Estate Planning: Life Insurance and the Gross Estate of the Insured

What benefits payable at death are included in the term “life insurance” for estate tax purposes?

 IRC Section 2042 deals with the estate taxation of proceeds from insurance on the life of a decedent. According to this code section and regulations, the term “insurance,” means life insurance of every description.  In the case of a retirement income endowment, the death proceeds are treated as insurance proceeds if the insured dies before the terminal reserve value equals or exceeds the face value. If the insured dies after that time, the proceeds are treated as death proceeds of an annuity contract.

With respect to the proceeds of “no-fault” automobile liability insurance, the IRS has ruled on three categories of benefits:

(1)  Survivors’ loss benefits. These are benefits payable only to certain named dependent survivors of the insured. If the insured dies leaving no such eligible dependents, no benefits are paid. The value of any such benefit is not includable in the insured’s gross estate under IRC Section 2033 (defines what is includible in the gross estate) or under IRC Section 2042(2) because if the proceeds are life insurance and the insured would not any incidents of ownership at death.

(2)  Basic economic loss benefit. This benefit covers the insured’s medical expenses and loss of income arising from the insured’s injury while operating an automobile. The value of this benefit is includable in the insured’s gross estate under IRC Section 2033, but not under IRC Section 2042(1) (life insurance proceeds payable to or for the insured’s estate).

(3)  Death benefit. This is a benefit payable unconditionally to the estate of the insured and to the estate of any passenger in the insured’s car killed in a covered accident. The value of this benefit is includable in the estate of each insured receiving the benefit.

When are death proceeds of life insurance includable in an insured’s gross estate?

They are includable in the following four situations:

(1) The proceeds are payable to the insured’s estate, or are receivable for the benefit of the insured’s estate;

(2) The proceeds are payable to a beneficiary other than the insured’s estate but the insured possessed one or more incidents of ownership in the policy at the time of the insured’s death, whether exercisable by the insured alone or only in conjunction with another person

(3) The insured has made a gift of the policy on the insured’s life within three years before death; or

(4) The insured has transferred the policy for less than an adequate consideration (i.e., the transaction was not a bona fide sale) and the transfer falls within one of the rules for incurability in the gross estate under one of the IRS code provisions. Under these circumstances, the value of the proceeds in excess of the value of the consideration received is includable in an insured’s estate.

If life insurance proceeds are payable to an insured’s estate, is the value of the proceeds includible in the insured’s estate?

Yes. The entire value of the proceeds must be included in the insured’s gross estate even if the insured possessed no incident of ownership in the policy, and paid none of the premiums. Proceeds are includable in an insured’s gross estate if they are receivable by or for the benefit of the insured’s estate. Thus, if the beneficiary is under a legally binding obligation to pay debts or taxes of the insured’s estate, the amount of proceeds required to discharge these debts and taxes (to the extent of the beneficiary’s obligation) is includable in the insured’s gross estate.

State law generally requires a life insurance beneficiary to forfeit the proceeds if the beneficiary is convicted of feloniously killing the insured. Where state law further provides that in such case proceeds will be distributed to beneficiaries of the insured’s estate (other than to the felon), it has been held that the proceeds are treated for federal estate tax purposes as payable to the insured’s estate.

When are life insurance proceeds payable to a beneficiary other than the insured’s estate includable in the insured’s estate?

Proceeds are includable in an insured’s gross estate if the insured legally possessed and could legally exercise any incidents of ownership at the time of the insured’s death. It does not matter that the insured did not have possession of the policy and therefore was unable to exercise ownership rights at the time of death, or that the insured was unable as a practical matter to effect any change in the policy because the policy was collaterally assigned.

Proceeds are includable in an insured’s gross estate if the insured possesses any incidents of ownership at death including, but not limited to, the following:

  • the right to change the beneficiary;
  • the right to surrender or cancel the policy;
  • the right to assign the policy;
  • the right to revoke an assignment;
  • the right to pledge the policy for a loan; or
  • the right to obtain a policy loan.

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