Is Your Ilit Really a Grantor Trust?By: Scott P. Borsack I am often times reminded of the less than exciting existence that admitted tax attorneys live from day to day. Just recently I had one of those moments when a colleague and I had the opportunity to discuss a small corner of the grantor trust universe, specifically Code Section 677(a)(3). You must know that section; by its application many life insurance trusts are classified as so called grantor trusts. We both acknowledged that we had always been schooled that a life insurance trust which allowed the trustee to use trust income to pay premiums upon policies of insurance on the life of the grantor which are held by the trust, was indeed a grantor trust under the aforementioned code section. For most life insurance trusts there rarely if ever is any income to contend with prior to maturity of the life insurance policies held by the trust. As a result, we all do not pay much attention to the implications of Code Section 677(a)(3). The reason for our conversation, contrary to common experience, was a trust with present income. Our facts were even more uncommon. Here the grantor had paid enough in premium over the first few years of the trust so that the policy was fully endowed - dividends from the contract were paying annual premiums. In a particular year the trust collected a significant amount of income but had no premium to pay. The trust provided that income would be paid to a particular beneficiary during the lifetime of the grantor. The grantor had no obligation of support as to that beneficiary. Advisors to the trustee had concluded that in this particular year the income earned by the trust was not includable in the income of the grantor. Other interested observers took a contrary position, suggesting that since the trust instrument allowed trust income to be used to pay premiums, and that consent of an adverse party was not required in order to direct income to the payment of premiums, the income of the trust was indeed chargeable to the grantor under Code Section 677(a)(3). It was from this point that our odyssey began. Given that there were two divergent views on the same set of facts, some research was clearly in order. We quickly learned that cases interpreting Code Section 677(a)(3) could not readily be found. A reading of the code section was not terribly instructive beyond the assumptions that my colleague and I had long held. Particularly, Code Section 677(a)(3) provides that
Seems clear enough - a trust with a policy of insurance on the life of the grantor that allows the trustee to use income to pay premiums will require that income of the trust be included as income of the grantor. Indeed, it was too simple and we could not end our consideration with just the Code. Our modern day Code Section 677(a)(3) was not the first attempt by lawmakers to deal with the issue. Rather, the current section was taken largely from section 167(a)(3) of the various Revenue Acts adopted in the 1930's. That predecessor section contained remarkably similar provisions to current law. Specifically, it provided that
There were plenty of cases interpreting section 167(a)(3). Even the Internal Revenue Service, when interpreting Code Section 677(a)(3) cited cases under the predecessor statute. See e.g. GCM 37288 (1977). So we had a trail of precedent to apply to the problem. One of the earliest judicial forays into the area was undertaken by the United States Supreme Court which considered the use of trust income to pay life insurance premiums in Burnet v. Commissioner, 289 U.S. 670 (1933). There a grantor raised a constitutional challenge to the predecessor to section 167(a)(3) (which also bore striking similarities to Code Section 677(a)(3)). Regarding the issue at hand, the Court held that a grantor may properly be charged with that portion of the income of a trust which is used to pay the premium on policies of insurance on the life of the grantor. The predecessor to the United States Tax Court, the Board of Tax Appeals had many opportunities to interpret section 167(a)(3). One of the first cases was Mott v. Commissioner, 30 B.T.A. 1040 (1934) wherein the grantor created three trusts and purchased life insurance which was payable to the beneficiaries of the trusts. The trusts had substantial income, no part of which was used to pay premiums. The trust beneficiaries paid the premiums from their separate assets. The court held that since the trust instrument authorized the grantor, who was the trustee, to use trust income to pay the premiums of insurance, the grantor was chargeable with reporting as taxable income the amount which was necessary to pay the premium, regardless of whether the income was actually so used. Similarly decided, Heffelfinger v. Commissioner, 32 B.T.A. 1232 (1935) held that the portion of the income of a trust which could be used to pay premiums, but no more than that amount, was properly chargeable to the grantor in the year such income was earned. In Moore v. Commissioner, 39 B.T.A. 808 (1939) the court concluded that the application of section 167(a)(3) "depends upon the existence in the tax year of the policies upon which it would have been physically possible for the trustees to pay premiums and the amount of the premiums so payable." In that case the Service was fishing for alternative arguments to tax income of a trust to the grantor. The trust instrument permitted the trustees to use income to pay premiums on policies of insurance which the trust holds. Since the instrument authorized the trustee to use trust income to purchase a policy of insurance, the income of the trust could be charged to the grantor under section 167(a)(3), argued the Service. Apparently, neither the grantor nor the trustee had purchased a policy of insurance upon the life of the grantor in the year the income was earned, or at any time prior. Absent a policy, one essential element of the recipe was missing. Following Mott and Heffelfinger, the court concluded that since there was no evidence adduced that a premium was paid, or that a policy of insurance on the life of the grantor had been purchased or was owned by the trust, the grantor could not be charged with any of the income of the trust. In Rand v. Commissioner, 40 B.T.A. 233 (1939) the court found that the grantor could only be compelled to report that portion of the income of a trust which would be required to pay premiums on a policy of life insurance on the life of the grantor; any excess was not taxable to the grantor. That the excess income could be accumulated and used in subsequent years to pay premiums on such a policy did not change the outcome; income must actually be used to pay premiums in the year earned. Accord, Iverson v. Commissioner, 3. T.C. 756, 774 (1944). So, in Weil v. Commissioner, 3 T.C. 579 (1944) where the grantor paid the premiums on insurance policies which he owned, as did his trust which had income greater than that required to pay premiums on the insurance policies which it owned, the grantor was only charged with reporting that portion of trust income which was used to pay the premiums on policies which the trust owned. Without a premium to be paid, the amount of income which a grantor trust collects is not material. Unless the trust can pay a premium with that income, there is nothing for the grantor to include on account of such income. Finally, Chandler v. Commissioner, 41 B.T.A. 165 (1941) held that where income is not actually used to pay premiums, section 167(a)(3) does not cause the income of the trust to be charged to the grantor. There annual premiums were paid by dividends earned on the policies of insurance and from contributions made by the grantor. The income of the trust was used for other purposes. Since no part of the income was devoted to the payment of premiums, the court concluded that the grantor could not be charged with the income of the trust under section 167(a)(3). From these cases we can draw some conclusions. First, in order to tax a grantor with the income earned by a trust authorized to purchase life insurance on the life of the grantor, the trust must actually own such a policy of insurance. Second, the "facts" of the policy must require a payment of premium in the year that the income is received by the trust; if the policy is endowed or otherwise does not require the payment of premium in that year, the grantor cannot be charged with reporting income. If the income received by the trust is greater in amount than the premium obligation which was satisfied with trust income, only that portion of the income directed to the payment of premiums in the year of receipt can be charged to the grantor as income. Finally, if no part of the income is used to pay a premium on an insurance policy owned by the trust, the grantor cannot be charged with that income under Code Section 677(a)(3). None of this was readily apparent from a reading of Code Section 677(a)(3), or my class notes from various degree and continuing legal education programs. And what can we take from these conclusions, you ask. Do not assume that a trust which you intend to qualify for grantor trust treatment satisfies the grantor trust rules simply because you have authorized the trustee to pay insurance premiums from trust income. There is a significant argument to be made that unless the trust owns a policy of insurance and uses income to pay a premium that income earned by the trust will not be taxable to the grantor under Code Section 677(a)(3). If the grantor does not have to report such income, the trust itself will be liable for the tax on the income. Given the steep rate table for trusts, it is possible that failing to satisfy the requirements of Code Section 677(a)(3) could actually subject the income to a greater tax. If the trust instrument does not authorize lifetime sprinkling of income upon a class of beneficiaries, a trustee is left powerless to ameliorate the tax harm and has no choice but to pay the tax. The old adage about belt and suspenders, therefore, has some application here. Include two provisions in your grantor trust to qualify the income for grantor trust treatment and do not rely solely on Code Section 677(a)(3). In the end you will likely be happier for the inclusion of a second means of qualifying as a grantor trust. Mr. Borsack is a partner in the Tax, Trusts and Estates Practice Group of White and Williams, LLP headquartered in Philadelphia. Mr. Borsack is a frequent author and lecturer on subjects of estate and tax planning.
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