In addition to special favorable capital-gains tax treatment for “community property” (Chapter 6) and special estate-tax treatment for property left in an “exemption trust,” (Chapter 9) the IRS also provides special estate tax treatment for life insurance in certain limited circumstances.
Life insurance proceeds are only included in a deceased person’s estate if: i) at the time of death, the person had “incidents of ownership” over the policy; or ii) an existing life insurance policy is transferred to an Irrevocable Life Insurance Trust (ILIT) within three years of death. The theory is that only property belonging to the deceased person is subject to tax, so that if the deceased person did not own the policy or act in some manner that was equivalent to ownership, then it is unfair to charge an estate tax.
Logically, one solution is to simply have someone else buy the life insurance policy and pay the premiums. Unfortunately, if the beneficiaries are going to be the insured person’s children, it is unlikely that they will independently go out and buy a life insurance policy, and often they lack adequate funds to pay for the policy. One common solution to remove life insurance proceeds from the estate of a deceased person , is for the other spouse to purchase the insurance. Thus, Mrs. Jones would buy a life insurance policy on Mr. Jones’ life, and Mr. Jones would buy a policy on Mrs. Jones’ life with the children as the beneficiaries of the policies.
Alternatively, Mr. and Mrs. Jones could create an irrevocable “life insurance trust.” They should name an independent trustee (often the Trust Dept. at a bank or a CPA), and would give the trustee enough money to buy the policies and pay the first year’s insurance premiums. Then, each year, Mr. and Mrs. Jones could make a gift to the trust adequate to fund the next year’s insurance premiums.
“Incidents of Ownership”
Unfortunately, estate planning to avoid taxes on life insurance is made more complex by broad IRS rules used to decide whether a deceased person had “incidents of ownership” over a policy.
The most obvious evidence of “ownership” is the name on the policy. If the policy says that it is owned by Mrs. Jones, and it insures the life of Mr. Jones, that should be enough. But it’s not.
The IRS also looks to see who paid for the insurance premiums, and from what source. If the insurance premiums were paid by Mr. Jones, or if Mrs. Jones paid the premiums from a community checking account, the IRS will assert that Mr. Jones owned the policy because his money was used to pay the premiums.
A person also has “incidents of ownership” if they have the right to change a beneficiary, or the right to borrow against the policy’s cash value, among other things.
In several published cases, many careful steps were taken to remove ownership of a policy from a particular person, but then some simple act (such as paying a premium or designating a new beneficiary) resulted in the insurance being included in the person’s estate, causing a large increase in estate taxes.
Effect of Insurance Inclusion in Estate
The practical effect of having life insurance included in a person’s taxable estate is to substantially increase the amount of estate taxes due, in direct proportion the amount of the insurance proceeds and the applicable marginal estate-tax bracket. Thus, if a person dies with a $500,000 estate plus a $500,000 life insurance policy, the tax difference would be $125,250. If a person died with a $3 million estate plus a $500,000 policy, the tax difference would be $275,000.