Revenue Ruling 2009-13 and the Transfer-for-Value Rule

Revenue Ruling 2009-13 is guidance from the Internal Revenue Service (IRS) that impacts estate planning with life insurance and trusts. The ruling clarifies the income tax consequences when a life insurance policy is transferred between different types of trusts. It provides a framework for these transactions, particularly when dealing with trusts where the creator, or grantor, retains certain powers.

The Scenarios and Holdings of the Ruling

Revenue Ruling 2009-13 presents two scenarios. In the first, an individual establishes two separate “grantor trusts,” where for federal income tax purposes the grantor is treated as the owner of the assets. The trustee of the first trust transfers a life insurance policy on the grantor’s life to the second trust for cash. The IRS concluded this transaction does not constitute a “transfer for valuable consideration,” so the associated tax rule is not triggered.

The second situation involves a transfer from a “non-grantor trust,” where the grantor is not treated as the owner, to a grantor trust. This trust sells the life insurance policy to a separate grantor trust where the insured individual is the grantor. In this case, the IRS determined the sale was a transfer for valuable consideration but held that the transaction qualified for an exception to the rule.

The Transfer-for-Value Rule Explained

Under Section 101 of the Internal Revenue Code, the proceeds of a life insurance policy paid out upon the death of the insured are generally not included in the beneficiary’s gross income. The transfer-for-value rule creates an exception to this principle. If a life insurance policy is transferred for something of value, the income tax exclusion is lost.

When the rule is triggered, the death benefit becomes taxable as ordinary income. The taxable amount is the total death benefit received less the amount the new owner paid for the policy and any subsequent premiums they paid. “Valuable consideration” is a broad concept and is not limited to cash payments; it can include any form of compensation or reciprocal promise.

The Internal Revenue Code provides exceptions that allow the death benefit to remain income tax-free even if a transfer for value occurs. These exceptions apply if the policy is transferred to:

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

A transfer that qualifies for one of these exceptions preserves the favorable tax treatment of the life insurance proceeds.

IRS Rationale for the Ruling’s Conclusions

The IRS’s reasoning in Revenue Ruling 2009-13 hinges on the tax status of grantor trusts. Because a grantor trust is effectively disregarded for income tax purposes, the IRS treats transactions as if they were made by the grantor personally.

In the first situation, the transfer was between two grantor trusts of the same person. The IRS viewed this as the grantor transferring an asset to himself. Since an individual cannot engage in a sale with oneself for tax purposes, the agency concluded that no “transfer” had occurred, making the transfer-for-value rule inapplicable.

The analysis for the second situation was different. The transfer from a non-grantor trust to a grantor trust was a transfer for valuable consideration. However, because the recipient trust was a grantor trust, the transfer was treated as being made directly “to the insured” grantor. This allowed the transaction to fit within the “transfer to the insured” exception, preserving the tax-free nature of the death benefit.

Practical Applications in Estate Planning

Revenue Ruling 2009-13 provides a method for modifying irrevocable life insurance trusts (ILITs) that are structured as grantor trusts. A trust created years ago may no longer be optimal if its administrative provisions are outdated, the named trustee is no longer suitable, or family circumstances have changed.

The ruling offers a safe harbor for fixing these issues without jeopardizing the tax-advantaged status of the life insurance policy. An individual can establish a new ILIT with modern provisions and a different trustee. As long as both the old and new trusts are grantor trusts with respect to the insured, the life insurance policy can be sold from the old trust to the new one.

This ability to move a policy allows for the correction of drafting errors, adaptation to new laws, or the implementation of a better administrative strategy. Selling the policy from one grantor trust to another allows a family to update their life insurance planning without triggering the transfer-for-value rule.