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Wednesday, September 06, 2006

TRUST CONSIDERED TO BE A GRANTOR TRUST BASED SOLELY ON POWER TO PAY INSURANCE PREMIUMS ON LIFE OF GRANTOR

A grantor trust is a trust whose income is generally taxable to the grantor/settlor by reason of specific Internal Revenue Code provisions that mandate such treatment. In contrast, a nongrantor trust is a separate taxpayer whose income is generally taxable either to the trust itself and/or its beneficiaries and not the grantor.

Code Section 677(a)(3) is one of those provisions that gives rise to grantor trust status. It provides that a trust will be a grantor trust if its income, without the approval or consent of any adverse party is, or, in the discretion of the grantor or a nonadverse party, or both, may be applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor's spouse. There is case law to the effect that where no insurance policy is owned by the trust, the mere power to purchase a policy and pay premiums is not enough to create grantor trust status. Thus, there is uncertainty as to when and how these provisions apply. Do they if the trust does not own an insurance policy? Do they apply only to the extent that trust income is applied to premium payments? There is conflicting authority on these questions.

A recent IRS field advice (LAFA 20062701F) muddies the water further. In the advice, a trust explicitly allowed the use of trust funds to purchase life insurance on the life of the grantor. The trust funds were used to pay premiums on life insurance on the life of the grantor, but the trust was not the owner of the policy. The advice concludes that a grantor trust existed - it was enough that the trust was authorized to pay the premiums - it did not have to own a life insurance policy to give rise to grantor trust status.
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