10 life insurance tax facts you need to know

A federal apportionment statute provides in pertinent part as follows: “Unless the decedent directs otherwise in his will, if any part of the gross estate on which tax has been paid consists of proceeds of policies of insurance on the life of the decedent receivable by a beneficiary other than the executor, the executor shall be entitled to recover from such beneficiary such portion of the total tax paid as the proceeds of such policies bear to the taxable estate.”

In McAleer v. Jernigan, the decedent’s former wife was the beneficiary of insurance on the decedent’s life. The decedent, who died domiciled in Alabama, did not direct in his will where the burden of death taxes should fall. The Alabama statute said that unless the decedent directed otherwise, the executor was to pay death taxes out of estate property (i.e., from the residuary estate). The statute also said that the executor was under no duty to recover any pro rata portion of such taxes from the beneficiary of any nonprobate property. In a suit by the executor to recover from the life insurance beneficiary a pro rata share of the estate tax due (the insurance proceeds having been found includable in the gross estate for federal estate tax purposes), the Eleventh Circuit held that the federal statute, IRC Section 2206, prevailed over the state statute and allowed the executor to recover.

Q: Can arrangements for payment of the proceeds of life insurance and annuity contracts attract the generation-skipping transfer tax?

A: Yes. Regardless of what form an arrangement may take (whether, for example, the arrangement is a life insurance trust, an agreement with the insurer for payment of proceeds under settlement options, or an outright payment to a beneficiary), if an insured (or annuitant) transfers benefits to a “skip person,” generally, the insured has made a generation-skipping transfer.

For purposes of the generation-skipping transfer tax, the term “trust” includes any arrangement (such as life estates, estates for years, and insurance and annuity contracts) other than an estate that, although not a trust, has substantially the same effect as a trust. In the case of an arrangement that is not a trust but that is treated as a trust, the term “trustee” means the person in actual or constructive possession of the property subject to such arrangement.

The IRS has been given authority to issue regulations that may modify the generation-skipping rules when applied to trust equivalents, such as life estates and remainders, estates for years, and insurance and annuity contracts. The committee report states that such authority, for example, might be used to provide that the beneficiary of an annuity or insurance contract be required to pay any generation-skipping tax.

Regulations provide that the executor is responsible for filing and paying the GST tax if (1) a direct skip occurs at death, (2) the property is held in a trust arrangement, which includes arrangements having the same effect as an explicit trust, and (3) the total value of property subject to the direct skip is less than $250,000. The executor is entitled to recover the GST tax attributable to the transfer from the trustee (if the property continues to be held in trust) or from the recipient of the trust property (if transferred from the trust arrangement).

Regulations provide a number of examples that treat insurance proceeds as a trust arrangement. Where insurance proceeds held by an insurance company are to be paid to skip persons in a direct skip at death (a direct skip can occur whether proceeds are paid in a lump sum or over a period of time) and the aggregate value of such proceeds held by the insurer is less than $250,000, the executor is responsible for filing and paying the GST tax. Consequently, the insurance company can pay out the proceeds without regard to the GST tax (apparently, the insurance company could not do so if the executor attempts to recover the GST tax while the company still holds proceeds). Where the value of the proceeds in the aggregate equals or exceeds $250,000, however, the insurance company is responsible for filing and paying the GST tax.

Q: How can the generation-skipping transfer (“GST”) tax exemption be leveraged using an irrevocable life insurance trust?

A: Leveraging of the GST tax exemption (see Appendix D) can be accomplished by allocating the exemption against the discounted dollars that the premiums represent when compared with the ultimate value of the insurance proceeds. However, in the case of inter vivos transfers in trust, allocation of the GST exemption is postponed until the end of an estate tax inclusion period (“ETIP”). In general, an ETIP would not end until the termination of the last interest held by either the transferor or the spouse of the transferor during the period in which the property being transferred would have been included in either spouse’s estate if that spouse died.

Of course, the transferor should be given no interest that would cause the trust property to be included in the transferor’s estate. Furthermore, the transferor’s spouse should be given no interest that would cause the trust property to be included in the transferor spouse’s estate if the transferor spouse were to die.

The property is not considered as includable in the estate of the spouse of the transferor by reason of a withdrawal power limited to the greater of $5,000 or five percent of the trust corpus if the withdrawal power terminates no later than sixty days after the transfer to the trust. Also, the property is not considered as includable in the estate of the transferor or the spouse of the transferor if the possibility of inclusion is so remote as to be negligible (i.e., less than a five percent actuarial probability). Furthermore, the ETIP rules do not apply if a reverse QTIP election is made. Otherwise, if proceeds are received during the ETIP, the allocation of the GST exemption must be made against proceeds rather than premiums and the advantage of leveraging is lost.

Example 1. [Twenty years in this example only is based upon the $1 million GST exemption prior to any inflation or other adjustment after 1998.] G creates a trust for the benefit of his children and grandchildren. Each year he transfers to the trust $50,000 (to be used to make premium payments on a $2 million insurance policy on his life) and allocates $50,000 of his GST exemption to each transfer. Assuming G makes no other allocations of his GST exemption, the trust will have a zero inclusion ratio (i.e., it is not subject to GST tax) during its first twenty years. At the end of twenty years, G will have used up his GST exemption and the trust’s inclusion ratio will increase slowly with each additional transfer of $50,000 to the trust. If G died during the twenty year period, the insurance proceeds of $2 million would not be subject to GST tax. Part of the $2 million proceeds may be subject to GST tax if G died in a later year. To insure that the trust has a zero inclusion ratio, use of a policy that becomes paid-up before the transfers to trust exceed the GST exemption may be indicated.

Example 2. Same facts as in Example 1, except that the trust is created for G’s spouse, S, during her lifetime, and then, to benefit children and grandchildren. If the trust is intended to qualify for the marital deduction (apparently, other than if a reverse QTIP election is used), the valuation of property for purpose of the ETIP rule is generally delayed until G or S dies because the property would have been included in S’s estate if she died during the ETIP. Consequently, if the $2 million insurance proceeds are received during the wife’s lifetime, the GST exemption is allocated against the $2 million proceeds, and a substantial amount of GST tax may be due upon subsequent taxable distributions and taxable terminations from the trust. Because allocation of the exemption must be made against the proceeds if they are received during the ETIP, the advantage of leveraging enjoyed in Example 1 is lost.

NOTE: The 2011 GST tax lifetime exemption is $5 million, and for 2012, it is $5.12 million. The 2010 Tax Relief Act also unified the lifetime gift exemption with the estate tax exemption of $5 million for 2011 and $5.12 million for 2012. The exemption is expected to revert to $1 million in 2013.This temporarily increased exemption will provide transferors with flexibility in funding life insurance premiums through irrevocable life insurance trusts as it allows the transferor to front-pay premium payments in 2011 and 2012 with the unused portion of the $5 million exemption ($10 million for married couples). In addition, the Act provides portability of unused exemptions among spouses; any unused exemption of a spouse who dies in 2011 may be used by the surviving spouse.

Q: Are gifts of life insurance to charitable organizations subject to gift tax?

A: Generally, no. An individual may take a gift tax deduction for the full value of gifts to qualified charities of life insurance and annuity contracts, and of premiums or consideration paid for such contracts owned by qualified charities. Such a deduction is not allowed where an insured assigns (even irrevocably) to a charity the cash surrender value of a life insurance policy (either paid-up or premium paying), including a right to death proceeds equal to the cash surrender value immediately before death, if the donor retains the right to name or change the beneficiary of proceeds in excess of the cash surrender value and to assign the balance of the policy subject to the charity’s right to the cash surrender value. According to the IRS, such a gift is neither one of the donor’s entire interest in the property nor one of an undivided portion of the donor’s entire interest in the property, and so the deduction is disallowed under IRC Section 2522(c).

If the law in the state of the donor’s domicile does not recognize that a charity has an insurable interest in the life of the donor, a charitable deduction may not be allowed for a gift of a newly issued insurance policy (or premiums paid thereon) or for gifts of premium payments on a policy applied for and issued to the charity as owner and beneficiary.

Q: If life insurance proceeds are payable to a religious, charitable, or educational organization, is their value taxable in the insured’s gross estate?

A: Generally, no. If the insured has any incident of ownership in the policy at the time of death, the proceeds are includable in the insured’s gross estate, but a charitable deduction is allowable for their full value.

If, however, the law in the state of the donor’s domicile does not recognize that a charity has an insurable interest in the life of the donor, complications may arise. In some states, a charity may not have an insurable interest with respect to a newly issued insurance policy given to the charity or for a policy applied for and issued to the charity as owner and beneficiary. If the charity does not have an insurable interest and the insurer or the insured’s estate raises the question of lack of an insurable interest, the insured’s estate may be able to recover the proceeds (or the premiums paid). The proceeds are includable in the insured’s estate to the extent that the proceeds could be received by the insured’s estate. No charitable deduction may be allowed if the executor recovers the proceeds for the estate or if the executor were to fail to recover the proceeds and the proceeds passed to charity.

Q: Are death proceeds of life insurance taxable income if they are payable to a trust?

A: No, they generally are tax exempt income to the trustee and to the beneficiary when distributed.

Where proceeds are retained by the trust, earnings on the proceeds are taxed in the same manner as other trust income. The $1,000 annual interest exclusion, available where insurance proceeds are payable to a surviving spouse of an insured who died before October 23, 1986, under a life income or installment option, is not available if the proceeds are payable to a trust. Under some circumstances, proceeds of a policy transferred for value to a trust may not be wholly tax exempt.

This LifeHealthPro story is excerpted from 2015 Tax Facts on Insurance & Employee Benefits. Click here to receive a 10% discount on the book.

For more tax coverage, visit LifeHealthPro.com/taxplanning 

The content in this publication is not intended or written to be used, and it cannot be used, for the purposes of avoiding U.S. tax penalties. It is offered with the understanding that the writer is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought.