Protecting life insurance from estate taxes

Editor's note: The following article originally appeared in the Tennessee CPA Journal, July 2004, Vol. 49, No. 6, published by the Tennessee Society of CPAs, Brentwood, Tenn. It is reprinted here with permission.

By Joanie Sompayrac, CPA, JD,
and Kevin Martin, MBA

Broadly defined, life insurance is a policy purchased on the life of an individual that, upon the death of that individual, will pay a monetary benefit to a designated beneficiary.

There are two primary purposes for purchasing life insurance:

to provide benefits for family members or other loved ones in the event of the insured person's death; and
to make cash available after the insured person's death, especially to provide for business continuation and prevent forced sale of valuable, non-cash assets to pay estate tax or other expenses.

There are literally hundreds of different types of life insurance policies from which to choose when someone is trying to provide a benefit for heirs. However, most insurance vehicles generally fall into two basic categories — term and whole (or cash value).

With a term insurance policy, "the holder or owner of the policy pays a premium to the insurer sufficient to enable the insurer, in the event of death of the insured, to pay to the policy's beneficiaries the face amount of the policy." ₁

With whole life insurance (also known as cash-value life insurance), "the holder of the policy in essence acquires two separate interests — an insurance policy and a savings account. The annual premium paid for such a policy is typically several times that charged for a term policy, but unlike term insurance, the premium for this form of life insurance normally does not increase (nor does coverage decline) with the age of the insured." ₂

Because the premiums on this type of policy are higher than a term policy, this is where the savings component comes into play. The owner of the policy is then permitted to withdraw the cash surrender value and / or borrow against this cash surrender value. However, by doing this, the owner of the policy will decrease the amount of death benefit that would be paid to the beneficiary upon the death of the insured.

Some variations on these two basic types of insurance are universal life, variable life, variable universal life, survivorship life and first-to-die life insurance policies. Regardless of what type of insurance policy one uses, the estate tax implications of using insurance as part of a succession plan should be considered.

Tax implications of life insurance

When considering how life insurance proceeds will be affected by taxes, the majority of people only consider the income tax implications that would be involved. Too often, people do not consider or even think about what the impact of estate taxes will be on the actual money that the beneficiary will get from the proceeds. With a couple of exceptions, life insurance proceeds are generally not taxable for income tax purposes. ₃

Further, if life insurance proceeds are held by the insurer after the insured's death, interest earned on the proceeds is taxable. ₄ Consequently, the income tax implications of life insurance can be an issue despite the commonly held belief that they are not.

While such an occurrence may not be common, there are instances in which a decedent may have pre-arranged with the insurer to hold the proceeds in trust for a term before payment of the proceeds to a beneficiary or group of beneficiaries. While those proceeds would be excludable from gross income under IRC § 101(a), the interest income earned on those proceeds while they are being held by the insurer are included in gross income under IRC § 101(c). As noted, however, these arrangements are not frequent, but they do arise.

More important, though, are the estate tax implications inherent in the use of life insurance in estate planning. Internal Revenue Code § 2042 states:

"The value of the gross estate shall include the value of all property (1) receivable by the executor, to the extent of the amount receivable by the executor as insurance under policies on the life of the decedent; (2) receivable by other beneficiaries, to the extent of the amount receivable by all other beneficiaries as insurance under policies on the life of the decedent with respect to which the decedent possessed at his death any incidents of ownership, exercisable either alone or in conjunction with any other person."

For purposes of the preceding sentence, the term "incident of ownership" includes a reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent.

Incidents of ownership are important when considering the tax impact of life insurance proceeds, because without the decedent having any incidents of ownership, the proceeds of this policy may not be includable in the estate. Consequently, it is very important to understand what the term "incidents of ownership" means.

The term "incidents of ownership" encompasses far more than legal title to a policy. Generally speaking, the term refers to the right of the insured or his estate to the economic benefits of the policy. Therefore, it may include the power to change the beneficiary, the power to surrender or cancel the policy, the right to assign the policy, the authority to revoke an assignment, the right to pledge the policy for a loan or the ability to obtain from the insurer a loan against the surrender value of the policy. ₅

A decedent would also be considered to have incidents of ownership in an insurance policy on his life if that policy is held in trust and under the terms of the trust. The "decedent (either alone or in conjunction with another person or persons) has the power (as trustee or otherwise) to change the beneficial ownership of the policy or its proceeds or the time or manner of enjoyment thereof, even though the decedent has no beneficial interest in the trust."₆

Therefore, a taxpayer wishing to avoid having the proceeds of a life insurance policy included in her estate, in addition to not making it payable to the taxpayer's estate, should avoid ever possessing any power to control who benefits from the policy, whether the policy is canceled or surrendered, ever used as collateral for a loan, or whether it can be used to provide any other economic benefit for the insured. The insured taxpayer may also be considered to possess an "incident of ownership" in a policy on the taxpayer's life if the policy is owned by a corporation and the taxpayer is the sole or controlling shareholder and the proceeds are not payable to the corporation. In such instances, the proceeds will be includible in the gross estate. ₇

Suppose client A understands these rules and thinks, "Well, I will just wait, and if I am sick, then I will transfer all incidents of ownership to someone else prior to my death. Then I will no longer have any ownership of the policy and then it will not be included in my estate." Unfortunately, this will not work because of Internal Revenue Code § 2035. This section states that certain property will still be pulled back into the gross estate of the decedent if:

the decedent made a transfer (by trust or otherwise) of an interest in any property or relinquished a power with respect to any property, during the three-year period ending on the date of the decedent's death; and
the value of such property (or an interest therein) would have been included in the decedent's gross estate under § 2036, § 2037, § 2038 or § 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death. The value of the gross estate shall include the value of any property (or interest therein), which would have been so included. ₈

In effect, IRC § 2035 will then pull a life insurance policy back into the decedent's gross estate and make it taxable, before consideration of the lifetime exclusion, if the decedent attempts to give up incidents of ownership within three years of his or her death. Consequently, waiting until someone is sick to transfer ownership rights in an insurance policy would generally be a risky proposition, at best.

Protecting life insurance from estate taxes

So how can you provide security and income for your beneficiaries and not have up to 55 percent of your death benefits go to the government for estate tax purposes?

Clearly, with the increasing lifetime exclusions granted by Congress, if you are someone who has a very limited amount of life insurance and few other assets, then the value of your estate is going to fall well under the applicable exclusion amount and estate taxes will not be a major concern. The current applicable exclusion amount is $1.5 million and will be increasing as follows:

2004 and 2005: $1.5 million
2006 through 2008: $2 million
2009: $3.5 million
2010: Estate tax repealed
2011 and beyond: $3.5 million

As the lifetime exclusion table illustrates, one must have substantial assets at death before the estate tax will be triggered. However, it is important to remember that the decedent's lifetime taxable gifts chip away at this lifetime exclusion amount, so if a decedent has made lifetime taxable gifts and dies possessive of a home, life insurance and retirement plan, the estate tax may come into play quite swiftly. If life insurance is a major part of one's estate plan, then it would be wise to plan now for how to maximize the benefit while minimizing the tax implications.

What can be done to avoid inclusion of life insurance?

Avoid payment to the executor: Clearly, one way to avoid inclusion of life insurance proceeds would be to make sure it is not payable to the executor in his or her capacity as executor of the decedent's estate.
Make certain that insured avoids incidents of ownership: Make sure the beneficiary of the policy is also the owner. If the beneficiary is a child, the parent could give the child the premium payments, which in most cases would fall under the annual exclusion amounts so they would not be taxable gifts.

If the parent has already purchased and taken ownership of the policy, that parent could transfer ownership of the policy immediately. The parent might be subject to tax on the cash surrender value (or interpolated terminal reserve value) of the policy, but assuming the parent survives for more than three years after the transfer, it gets the policy out of the reach of the estate.

One thing that you have to be cautious about in this situation is that an unanticipated sequence of deaths could possibly throw this policy back into the estate of the insured. An example of this would be if a husband were to purchase a policy on his wife's life and name their children as beneficiaries of the policy, but he dies before her and leaves his entire estate to her. Since he had ownership of the policy on her life, that policy would now become part of her estate. The only way she could avoid this would be to make a timely disclaimer of all interests in the policy.
Surrender any existing incidents of ownership in existing policies on one's own life: Inclusion of the cash value of policies on another person's life in a decedent's estate is generally not problematic because that other person is alive, and the cash value included in the gross estate may be nominal compared to the rest of the estate. What the potential decedent needs to avoid is dying while possessing any incidents of ownership on any life insurance policies on his or her life. Inclusion of these policies in the gross estate will obviously be at face value, which is much higher and more problematic.

Therefore, if life insurance makes up a substantial portion of one's estate, one should make sure that he or she has irrevocably surrendered all incidents of ownership, the power to change the beneficiary, the power to surrender or cancel the policy, the right to assign the policy, the authority to revoke an assignment, the right to pledge the policy for a loan or the ability to obtain from the insurer a loan against the surrender value of the policy. ₉
Transfer policies to an irrevocable life insurance trust: Sometimes an insured may want to set up life insurance that can be flexible to allow for changes that may occur. Some of these changes could be the birth of a child or the change in the economic welfare of one or more dependents of the insured. The insured may want the policy to be flexible enough so that if these changes occur, then the proper distribution of the proceeds can be made to accommodate the changes in the family financial status, while also allowing for proper tax savings maximization. By transferring life insurance policies to an irrevocable life insurance trust (or having the trust actually purchase the policies), the trust will possess the incidents of ownership instead of the decedent.

"In establishing the trust, care must be taken so that the insured does not retain any rights of ownership or powers with respect to the trust that could result in its inclusion in the estate under not only § 2042 but also § 2036, § 2037 or § 2038." ₁₀

It should also be noted that if a policy is transferred into the trust within three years of the death of the insured, then this policy's proceeds would be pulled back into the estate under IRC § 2035. Also, make sure that the trust does not have any provisions mandating that any insurance proceeds be used to pay any expenses of the decedent's estate.

Conclusion

Use of life insurance can be an easy and effective way to provide for heirs and preserve business assets, and with relatively little effort, you can completely avoid any estate tax on the proceeds. All it takes is a working knowledge of the rules and some planning.

Internal Revenue Code § 2042 and the related treasury regulations are pretty clear in offering guidance on how to avoid inclusion of life insurance proceeds in a decedent's estate. Careful planning now can avoid depleted cash flow and heartache later.

Notes

1. Campfield, Regis; Dickinson, Martin; Turnier; Taxation of Estates, Gifts and Trusts, (West Group) 22nd Edition, 17,001.

2. Ibid.

3. For example, IRC § 101(a)(2) clearly states that if an insurance policy is transferred for valuable consideration prior to the death of the insured, some of the proceeds may be taxable. "In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract, or any interest therein, the amount excluded from gross income by paragraph (1) shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee.

4. See IRC § 101(c)

5. Treasury Regulation § 20.2042-1(c)(2)

6. Treasury Regulation § 20.2042-1(c)(4)

7. Treasury Regulation § 20.20.2042-1(c)(6)

8. IRC § 2035

9. Treasury Regulation § 20.2042-1(c)(2)

10. Campfield at 17,065.

Works cited

Campfield, Regis; Dickinson, Martin; Turnier; "Taxation of Estates, Gifts and Trusts," (West Group) 22nd Edition

Internal Revenue Code §§101, 2033, 2035, 2036, 2037, 2038 and 2042

Treasury Regulation § 20.2042

Joanie Sompayrac, CPA, JD, is an associate professor of accounting at the University of Tennessee at Chattanooga. She can be reached at Joanie-Sompayrac@utc.edu.

Kevin Martin, MBA, is a general accounting manager with Maytag Services, LLC. He can be reached at KMartin@maytag.com.

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