The IRS has just issued Revenue Ruling 2008-22. The ruling states that giving a grantor of a trust the authority to substitute property of equal value will not, by itself, cause the trust to be included in the grantor’s estate for federal estate tax purposes. What’s going on here?

Giving a grantor of a trust the power to replace the property in a trust with property of equal value will make the trust a grantor trust for federal income tax purposes. That means that, for income tax purposes, the trust income will be considered the income of the grantor. Here’s what else it means. If a trust owns a life insurance policy on the life of the grantor, which is a common occurrence when large amounts of life insurance are purchased (because holding the insurance in an irrevocable trust can avoid inclusion of the policy proceeds in the estate for federal estate tax purposes), the grantor might decide after a while that he or she does not like the terms of the trust. But if it’s an irrevocable trust, the grantor can’t amend it. What to do?

What to do is to have the trust sell the policy to another irrevocable trust for the fair market value of the policy. The new trust could have the terms the grantor now prefers. But there are rules in the Internal Revenue Code that state that if an insurance policy is transferred for value, the bulk of the proceeds could be subject to federal income tax. That’s not good. But the IRS has ruled that a transfer from one grantor trust to another grantor trust (of the same grantor) will not create a problem under the transfer for value rules, so the insurance proceeds will continue to be exempt from federal income tax in the new trust.

This ruling helps to assure the success of a valuable planning technique. If a grantor has set up an irrevocable life insurance trust but now doesn’t like the dispositive provisions, a way is clear to get the policy into a new trust with the preferred provisions. This is especially helpful where the grantor has become much older since the original purchase of the insurance, or is having health problems, so buying new insurance could either be much more costly or not possible at all.