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Can a trust own life insurance on a person? The Eastern District of Virginia thought not under Maryland law, and the U.S. Court of Appeals for the 4th Circuit just heard oral argument on Jan. 31 in the case, Chawla v. Transamerica Occidental Life Insurance Co. The Chawla decision highlights a concern of many estate-planning attorneys about how many state laws, whether in statutes or case law, do not include a trust as an entity that has an insurable interest in the insured’s life. The matter is important enough for estate planning reasons that the Maryland Legislature is considering House Bill 271, which reputedly will address the problems raised by the Chawla case. Unfortunately, the bill will make it even harder for certain trusts to purchase life insurance. A substantial reason for the lower court’s decision in Chawla was the alleged medical misrepresentations by the insured, Harald Geisinger, on the application for the life insurance policy. But the insurance company may have known about his medical condition anyway, and so the insurer argued that the owner of the policy, Geisinger’s trust, did not have an insurable interest in Geisinger. After Geisinger died in 2001 from a heart attack, Vera Chawla, the trustee of the trust, applied, on behalf of the trust, for the payment of the death benefit under the policy. The insurer rescinded the policy and repaid the premiums. Chawla sued, alleging breach of contract. The Eastern District of Virginia held that under Maryland law, Chawla’s claim failed because, among other reasons, the trust “maintained no insurable interest in the life of the decedent thus rendering the policy void.” In every state, a person must have an insurable interest in the insured to purchase life insurance on his or her life. Otherwise the life insurance policy is void as a matter of law. Those individuals who have an insurable interest in the insured are defined in the state’s statute or case law. Under the current Maryland statute, only those individuals who are closely related to the insured, have a pecuniary interest in the insured’s continued life, or have other types of relationships with the insured have the requisite insurable interest. The court in Chawla determined that the trustee of a trust, as a person, did not meet the requirements. INSURABLE INTERESTS The reasoning behind the requirement for an insurable interest is that it prevents someone from speculating on a person’s life by buying a life insurance policy on that person. The possible ramification of allowing such policies would be that any person so insured could not feel safe in light of any investor’s natural desire to see his or her investment “pay off.” Because this restriction is based on public policy, it cannot be contracted around, even if the insured consented to the purchase. A person can always purchase insurance on his or her own life and designate anyone as the beneficiary. So if Geisinger had purchased the policy on his life himself and named his trust as a beneficiary, or named himself as the beneficiary and subsequently gave or sold the policy to his trust, the insurer would not have succeeded on this argument. But if the insured purchases the policy, the death benefit will be includable in the insured’s taxable estate. If the insured later transfers the policy, the transfer can create tax problems under the “three-year rule” of section 2035 of the Internal Revenue Code, which, if the insured died within three years of transferring the policy to a trust (or in this case, to Chawla), causes the inclusion of the death benefit in the insured’s estate, notwithstanding the transfer. The common means of avoiding inclusion in the estate, therefore, is to have an irrevocable trust purchase an insurance policy on the insured. But that arrangement raises the question in Chawla of whether the trust, as the purchaser of the policy, has an insurable interest in the insured. A few states, such as Virginia and Delaware, have already addressed the problem raised in Chawla. These statutes specifically provide that the trustee of a trust established by the insured has an insurable interest in the insured who created the trust. Maryland’s proposed legislation, however, states that a trustee only has an insurable interest in the insured if, among other requirements, on the date the policy is issued, the life insurance proceeds are primarily for the benefit of trust beneficiaries who have an insurable interest in the life of the insured. Many states, including the District of Columbia, do not have an insurable interest statute as detailed as the ones discussed above, if they have one at all. WITHOUT AN INSURABLE INTEREST If no insurable interest exists, there are several possible results. One possibility is that the insurance contract is void and all of the agreements between the parties in the contract disappear. Since the contract is void, all premiums paid are returned. Although the insurance contract is void, is the payment of the death benefit enforceable against the insurance company under an estoppel theory? It depends. The estoppel theory holds that the insurance company should be prevented from arguing that it should not have to pay the death-benefit proceeds because promises were exchanged and consideration in the form of premiums was paid. Thus, a contract exists, and the insurance company must pay out an amount equal to the death benefit under the contract. In Chawla, the District Court rejected the estoppel argument on the grounds that a Maryland court has held that the public interest behind the insurable interest doctrine overrides estoppel. Therefore, the insurer could not be estopped from claiming that it did not have to pay the death benefit because of a lack of an insurable interest. If the insurance company could not raise the estoppel argument, and therefore had to pay out an amount equal to the death benefit, there still might be no life insurance policy, at least for tax purposes. The insurance company might be considered making a payment it is contractually obligated to make and not paying out a death benefit under the policy (since there is no policy because of the lack of an insurable interest). Accordingly, as a payment under a contract, it is questionable if such a payment would be excludable from the taxable income of the recipient under Section 101(a)(1) of the Internal Revenue Code, as is normally the case with insurance death benefits. If this section does not apply, the only tax-free amount the recipient would receive is an amount equal to the recipient’s basis in the policy, which would equal premiums paid. The law in many other states is not the same as Maryland’s. Other states provide that the insurance company must pay the death benefit on a void policy, but it is paid to the estate of the insured. This alternative, however, will result in the inclusion of the death benefit in the taxable estate of the insured. COLLECTION OF BENEFICIARIES Does an insurance trust have an insurable interest in states where the common law or statute does not specifically address a trust? There is no case law, other than the Chawla case, on point. There are two ways of looking at the trust with respect to an insurable interest statute. Either the trust is a separate entity and the insurable interest statute is applied to that entity, unsuccessfully in the Chawla case, or the trust is a collection of trust beneficiaries and the insurable interest statute is applied to the beneficiaries. Tax author Howard Zaritsky points out that when courts have analyzed how a particular statute, such as the Bankruptcy Code, has applied to a trust, courts have found trusts to be a collection of their beneficiaries and applied the statutes to the beneficiaries and not to the trusts themselves. Many practitioners take comfort in this and believe this second line of reasoning — that a trust is a collection of trust beneficiaries, and the insurable interest rules are applied to those beneficiaries — will protect their insurance trusts from attack because most insurance trust beneficiaries are closely related to the insured. This is also the approach of the proposed Maryland legislation. But is this really the case? Such a position doesn’t address the present uncertainty under the state statutes of just who is “closely related by blood or by law.” Interpreting a trust as a collection of beneficiaries may mean that beneficiaries who are not related to the insured will not be permissible beneficiaries of an insurance trust. Consider, for example, stepchildren, who are beneficiaries of the insurance trust as part of the overall estate plan when there has perhaps been a pooling of assets within the marriage and children of both parents are treated the same under each parent’s estate plan. Consider, too, unmarried partners who wish to insure each other’s lives and want to use an insurance trust because they do not have the advantage of the marital deduction to shield the proceeds from estate tax. Unless these individuals are found to have another type of insurable interest in the insured, a trust with such beneficiaries will be unable to obtain insurance on the insured. In advising clients, attorneys need to be mindful that they may be allowing their clients to enter into what is essentially a one-sided contract. The owner pays the premium, but there is no certainty that the insurance company must pay the death benefit to the trust. The insurance company can withdraw from the contract at any time by claiming that the owner does not have an insurable interest. The proposed Maryland legislation, by its terms, will apply to all trusts “existing before, on, or after June 1, 2006, regardless of the effective date of the governing instrument under which the trust was created, but only as to life insurance policies that are in force and for which the insured is alive on or after June 1, 2006.” If a trust acquired a policy before this date and the insured is still alive on June 1, but the beneficiaries of the trust did not have an insurable interest in the insured on the date the policy was purchased, such policies will be void as a matter of law. In the absence of the Maryland proposed legislation, if the decision in the Chawla appeal is not restricted to the facts and affirmatively states that a trust, as an entity, does have an insurable interest in the insured, trusts subject to the jurisdiction of the 4th Circuit will have an insurable interest. If the 4th Circuit reverses the lower court’s decision based on the facts of the case and does not take a broader position that can be applied to all trusts, practitioners will be left with a case that can easily be distinguished on its facts from the more usual insurance trust. If the 4th Circuit finds that a trust has an insurable interest in the insured if the trust beneficiaries of the trust have an insurable interest in the insured, then the insurer will have to pay the death benefit to the trust in the Chawla case. The court’s decision will be similar to the Maryland proposed legislation. This decision, as is the case with the legislation, raises issues for trusts whose beneficiaries do not have the requisite insurable interest set forth in the statute. As more practitioners look at holding insurance in entities, this issue will be raised in every state without a statute that specifically addresses trusts. Eventually, the determination of whether an insurance trust or other type of entity has an insurable interest in the insured will have to be developed by the individual state courts, if it is not addressed proactively with an appropriate legislative solution that is consistent across the country . Without such consistency, the area of insurance trusts and other entities holding life insurance policies will likely turn into a legal quagmire.
Mary Ann Mancini is a partner in the D.C. office of Williams Mullen, where she specializes in estate planning.

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