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FEDERAL ESTATE TAXATION OF LIFE INSURANCE

The most fundamental issue associated with estate planning with life insurance products is whether the death benefits will be subject to federal estate taxation. Estate taxes are payable on property included in a decedent�s gross estate if the decedent�s estate exceeds the available deductions and credits. 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:

 

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. 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.

 

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 additional 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 insured�s estate.

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 determining inclusion. If the insured held an incident of ownership at the time of his or her death, the policy will be included in his or her gross estate. An incident of ownership is broadly defined for this purpose 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 scope of the federal estate tax, the insured must divest himself or herself of all significant rights and privileges under the contract.

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. 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 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 the client has effectively transferred all traditional ownership rights to a life insurance policy.

Incidents Held by the Insured in a Fiduciary Capacity

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. The mere participation of the insured as fiduciary is enough to cause inclusion of the death proceeds in such insured�s gross estate for tax purposes.

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. 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.

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. The IRS has published an analogous ruling for general partnerships causing inclusion in a partner�s estate if a partnership-owned policy on the partner�s life is not payable to the partnership.

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.

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. Under this 3-year rule, life insurance transferred to a third party for less than full consideration 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 if 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 even if the sale occurs within 3 years of the insured�s death.

Most of the disputes and litigation between the taxpayer and the IRS on this issue 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. 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 a recent circuit court case, the IRS announced that it will no longer litigate life insurance cases where the policy covering the decedent�s life was owned and applied for by a third party. 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.)

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 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 qualified terminal interest property (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 provides all income to the surviving spouse and the 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.

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 in 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.

Policies Owned by a Decedent on the Lives of Others

Under third-party ownership of life insurance, which has become extremely popular for estate planning, it is quite possible that a policyowner will die before the actual insured. When this happens, a life insurance policy is treated the same way as any other property the decedent owned at the time of death. That is, the policy is included in the decedent�s gross estate at its fair market value determined in the same manner as previously discussed with respect to determining the gift tax value of the policy.

Responsibility for Payment of Federal Estate Taxes by Life Insurance Beneficiaries

Federal estate taxes attributable to life insurance proceeds included in the decedent�s gross estate will be recoverable by the executor from the beneficiary of the life insurance policy unless the decedent�s will provides a contrary provision for tax apportionment. This rule ensures that an executor will be able to collect estate taxes caused by life insurance even though the life insurance is paid to a named beneficiary and is not subject to the executor�s control.

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