Rev Rul 2004-59 and the Transfer-for-Value Rule

Revenue Ruling 2007-13 from the Internal Revenue Service (IRS) provides guidance on the tax treatment of life insurance policies held within specific types of trusts. This ruling addresses the income tax implications that arise when a life insurance policy is transferred from a grantor trust back to the individual who created the trust, known as the grantor. The guidance clarifies how such a transaction interacts with complex tax rules, providing a framework for understanding the consequences.

The Transfer-for-Value Rule Explained

The Internal Revenue Code contains a provision known as the transfer-for-value rule, detailed in Section 101, which can have tax consequences for life insurance beneficiaries. This rule states that if a life insurance policy is transferred for any type of valuable consideration, the death benefit proceeds generally lose their income-tax-free status. This consideration is not limited to money but can include other property or the assumption of a liability.

When the transfer-for-value rule is triggered, the life insurance proceeds become taxable as ordinary income. The taxable amount is the total death benefit minus the value of the consideration paid for the policy and any subsequent premiums paid by the new owner. This can result in a substantial tax liability, undermining the purpose of the life insurance.

There are several exceptions to this rule that preserve the tax-free nature of the death benefit. These exceptions apply to transfers to:

• The insured person
• A partner of the insured
• A partnership in which the insured is a partner
• A corporation in which the insured is a shareholder or officer

Another exception applies when the transferee’s basis in the policy is determined by reference to the transferor’s basis, such as in the case of a gift.

The IRS’s Analysis in Rev. Rul. 2007-13

The core of Revenue Ruling 2007-13 centers on the IRS’s interpretation of a transaction involving a grantor trust. The ruling describes a situation where a grantor establishes an irrevocable trust that purchases a life insurance policy on the grantor’s life. A key element is that the trust is structured as a “grantor trust” for federal income tax purposes, meaning the grantor is treated as the owner of the trust’s assets and is responsible for paying taxes on its income.

The ruling addresses what happens when this trust transfers the life insurance policy back to the grantor. Because the tax code treats the grantor as the owner of the trust’s assets for income tax purposes, the IRS concluded that the transfer of the policy from the trust to the grantor is treated as a transfer to the insured. This is a critical distinction because a transfer to the insured is one of the specific exceptions to the transfer-for-value rule, meaning the transaction does not trigger the rule, even if consideration is paid.

Tax Consequences for the Grantor and Trust

The analysis in Revenue Ruling 2007-13 leads to favorable tax consequences for the trust and the grantor. By treating the transfer as an exception to the transfer-for-value rule, the ruling prevents immediate tax liabilities and preserves the long-term tax benefits of the life insurance policy.

One primary consequence is that the trust does not recognize any gain or loss on the distribution of the policy to the grantor. Even if the policy has a cash surrender value that exceeds the premiums paid, the trust is not taxed on this built-in gain. This is a result of the IRS treating the transfer as a non-event for income tax purposes.

For the grantor, the basis in the received policy is a carryover basis, meaning the grantor’s basis is the same as the trust’s basis at the time of the transfer. Because the transaction qualifies for the “transfer to the insured” exception, the death benefit of the life insurance policy retains its income-tax-free status. This ensures that beneficiaries will receive the full proceeds without paying income tax on them.

Practical Applications and Planning

Revenue Ruling 2007-13 provides an “exit strategy” for individuals who have placed life insurance policies inside Irrevocable Life Insurance Trusts (ILITs) that are structured as grantor trusts. This guidance allows planners and grantors to unwind a trust structure without triggering the transfer-for-value rule. This is useful when circumstances change after the initial setup of the trust.

Practical scenarios where this ruling is advantageous include when a grantor can no longer afford the ongoing premium payments for the policy. In another case, the original purpose for the trust may no longer exist due to a divorce, a change in family dynamics, or alterations in estate tax laws that reduce or eliminate the need for the trust.

The ruling allows the grantor to retrieve the policy from the trust, providing access to its cash value or relieving the trust of the premium burden. By transferring the policy back to the grantor, the arrangement can be terminated cleanly. This ability to unwind the structure without adverse tax consequences makes the use of grantor trusts in life insurance planning more adaptable.