Insurance demutualization in an Irrevocable Life Insurance Trust

[Confusedreturn]

Hi,

I am sorting out who is responsible for taxes on an ILIT. My understanding is that it is an irrevocable complex grantor trust. I have a scenario where no income was paid but now the insurance company has demutualized. First, the stock pays dividends so are dividends considered income at the trust, beneficiary, or grantor level? Second, if the shares are sold, are the capital gains taxed at the trust, beneficiary, or grantor level? Third, if the insurance policy is surrendered and the cost basis is less than the surrender value, a 1099-R will be generated. At which level (trust, beneficiary, or trust) will the 1099-R be taxed at? I am curious about this as I read that stock received as part of a demutualization is not a taxable event and is considered principal for the trust, not income. Should the proceeds of all these events be considered a principal distribution and not income? 

Thanks!

[DaveF1006]

It depends. All income is reported at the entity(Trust) level. If the distributions were distributed to the beneficiaries, then the income would be reported on their k-1's to report on their own individual tax returns according to the Trust allocation agreement. If the income was not passed to the beneficiaries on a k-1, then the trust will need to pay the tax. 

As far as a stock dividend, you would add this to the basis of the stock that the trust owns in the insurance company and then apportion the amount of the dividend to each share of stock. For an example, if you own 100 shares at $10 a share and the stock dividend is $1000, then each share of stock will have an added basis of $10 thus each share of stock is now worth $20 for an overall basis of $2000. Knowing the basis for each share of stock is important especially if you decide to sell fractional shares instead of the entire lot in the future.

This is not a taxable event thus the dividend is not taxable. The stock dividend is not reported in your return but added in at the accounting level to the basis of your stock.

[Confusedreturn]

Thanks Dave but I don't think this is correct. Normal income generated in a grantor trust is normally taxed at the grantor level. The twist here is the insurance company demutualized. Per the IRS, the cost basis of the shares is zero (courts disagree) and the cash dividends subsequently paid are income (1099-DIV) and are not added to the cost basis. 

The trick here is how to handle stock and dividends received in an irrevocable grantor trust (also known as an Irrevocable Life Insurance Trust or ILIT) as a result of a demutualization. The insurance policies were gifted to the trust and if the company did not demutualize, everything would have been fine. The demutualization creates an issue for who is responsible for the taxes. The shares are registered as being owned by the trust but if the grantor is responsible for taxes when they are sold, s/he should have the right to transfer the shares somewhere else but that causes issues as the stock has to be re-registered.

Thoughts?

Thanks,

Kevin