Estate planning is a complicated business. Before you sit down with clients, find out what Uncle Sam will demand if a life insurance policy or an annuity is part of their estate, or part of a recent inheritance.
1. 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 his or her life within three years before his or her death.
(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 includability contained in IRC Sections 2035, 2036, 2037, 2038, or 2041. Under these circumstances, the value of the proceeds in excess of the value of the consideration received is includable in an insured’s estate. A grantor may retain the power to substitute property of an equivalent value. Such a power, in and of itself, generally does not cause the trust corpus to be includable under IRC Section 2036 or 2038.
2. What are the incidents of ownership that, if held by an insured, will cause life insurance proceeds to be includable in the insured’s estate?
Proceeds are includable in an insured’s gross estate if the insured possesses any of the following incidents of ownership at his or her death:
- 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.
The reservation of a right to make premium loans has been held to be an incident of ownership. A right to change contingent beneficiaries, who are to receive benefits after the primary beneficiary’s death, also is an incident of ownership.
The mere right to change the time or manner of payment of proceeds to the beneficiary, as by electing, changing, or revoking settlement options, has been held an incident of ownership, but the Tax Court and the U.S. Court of Appeals for the Third Circuit have held to the contrary. (In 1981, the IRS reiterated its opposition to the Third Circuit’s holding in Connelly, and indicated its intent to continue to oppose that result in all circuits except the Third (Pa., Del., N.J., Virgin Islands).
According to a Technical Advice Memorandum, trust provisions that changed the beneficial interest from a decedent’s spouse to the decedent’s children if the decedent and the decedent’s spouse became divorced were not the equivalent to a retained incident of ownership that would bring the life insurance proceeds into the decedent’s estate. The memorandum implies that the result would have been different if the trust had provided that the beneficial interest would revert to the decedent upon divorce.
The right to receive disability income is an incident of ownership if payment of disability benefits would reduce the face amount payable at death. But where an employer corporation owned the policy and the insured employee was entitled to benefits under a disability income rider, the IRS did not claim that the right to the disability income was an incident of ownership that would cause the proceeds to be includable in the insured’s gross estate.
A more than 5 percent reversionary interest in the proceeds is an incident of ownership. When a wife, who owned insurance on her husband’s life and who was the primary beneficiary, changed the contingent beneficiary from her estate to whomever the insured named in his will, the IRS ruled that the insured did not possess at his death an incident of ownership.
3. What are the incidents of ownership of employer-paid death benefits that would cause life insurance proceeds to be includable in the insured’s estate?
An employee insured’s right to designate the beneficiary of an employer-paid death benefit is not treated as an incident of ownership in the insurance funding the benefit if the employer is sole owner of the policy and sole beneficiary for its exclusive use. The IRS has taken the position that if the insured under a corporation-owned policy has an agreement with the corporation giving the insured the first right to purchase the policy for its cash surrender value if the corporation decides to discontinue the coverage, the purchase option is an incident of ownership. The Tax Court has held, however, that the insured’s contingent purchase option as described in Revenue Ruling 79-46 is not an incident of ownership within the meaning of IRC Section 2042(2).
The IRS also has ruled that where, under an insured stock redemption agreement, a stockholder had the right to purchase the policies the corporation owned on the insured’s life if the insured ceased being a stockholder, such contingent purchase option was not an incident of ownership in the insurance. An insured who held the right to purchase a policy upon termination of a buy-sell agreement did not possess incidents of ownership so long as the contingency had not occurred, but would possess incidents once the agreement was terminated.
Also, a shareholder was not treated as holding incidents of ownership in a life insurance policy where the shareholder could purchase a corporate-owned policy upon disability, or upon a cross-purchase of the shareholder’s stock if the shareholder dissented to sale of the corporation to a third party or a public offering. However, an insured was treated as holding incidents of ownership in a policy held in a trusteed buy-sell arrangement where the insured was considered to have transferred the policy to the trust and retained the right to purchase the policy for its cash surrender value.
The right to receive dividends has been held not to be an incident of ownership in the policy. It has been held that if the insured has the power to terminate the interest of the primary beneficiary with only the consent of the secondary beneficiary, the insured has an incident of ownership. However, a sole shareholder would not be treated as holding incidents of ownership in a life insurance policy on the shareholder’s own life where a collateral consequence of a termination of an employee’s employment would be a termination of the employee’s option agreement to purchase the shareholder’s stock with a corresponding change in beneficiary of the insurance proceeds held in an irrevocable life insurance trust created by the employee.
The assignment of a life insurance policy by a third-party owner as an accommodation to the insured to cover the insured’s debts does not in itself create in the insured an incident of ownership. But if a policy owner collaterally assigns a policy as security for a loan and then makes a gift of the policy subject to the assignment, the donor will be deemed to have retained an incident of ownership.
Where an insurance funded buy-sell agreement prohibited each partner from borrowing against, surrendering, or changing the beneficiary on the policy each owned on the life of the other partner without the insured’s consent, the Tax Court held that the decedent-insured did not possess an incident of ownership in the policy insuring the decedent-insured’s life. However, it has been reported that the IRS, citing an internal ruling dated January 7, 1971, has declined to follow the decision.
An insured was treated as holding incidents of ownership in a policy held in a trusteed buy-sell arrangement where the trust could only act as directed by the shareholders through the buy-sell agreement and the insured could thus withhold consent to the exercise of policy rights.
Where an insured absolutely assigned a policy that required the insured’s consent before the policy could be assigned, or the beneficiary changed, to someone who had no insurable interest in the insured’s life, IRS ruled that the insured had retained an incident of ownership.
Similarly, the Tax Court has held that an employee’s right to consent to a change of beneficiary on a split dollar policy owned by the employee’s employer on the employee’s life is an incident of ownership. The Tax Court also has held that where the insured assigned policies, retaining the right to consent to the assignee’s designating as beneficiary, or assigning the policies to, anyone who did not have an insurable interest in the insured’s life, the assignee’s act of designating an irrevocable beneficiary did not eliminate the insured’s retained incidents of ownership. The Third Circuit reversed the Tax Court in this case, however, taking the position that because under the facts presented the insured could not have enjoyed any economic benefit from exercising the insured’s veto power over the designation of beneficiaries or assignees, the insured’s retained power did not amount to an incident of ownership. The insured’s right to purchase the policy from an assignee was treated as equivalent to the right to revoke an assignment, which is an incident of ownership.
4. Can an insured remove existing life insurance from his or her gross estate by an absolute assignment of the policy but retaining a reversionary interest?
A reversionary interest in a policy is an incident of ownership if, immediately before the insured’s death, the value of the reversionary interest is worth more than five percent of the value of the policy. The insured will have no such reversionary interest, however, if the policy is purchased and owned by another person, or if the policy is absolutely assigned to another person by the insured. Regulations state that the term “reversionary interest” does not include the possibility that a person might receive a policy or its proceeds by inheritance from another person’s estate, by exercising a surviving spouse’s statutory right of election, or under some similar right. They also state that, in valuing a reversionary interest, interests held by others that would affect the value must be taken into consideration. For example, a decedent would not have a reversionary interest in a policy worth more than 5 percent of the policy’s value, if, immediately before the decedent’s death, some other person had the unrestricted power to obtain the cash surrender value of the policy; the value of the reversionary interest would be zero.
An insured was treated as holding a reversionary interest in a policy held in a trusteed buy-sell arrangement where the insured was considered to have transferred the policy to the trust and retained the right to purchase the policy for its cash surrender value upon termination of the buy-sell agreement. However, a policy held in a trusteed buy-sell arrangement would not be includable in an insured’s estate under IRC Section 2042 where (1) proceeds would be received by a partner’s estate only in exchange for purchase of the partner’s stock, and (2) all incidents of ownership would be held by the trustee of the irrevocable life insurance trust.
5. If life insurance proceeds are required under the terms of a property settlement agreement or a divorce decree to be paid to certain beneficiaries, are the proceeds includable in the insured’s estate?
Includability of Proceeds or Premiums
The IRS has ruled that where a divorced wife had an absolute right, under terms of a property settlement agreement incorporated by reference in a divorce decree, to annuity payments after the death of her former husband, and such payments were to be provided by insurance on his life maintained by him for that purpose, the former husband possessed no incidents of ownership in the insurance at his death. As a result, no part of the insurance proceeds was includable in his estate. Also, the Tax Court has held that where a divorced husband was required under a property settlement agreement to maintain insurance on his life payable to his former wife, if living, but otherwise to their surviving descendants or to his former wife’s estate if there were no surviving descendants, the insured possessed no incidents of ownership in the insurance. The insurance, in other words, was not merely security for other obligations. In another case, the Tax Court held that where an insured was subject to a court order requiring the insured to maintain insurance on his life payable to his minor children, such court order, operating in conjunction with other applicable state law, effectively nullified incidents of ownership the insured would otherwise possess by policy terms.
When, on the other hand, the divorced husband was merely required to maintain a stated sum of insurance on his life payable to his former wife so long as she lived and remained unmarried, the insured was held to have retained a reversionary interest sufficient in value to make the proceeds includable in his estate It also has been held that where, pursuant to a divorce decree, the proceeds of insurance maintained by a divorced husband on his own life to secure alimony payments are paid following the insured’s death directly to the former wife, the proceeds are includable in the insured’s estate. The Board of Tax Appeals reasoned that because the proceeds satisfy a debt of the decedent or his estate, the result is the same as if the proceeds are received by the decedent’s executor.