Asset Substitution Right May Be Included in Trust

Advanced Asset Management recently published an article entitled Insurance Trust May Include Asset Substitution Right (Dec. 2011). The article is below, in full: 

In Rev. Rul. 2011-28

The ruling assumes that D, a U.S. citizen, funds an irrevocable trust with cash. The trust purchases a life insurance policy on D. The beneficiaries of the trust are D’s heirs.

There is an independent trustee of the trust and D is prohibited from serving as trustee. D makes gifts annually to the irrevocable trust and they are used to pay premiums. When D passes away, the insurance proceeds will be received by the trust for the benefit of D’s heirs.

Under Sec. 2042(2) the gross estate includes all assets and insurance if there are any retained “incidents of ownership” in the policies. Reg. 20.2042-1(c)(2) indicates that the incidents of ownership are primarily those powers that grant economic benefit or control to the insured. These include the right to change the beneficiary, to surrender or cancel the policy, to assign the policy, to pledge the policy for a loan or to obtain a loan against the surrender value.

Reg. 20.2042-1(c)(4) expands the incidents of ownership provision by noting that the ability to change beneficial ownership or control proceeds will trigger estate inclusion.

In Rev. Rul. 84-179, 1984-2 C.B. 195, the taxpayer purchased a policy and created an irrevocable trust for his spouse with no retained incidents of ownership. However, the spouse died and the insured became trustee of the trust for the benefit of a child. Even though the trustee powers included various rights over the policy, the indirect method of acquiring those rights through a successor trusteeship enabled the individual to avoid the categorization of an incident of ownership that would require estate inclusion.

However, the ruling noted that where powers are held in a fiduciary capacity and the taxpayer creates the policy and then serves as trustee, those incidents of ownership will require inclusion.

In Estate of Jordahl v. Commissioner

In Rev. Rul. 2008-22, 2008-16 I.R.B. 796, a grantor also created an irrevocable trust for heirs with a retained power to substitute other assets of equivalent value for trust property. The retained power was deemed to not require Sec. 2036 or Sec. 2038 inclusion because of the fiduciary obligation.

Special thanks to Jim Hillhouse (WealthCounsel)for bringing this article to my attention.