D—Funded Credit Shelter Trusts as Potential
Purchasers of Life Insurance
How to Achieve a Second Step-Up in Basis of Deceased Spouse’s
Property
Significant tax advantages can be achieved by widows and
widowers who are beneficiaries of credit shelter trusts (established upon the
deaths of their respective spouses), through the purchase by the credit shelter
trust of insurance on the life of the surviving spouse. Since the subject involves
a vast potential market for life insurance, through which a family can
effectively achieve a second step-up in basis of property passing at death, it
warrants a careful analysis.
Millions of dollars in life insurance premiums can be
generated from sales in this special market. One of the appealing aspects of
investing credit shelter trust monies in life insurance is that when the trust
is ultimately distributed to children (or other heirs) after the death of the
surviving spouse, the property will have achieved, in effect, two successive
step-ups in basis subsequent to the death of the first spouse. If one were to
ask an "expert tax advisor" in their community if credit shelter
trust assets receive a basis step-up at the time they are received by a decedent’s
heirs (i.e., after the death of the surviving spouse), they would probably
wonder what on earth you are talking about, and reply in the negative. Yet,
such a result is effectively possible with life insurance.
In summary, it works as follows: Consider a spouse with
appreciated assets who dies. The appreciated assets are transferred by the
decedent’s will to a credit shelter trust, taking a stepped-up basis equal to
the market value at which they were included in the gross estate (yet escaping
estate taxation through application of the applicable exemption amount). Assume
that before the assets appreciate further in value some portion is sold by the
trustee at no taxable gain. The proceeds of the sale are used to purchase an
insurance policy on the life of the surviving spouse. When the surviving spouse
dies, the death benefit will be received by the trust income tax free under
I.R.C. §101. Thus, in effect, the property that was received by the trust with
a stepped up basis upon the death of the first spouse will have grown to an
amount equal to the insurance death benefit by the time the second spouse dies.
This second increase in value (occurring between the death of the first spouse
and the death of the second spouse) is not subject to income tax, because of
Code §101, and thus, there has effectively been a second
step-up in basis for the increased asset amount eventually received by
the couple’s heirs.
Life Insurance in Testamentary Credit Shelter Trusts
For many years the testamentary credit shelter trust has been
a standard element in estate planning for married persons. These trusts, created upon death and funded
to the extent of the decedent`s applicable exemption amount ($1 million in 2002
and 2003, and increasing thereafter), represent a vast potential market for
life insurance. Life insurance on the
life of the surviving spouse can be a highly suitable asset for credit shelter
trusts, although there are technical obstacles to such an investment, particularly
when the surviving spouse is the trustee of the trust or when the surviving
spouse holds certain other powers over trust property. This discussion focuses on the advantages of
life insurance as an asset of a credit shelter trust and the circumstances in
which such an investment would be indicated.
The potential technical obstacles to such an investment are identified,
and solutions are suggested which would clear the way for acquisition of the
insurance.
Leaving All Assets To The Surviving
Spouse Can Be Unnecessarily Costly
Current estate and gift tax law permits unlimited transfers
of property between spouses without transfer tax. Thus, when a married person dies, all of his or her property may
be transferred to the surviving spouse with no estate tax liability, regardless
of the size of the estate. However,
when the surviving spouse later dies the then-current value of all of this
property still held by the surviving spouse is taxable in his or her estate.
Every individual is entitled to transfer up to $1 million of
property free of estate or gift tax. [Current law provides for an increase in
the exemption amount to be phased in as follows: $1.5 million in 2004 and 2005;
$2 million in 2006 through 2008; $3.5 million in 2009. The estate tax is
repealed for the year 2010, but reinstated in 2011, with an exemption amount of
$1 million.] Thus, a married couple can effectively shelter from transfer tax
an amount at least double the applicable exemption amount (or $2 million, based
on the current exemption amount).
However, half of this shelter will be lost if the first spouse to die
leaves all of his or her property outright to the surviving spouse (since the
surviving spouse’s estate will include the first decedent’s property, but will
only one $1 million exemption will be applicable). On the other hand, if this
first $1 million of assets is transferred not to the surviving spouse outright,
but to a trust for the primary benefit of the surviving spouse, and if the
spouse`s rights with respect to the trust property are appropriately limited,
the property will not be includable in the estate of the surviving spouse, and
the married couple will have been able to utilize the full $2 million of
available exemption
This preservation of the applicable exemption amount of the
first spouse to die is a fundamental objective in estate planning for married
couples, and the transfer of this applicable exemption amount to a trust for
the primary benefit of the surviving spouse is the commonly used method of
achieving this objective. These trusts
are referred to in estate planning as "credit shelter" trusts or
"bypass" trusts.
Life Insurance As A Credit Shelter
Trust Asset
Under an estate plan utilizing a credit shelter trust, the
surviving spouse is often named as the income beneficiary of the trust for his
or her lifetime, and upon his or her death, the trust is distributed or held
for the benefit of the couple`s children and/or grandchildren. If the income from the assets which the
surviving spouse ends up owning outright (i.e., the assets received outright
from the deceased spouse, plus all of the assets originally owned by the
surviving spouse in his or her own right) is adequate for the surviving
spouse`s standard of living, it is highly advantageous to focus the investment
of the credit shelter trust assets on growth of principal, rather than current
income. Because these assets in the
credit shelter trust will not be included in the estate of the surviving
spouse, increases in value during his or her lifetime can pass to the children
undiminished by estate tax. This
technique of "leveraging" a transfer tax exemption to shelter future
growth of assets transferred in trust is a fundamental concept of estate
planning.
Life insurance has always been regarded as a highly effective
vehicle for leveraging of transfer tax exemptions. The irrevocable inter vivos life
insurance trust has long been recognized as a useful planning device which uses
this leveraging concept. Yet, little
attention has been given by planners to the utilization of life insurance in a
testamentary credit shelter trust. The
use of trust assets for the purchase of an insurance policy on the life of the
surviving spouse can be a means of assuring significant leverage, i.e.,
tax-free growth of the trust corpus as of the date of the surviving spouse`s
death--without regard to the ultimate longevity of the surviving spouse, a
factor which would have a material and unpredictable effect on the extent of
the growth of a credit shelter trust funded with a traditional securities portfolio.
The balance of this discussion focuses on technical issues
which can arise when a credit shelter trust owns—or the trustee contemplates
purchasing—insurance on the life of the surviving spouse.
Authority Of Trustee To Purchase Life
Insurance
A preliminary question is whether the purchase of a life
insurance policy would be a legally proper investment by a credit shelter
trust. In general, state law governs the types of investments into which a
trustee may place trust assets. These
rules are generally broad, intended primarily to limit excessive exposure to
risk, and do not limit powers otherwise specifically granted in the trust
instrument. A well-drafted trust
instrument will delineate the investment powers of the trustee. If the purchase of insurance by the credit
shelter trust is contemplated at the planning stage, the trust instrument might
contain a clause specifically granting authority to acquire a life insurance
policy. Even if life insurance is not specifically
mentioned, the trustee is often given virtually unlimited discretionary
authority, either by the trust instrument itself or under state law. Most
states have abandoned so-called "legal list" statutes, which
delineated specific types of permissible trust investments, in favor of a broad
standard of prudent judgment on the part of the trustee, exercised in the
context of the known objectives of the trust. Thus, in most instances, the
purchase of an insurance policy would be permissible, as a matter of trustee
discretion [See generally, Restatement (Third) of Trusts P.I.R §227 (1990)].
Avoiding Inclusion Of The Insurance
Proceeds In The Surviving Spouse`s Estate: The "Incidents Of
Ownership" Test
Assuming that the trustee has the authority to acquire a life
insurance policy on the life of the surviving spouse,
does the fact that the surviving spouse is the insured party raise the
possibility that the insurance proceeds would be includable in the gross estate
of the surviving spouse when he or she dies?
Whether the proceeds of life insurance are includable in the gross
estate of the insured party depends upon whether, at the time of death (or
within the three-year period prior to death) the insured held any
"incidents of ownership" with respect to the policy [I.R.C. §§2042
and 2035]. The Treasury Regulations provide a lengthy interpretation of the
meaning of "incidents of ownership."
The term is not limited to ownership in the technical legal sense. "Generally speaking, the term has
reference to the right of the insured or his estate to the economic benefits of
the policy," including certain powers over the policy. [See Treas. Reg.
§20.2042-1(c).]
When credit shelter trusts are utilized in estate planning
for married couples, the parties typically desire that the surviving spouse be
given significant lifetime benefit from, and possibly control over, the trust,
but short of such benefit or control as would cause the trust assets to be
included in the surviving spouse`s gross estate. Thus, in many cases, the surviving spouse will be given a lifetime
income interest and a limited (or special) power of appointment over trust
assets. The surviving spouse is also
sometimes designated as the trustee.
Each of these benefit/control elements in the surviving spouse requires
analysis as to whether they would cause the surviving spouse to be deemed to
hold incidents of ownership if the trust should acquire an insurance policy on
his or her life.
Incidents Of Ownership If The Insured
Holds A Limited Power Of Appointment
Treasury Regulations provide that "[a] decedent is
considered to have an `incident of ownership` in an insurance policy on his
life held in trust if, under the terms of the policy, the decedent (either
alone or in conjunction with another person or persons) has the power (as
trustee or otherwise) to change the beneficial ownership in the policy or its
proceeds, or the time or manner of enjoyment thereof, even though the decedent
has no beneficial interest in the trust" [Treas. Reg. §20.2042-1(c)(4)].
Thus, it seems quite clear that if the surviving spouse holds a limited power
of appointment over the credit shelter trust, and the trust acquires an
insurance policy on his or her life, the insurance proceeds will be included in
the insured`s gross estate.
This result can be avoided if anticipated in the trust
planning and drafting stage. For
example, the power of appointment can be drafted to specifically exclude any
insurance policy on the life of the power holder [ see
Ltr. Rul. 9111028]. In the
alternative, the trust can provide that the entire power of appointment is to
be voided if the trust acquires an insurance policy on the life of the power
holder [see Ltr. Rul.
9602010]. In both of these letter rulings reflecting real life examples, the
planners contemplated a potential advantage of life insurance as a trust asset
and drafted provisions that would permit the flexibility to acquire such
insurance without the risk of the death benefit being included in the insured`s
gross estate by reason of "incidents of ownership."
Incidents Of Ownership If The Insured
Is Trustee Of The Trust
As part of a typical scenario of granting as much control as
possible to the surviving spouse, he or she is sometimes designated as trustee
of the credit shelter trust. This will
not per se cause the trust to be included in the surviving spouse`s gross
estate (as long as the trustee`s authority to invade corpus for his or her own
benefit is specifically limited); however, if the trust owns an insurance
policy on the life of the surviving spouse/trustee, the above-discussed rules
of Code Section 2042 come into play.
Because the insured party is the trustee of the trust which owns the
policy, he or she is likely to be deemed to hold incidents of ownership in the
policy, causing the death benefit to be included in his or her gross
estate--unless the authority of the trustee with respect to the policy is
sufficiently limited.
In 1984 the IRS ruled that when an insured holds a policy on
his or her own life in a fiduciary capacity (i.e., as trustee of the trust
which owns the policy), he or she is deemed to hold "incidents of
ownership" if the fiduciary powers could have been exercised for his or
her own benefit or if he or she had originally transferred the policy to the
trust or provided the funds for maintaining the policy [Rev. Rul. 84-179, 1984-2 C.B. 195]. In the normal credit shelter trust situation, the policy would
not have been transferred to the trust by the trustee/insured, nor would he or
she be providing funds for maintaining the policy. The policy will have either been transferred by the trust grantor
(the first spouse to die) or initially purchased by the trust after the
grantor`s death, and would be maintained with other assets acquired by the
trust from the grantor.
That analysis leaves as the only significant factor under the
1984 ruling, the extent to which the insured/trustee is able to exercise his or
her authority over the policy for his or her own benefit. Unless some restrictions over the trustee`s
normal authority as owner of an insurance policy are created in the trust
instrument, the trustee would indeed be able to exercise that authority for his
or her own benefit. For example, a
trustee with unfettered authority could at some point decide to surrender the
policy and invest the proceeds in income-producing securities. If the trustee is also the income
beneficiary of the trust, as would be the case for a typical credit shelter
trust, this would certainly result in the trustee`s benefiting from the exercise
of his or her fiduciary authority. [See Estate of Freuhauf v. Comm`r, 427 F.2d 80 (6th Cir. 1970).]
This problem can be dealt with through trust provisions that
specifically limit the authority of the trustee over a life insurance policy
held by the credit shelter trust. The
IRS has ruled that a trust containing a provision that prohibits any individual
trustee whose life is insured by a policy owned by the trust from exercising
any power conferred on the owner of such policy did not convey incidents of
ownership over the policies to the trustee/insured [Ltr.
Rul. 9111028]. The insurance policy was also excluded
from the special power of appointment which the trustee held over trust
property.
Incidents Of Ownership If The Insured
Is A Beneficiary Of The Trust
What if the proposed insured is not the trustee of the trust,
but merely a trust income beneficiary?
A mere beneficial interest (e.g., a lifetime income interest without a
power of appointment) does not appear to involve the type of control contemplated
in the regulations defining "incidents of ownership." This appears to be borne out, without direct
discussion of the point, in some IRS letter rulings. [See, e.g., Ltr. Rul.
9434028; Ltr. Rul. 9111028.] In addressing the issue of the
insured as trustee and/or holder of a special power of appointment, the IRS has
held that the insured did not possess incidents of ownership, without
discussing the fact that the insured was also an income beneficiary of the
trust. In a 1996 ruling, the fact that
the insureds were income beneficiaries of the trust
was clearly stated, and after concluding that the special powers of appointment
were not operative if the trust owned insurance policies on their lives, the
IRS held that the insureds would not be considered to
hold incidents of ownership in the trust-owned policies [Ltr.
Rul. 9602010]. Accordingly, a mere income interest in
a trust would not give rise to an incident of ownership in an insurance policy
owned by the trust.
Potential Revision Of Existing Trust
Structure To Allow For Purchase Of Insurance Without "Incidents Of
Ownership"
As discussed above, "incidents of ownership" in the
insured can be avoided with appropriate trust provisions if the possibility of
insurance being acquired by the credit shelter trust is recognized at the
planning stage. What can be done,
however, when such planning was not done, but the trustee eventually determines
that an insurance policy on the life of the surviving spouse is a desirable
trust investment? If the surviving
spouse is the trustee or holds a limited power of appointment over trust
assets, either of these conditions will be deemed incidents of ownership unless
the trust arrangement can be revised to eliminate them. Some potential approaches are discussed
below.
Resignation As Trustee
As long as the insured is the trustee and there are no trust
provisions limiting his or her authority over the policy, the policy proceeds
will be includable in his or her gross estate.
One solution would be for the proposed insured to resign as trustee and
have the successor trustee acquire the insurance policy for the trust. [Note
that if the policy is acquired by the trust prior to the resignation of the
insured as trustee, there would remain a risk of inclusion of the death benefit
in the estate of the insured if he or she were to die within the first three
years after resignation as trustee [I.R.C. §2035]]. Such a solution was the
subject of a favorable IRS letter ruling in 1994 [Ltr.
Rul. 9434028].
Of course, the feasibility of such a course of action would depend upon
the facts of the given situation, e.g., the degree of importance of the loss of
control over trust assets, and the degree of confidence that the designated
successor trustee will act as desired with respect to the surviving spouse`s
interests.
Delegation Of Trustee`s Authority Over
The Insurance Policy
Assuming that the surviving spouse would not want to resign
the trusteeship altogether, it might be possible to remain as principal
trustee, but insulated from any power over the insurance policy. In a 1995 letter ruling [Ltr.
Rul. 9542007], the trust at issue provided for
certain co-trustees. The trustees petitioned the local probate court for
modification of the trust to allow for a special sub-trust which could acquire
life insurance, and the trustees of which would be
only those trustees of the original trust who were not beneficiaries. The ruling held that under such an
arrangement, the insurance proceeds would not be includable in the gross estate
of the insured co-trustee.
(It should be noted that the favorable holdings in Ltr. Rul. 9542007 and Ltr. Rul. 9538035, discussed
below, erroneously overlooked the additional fact that the insured held a
limited power of appointment over the trust, which would amount to an incident
of ownership, despite the elimination of authority over the policy in the
capacity as trustee. Both of these
rulings were subsequently withdrawn without published explanation. Upon inquiry, the IRS branch responsible for
these rulings confirmed that they were in fact withdrawn because of this
oversight. The revoked rulings
nonetheless provide useful examples of potential trust modifications to
insulate a trustee-insured from authority over the trust-owned insurance
policy.)
In another 1995 letter ruling [Ltr.
Rul. 9538035] a series of trusts were proposed to
acquire insurance on the lives of their respective primary beneficiaries. The beneficiaries were not trustees, but
each could be appointed as successor trustee of his or her respective trust if
the original trustee resigned or otherwise failed to serve. However, they were specifically prohibited
from becoming trustees if their respective trusts held insurance policies on
their respective lives. A beneficiary
could become successor trustee only in the event that his or her trust was
partitioned into two separate trusts, one of which would hold the insurance
policy and the other would hold all other assets; the beneficiary could then
become successor trustee with respect only to the portion that did not hold the
insurance policy. While it appears from
the ruling that such potential partitioning may have been provided for in the
original trust instruments, the ruling at least suggests the possibility of
such a trust partitioning as a solution to the incidents of ownership problem,
even without such specific authorization.
In general, the insulation of a trustee from direct authority
over an insurance policy owned by the trust on his or her life, unless set
forth in the original trust instrument or accomplished through outright
resignation as trustee, would require modification of the trust terms. Such modification would be governed by state
law applicable to trusts and would in most instances require a petition for
local court approval.
[Be mindful that a very common provision in so-called
beneficiary-controlled trusts is the granting of power to the beneficially
interested trustee to appoint an independent trustee to hold or exercise any
"tax-sensitive" powers, i.e., powers, such as control over an
insurance policy, which might trigger adverse tax consequences if possessed by
a non-independent trustee.]
Elimination Of Power Of Appointment
Over Trust-Owned Policy
If the trust instrument grants the surviving spouse a limited
power of appointment over the credit shelter trust, this power would have to be
eliminated or modified in order to clear the way for the trust to acquire an
insurance policy on the life of the spouse without the death benefit being
includable in the spouse`s gross estate under the incidents of ownership
test. Depending upon the terms of the
power of appointment and the applicable state law, the power might be
eliminated through a formal "release" executed by the power holder.
With respect to a limited power of appointment, there is no
gift tax issue connected with release of the power. Unlike the case of a general power of appointment, a release of a
limited power is not considered a transfer of the underlying property [Reg.
§25.2514-3(e), Ex. (3)]. Thus, should
the surviving spouse determine that the acquisition of life insurance by the
credit shelter trust is sufficiently attractive to justify giving up (or
restricting) his or her limited power of appointment, there would be no tax
obstacle to doing so. However,
reference must be made to applicable state law to determine whether there are
any restrictions and/or procedural requirements with respect to releases of
powers of appointment.
[Note: A power of appointment, like other property bequeathed
in a will, may be rejected through a “disclaimer,” which when formally
completed within a statutorily designated period following the decedent’s
death, typically nine months, will result in the power never actually vesting
in the designated power holder. However, the discussion here of “releases” of
powers of appointment relates only to subsequent relinquishment of powers not
originally disclaimed.]
Generally prevailing law permits releases of powers of
appointment by action of the power holder without need for a court petition.
Certain formal procedures may be required by state statute, and thus, if a
release of a power of appointment is planned in connection with the acquisition
of an insurance policy by a credit shelter trust, legal assistance must be
sought with respect to these non-tax requirements. For example, California Probate Code Section 661 provides,
"unless the creating instrument otherwise provides, a general or special
power of appointment that is a discretionary power, whether testamentary or
otherwise, may be released, either with or without consideration, by a written
instrument signed by the donee and delivered as
provided in [this section]." The
section goes on to discuss permissible partial releases, the requirements for
delivery of the written instrument of release, and recording of the instrument
when real property is involved.
With regard to partial releases, the
Assuming that a total or partial release can be effected under applicable state law, a question arises as to
the timing of the execution and delivery of such a release. If the release is executed after the trust
has actually acquired the insurance policy, Code section 2035 will come into
play; if the insured dies within three years after the effective date of the
release, the insurance proceeds will be includable in his or her gross
estate--as a result of having disposed of an incident of ownership within the
three-year period preceding death. On
the other hand, if this risk is to be avoided by executing the release prior to
the trust`s acquiring the policy, there is a potential technical issue in the
case of a partial release applicable only to the insurance policy: can such a
partial release be effected with respect to specific appointive property which
was not even part of the appointive property pool at the time the release was
executed and delivered? Could the IRS
argue that such a purported release was not legally effective? Again, such an issue would have to be
determined through interpretation of applicable state law.
Conclusion
An insurance policy on the life of the surviving
spouse/beneficiary may be an especially attractive investment vehicle for a
credit shelter trust. While life
insurance is commonly used as a funding vehicle to materially leverage the gift
tax annual exclusion and the applicable exemption amount in the context of
inter vivos irrevocable life insurance trusts, in the
context of its testamentary cousin, the credit shelter trust, life insurance is
often overlooked--even though the factual circumstances may be such that
similar leveraging with life insurance would be highly advantageous. Indeed,
such an arrangement can achieve, in effect, a second step-up in basis in
property passing at death in the case of a married couple.
Care must be taken to avoid the insured`s possessing
incidents of ownership in the policy, which would cause the death benefit to be
included in the insured`s gross estate.
Incidents of ownership may be present if the insured is either a trustee
of the credit shelter trust or holds a power of appointment over trust
property. If the possibility that life
insurance might be acquired by the credit shelter trust is contemplated in the
estate planning stage, the factors potentially giving rise to incidents of
ownership can, in most instances, be avoided with careful drafting. In the case of an existing credit shelter
trust desiring to acquire such insurance, steps can be taken to eliminate
potential incidents of ownership through modification of the insured`s position
or powers as trustee and/or full or partial release of his or her limited power
of appointment.