By Ken Berry, J.D.
Wealthy individuals often set up an irrevocable life insurance trust (ILIT) to avoid federal estate tax on large insurance policies. But a small misstep could lead to a tax disaster. In a new case, Estate of Becker, T.C. Memo 2024-89, 79/24/24, the Tax Court ruled that the “step transaction doctrine” didn’t trip up the taxpayer’s intentions.
Background: Generally, insurance proceeds paid out to the insured’s beneficiaries are exempt from federal estate tax as long as the insured doesn’t possess any “incidents of ownership” in the policies. This includes not only direct ownership of a policy, but also certain rights such as the ability to change the beneficiaries of the policy.
Accordingly, taxpayers often use an ILIT as a way around any potential estate tax problems. If the ILIT owns the life insurance policies or ownership rights of policies are transferred to ILIT, there’s no estate tax liability on the proceeds. Note: If a transfer occurs within three years of death, the life insurance proceeds revert to the taxable estate.
However, the IRS may apply the “step transaction” doctrine to show that a series of transactions should be treated as a single transaction designed to circumvent the rules. The idea is to rely on substance over form.
Facts of the new case: The taxpayer, a physician residing in Maryland, created an ILIT in 2014. The trust was set up in Maryland in compliance with the laws of the state. The trust document named the taxpayer’s son and one of his daughters as co-trustees.
The taxpayer’s spouse, children and grandchildren were designated beneficiaries of the trust. The trust was designed to hold assets for the benefit of the beneficiaries, notably insurance policies on the taxpayer’s life. Under the trust agreement, the trustee can’t borrow on any insurance policy held by the trust to pay any premiums due on the policy.
The taxpayer, the grantor of the trust, relinquished all power to alter, amend, revoke, or terminate the trust agreement in any way. He did not retain or have any vested or contingent beneficial interest in the trust or any possible reversionary interests. Finally, the taxpayer didn’t maintain any control over the administration or disposition of any assets held in the trust.
The trust acquired two life insurance policies on the taxpayer’s life in 2014 and was named as sole beneficiary of both policies. The first had a total death benefit of $11.47 million and a required initial premium of almost $1 million. The second policy had a total death benefit of $8 million with a required initial premium of nearly $700,000.
Key point: The taxpayer wasn’t the owner of the policies at any time nor did he retain any incidents of ownership. However, funding for purchasing the life insurance policies involved a complex series of promissory notes with other unrelated parties in exchange for 75% of the death benefit.
Then the taxpayer died unexpectedly in a car accident in 2016. Applying the step transaction doctrine, the IRS argued that the real beneficiary was an unrelated funding party, so the proceeds should be included in the taxpayer’s estate. However, after a careful analysis of Maryland law under the step transaction doctrine, the Tax Court concluded that the ILIT setup was bulletproof.
Of course, any federal estate tax liability on life insurance proceeds may be sheltered from tax at least partially by the estate tax exemption. The exemption is $13.99 million for 2025, but is scheduled to revert to $5 million, plus inflation indexing, in 2026.
Bottom line: Don’t take anything for granted. Have professional advisors ensure that an ILIT complies with all federal and state laws.
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Tags: Income Taxes, irrevocable trust, IRS, life insurance, Taxes, trust
