Back to the Basics with Life Insurance and Estate Tax

***This article is a follow-up to a prior article from 2019 which can be found here.

Life insurance is a great tool that can serve a variety of purposes. Most often, it is thought of as an income replacement/hedge against premature death to provide for one’s family, and it is certainly a great tool to accomplish that goal. But life insurance also has many planning uses including funding a buy-sell agreement, providing liquidity for estate taxes, equalizing bequests where one beneficiary gets a certain asset such as a business, and leveraging annual exclusions and gift tax exemptions to create large wealth transfers at death. So many people are familiar with life insurance and its benefits, but how is it taxed? My colleague Gray Edmondson previously wrote about the income tax aspects of life insurance proceeds[1] noting that the general rule is that life insurance proceeds are not subject to income tax. But what about estate tax? This article will briefly discuss the estate tax implications of life insurance.

A Review

Section 2042 of internal revenue code covers the inclusion of life insurance proceeds in a decedent’s estate. Section 2042 contains two provisions. First, under 2042(1), the proceeds of a life insurance policy on the life of the decedent that are payable to a decedent’s estate are included in the decedent’s estate. Second, under 2042(2), the proceeds of a life insurance policy on the life of the decedent are included in the decedent’s estate if the decedent held any “incidents of ownership” at death, whether exercisable alone or in conjunction with another person. Note that under Section 2035, life insurance policies or incidents of ownership that were gifted within three years of death will be included in the decedent’s estate as 2035 specifically references 2042 as a Section to which it applies. Properly structured it may be possible to avoid this three-year rule by a sale of the policy into trust rather than funding by gift.

Section 2042 is pretty straightforward as to proceeds received by the estate or proceeds from a policy that the decedent owned directly. However, the case is not so clear when determining what is meant by “incidents of ownership”. The statute provides that a reversionary interest (whether arising by the express terms of the policy, other instrument, or by operation of law) is an incident of ownership only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent.[2] Additionally the regulations provide some additional guidance, noting that the term is not limited to ownership of the policy in legal sense but rather speaks to the rights of the insured or his or her estate to the economic benefits of the policy.[3] “Incidents of ownership” include the power, individually or as trustee, to change the beneficiary, to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment thereof, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, and to obtain from the insurer a loan against the surrender value of the policy.[4]

In addition to direct ownership, incidents of ownership may be attributed to a decedent through certain powers held or ownership attribution. Where the decedent is a trustee of a trust holding a policy on his or her life, the ownership of the policy in the decedent’s capacity as trustee will be attributed to the decedent for estate tax purposes.[5] Under the regulations, a decedent is treated as having incidents of ownership of an insurance policy on the decedent’s life held in trust if, under the terms of the policy, the decedent, either alone or in conjunction with any person or persons, has the power (as trustee or otherwise) to change the beneficial ownership in 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]

Ownership may also be attributed from a corporation that holds a policy on the decedent’s life where the decedent owns more than 50% of the voting power of the corporation.[7] However, the regulations state that in the case of economic benefits of a life insurance policy on the decedent’s life that are reserved to a corporation of which the decedent is the sole or controlling shareholder, the corporation’s incidents of ownership will not be attributed to the decedent through the decedent’s stock ownership to the extent the proceeds of the policy are payable to the corporation rather than to a third party, shareholder, etc.[8]

Where a grantor of a trust retains the power to remove or replace the trustee, ownership of a policy held in the trust may be attributed to the grantor where such power is not properly limited.[9] While it was much more of concern in the past, Revenue Ruling 95-58 has now provided great comfort on this issue providing that a grantor’s holding of such power will not trigger estate inclusion as long as the power is properly limited such that the grantor cannot exercise the power to appoint related and subordinate trustees within the meaning of Section 672(c). While Revenue Ruling 95-58 was addressing estate inclusion under Sections 2036 and 2038, this rationale has been extended to Section 2042 in PLR 200314009.

This is just a sampling of some of issues regarding incidents of ownership that come up quite often, it is by no means meant to be an exhaustive list or a in depth discussion on each particular issue.

Conclusion

As noted above, the estate tax consequences of a policy owned directly by a decedent or one in which the decedent’s estate receives the proceeds are fairly straightforward and make sense, but there are numerous traps for the unwary when it comes to more complicated life insurance arrangements where the policy may be held in trust or in an entity. These more complicated structures include premium financed policies, life insurance split-dollar arrangements, private placement life insurance, use of life insurance to fund business arrangements (buy-sell agreements, security for business financing, and the like), and a number of other arrangements. Anytime a large life insurance policy is being considered, it pays to seek out some proper planning advice as to how to best hold said policy in a manner that does not cause a tax headache down the road.

Planning with an irrevocable life insurance trust (“ILIT”) is a great way to protect against estate inclusion, provided the ILIT is properly drafted. It’s not uncommon that a high earning individual may have a large life insurance policy and own it outright without thinking about the potential estate tax consequences. The use of a properly structure ILIT can mitigate this issue and provide a great way to provide for family in a generational type trust without any adverse estate tax consequences.

[1] https://esapllc.com/lifeinsurance2019/

[2] §2042(2).

[3] Treas. Reg. §20.2041-1(c)(2).

[4] Id.

[5] Treas. Reg. §20.2041-1(c)(4).

[6] Id.

[7] Treas. Reg. §20.2041-1(c)(6).

[8] Id.

[9] Rev. Rul. 95-58.