The Estate, Gift, and Income Tax Consequences of Utilizing Life Insurance in an Estate Plan

The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $13.61 million.

For individuals that may be subject to the estate and gift tax, there are a number of planning opportunities available to mitigate the harsh consequences of the estate and gift tax. One method that may potentially be utilized is life insurance. Life insurance is a tax-favored asset. Why? First, the increase in its cash value (its “inside buildup”) accumulates tax-free, as long as it remains in the policy. Second, in most cases, the proceeds pass to the beneficiary free of income tax and, if proper steps are taken, free of estate tax. Most of the estate planner’s efforts regarding life insurance are directed toward keeping the proceeds out of the insured’s estate. This article discusses how grantor retained annuity trusts may be utilized to avoid the estate and gift tax.

Estate Tax Considerations

Many are surprised to learn that life insurance is generally subject to the U.S. estate tax.
Life insurance is generally included in the insured’s estate for estate tax purposes if the proceeds are receivable by the personal representative of the insured’s estate (whether or not the insured’s estate is the designated beneficiary of the policy). Life insurance is also taxable in the estate of the insured if the insured has any “incidents of ownership” in the policy. In community property states, however, only one-half of the proceeds payable to a decedent’s estate or subject to the insured’s incidents of ownership are includible in the decedent’s estate, if the local community property law provides that one-half of the proceeds belong to the decedent’s spouse. The Internal Revenue Code says that a deceased person who kept any “incidents of ownership” of a transferred life insurance is still considered to own the policy for purposes of the estate tax.

“Incidents of ownership” include rights to name the beneficiary, surrender or cancel the policy, assign the policy, pledge the policy for a loan, or otherwise enjoy the economic benefits of the policy. If the insured has an option to acquire an insurance policy on his life for less than the fair market value of the policy, he may have an incident of ownership over the policy.

Incidents of Ownership Held by Entities

Corporations

Incidents of ownership may, in certain circumstances, be attributed to the insured from entities in which the insured has an interest. If the insurance proceeds are payable to the corporation in which the insured holds an interest, the corporation’s incidents of ownership in the life insurance are not attributed to the insured. This rule avoids double estate taxation of the insurance proceeds, which are already indirectly included in the estate as part of the value of the deceased insured’s stock. However, to the extent that the insurance proceeds are payable to someone other than the corporation, the proceeds will be taxable in the insured’s estate if (1) he or she can personally exercise any incident of ownership in the policy (such as naming the beneficiary) or (2) even if he or she cannot personally exercise any incident, the corporation’s incidents of ownership are attributed to the insured because he is a controlling shareholder. The insured will be considered a controlling shareholder only if, at the time of his death, he or she owned stock possessing more than half of the voting of the corporation.

Partnerships

Incidents of ownership should not be attributed to a partner if the partnership is the beneficiary. Otherwise, double estate taxation of all or a portion of the proceeds would result because of the inclusion of the insurance proceeds in the estate along with the partnership interest, the value of which was proportionately increased by the partnership’s receipt and retention of the insurance proceeds. If the partnership is not the beneficiary, and the insured can actually exercise any incident of ownership, the policy will be includable in the insured’s estate. Moreover, even if the insured cannot personally exercise any incidents of ownership, but the partnership can, the insured might still be deemed to possess the partnership’s incidents of ownership, regardless of the amounts of his interest in the partnership.

Trusts

If the insured has a power of appointment over an insurance policy on his life, the policy may be included in his estate, since the insured has the power to direct the recipient of the proceeds. A “power of appointment, sometimes called a “power,” is the power to affect the beneficial ownership of property which one does not own- usually property owned by trust. A power by appointment may be exercisable during the exercising person’s lifetime (a “power by deed”), or by will (a “testamentary power”), or both. For example, if Trust A owns real property and Mom, at her discretion, can direct the trustee to distribute the real property to Some or Daughter, Mom has a power of appointment over the real property.

How to Avoid Bringing Life Insurance in a Decedent’s Estate

Life insurance policies are an important estate planning tool. If planned correctly, a life insurance policy and proceeds will not be included in an insured’s estate. Life insurance on a high net worth individual is usually held by an irrevocable life insurance trust (“ILIT”). A properly drafted ILIT can allow the proceeds of life insurance policies held in the trust to pass free of estate tax on the deaths of both the insured and the insured’s spouse, while providing financial support for the insured’s surviving spouse and descendants and/or liquidity fortaxes in the insured’s or surviving spouse’s estate.

A contributor to the ILIT (usually the insured) assigns an insurance policy to the trust. Or, in the alternative, the ILIT’s trust may buy the policy with trust cash (usually contributed by the insured). The insured is not the trustee and retains no benefits in the trust. During the insured’s lifetime, premiums are paid by the trustee with trust cash, which may be received by the trustee as gifts from the insured. The beneficiaries of the trust do not contribute to it. At the insured’s death, the insurance company pays the policy proceeds to the trust. The policy proceeds are thereafter held in trust for the benefit of the insured’s spouse, descendants, or other beneficiaries, as the trust instrument provides. If liquidity is needed in the insured’s estate, the trustee may use the proceeds to purchase assets from the insured’s estate or lend money to the insured’s estate, if the instrument permits.

The usual way to transfer a policy and or cash to pay premiums is by gift. One advantage of life insurance is that the gifts necessary to keep the ILIT out of the estate are measured by the value of the gifted premiums, or by the date-of-gift value of the gifted premiums, or by the date-of-gift value of the policy, in the case of a gift of an existing policy. Transfers to the trust for the purpose of paying premiums may be structured in such a way that transfers to the trust qualify for the annual exclusion of $18,000 (for the 2024 calendar year) for gift tax purposes.

Gift Tax Consideration

If an insured gives a permanent life insurance policy to another person, including a beneficiary, the transaction is regarded as a gift for purposes of the gift tax. Gifts of a life insurance policy are generally subject to the same rules that apply to other gifts. If an insured relinquishes rights under an insurance policy in favor of another for less than full and adequate consideration, there is a taxable gift. The value of an unmatured insurance policy for gift tax purposes is generally its replacement cost according to the regulations, however, when a contract has been in force for some time and the policy is paid, the replacement cost is not readily ascertainable. In such instances, the value is usually the “interpolated terminal reserve value” at date of transfer plus the gross premium that is still unearned. See Treas. Reg. Sections 20.2031-6(a)(2) and 25.2512-6(a). The interpolated terminal reserve is a value calculated from a life insurance policy’s reserve value at a specific point in time. The interpolated terminal reserve must be obtained from the insurance company, and will usually approximate the cash surrender value of the policy. The value of a new policy is the premium paid. The value of a term policy is generally the unearned premium at the date of transfer. If an employee’s interest in a group term policy is assigned, a gift is made to the assignee each time the employer pays a premium.

Income Taxation of Life Insurance Proceeds

Life insurance proceeds generally do not constitute taxable income. There are, however, a number of exceptions to this general rule. Under the transfer-for-value rule, if a policy has been sold during the insured’s life, then the proceeds will generally be taxable income to the beneficiary, except to the extent of the transferee’s investment in the contract. The following policy transfers are excepted from the transfer for value rule: 1) transfers to the insured; 2) transfers to a partner of the insured; 3) transfers to a partnership in which the insured is a partner; 4) transfers to a corporation in which the insured is a shareholder or officer; and 5) transfers in which the basis of the transferee is determined wholly or partly by reference to the transferor’s basis (the “tacked-basis exception).

Insurance policies do not just provide death benefits. During an insured’s lifetime, a non-term insurance policy may increase in value. The insurance company may pay dividends to the owner of the policy or, at the owner’s election, may apply them to the payment of future premiums or installments due on policy loans. If the owner needs to raise cash, he or she may borrow money against the cash surrender value of the policy or simply surrender the policy. These and other events that occur before the policy matures may have income tax consequences.

A critical fact in determining the income tax consequences of owning a life insurance contract is the amount of the owner’s “investment in the contract.” This concept is equivalent to the “basis” of other assets. Generally, the owner’s investment in an insurance contract is the total amount of premiums or other consideration paid for the contract, reduced by total amounts ever received under the contract which were not included in taxable income.

Sometimes high-net-worth individuals will overfund a life insurance policy then take loans from against the policy. In these cases, the Internal Revenue Service (“IRS”) may classify the policy as a Modified Endowment Contract or (“MEDs”). An insurance policy is a MEC if the total premiums paid at any time during the first seven contract years exceed the total net level premiums which would have been paid by that time the policy provided for paid-up future benefits in the face amount of the policy after the payment of seven level annual payments. An insurance policy is also a MEC if it is received in exchange for a MEC, For example, suppose that father has a policy with a $1,000,000 face amount. The policy is a MEC if, at any time during the first seven years of the policy, the amount of the total premiums paid exceeds the total amount of premiums which would have been required to buy an $1,000,000 policy that is paid up after seven years. (“Paid up” means that no further premiums are required to continue the policy in effect, regardless of the investment performance of the policy or the company).

If a policy is a MEC, any distribution from the policy during the insured’s lifetime will be treated as follows:

1. The distribution will be treated as taxable income, to the extent that the cash surrender value before the distribution exceeds the owner’s investment in the contract; for this purpose, distribution includes policy loans and dividends retained by the insurer to pay principal or interest on the policy loan.
2. Any distribution in excess of the above income amount will be considered a nontaxable return of basis to the extent of the investment in the contract.
3. Further distributions will be included in gross income.
4. Additionally, a ten percent penalty tax is imposed on any distribution that is treated as income unless (1) the recipient is disabled or at least 59 ½ years old or (2) the distribution is part of a series of substantially equal payments made at least once a year for the recipient’s life or life expectancy or the joint lives or joint life expectancy of the recipient and her beneficiaries. See IRC Section 72(v).

Use of Joint and Survivor Policies

Many high-net-worth couples do not need a policy to take care of the support needs of the surviving spouse; rather, their primary concern is to provide for the payment of estate taxes, for the replacement of assets left to charity, or for the support of their children and grandchildren, as the case may be. Hence, a popular technique is to purchase a policy which matures on the death of the survivor of the husband or wife.

Riders are also available for some joint and survivor policies: (1) to provide some benefit on the death of the first spouse to die (so that the cash can be used to fund future premiums or to buy a split-dollar policy which is being rolled out); (2) to provide increased benefits to cover estate tax attributable to the policy if both spouses die within three years of obtaining the policy; and (3) to split the policy into two individual policies on a divorce.

Split-Dollar Funding- The Alternative for Funding of Life Insurance Premiums

Many life insurance policies used as part of an estate plan will be owned by an ILIT to minimize the risk of an estate tax assessment. However, if life insurance premiums are greater than the $18,000 gift tax exclusion, one popular way to fund the ILIT is to utilize split dollar funding. Split dollar funding is a technique in which a funding party, typically the grantor of an ILIT or an entity in which the grantor has an ownership interest, advances money to pay premiums in return for a promise by the trust to repay the advanced premiums upon the triggering of certain triggered events, such as the death of the insured. The attractive feature of split-dollar funding in estate planning is the fact that the amount of the gift made to the third-party owner of the term portion of the policy is not measured by the premium rather, it is measured by the cost of term insurance for a standard-risk insured, which will generally be significantly less than the premium cost.

Conclusion

Life insurance is often utilized as part of an estate plan. However, The taxation of life insurance can be complicated. If you intend to utilize life insurance as part of an estate plan, you should consult with a tax attorney that understands the estate, gift, and income tax consequences associated with life insurance policies.

Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.