283 / Can an existing life insurance policy be transferred between two trusts, both of which were established by the insured, without loss of the income tax exemption for death proceeds?

A sale to the insured is an exception to the transfer for value rule ( Q 279).¹ The IRS has ruled privately that a transfer between two trusts, one of which benefitted the taxpayer directly (Trust A) and the second of which was a grantor trust established by the taxpayer (as grantor) for the benefit of his children and grandchildren (Trust B), would not violate the transfer for value rule because the transaction fell within the exception permitting sale of a policy to the insured himself.²

While both trusts were irrevocable, the taxpayer retained the power to reacquire assets he had placed within Trust B by substituting assets of equal value. The independent trustee responsible for overseeing Trust B was required to ensure that any substituted assets were of equal value to the assets the taxpayer chose to reacquire.

Trust A owned a life insurance policy on the taxpayer’s life, which the taxpayer wished to transfer into Trust B using his power of substitution. Because the taxpayer was both grantor of Trust B and the insured individual under the policy, the transaction was considered a transfer of the policy to the insured himself (the grantor and the grantor trust are treated as a single entity for tax purposes).

Therefore, even though the transfer was technically a transfer of the policy from one trust to another, it was considered to fall within the exception to the transfer for value rule permitting transfers to the insured himself.

Further, the value of the policy would not be included in the taxpayer’s gross estate for estate tax purposes even though the taxpayer retained the right to move the policy between two irrevocable trusts. Typically, this type of power over an asset could cause the courts to find that a taxpayer retained incidents of ownership in an asset sufficient to warrant the asset’s inclusion in the estate.

In this case, however, the taxpayer could never reduce the value of the assets in Trust B because he was required to substitute assets of equal value—and an independent trustee was present to verify equivalence. Additionally, the taxpayer could not increase his own net worth through a transfer because, again, the values of the substituted assets were required to be equal.

Likewise, the IRS found that the transfer of a survivorship policy insuring the joint lives of husband and wife between trusts both of which the husband insured was the grantor, where the husband and wife were also partners in a partnership unrelated to either trusts.³