Do you have an Irrevocable Life Insurance Trust ("ILIT") that has unfavorable terms or was poorly drafted? If so, then Rev. Rul. 2007-13, will brighten your day.

Since ILITs by design are irrevocable, there are few options once the ILIT has been signed and funded if you want to change any of its terms. This could mean that the insurance proceeds will pass at the death of the Insured/Grantor in a manner that may be disadvantageous for tax purposes or not in accord wtih the Grantor's intent.

At Cox & Nici, for some time now, we have been using ILIT rescue planning techniques, which were recently blessed by the IRS in the above-referenced ruling. The rescue techniques involve the Grantor of the old ILIT establishing a new ILIT with better terms, followed by a sale of the insurance policy from the old ILIT to the new ILIT in exchange for a promissory note.

Almost all ILITs are by nature "Grantor" trusts for federal income tax purposes. This means that, for tax purposes, they are disregarded and the income of the ILIT is taxable to the Grantor of the ILIT (i.e., the insured who created the ILIT) even though, for distribution purposes, the income passes to the beneficiaries of the ILIT and not the Grantor. Since the ILIT holds only a non-income producing life insurance policy, there is no income to report.

Typically, a sale of a life insurance policy is a taxable event under §102(a)(2) of the Internal Revenue Code. If the policy is sold for cash, the cash received is taxable income, or, if sold in exchange for a promissory note, the interest payments are taxable income. The sale is disregarded, however, when the seller and the buyer are the same person.

Under the ILIT rescue planning technique, the sale occurs between two ILITs created by the same Grantor, which are both disregarded for tax purposes. They are, therefore, the same party. Since the "Seller" and the "Buyer" are the same for federal income tax purposes, the sales event is disregarded. The policy is sold at its fair market value (i.e., cash value) as of the date of the sale. This amount is usually far lower than the death benefit of the policy. Therefore, the old ILIT will hold only an ever-decreasing low value promissory note and the new ILIT will hold the life insurance policy (with the higher death benefit). This minimizes the problems associated with the old ILIT and maximizes the advantages of the new ILIT.