IDEAS March Bigger is Not Always Better - What to do When a Non-Grantor Trust Owns a Policy with a (Growing) Loan

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1 IDEAS March 2012 Bigger is Not Always Better - What to do When a Non-Grantor Trust Owns a Policy with a (Growing) Loan Summary A loan on a life insurance policy can present challenges for a trustee, particularly when the trustee doesn t have the cash to pay future premiums. One option is to try to keep the policy in force. Another is to surrender the policy. With a non grantor trust, income tax on the gain will be owed by either the trust or the beneficiaries. Another option is to distribute the policy, which might cause the trust to recognize gain to the extent the loan exceeds basis. Related Information Trusts and Taxes; Income Tax Basics of Life Insurance Background Many years ago, Goldie created a non-grantor irrevocable trust for the benefit of her two children, Kate and Oliver. The only asset in the trust is a life insurance policy on Goldie s life. Under the terms of the trust, the trustee has the discretion to make distributions of income and principal to Kate and Oliver during Goldie s life. At her death, the trust will divide into equal shares to be distributed outright to the children. Goldie stopped making gifts to the trust to pay premiums several years back. The trustee has been paying the premiums through a combination of loans and partial surrenders. As a result, the policy currently has a gross cash value of $350,000 and zero tax basis (so it is all built-in gain). The outstanding balance of the loan is $150,000 (making the net cash value $200,000). Facing a prospect of a growing loan balance and no additional funds to pay future premiums, the trustee is wondering what his options are. Let s look at some of the possibilities. 1 Options and their consequences 1. Keep the policy in force. Perhaps the best option tax-wise is to make every effort to keep the policy in force inside the trust until the insured passes away. The death benefit should solve most tax problems. If the trustee decides to go this route, he will need to address future cash flow needs to manage the outstanding loan balance and the payment of future premiums. If Goldie truly can t make additional gifts, Kate and Oliver might consider lending money to the trust. 1 The first place the trustee will want to look is at the trust agreement to determine what actions are allowable under the terms of the trust. If the trust document is silent on an issue, the trustee should then look to state law The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 1 of 5

2 2. Distribute the policy to the beneficiaries. If keeping the policy in force inside the trust is not realistic, the trustee might also consider distributing the policy to Kate and Oliver. 2 They can then choose whether to pay future premiums and/or pay down the loan, or whether to surrender the policy. a. Tax consequences. Are there any tax consequences upon the distribution of the policy to Kate and Oliver? The issue is whether the trust recognizes gain on the amount of the loan in excess of basis ($150,000 in this case). It seems there s no definite answer to this question. i. On one hand, there is the general rule that a trust does not trigger gain or loss whenever the trustee distributes property in kind to beneficiaries. 3 There are some exceptions to this general rule. Treasury Regulation 1.661(a)-2 states that gain or loss is realized upon the distribution of property in kind from a trust if it is in satisfaction of a right to receive a distribution of a specific dollar amount, of specific property other than that distributed, or of trust income. 4 Importantly, distributions of assets with liabilities in excess of basis are not among the listed exceptions. If the I.R.S. and Congress intended the trust to realize gain on the distribution, then they could easily have said so. From that silence, we perhaps could infer that the general rule of no tax prevails. ii. On the other hand, the trust might trigger gain under This Code section and its regulations provide that when there is a sale or other disposition of property, the transferor recognizes gain to the extent the amount realized exceeds the transferor s basis in the property, 5 and the amount realized includes the amount of liabilities from which the transferor is discharged. 6 A sale or other disposition of property subject to a nonrecourse liability discharges the transferor from that liability. 7 A policy loan is a nonrecourse liability, so in other contexts the part gift/part sale rules generally require an individual transferor to recognize gain to the extent a policy loan exceeds his basis in the contract (e.g., Dad giving to Son a policy with a loan on it). 8 Of course, transfers from individuals are different than transfer from trusts individuals make gifts whereas trusts make distributions but the I.R.S. nonetheless might argue that a trust distribution of a policy with a loan is a sale or The distribution must be allowable under the terms of the trust and/or state law. 643(e). In addition, a trustee can make an election to recognize gain or loss. 643(e). 1001(a). Treas. Reg (a). Treas. Reg (a)(4)(i). Treas. Reg (e) The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 2 of 5

3 other disposition under the terms of After all, the rationale is similar to the part gift/part sale situation. The trust, as a taxpayer, benefits when it is relieved from the obligation of paying off the loan. The beneficiaries take the policy subject to the loan. Under this theory, the trust would recognize gain on the distribution. 9 Does 1001 trump the general rule that distributions in kind from a trust to a beneficiary do not result in gain recognition? As far as we can tell, no definitive guidance exists. b. Beneficiaries basis in policy. If no gain is triggered on the distribution, the trust s basis in the policy will carry over to Kate and Oliver. 10 However, if gain is triggered on the distribution, then the basis will be increased by the amount of the gain that is recognized, effectively meaning that their basis will match the amount of the loan. 11 c. Who pays the tax? If this non-grantor trust triggers gain on the distribution of the policy to Kate and Oliver, they will likely end up owing the tax. This is because the trust will be deemed terminated if there are no more assets in the trust. And upon the termination of a trust, all of the income is passed out to the beneficiaries Surrender the policy in the trust. Another option for the trustee is simply to surrender the policy for its net cash value. The trust ends up with the net cash of $200,000, but also taxable ordinary income on the $350,000 gain in the policy. 13 Who pays the tax? Since this is a non-grantor trust, there are only two possibilities: the beneficiaries or the trust. 14 a. When do the beneficiaries pay the tax? Kate and Oliver would be responsible for paying the tax to the extent that the trustee makes actual distributions of the $200,000 cash to them. 15 If the trustee determines that, under the terms of the trust or state law, the trust can be terminated and all assets distributed out to Kate and Oliver, then Kate and Oliver would pay the tax on the gain in the surrendered policy. 16 But wait do Kate and Oliver pay tax on just the $200,000 they receive or the whole $350,000 of gain? They pay the income taxes on the whole $350,000 of gain. 17 But the 9 If this trust were a grantor trust, it is likely that the individual grantor, Goldie, would owe tax on gain when the policy is transferred to Kate and Oliver. In TAM , the I.R.S. concluded that debt securing trust property is included in the grantor s amount realized when the grantor trust terminates and the assets are transferred to remainder non-grantor trusts (e)(1) (e)(1) and 662; Treas. Reg (a) Because there is zero tax basis, the trust will receive a Form 1099 for the year for the entire $350,000 of taxable gain. 14 If, instead, this were a grantor trust, Goldie would pay the tax. See Trusts and Taxes, Advanced Planning Bulletin, September 2011, for a discussion of the difference between grantor trusts and non-grantor trusts and 662. In determining a trust s income tax liability, a trust receives a deduction for distributions made to beneficiaries (up to the amount of the trust s distributable net income ( DNI )). The trust beneficiaries, then, report and pay income taxes on their portion of the taxable income from the trust. 16 The trustee reports the gain as ordinary income on the final fiduciary income tax return (Form 1041) for the trust. The income is passed out to the beneficiaries on a Schedule K ; Treas. Reg (b)-2(a) The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 3 of 5

4 good news for them is that their liability for the income taxes is limited to the amount they receive from the trust. 18 So even if the income tax bill were in excess of $200,000, Kate and Oliver would still be liable only up to $200,000. b. When does the trust pay the tax? To the extent that the trust income is not passed out to Kate and Oliver, then the trust pays the tax. 19 Conclusion i. So, the trust will pay the tax if the cash remains in the trust (and no distributions are made to Kate and Oliver during that taxable year). This is all well and good if the net cash received by the trust is sufficient to pay the tax on the gain. 20 ii. What happens, though, if the net cash is not sufficient to pay the tax? This could occur when a policy loan grows so large that it nearly matches the contract s cash value and forces it to lapse at a time when there is little or no net cash left for the policyowner known as a surrender squeeze but could also happen well before that. The I.R.S. will want to knock on the doors of the trustee and beneficiaries to collect the tax. We already know that the beneficiaries liability is limited to the amount of assets they receive from the trust, and if they receive zero, they appear to be off the hook. As for trustees, their liability for taxes is generally limited to the assets in the trust. 21 But again, the net cash value received by the trust won t be big enough. The I.R.S. can go after the trustee personally to collect the tax under limited circumstances put forth in 31 U.S.C To be personally liable under this section, the trustee must have knowledge of the tax liability or notice of the facts that would lead a reasonably prudent person to inquire as to existence of the tax liability. He also must have distributed trust assets to beneficiaries or creditors with lower priority than the I.R.S. Even then, the trustee s personal liability is limited to the amount of the payments or distributions he made from the trust. Given all this, it might just be the case that the I.R.S. is out of luck where the only asset in the trust is a life insurance policy and there simply isn t enough money to pay the tax bill. Borrowing against trust-owned policies to pay premiums can be a useful tool when cash flow is tight, but it is important that trustees manage policy loans with extreme care. If the loan balance gets too large, the trustee might find himself facing very nasty consequences. The insurance coverage could disappear, only to be replaced by a large tax bill for the beneficiaries or the Treas. Reg (b)-2(a); Robert J. LeBeau, T.C. Memo (June 23, 1992). 641(b). This article deals with federal taxes; clients and their advisors must always keep in mind any state or local taxes. 6903(a); Fletcher Trust Co. v. Comm r, 141 F.2d 36 (7 th Cir. 1944) The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 4 of 5

5 trust. 22 And even if the parties can avoid personal liability for taxes by the way, don t be surprised if the government pursues creative arguments the trustee could still be personally liable for a breach of fiduciary duty action brought by unhappy trust beneficiaries. Handling policy loans poorly can be an expensive mistake. This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might require the following statements. This information was compiled by the advanced planning attorneys of The Northwestern Mutual Life Insurance Company. It is intended solely for the information and education of Northwestern Mutual Financial Network Representatives, their customers, and the legal and tax advisors to those customers. It must not be used as a basis for legal or tax advice, and is not intended to be used and cannot be used to avoid any penalties that may be imposed on a taxpayer. Northwestern Mutual and its Financial Representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent tax advisor. Tax and other planning developments after the original date of publication may affect these discussions. To comply with Circular The determination of liability for taxes and the collection of those taxes can be quite a quagmire (and fact specific). When trust assets are insufficient to pay debts and expenses, the trustee should consult with a tax advisor to determine the federal and state law implications. And don t forget, if it is instead a grantor trust as many irrevocable trusts holding life insurance are then it is the grantor who is personally liable for tax bills generated by the trust The Northwestern Mutual Life Insurance Company, Milwaukee, WI Page 5 of 5