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PART 2—COURSE READING

LIFE INSURANCE IN ESTATE PLANNING

Ted Kurlowicz

INTRODUCTION

 

Life insurance planning is an essential component of the estate planning process for wealthy individuals. For individuals of modest wealth, life insurance coverage often represents the most significant asset left to beloved heirs. Because of the relative importance of life insurance in an individual’s estate plan, it is critical that life insurance planning be performed appropriately.

Several unique aspects of life insurance make the product a vital asset in the estate planning process. For example, some favorable tax rules apply only to life insurance; life insurance enjoys a significant appreciation in value upon the death of the insured; life insurance is self-completing and provides its benefits when estate taxes and other settlement costs have to be paid and the income or other services of the insured must be replaced. Furthermore, life insurance products offer a substantial degree of flexibility in the estate planning process.

In this course, we will first cover the basic purposes of life insurance in estate planning. We will then explain the general tax implications of life insurance transactions. Next, we will review some practical planning applications for life insurance in the estate planning process.Later we will discuss the life insurance trust, generally regarded currently as the single most powerful estate planning technique.

I. LIFE INSURANCE SERVES TWO PURPOSES

The goal of life insurance in the estate plan depends on many factors specific to the client. However, the goals for life insurance in general can be divided into two categories: Life insurance can serve either as an estate enhancement or as an estate liquidity device. The goals of a specific client for his or her life insurance planning depend on his or her age, family circumstances, and financial status.

A. Estate Enhancement Purposes

A vast majority of individuals have the perception that their accumu-lated estate will not be as substantial as they would like at the time of their death. In many cases, a decedent’s estate will not be sufficient to provide for the basic needs of his or her heirs. This is particularly true for (1) young clients, (2) clients with family members dependent on their income, and/or (3) clients with small to moderate-sized estates.

These clients generally have estate enhancement as the primary goal for their life insurance coverage since they are either too young or have otherwise failed to accumulate sufficient wealth to provide for their heirs. Furthermore, these clients might have their peak earning years in front of them. The basic support needs of their family, such as educational, medical, and retirement savings programs, depend on this income.

It is essential for these clients to investigate their life insurance coverage needs and secure sufficient insurance to enhance their estates to a size that is, at the very least, adequate to handle their dependent family members’ basic needs. Since their death will cause the loss of income otherwise available to meet those basic needs, life insurance is the perfect estate enhancement device to replace the financial loss created by premature death.

B. Estate Liquidity Purposes

For older clients or clients with large estates, estate liquidity planning is the primary goal of life insurance coverage. Their children’s support and educational expense needs are usually a thing of the past. In addition, these older clients are nearing the end of their income-producing years, and they should, presumably, have less income to replace. If they have accumulated enough wealth or if they have an adequate retirement plan, these clients’ needs for estate enhancement from life insurance should have diminished in importance relative to their estate liquidity needs.

Probate Expenses. Although clients with substantial accumulated wealth should have sufficient assets in their estate to provide for the basic needs of their heirs, life insurance planning for such individuals remains critical. Estate settlement costs generally increase with the size of the estate. The cost for professionals, such as executors, attorneys, accountants, and appraisers, to settle an estate is often based on a percentage of the total size of the probate estate. In some cases, settlement costs are incurred even for nonprobate assets. Generally speaking, the larger the estate, the greater the complexity and the need for costly professional help. One advantage of life insurance is that it avoids probate if it is paid to a named beneficiary.

Death Taxes. Federal estate taxes, generation-skipping taxes, and state death taxes also increase with the size of the estate. The federal estate tax and state death taxes in many states are based on a progressive rate schedule. Larger estates are subject to higher transfer-tax brackets. For affluent clients, the shelter offered by the federal estate tax marital deduction and unified credit is inadequate to protect their estates from substantial estate taxes. In many cases, although the marital deduction will shelter all of the estate from taxes at the death of the first spouse, the death of the surviving spouse will often create a substantial tax problem for the family.

State death taxes often follow a different set of rules. In some states a significant first death tax has to be paid to the state even if substantially all property is left to the surviving spouse.

Liquidity Needs. Wealthy clients often face an additional problem. Frequently, their accumulat-ed wealth contains specific assets that are not liquid. For example, wealthy individuals often own closely held businesses that may be unmarketable to outsiders. Wealthy individuals are also likely to own expensive personal property, such as artwork, home furnishings, and automobiles. Death taxes and other estate settlement costs are based on the full value of such assets owned by the estate. The value of these assets may be high for the purposes of the federal estate tax and state death taxes, and substantial death costs may be incurred. Moreover, the assets may be unmarketable, or very difficult to sell, in the finite time period required to settle the estate. Even if the sale of such assets is feasible, the heirs often want to continue to hold their family assets. However, the heirs must pay estate settlement costs in cash relatively soon after the decedent’s death. The federal estate tax and most state death taxes are due within 9 months of the date of death.

The problems faced by wealthy individuals’ estates and heirs can often be mitigated by life insurance. For these individuals, the goal of life insurance is estate liquidity or wealth replacement. The wealthy client can purchase life insurance to provide death proceeds equal to the size of the anticipated shrinkage of the estate for death taxes and other settlement costs. In addition, because the life insurance benefits are paid in cash, the estate can be settled immediately. Thus, the nonliquid assets can either be retained by the estate to distribute to family heirs or sold later when an appropriate buyer can be found.

Much of the discussion in this course concerns the appropriate design of life insurance for estate liquidity purposes. It is important to arrange life insurance coverage appropriately to solve individuals’ estate liquidity problems. An inappropriate life insurance plan can lead to the inefficient use of life insurance as an asset in the estate plan. Improperly designed, life insurance will add to the estate’s settlement costs.

II. LIFE INSURANCE PRODUCTS

Competitive forces in recent years have caused the insurance industry to produce many types of life insurance products. This discussion will not attempt to examine the intricacies of every type. Only a general knowledge of each type of product is necessary to understand the uses of the products in the estate plan discussions that follow. Nevertheless, the services of a competent life underwriter are essential to the estate planning process since the selection of the most appropriate product in a particular estate planning case will maximize the efficiency of the client’s entire financial plan. For the purposes of this discussion, the types of products are separated into single life policies and multiple life policies.

A. Single Life Coverage

Term Life

Term life insurance provides coverage for a finite period of time. The specified face amount of the policy will be paid to a designated beneficiary if the insured dies during that time period. If the insured survives the time period, the policy expires and the coverage terminates. The finite time period in term insurance policies is expressed as a number of years—for example, one, 5, or 10. Term insurance generally has a premium that increases with the attained age of the insured. If the coverage needs are longer than the specific term, a renewability provision should be considered. This provision allows the insured to renew without providing new evidence of insurability.

Conversion privileges are often included with term insurance policies. This provision permits the insured to change a term policy for a permanent life policy without giving evidence of insurability. Term insurance is generally appropriate for estate planning uses only if the coverage need is temporary. If the coverage need is anticipated to continue for a substantial period of time, a more permanent life insurance policy or, at the very least, a conversion privilege in the term policy is recommended.

Permanent Life Insurance

I have chosen to arbitrarily categorize many types of life insurance as permanent. The main feature of permanent insurance is that the coverage is designed to exist beyond a fixed term for the entire life of an insured. A distinguishing characteristic of permanent insurance is the existence of a cash value or accumulation build-up within the policy. Permanent coverage can be designed either on a fixed-price premium or flexible-premium basis.

Fixed-price premium life insurance, traditionally called whole life insurance, is life insurance coverage in which a constant guaranteed premium is paid for a specific face amount of coverage. Of course, it is not actually that simple. Many contracts are participating; that is, the contract permits the insured to participate in favorable investment and mortality experience that the insurer might actually realize on that specific class of whole life policies. The participation feature provides for policy dividends that can be used to increase the death benefit or offset future premiums. Thus, participating contracts might not actually require the insured to pay a fixed premium for the remainder of his or her life. Or the dividend performance of such contracts might result in an increasing death benefit over the life of the policy.

In flexible-premium life insurance policies (generally referred to as universal life policies), the insured pays a stipulated premium in the first year of coverage. Afterward, the insured may choose to pay whatever amount of annual premium he or she desires. Since flexible premiums provide for a cash-value accumulation similar to fixed-premium policies, the cash value will either grow or be expended to pay required annual policy charges after the first year. The performance of the policy and the size of premiums actually contributed by the insured after the first policy year will determine the growth (or shrinkage) of the cash value. The actual death benefit of a universal life policy is similarly flexible. The amount of the death benefit paid will depend on the actual premiums contributed by the insured and the policy options selected.

Another type of permanent life insurance policy, variable life insurance, gives the policyowner the ability to select the investment vehicle for the cash value of his or her policy. Presumably, by choosing the investment mix for the cash value of the policy, the insured can be protected from inflation and can participate in the growth of the economy. However, the investment risk for the cash value falls entirely on the insured. Both fixed-premium and flexible-premium variable life insurance products are available.

B. Multiple Life Policies

Survivorship Life Insurance

Survivorship life insurance (also called second-to-die or last-to-die insurance) is a permanent life insurance policy that provides coverage on the lives of two individuals. The death benefit under the survivorship policy is payable upon the death of the survivor of the two insureds. Although survivorship life insurance is suitable for several purposes, it is generally used to provide coverage for a married couple. This coverage works extremely well under the current estate tax rules that allow an unlimited federal estate tax marital deduction at the first death of a married couple.

As with single life policies, survivorship life insurance coverage can be designed in many fashions. For example, fixed-premium or flexible-premium survivorship coverage is available. In many cases, survivorship policies combine some term insurance element with permanent coverage. The estate tax planning benefits of survivorship coverage will be discussed in greater detail below.

Joint Life Insurance

Joint life insurance covers the joint lives of multiple insureds. As opposed to survivorship life insurance, joint life coverage provides its death benefit at the first death of the joint insureds. Thus, joint life is often referred to as first-to-die coverage. Joint life insurance is less widely used than survivorship life insurance, but it has significant estate planning implications for co-owners of a closely held business. Joint life coverage is generally used in a buy-sell agreement in which the first death of two or more co-owners of the business will create the need to fund the purchase price required under the buy-sell agreement. The premium required for a joint life coverage is attractive compared to the premiums for separate individual policies on each of the co-owners.

III. TRANSFER TAX IMPLICATIONS OF LIFE INSURANCE

The financial services professional involved in estate planning must thoroughly understand the estate, gift, and generation-skipping transfer tax implications of life insurance. Often, life insurance planning is specifically driven by the need to provide estate enhancement or liquidity on the most cost-effective basis. Unique tax advantages usually exempt life insurance policy cash-value build-up and death benefits from income taxes. Thus, the potential transfer taxes become the most significant costs in life insurance planning.

IV. FEDERAL ESTATE TAXATION OF LIFE INSURANCE

The first step in the estate planning process is to estimate the size of the estate owner’s gross estate. Secs. 2033–2046 of the Internal Revenue Code tell us what property interests must be included as part of this gross estate for purposes of imposing the federal estate tax. Frequently, life insurance is the single largest asset or group of assets in the gross estate. Including life insurance can often mean the difference between a federal estate tax liability and no tax liability. For this reason, we should look at the factors that determine when life insurance is included in the decedent-insured’s gross estate for federal estate tax purposes:

A. Life Insurance Payable to an Estate

In general, life insurance should not be payable to a decedent’s estate. There are many reasons in addition to avoiding federal estate taxation why estate planners seldom recommend such a beneficiary designation. These reasons include the following:


In some instances, death benefits payable to named beneficiaries are included in an insured’s gross estate if the proceeds can or must be used to pay settlement costs. The regulations under Sec. 2042 make it clear that proceeds payable to a named beneficiary (such as a trustee) are includible in the insured’s gross estate if the beneficiary has a legal obligation to use the proceeds to pay the settlement costs for the estate. For example, life insurance used as collateral for a loan is payable to the estate to the extent that the loan is a debt of the estate.

Failure to make an effective beneficiary designation could also cause the proceeds to be payable to the estate.

Example: Mr. Jones is the designated beneficiary of his wife’s life insurance policy. Mr. Jones murders his wife and because of the "slayer’s statute" under state law, he cannot collect the proceeds. If no contingent beneficiary is named, the proceeds are returned to the estate, and they are subject to probate expenses and inclusion in Mrs. Jones’s gross estate for federal estate tax purposes.

Although Sec. 2042(1) includes policies payable to the executor, this definition should not be interpreted strictly. The spirit of the law indicates that inclusion of the proceeds in the insured’s gross estate results when proceeds are paid in a manner to benefit the estate. In contrast, inclusion should not occur under this provision when the proceeds are not intended to benefit the insured’s estate. The case of Friedberg v. Commissioner, T.C. Memo. 1992-310 demonstrates that the statute need not be taken literally. In this instance, the designated beneficiary was also, coincidentally, named executor of the insured’s estate. Since the policy was payable to the beneficiary in an individual capacity and was not intended to be available to the estate, the court held that the proceeds were not includible.

It should be noted that life insurance is includible in the gross estate, as discussed below, if the insured held any incidents of ownership at the time of death, whether or not such policy is payable to the estate. Thus it may not cause any harm from an estate tax standpoint if the policy is paid to the estate. However, in instances where the insured did not own incidents of ownership, it is critical to avoid having the proceeds deemed payable to the estate. In such instances, the planning dilemma is finding a method to permit the proceeds to enhance estate liquidity while avoiding inclusion in the insured’s gross estate. An irrevocable life insurance trust can be used to meet this goal.

Life Insurance Payable to a Decedent’s Testamentary Trust

In addition to problems created by making life insurance payable to a decedent’s estate, there are also complications if life insurance is owned by a third party and made payable to a decedent’s testamentary trust. The difference between a testamentary trust and a living trust is that a testamentary trust is created in a decedent’s will and takes effect only at death. Depending on the trust law of the particular state, life insurance payable to a decedent’s testamentary trust might actually be considered payable to his or her estate. This could cause inclusion of the proceeds in the gross estate and might subject the proceeds to the expenses of probate and the claims of creditors. The result will vary from state to state, and financial services professionals must consult local laws.

B. Possession of Incidents of Ownership

When insurance proceeds are paid to a named beneficiary other than the insured’s estate, incidents of ownership in the policy at the time of death are the key criteria for inclusion. An incident of ownership is broadly defined as any right to the economic benefits of the policy. The regulations provide that incidents of ownership include (but are not limited to) the power to

Like any other property, the insurance policy is an asset that may be freely assigned by a policyowner in a gift or sale. Thus it is possible for the policyowner to transfer all right, title, and interest to any other individual or entity. It is also possible to transfer limited interests to others while retaining some of the privileges and rights in the policy. But to remove the proceeds from the ambit of the federal estate tax, the insured must divest himself or herself of all significant rights and privileges under the contract.

Example: James White, a widower, transferred ownership of three whole life insurance policies to his daughter, Mitzi, 6 years ago. However, it was clear at the time of the transfer that James still had the right to borrow against the substantial cash values of the policies and the right to change the beneficiary by written notification to the insurance company’s home office. Although James effectively transferred title in the policies to his daughter, the policies’ proceeds will still be included in his gross estate for federal estate tax purposes since he retained the right to borrow against these policies and to change the beneficiary. In order to have successfully removed the proceeds from the gross estate, James must not have reserved the rights to borrow and to change the beneficiary.

The issue of incidents of ownership has been involved in a great deal of litigation over the years. This is because the facts and circumstances of a particular situation are often unusual and cannot be easily categorized into one of the traditional ownership rights. It is clear that a directly held incident will cause inclusion, even if the incident is exercisable only with another’s consent. In many cases, inclusion will occur even if the insured is unaware that such incidents are held or is incapable of exercising the incidents. The discussion below is not intended to be an exhaustive survey of all possible Sec. 2042(2) scenarios, but it will offer some guidance in using life insurance in many estate and business planning situations. The scenarios that follow examine some hidden incidents of ownership after assuming that the client has effectively transferred all traditional ownership rights to a life insurance policy.

Incidents Held by the Insured in a Fiduciary Capacity

The regulations indicate that the IRS’s position is that an incident of ownership that can be exercised by the insured as trustee will cause the policy to be included in the insured’s gross estate. This rule applies even if the insured is not a beneficiary of the trust. This is a unique treatment of life insurance as an asset of the estate. In many other circumstances, the trustee is not deemed to control an asset (other than life insurance) personally if ownership rights can be exercised only in favor of the beneficiaries.

It seems clear, therefore, that the insured should not gift a policy on his or her life to a trust in which the insured will be trustee even if the trust is irrevocable and the insured cannot benefit. In addition, the insured should not have power to become trustee in the future. But there have been mixed results in cases and rulings on this subject. For example, the IRS recently issued a private ruling in which incidents were not attributed to a trustee who obtained ownership of a policy on her life as trustee of her husband’s testamentary trust. The husband had previously owned the policy, and the trustee was prohibited from exercising incidents of ownership in the policy. However, the facts of this ruling are unusual, and the prudent approach is to avoid having the insured as trustee (or potentially a successor trustee) of a trust that might acquire a policy on the insured’s life.

Right or Option to Repurchase Policy

Several recent rulings have addressed the issue of whether the retention of the right or option to repurchase a policy will cause its inclusion in the insured’s gross estate. The cases have involved different facts and circumstances. In one, the insured retained the right to repurchase the policy after making a gift of the policy to a third party. In others, business life insurance used to fund buy-sell agreements was subject to contingent repurchase options.

The IRS’s position in these rulings is that an unrestricted right or option to repurchase the policy is an incident of ownership that creates inclusion under Sec. 2042(2). However, an option to repurchase the policy subject to a contingency beyond the insured’s control does not create an incident of ownership unless the contingency has occurred and the option is available at the time of the insured’s death.

Giving the insured the right to repurchase or reacquire a policy is clearly a planning mistake if the policy was transferred to avoid inclusion in the insured’s estate. A better approach might be to remain silent about this matter. Presumably the insured could, at a later date, reach an agreement with the third-party owner to repurchase the policy for fair market value if the insured desires. Of course, the insured would then own incidents of ownership but only if the repurchase occurs.

Incidents Attributed to Business Owner

The regulations provide that incidents of ownership held by a corporation will, in some circumstances, be attributed to a majority shareholder. Thus, corporate-owned life insurance may cause estate tax problems for an insured shareholder. The incidents are attributed if (1) the corporation owns life insurance on the life of a controlling (greater than 50 percent voting power) shareholder, and (2) the benefits are not payable to, or for the benefit of, the corporation. Although the issue of attributed incidents is confusing, it must be considered whenever business life insurance is contemplated. The life insurance owned by a corporation on the life of a majority shareholder could have a negative impact on the insured-shareholder’s estate in either one of two ways. First, the death benefits will be includible in full in the deceased insured majority shareholder’s estate if the proceeds are not payable to, or for the benefit of, the corporation. Second, even if the proceeds are payable to the corporation, the regulations indicate that the value of the stock held by the deceased shareholder’s estate should be enhanced for estate tax valuation purposes proportionately with the increase in the value of the corporation caused by the receipt of the proceeds. The regulations offer some guidance as to what is meant by "payable to or for the benefit of the corporation." Life insurance payable to the corporation to fund a corporate need will not cause incidents to be attributed to the insured. Examples of corporate-owned life insurance used to meet corporate needs include the following:


Life insurance is also deemed payable for the benefit of the corporation, in some instances, even if it is payable to a third party. For example, life insurance payable to satisfy a business debt will not cause corporate incidents to be attributed to the insured-shareholder. It is not unusual for a creditor to require insurance on a key person when loaning funds to a corporation. Insurance purchased by the corporation on a majority shareholder’s life for this purpose will not cause inclusion in the shareholder’s estate. However, the value of the stock held by the decedent will increase for estate tax purposes to the extent that the corporation’s debt is satisfied. Inclusion should also not occur for life insurance payable to the majority shareholder’s named beneficiary under a death-benefit-only (DBO) deferred-compensation plan, provided the plan had been established to meet a legitimate corporate need to compensate the shareholder as a key employee. That is, the life insurance should avoid direct inclusion, but the estate tax value of the corporation should increase since its liability under the DBO plan is satisfied. (Without the insurance funding, the death of the participant in the DBO plan would cause the stock value to drop by the amount owed to the selected beneficiary.)

Finally, the regulations exempt group term life (Sec. 79) insurance from the attributed-incidents rule. Thus, the ability of the corporation to cancel or change the group term policy does not cause incidents to be attributed to the majority shareholder even though he or she is likely to control corporate decisions.

The IRS has, on occasion, extended the attributed-incidents rule in a troubling manner. In a split-dollar plan, for example, the IRS has taken the position that the corporate-held incidents (such as access to the cash surrender value) will be attributed to the majority shareholder who participates in the split-dollar plan. Although these rulings have been much criticized, the planner should exercise caution in designing a split-dollar plan if the majority shareholder is trying to avoid inclusion of the proceeds in his or her estate.

Another question is "Does the attributed-incidents rule apply to other entities?" In Revenue Ruling 83-147, the IRS answered this question affirmatively with respect to partnerships. Generally, a partnership is treated as an aggregate of its partners. Thus the partnership’s ability to exercise incidents of ownership could be attributed to insured general partners unless the insurance is payable to or for the benefit of the partnership.

C. Transfers of Policies within 3 Years of Death

Policies are often transferred to others so that they will not be in the decedent-insured’s gross estate. Inclusion will still result, however, if the insured dies within 3 years of a gratuitous transfer (Sec. 2035). Under this 3-year rule, life insurance transferred to a third party within 3 years of an insured’s death is automatically includible in the insured’s gross estate. Transfers made more than 3 years before the insured’s death are not normally includible in the insured’s estate, assuming the insured has retained no incidents of ownership. In addition, sales to a third party for the full fair market value of the policy will not be included under Sec. 2035 even if the sale occurs within 3 years of the insured’s death.

The 3-year rule applies differently to life insurance transfers than it does to most transfers of other property. Other forms of property transferred within 3 years of death are generally excluded from the decedent’s gross estate. However, if a donor assigns an interest in a life insurance policy on his or her life and dies within 3 years of the assignment, the full amount of the proceeds will be included in the donor-decedent’s gross estate. This rule applies if any incident of ownership in the policy is transferred or released within 3 years of death.

The remainder of the material in this reading focuses on the planning necessary to keep the proceeds of life insurance on the insured’s life out of his or her gross estate. Although the 3-year rule applies to transfers of policies in which the insured possesses an incident of ownership, transferring or assigning the policy might still be an appropriate planning step. The insured simply has to live more than 3 years following the transfer to avoid the proceeds’ inclusion in his or her gross estate. And even if the insured dies within 3 years, he or she will be no worse off from an estate tax standpoint since the policy would have been included in any event had the transfer or assignment not occurred.

Most of the disputes and litigation between the taxpayer and the IRS under Sec. 2035 have involved the question of whether a transfer of the policy has occurred. Usually these have been cases in which a third party, such as a family member or life insurance trust, has applied for and owned the policy covering the decedent’s life. Generally, the IRS has attempted to treat the third-party owner as an agent of the insured for the purpose of acquiring the life insurance by applying the "constructive transfer" theory to the transaction. That is, the IRS has treated the insured as the original owner who is deemed to have transferred the policy to the third-party owner at the time application is made for the policy by the third party.

Another theory the IRS has applied is the "premium payment test." This theory imputes a transfer by the insured if the insured pays premiums on the policy covering his or her life even if the policy is owned by a third party. Thus, any premium payment by the insured within 3 years of his or her death will, if this theory applies, cause inclusion of the full proceeds under Sec. 2035.

Fortunately, the IRS has been largely unsuccessful in litigating these cases because the courts have given the term "transfer" its traditional meaning. Following its loss in circuit court case Estate of Headrick v. Commissioner, the IRS announced that it will no longer litigate life insurance cases under Sec. 2035 where the policy covering the decedent’s life was owned and applied for by a third party (Action on Decision [AOD] 1991-012). Thus inclusion of a life insurance policy in the decedent’s estate will be avoided if a third party applies for and owns the policy covering the decedent’s life, even if the decedent makes premium payments within 3 years of his or her death. (Of course, such premium payments are gifts by the insured and may be taxable under the gift tax rules.)

Although the IRS has backed down on the application of Sec. 2035 to third-party-owned life insurance, planning in this area should still be performed with extreme caution. The facts in the Headrick case were extremely favorable to the taxpayer: Headrick, an attorney, had clearly established the third-party ownership from the life insurance policy’s inception. No explicit or implicit evidence suggested that the third-party owner was acting as the agent of the insured. In cases where the third-party owner is under the direction of the insured or where the original ownership of the policy is unclear, the IRS may still attempt to invoke Sec. 2035.

For example, a recent private letter ruling involved the application of Sec. 2035 to the conversion of a group term life insurance policy. Under the facts of the ruling, the insured was covered by a group life insurance policy provided by his employer. Since the insured had problems with insurability, he used the conversion privilege in the policy at the termination of his employment and created an irrevocable trust to apply for the permanent policy created in the conversion. The IRS reasoned that the insured had transferred the group term life insurance policy to the trust, and therefore Sec. 2035 should apply to the new permanent contract held by the trust. Two factors make this application of Sec. 2035 seem reasonable. First, the insured had owned incidents of ownership in the group life coverage. Second, the permanent contract would not have been available (because of insurability problems) except for the conversion privilege in the group term life insurance. The insured could have avoided the problem entirely by assigning all rights in his group term life coverage to the trust prior to the conversion, provided the assignment occurred more than 3 years prior to his death.

D. Life Insurance and the Federal Estate Tax Marital Deduction

Life insurance proceeds payable at the insured’s death to the insured’s surviving spouse can qualify for the federal estate tax marital deduction. Since the marital deduction is unlimited, the full value of life insurance proceeds payable in a qualifying manner to the surviving spouse will be deductible from the insured’s gross estate.

The federal estate tax marital deduction is available only under the following circumstances:


Under these rules, life insurance proceeds payable outright to a citizen surviving spouse as named beneficiary will qualify for the marital deduction. If the surviving spouse is a resident alien, the marital deduction can be preserved by assigning the proceeds to a qualified domestic trust. If the proceeds are payable to the insured’s estate, the proceeds will qualify for the marital deduction if the surviving spouse receives the proceeds under the terms of the decedent’s will or the state intestacy statute.

Qualification for the marital deduction becomes more complicated if the surviving spouse does not receive the proceeds outright. For example, life insurance proceeds payable to a surviving spouse under available settlement options may or may not qualify for the marital deduction. Some settlement options terminate payment at the surviving spouse’s death. If the remaining payments are not payable to the surviving spouse’s estate or subject to the surviving spouse’s control, the marital deduction will not be available unless the estate is eligible to make the QTIP election.

If the proceeds of a life insurance policy are payable to a trust benefiting the surviving spouse, qualification will depend on whether the trust otherwise qualifies for the federal estate tax marital deduction. Thus, the marital deduction depends on whether the trust remainder interest is payable to the surviving spouse’s estate or subject to the surviving spouse’s general power of appointment. Absent such provisions, the trust can qualify only if the deceased spouse’s executor makes the QTIP election.

In a recent private letter ruling, a husband transferred a policy purchased on his life to an irrevocable life insurance trust benefiting his wife and children. Since the husband transferred the policy to the trust within 3 years of his death, Sec. 2035 caused the proceeds’ inclusion in the husband’s estate. The terms of the trust provided for the following at the husband’s death:

 

Under the terms of this trust, the wife received a terminable interest since her interest would cease at her death. However, if the deceased husband’s executor makes the QTIP election, a marital deduction would be available for 50 percent of the proceeds because the surviving wife would have a 50 percent income interest in the trust.

E. Value of the Policy Includible in the Gross Estate

Policies on the Life of the Decedent

If a life insurance policy must be included in the decedent-insured’s gross estate for federal estate tax purposes, the amount that is included is the face amount of the policy. The face amount is the death benefit adjusted by (1) deducting any policy loan or other encumbrance and (2) adding any accrued or terminal dividends. Such concepts as cash value, total premiums paid, or reserves in the policy are irrelevant in this context and have nothing to do with the determination as to what amount is to be included in the decedent-insured’s gross estate.

The value included in the gross estate would appear, at first, to be unrelated to whether the policy is included under Sec. 2042 or 2035. Obviously, if the decedent-insured owned the policy at the time of his or her death, the full amount of proceeds must be included under Sec. 2042. But Friedberg v. Commissioner reveals a different test for inclusion under Sec. 2035. In this case, the decedent had transferred a policy on his life to his daughter. Following the transfer, the daughter paid the premiums as they came due. The insured died within 3 years of the transfer, and therefore the policy was included in his gross estate under Sec. 2035. 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