Avoiding Inclusion of Life Insurance Proceeds in Estate

IRC Sec. 2042 provides that all policies of insurance received by or “for the benefit of” the estate are included in the decedent’s gross estate. Proceeds paid to beneficiaries are also includible if the decedent assigned the policy but possessed any “incidents of ownership” at the time of death. Since the definition of that term is not particularly intuitive, it is essential not to run afoul of the definition as understood by the IRS.

Incidents of ownership include (a) a reversionary interest worth more than five percent of the value of the policy immediately before the decedent’s death; (b) the right to change a beneficiary; (c) the right to surrender or cancel the policy; (d) the right to revoke the policy; or (e) the right to obtain a loan from the policy. Although some incidents of ownership, such as retaining the right to borrow from the policy, clearly benefit the insured, Reg. Sec. 20.2042-1(c)(4) provides that the hallmark of “incidents of ownership” is the power to change beneficial enjoyment, rather than the retention by the insured of a beneficial interest. Generally, the grantor should avoid naming himself as sole trustee in order to avoid retaining unwanted “incidents of ownership.”

A gift in trust requiring the beneficiary to use the proceeds to pay estate tax obligations is “for the benefit” of the estate, and is includible. To avoid this problem, the trustee should be given the the power, exercisable in his absolute discretion, to lend money to the estate or to purchase assets from the estate. Since the trustee would not be under a legal obligation to lend money to the estate, the insurance proceeds would not be included in the decedent’s gross estate. If utilized, this technique may avoid the necessity of the executor selling a family business or other assets which might be difficult of valuation, or illiquid, to pay estate taxes.

If the decedent retains ownership or incidents of ownership, or dies within three years of making an assignment of an insurance policy, the insurance proceeds will be included in the gross estate. It is therefore important that the decedent’s Will make provision for whether or not the beneficiary is liable for estate taxes attributable to the insurance proceeds. If the Will is silent, IRC Sec. 2206 provides that the executor may recover from the beneficiary a pro rata portion of the total federal estate tax paid. New York case law follows this rule. However, if the decedent wishes that the beneficiary retain all proceeds with the estate tax liability to be paid by the residuary estate, the Will should so state.

To avoid the three year rule when the grantor wishes to make a gift in trust of an insurance policy, the grantor should direct the trustee (other than the grantor) of a newly formed irrevocable life insurance trust (in which the grantor retained no incidents of ownership) to purchase a new life insurance policy on the life of the grantor. Since the grantor never owns the policy, even if he dies within three years, the policy proceeds will not be included in his gross estate. This technique will only work with a new policy, however.

Avoidance of estate tax in the surviving spouse’s estate is also  important. The decedent’s Will may direct that the proceeds of his policy be held in trust, with the surviving spouse allowed an income interest in trust assets. If a QTIP election were made by the decedent’s executor, or if the surviving spouse were granted either a power to invade the corpus of the trust or a general power of appointment, inclusion in her estate would be unavoidable. Conversely, if no marital deduction were claimed by the estate of the decedent, and the surviving spouse’s right to invade the trust corpus were limited by an “ascertainable standard” for her health, education, support, or maintenance, inclusion in her estate could be avoided. Moreover, the surviving spouse could be given a noncumulative yearly right to withdraw the greater of 5 percent of the balance of the proceeds, or $5,000, without risking inclusion in her estate.

Premiums paid for by the trustee from funds provided by the grantor will result in no taxable gift if the $10,000 annual exclusion is utilized. To convert the future gift of premiums into one of a “present interest” which qualifies for the annual exclusion, each beneficiary must be given a yearly right of withdrawal in writing. This right may lapse after 60 days.

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