Tax Court Excludes Death Benefit

What Is Life Insurance Premium Financing?

Life insurance premium financing involves taking out a third-party loan to pay for a policy’s premium.  This can sometimes be used as an estate planning tool when a grantor wants to (1) keep cash invested in illiquid assets to take advantage of a step-up in basis or because those assets are generating a high return; or (2) a temporary bridge to an upcoming liquidity event.

Using Life Insurance Premium Financing To Set Up An Irrevocable Life Insurance Trust (Ilit)

As a Catholic estate planning lawyer can explain, Irrevocable Life Insurance Trusts are used to provide support for beneficiaries that are both income and estate tax free. When using financing to pay premiums in ILITs, grantors must pay particularly close attention to avoid issues with invalidating the insurance contract due to lack of insurable interest or loss of tax benefits through the step transaction doctrine.

Insurable Interest And Step Transaction Doctrine Issues.

The U.S. Tax Court recently examined these issues in Est. of Becker v. Comm’r, T.C. Memo 2024-89 (T.C. Sept. 24, 2024).

In Est. of Becker, Dr. Larry Becker created an irrevocable life insurance trust just under two years prior to his untimely death. Importantly, Dr. Becker did not retain, nor have, any beneficial interest in the Trust, whether vested or contingent, nor did he have any reversionary interests or possibilities of reverter under the Trust. The Trustees included Dr. Becker’s son and daughter, and the beneficiaries consisted of his wife, his children, and grandchildren.

The terms of the Trust Agreement provided that the Trustees “possess[ed] and own[ed] all the incidents of ownerships, rights, powers, interests, privileges and benefits of every kind that may accrue on account of any insurance policies.”

The Trust was funded by two insurance policies from Zurich American Life Insurance Co., one with a total death benefit of $11,470,000, and the second with a death benefit of $8,000,000.

The policy premiums were funded through a series of loans facilitated by intermediaries and secured by the total death benefits of the Policies.  There were multiple transactions over several months with a final loan and security agreement, and accompanying promissory notes, in favor of LT Funding, LLC (“LT Funding”). The Trust was obligated to pay LT Funding (i) seventy-five percent of the total death benefits of the policies, (ii) all premiums advanced by LT Funding, and (iii) interest on all premiums advanced by LT Funding at the rate of six (6) percent per year.

The IRS issued a deficiency notice claiming that the death benefits should be included in Dr. Becker’s gross estate under IRC §§2031 and 2042. The Commissioner argued that the payment of the life insurance proceeds to LT Funding was voidable because LT Funding did not have an “insurable interest” in Dr. Becker, thereby disqualifying it from treatment as a life insurance contract and including the death benefits in Dr. Becker’s gross estate.

To determine the interest in property, the court looks to state law-in this case, Maryland. The Court determined that an insurable interest existed where the primary benefit of the life insurance proceeds was for the Trust beneficiaries who were individuals “related closely by blood or law, a substantial interest engendered by love and affection…”  The Court further explained that “[i]t is well settled in Maryland that “‘if the policy of insurance was a valid one, at its inception,…the assignment of this policy, under all the authorities, would be legal, whether to a person having or not having an insurable interest in the life of the insured.’” (internal citations omitted).

The IRS then attempted to utilize the “step transaction doctrine” in an effort to collapse the loans into a single transaction which would result in a taxable event.  There are three parts to the step transaction doctrine analysis.  Namely, the binding commitment test, the end result test, and the interdependence test.

Here, the step transaction doctrine did not apply where (1) there was no formal agreement at the time the transaction took place, (2) there was no evidence that the parties had the subjective intent to transfer the death benefits at the time the policies were issued, and (3) because the Grantor had sufficient assets to fund the premiums himself, there was nothing to indicate that payment of the premiums would have been “fruitless” without the premium financing agreement.

In sum, when considering life insurance premium financing proper structuring and documentation can mean the difference between a favorable or unfavorable tax determination as our friends at Aptt Law LLC are familiar with.  The court in Est. of Becker illustrates that significant estate tax benefits can be preserved so long as the grantor to an ILIT does not maintain a beneficial interest or incidents of ownership in the trust, the transaction is structured to avoid triggering the step transaction doctrine, and the beneficiaries have an insurable interest as determined by state law governing of the trust.

If you need help with taxes and estate planning, contact a lawyer near you.