to be an effective means by which wealthy individuals can provide estate and income tax protection for their beneficiaries, particularly when owned in an irrevocable trust outside their taxable estates.
Information contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. This communication was written to support the promotion or marketing of the transactions addressed herein. Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.
Copyright 2023 Lion Street. For discussion purposes only. Lion Street does not provide tax or legal advice. Individuals should seek such advice from a tax or legal professional.
See IRC § 671-678.
2 See Revenue Ruling 85-13.
3 See Revenue Ruling 2004-64.
4 For property to be eligible for a § 1014 basis adjustment to fair market value, it must be acquired or passed from the decedent as defined
in § 1014(b). Property which is not eligible for basis adjustment under § 1014 includes that which constitutes a right to receive income
in respect of a decedent under § 691, and appreciated property acquired by the decedent by gift within one year of her death which is
reacquired by the donor of such property from the decedent (such reacquired property’s basis in the hands of the donor is limited to the
decedent’s basis immediately before her death). Treasury Regulation 1.1014-1(a) states the purpose of § 1014 is generally “to provide a
basis for property acquired from a decedent that is equal to the value placed upon such property for purposes of the federal estate tax.”
5 See Crane v. Commissioner, 331 U.S. 1 (1947), Revenue Ruling 73-183, Private Letter Rulings (PLRs) 200919027 and 200920032, Chief
Counsel Advice (CCA) Memos 200923024 and 200937028.
6 It is unclear whether a sale constitutes a “transfer” as referenced by IRC § 1015(b).
7 The letter suggests certain exceptions be considered to prevent disruption of businesses conducted for legitimate non-tax reasons.
8 The letter references PLR 9444033, which predated Rev. Rul. 2004-64 and took the position that the grantor’s payment of income tax
attributable to trust income would incur gift tax.
9 Other suggested actions included: 1) requiring Grantor Retained Annuity Trusts (GRATs) to have a minimum remainder value as a
percentage of the contributed assets; 2) requiring GRATs to have a minimum and maximum term of years; 3) prohibiting asset sales
and substitutions with GRATs that insulate the GRAT from downside risk; 4) requiring the transfer of a GRAT remainder interest be
valued without excluding the grantor’s retained interest to prevent a reduction in the value of the transferred remainder interest; and 5)
reissuing Obama-era proposed regulations under IRC § 2704 limiting valuation discounts for certain family-controlled entities.
10 The grantor trust laws were enacted in the 1950s when trusts were subject to the same income tax brackets as individuals to prevent
taxpayers from using trusts to spread out taxable income over lower brackets to reduce taxes but retain certain powers and control
over the trust akin to outright ownership. In the 1980s, the compressed income tax brackets now applicable to non-grantor trusts were
enacted subjecting trusts and estates to the highest federal income tax rate at $14,450 (for 2023) of taxable income, thus eliminating the
incentive to use trusts to reduce income taxes while retaining control, which mostly eliminated the need for the grantor trust laws as
originally enacted. Certain grantor trust powers cause inclusion of the trust’s assets and income in the grantor’s personal income but
not in the grantor’s estate, thereby creating the many estate planning strategies and opportunities used by ultra-wealthy families today
to shift more wealth to heirs and which don’t serve any real purpose for everyday Americans as a matter of tax policy. Therefore, it may
only be a matter of time before the grantor trust laws as they exist today are repealed or revised to reduce or eliminate their efficacy as
estate planning vehicles, especially in light of the Federal government’s need for tax revenue.
11 Interest credits added to the cash value are based on the type of policy and underlying investment options made available by the
carrier. Depending on the policy type, charges deducted from the cash value and interest crediting rates may be subject to change at the
insurer’s discretion based on its expectation as to future investment, operating and mortality experience.
12 See IRC § 7702.
13 Withdrawals from a policy that is not a Modified Endowment Contract (MEC) as defined under IRC § 7702A are income tax free up to
the basis in the policy, applied on a first-in-first-out basis. Policy loans from the insurer or a bank (including increases in such debt from
interest accruals) secured by the cash surrender value and death benefit that is not a MEC are not treated as deemed distributions and
not taxable if the policy remains in force until death, never becomes a MEC and the total loan is either repaid from the death benefit
proceeds or other sources during life. See IRC § 72(e)(5)(A)-(C), which cross-reference (e)(2)(A)-(B) and (e)(4)(A).
14 The exclusion from gross income of the death benefit proceeds may be limited to consideration and subsequent premiums paid for the
policy if the policy is transferred for valuable consideration in a transaction that is not a “carryover basis” transfer, a transaction where
the transferee does not meet one of the prescribed “certain persons” exceptions, or a transaction that is a reportable policy sale which is
defined as an acquisition of an interest in a life insurance policy, directly or indirectly, if the acquirer has no substantial family, business,
or financial relationship with the insured apart from the acquirer’s interest in the policy. See IRC § 101(a) and regulations thereunder.
Furthermore, if the policy is acquired by an employer on the life of an employee, the exclusion from gross income is limited to the total
premiums and other consideration paid for the policy unless the notice and consent requirements are met, and the insured was an
employee within the 12 month period leading up to her death or was a director or highly compensated employee as defined in § 101(j)
(2)(A)(ii) and (j)(5)(A) at the time the policy was issued. See IRC § 101(j) and IRS Notice 2009-48. Lastly, accelerated death benefits due to
the insured’s chronic or terminal illness paid to any taxpayer other than the insured may be subject to the aforementioned gross income
exclusion limitation if the insured is an officer, director or employee of the taxpayer or has a financial interest in a trade or business
carried on by the taxpayer. See IRC § 101(g)(5).
15 Life insurance was removed from the “tax expenditures list” in 2015 for the Joint Committee on Taxation and in 2016 for the Treasury
Department, indicating that the Federal government does not currently seek to change the tax treatment of life insurance. However,
a proposal was put forth by a Democratic Party Senator in the U.S. Senate in 2021 which would have changed the tax attributes for a
certain type of life insurance for certain ultra-wealthy taxpayers – so-called “private placement life insurance” (PPLI) for married joint
taxpayers owning $1 billion+ assets ($500 million+ assets for single taxpayers), married joint taxpayers with $100 million+ income ($50
million+ income for single taxpayers), and trusts with either $10 million+ income or $100 million+ assets. Although this particular Senator
continues to express scrutiny towards PPLI, this proposal may have little chance of passing both Chambers of Congress, if it even makes
it to the floor for a vote, based on the current political landscape and informed feedback from Finseca, a leading political advocacy
organization for the life insurance industry. However, no inference can be drawn from today’s political environment as to future legaslative action.
