Life insurance can be a valuable strategy in estate planning when ownership and beneficiary designations are properly structured. Indeed, an important step in updating any estate plan is to confirm ownership of life insurance and beneficiary designations to assure the intended objectives are achieved from both a tax and nontax standpoints.
Generally, if an insured dies owning life insurance, those proceeds will not be subject to income tax, but will be included in the insured’s estate for federal estate tax purposes. In other words, the value of any death benefit paid from a life insurance policy owned by the insured at his/her death is received income tax-free, but is added to the insured’s other assets to determine whether or not an estate tax is payable (i.e., an estate tax can be payable if the decedent’s entire estate exceeds the applicable estate tax exemption – currently $5,430,000). One strategy to avoid the proceeds being included in the insured’s estate is to not have the insured own the policy, nor possess any “incidents of ownership” over the policy as defined under the Internal Revenue Code. Incidents of ownership include such rights as the ability to surrender the policy, borrow from the policy cash surrender value, designate beneficiaries, or pledge the policy as security for a debt.
To avoid potentially adverse estate tax consequences, many insureds will create an irrevocable life insurance trust (“ILIT”), which is a special type of trust specifically intended to be the owner and beneficiary of life insurance. Because of how the ILIT is structured (including that the insured is not a trustee or a beneficiary, nor has any incidents of ownership), the death proceeds will not be included in the insured’s estate for estate tax purposes.
Ideally, the ILIT will be the applicant, owner, and beneficiary of a new policy to be purchased. This ensures that the death benefits are received by the ILIT estate tax-free from day one. However, what about an existing policy that is owned by the individual insured? Can the insured transfer it to a new ILIT that he intends to create to avoid the estate tax? The answer is “yes,” although for an existing policy that is gifted to an ILIT, the insured must survive for a period of three years from the date of the gift to avoid estate tax inclusion. The three year “lookback” rule is a provision in the Internal Revenue Code that was generally designed to prevent a death bed gift of the policy that would exclude the proceeds from the decedent’s estate.
An alternative to gifting the policy to the ILIT that avoids application of the three year rule is for the insured to sell the existing policy to an ILIT, where the ILIT also qualifies as a “grantor trust” for income tax purposes. For the sale of the policy to an ILIT to avoid the three year rule, the policy must be sold for fair market value. Depending upon the type of the policy and the insured’s age and health, determining fair market value can be somewhat difficult. However, many individuals utilize the sale strategy in an effort to avoid the three year rule.
Once the insurance policy is owned by the ILIT, care must be taken with respect to the premium payment process to avoid adverse gift and/or estate tax consequences. If the insured desires to pay the premium, the insured should make a gift of the premium payment amount to the trustee of the ILIT. The trustee of the ILIT will in turn use the gift to pay the premiums to the insurance company. The contribution to the ILIT from the insured is a gift to the beneficiaries of the ILIT. For the gift to be eligible for the gift tax annual exclusion and, therefore, not a taxable gift, the amount, when combined with other gifts by the insured during the year to each individual beneficiary, must not exceed the gift tax exclusion amount for the year, which is currently $14,000. In addition, the trust beneficiary must have a present interest in the amount gifted. For a contribution into an ILIT to qualify as a present interest, the beneficiary must have the present right to withdraw the amount gifted. Written notice of that withdrawal right should also be provided from the trustee to the beneficiary.
Often, individuals will hold life insurance policies in an ILIT, anticipating that those proceeds will be used to pay federal estate taxes upon the insured’s death. Technically, however, the ILIT cannot direct the proceeds to be used to pay the insured’s estate taxes, as that would result in the insured having an incident of ownership, thus causing the proceeds to be subject to additional estate tax. What typically happens is that the ILIT would receive the death benefit and in turn loan those proceeds to the insured’s estate, purchase assets from the insured’s estate, or distribute the proceeds to the ILIT beneficiaries, who often are the same beneficiaries of the decedent’s estate.
Generally, if an insured is the owner of a policy insuring his/her life, those proceeds will not be subject to income tax. However, if a non-insured is an owner of the policy there are certain circumstances under which the proceeds could be subject to income tax. For instance, if the insured sells the policy (other than to an ILIT that is a grantor trust, as described above, and other limited exceptions), the purchaser will be deemed to have acquired the policy for value and the proceeds received will be subject to income tax. This is known as the “transfer for value rule,” and must be carefully considered in connection with any transfer of a policy where consideration is involved to avoid the proceeds being subject to income tax.
The above is a very general outline of the many complex rules applicable to the taxation of life insurance. Please contact one of the members of our Tax Practice Group with any specific questions.