PLR 201327010 is an excellent review of the law of incidents of ownership. The insured’s wife owned policies on his life that at her death passed to “family trust” in which the insured was a beneficiary, had a broad testamentary special power of appointment, was trustee, and “trust protector” with the power to remove and replace trustees. The ruling summarizes the law on fiduciary powers and incidents of ownership as follows:
Section 20.2042-1(c)(4) provides, in pertinent part, that a decedent is considered to have an “incident of ownership” in an insurance policy on his life held in trust if, under the terms of the policy, the decedent (either alone or in conjunction with another person or persons) has the power (as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment thereof, even though the decedent has no beneficial interest in the trust.
Rev. Rul. 84-179, 1984-2 C.B. 195, considers whether, for purposes of § 2042(2) and § 20.2042-1(c)(4), a decedent possessed incidents of ownership in a life insurance policy on his life if the decedent transferred all incidents of ownership to his spouse. In the ruling, the decedent’s spouse designated their adult child as the policy beneficiary. Subsequently, the spouse died and under her will a residuary trust was established for the benefit of the child. The decedent was designated the trustee of this trust. The insurance policy on the decedent’s life was part of the residuary estate, and passed to the residuary trust. As trustee, the decedent had broad discretionary powers in the management of the trust property and the power to distribute or accumulate income. Under the terms of the policy, the owner could elect to have the proceeds made payable according to various plans, use the loan value to pay the premiums, borrow on the policy, assign or pledge the policy, and elect to receive annual dividends. The will precluded the decedent from exercising these powers for the decedent’s own benefit. The decedent paid the premiums on the policy out of other trust property and was still serving as trustee when he died.
Citing the legislative history of § 2042(2), the ruling concludes that a decedent will not be deemed to have incidents of ownership over an insurance policy on the decedent’s life where the decedent’s powers are held in a fiduciary capacity, are not exercisable for the decedent’s personal benefit, where the decedent did not transfer the policy or any of the consideration for purchasing or maintaining the policy to the trust from personal assets, and where the devolution of the powers on the decedent was not part of a prearranged plan involving the participation of the decedent. Further, the ruling continues, the decedent will be deemed to have incidents of ownership where the decedent’s powers are held in a fiduciary capacity and the decedent has transferred the policy or any of the consideration for purchasing and maintaining the policy to the trust. Moreover, where the decedent’s powers could have been exercised for the decedent’s benefit, they will constitute incidents of ownership in the policy, without regard to how those powers were acquired and without consideration of whether the decedent transferred property to the trust. Thus, if the decedent reacquires powers over insurance policies in an individual (non-fiduciary) capacity, the powers will constitute incidents of ownership even though the decedent is a transferee.
The fiduciary powers gave the decedent incidents of ownership. In addition, the testamentary special power of appointment was an incident of ownership.
The solution was to divide the trust so that the insurance was owned by one trust – over which the insured gave up all his rights – and the remaining assets by another in which the trustee stayed involved. There was no risk of capital gains under §1001 and Cottage Savings because the beneficiaries of each trust were the same.