How Does Revenue Ruling 2008-22 Affect Grantor Trusts?

Revenue Ruling 2008-22 from the Internal Revenue Service (IRS) provides guidance on how certain powers retained by a trust’s creator, or grantor, are treated for federal estate tax purposes. The ruling’s conclusions affect modern estate planning with irrevocable trusts. It clarifies a path for achieving specific income tax outcomes without triggering adverse estate tax results.

Understanding Incidents of Ownership

The term “incidents of ownership” is a concept in the taxation of life insurance proceeds. If a person possesses any incidents of ownership in a policy on their own life at death, the full death benefit is included in their gross estate. This inclusion can increase the taxable estate and potential federal estate tax liability, as the term refers to the right to the economic benefits of the policy.

Incidents of ownership are not limited to outright ownership. Examples include the power to change the policy’s beneficiary, the right to surrender or cancel the policy, the ability to assign it or revoke an assignment, and the power to borrow against its cash value. Possessing any of these rights is sufficient to cause the policy’s proceeds to be included in the decedent’s estate.

This rule is designed to prevent individuals from avoiding estate tax by simply transferring legal title of a policy while retaining control over its benefits. Understanding and avoiding the retention of these rights is an objective in estate planning strategies that involve life insurance.

The Core Holdings of the Revenue Ruling

Revenue Ruling 2008-22 addressed a scenario where a grantor established an irrevocable trust for their descendants. The trust instrument explicitly prohibited the grantor from serving as the trustee.

A feature of the trust was a power retained by the grantor, in a non-fiduciary capacity, to acquire any property held by the trust by substituting it with other property of equivalent value. This is called a “power of substitution.” The legal question was whether this power would cause the trust’s assets to be included in the grantor’s gross estate.

The IRS concluded that this power of substitution did not cause the assets to be included in the grantor’s estate. The rationale is based on the trustee’s duties. The ruling emphasizes that the trustee has a fiduciary obligation to ensure that the properties being exchanged are of equivalent value before completing the transaction.

This fiduciary oversight prevents the grantor from manipulating the power for their own benefit, for example, by acquiring an asset from the trust for less than its fair value. Because the trustee must ensure the trust receives property of equal value, the grantor cannot use the substitution power to reduce the value of the trust.

Implications for Grantor Trusts and Estate Planning

The ruling has practical implications for an estate planning tool: the intentionally defective grantor trust (IDGT). A grantor trust is a trust where, for income tax purposes, the grantor is treated as the owner of the trust’s assets and is responsible for paying any income taxes. While this may seem disadvantageous, it is often a deliberate strategy. When the grantor pays the income tax, the trust’s assets can grow without being diminished by taxes, an additional gift to the beneficiaries.

One way to trigger this grantor trust status is by including a power of administration as outlined in the Internal Revenue Code. The code provides that a grantor is treated as the owner of a trust if they retain a power to reacquire the trust corpus by substituting other property of equivalent value. This is the power at the center of Revenue Ruling 2008-22.

Before this guidance, there was uncertainty about using this power in an Irrevocable Life Insurance Trust (ILIT). Planners wanted to use the power of substitution to gain the income tax benefits of grantor trust status for the ILIT. However, they were concerned that the power would be deemed an incident of ownership, which would defeat the purpose of the ILIT by causing the life insurance proceeds to be included in the grantor’s estate.

Revenue Ruling 2008-22 provided reassurance by confirming that a properly structured power of substitution did not cause general trust assets to be included in the grantor’s estate. Building on this, the IRS later issued Revenue Ruling 2011-28, which confirmed that such a power will not be considered an “incident of ownership” in a life insurance policy. These rulings provide a safe harbor, allowing planners to design trusts that are “defective” for income tax purposes but effective for estate tax planning.