There’s a lot to keep straight when it comes to estate planning and taxes. For many individuals, it can feel overwhelming enough for them to opt out of the entire process. Even though estate planning can be daunting, there are a few basic facts that help keep it simple. In the article below, “12 more estate planning tax facts,” authors, Robert Bloink and William H Byrnes, layout the estate planning tax basics and make the thought of death and taxes an encouraging space to take charge of one’s life’s work.
Estate planning is a complicated business. Before you sit down with clients, find out what Uncle Sam will demand if a life insurance policy or an annuity is part of their estate, or part of a recent inheritance.See also: 10 estate planning tax facts you need to know
1. When are death proceeds of life insurance includable in an insured’s gross estate?
They are includable in the following four situations:
(1) The proceeds are payable to the insured’s estate, or are receivable for the benefit of the insured’s estate.
(2) The proceeds are payable to a beneficiary other than the insured’s estate but the insured possessed one or more incidents of ownership in the policy at the time of the insured’s death, whether exercisable by the insured alone or only in conjunction with another person.
(3) The insured has made a gift of the policy on his or her life within three years before his or her death.
(4) The insured has transferred the policy for less than an adequate consideration (i.e., the transaction was not a bona fide sale) and the transfer falls within one of the rules for includability contained in IRC Sections 2035, 2036, 2037, 2038, or 2041. Under these circumstances, the value of the proceeds in excess of the value of the consideration received is includable in an insured’s estate. A grantor may retain the power to substitute property of an equivalent value. Such a power, in and of itself, generally does not cause the trust corpus to be includable under IRC Section 2036 or 2038.
2. What are the incidents of ownership that, if held by an insured, will cause life insurance proceeds to be includable in the insured’s estate?
Proceeds are includable in an insured’s gross estate if the insured possesses any of the following incidents of ownership at his or her death:
- the right to change the beneficiary;
- the right to surrender or cancel the policy;
- the right to assign the policy;
- the right to revoke an assignment;
- the right to pledge the policy for a loan; or
- the right to obtain a policy loan.
The reservation of a right to make premium loans has been held to be an incident of ownership. A right to change contingent beneficiaries, who are to receive benefits after the primary beneficiary’s death, also is an incident of ownership.
The mere right to change the time or manner of payment of proceeds to the beneficiary, as by electing, changing, or revoking settlement options, has been held an incident of ownership, but the Tax Court and the U.S. Court of Appeals for the Third Circuit have held to the contrary. (In 1981, the IRS reiterated its opposition to the Third Circuit’s holding in Connelly, and indicated its intent to continue to oppose that result in all circuits except the Third (Pa., Del., N.J., Virgin Islands).
According to a Technical Advice Memorandum, trust provisions that changed the beneficial interest from a decedent’s spouse to the decedent’s children if the decedent and the decedent’s spouse became divorced were not the equivalent to a retained incident of ownership that would bring the life insurance proceeds into the decedent’s estate. The memorandum implies that the result would have been different if the trust had provided that the beneficial interest would revert to the decedent upon divorce.
The right to receive disability income is an incident of ownership if payment of disability benefits would reduce the face amount payable at death. But where an employer corporation owned the policy and the insured employee was entitled to benefits under a disability income rider, the IRS did not claim that the right to the disability income was an incident of ownership that would cause the proceeds to be includable in the insured’s gross estate.
A more than 5 percent reversionary interest in the proceeds is an incident of ownership. When a wife, who owned insurance on her husband’s life and who was the primary beneficiary, changed the contingent beneficiary from her estate to whomever the insured named in his will, the IRS ruled that the insured did not possess at his death an incident of ownership.
3. What are the incidents of ownership of employer-paid death benefits that would cause life insurance proceeds to be includable in the insured’s estate?
An employee insured’s right to designate the beneficiary of an employer-paid death benefit is not treated as an incident of ownership in the insurance funding the benefit if the employer is sole owner of the policy and sole beneficiary for its exclusive use. The IRS has taken the position that if the insured under a corporation-owned policy has an agreement with the corporation giving the insured the first right to purchase the policy for its cash surrender value if the corporation decides to discontinue the coverage, the purchase option is an incident of ownership. The Tax Court has held, however, that the insured’s contingent purchase option as described in Revenue Ruling 79-46 is not an incident of ownership within the meaning of IRC Section 2042(2).
The IRS also has ruled that where, under an insured stock redemption agreement, a stockholder had the right to purchase the policies the corporation owned on the insured’s life if the insured ceased being a stockholder, such contingent purchase option was not an incident of ownership in the insurance. An insured who held the right to purchase a policy upon termination of a buy-sell agreement did not possess incidents of ownership so long as the contingency had not occurred, but would possess incidents once the agreement was terminated.
Also, a shareholder was not treated as holding incidents of ownership in a life insurance policy where the shareholder could purchase a corporate-owned policy upon disability, or upon a cross-purchase of the shareholder’s stock if the shareholder dissented to sale of the corporation to a third party or a public offering. However, an insured was treated as holding incidents of ownership in a policy held in a trusteed buy-sell arrangement where the insured was considered to have transferred the policy to the trust and retained the right to purchase the policy for its cash surrender value.
The right to receive dividends has been held not to be an incident of ownership in the policy. It has been held that if the insured has the power to terminate the interest of the primary beneficiary with only the consent of the secondary beneficiary, the insured has an incident of ownership. However, a sole shareholder would not be treated as holding incidents of ownership in a life insurance policy on the shareholder’s own life where a collateral consequence of a termination of an employee’s employment would be a termination of the employee’s option agreement to purchase the shareholder’s stock with a corresponding change in beneficiary of the insurance proceeds held in an irrevocable life insurance trust created by the employee.
The assignment of a life insurance policy by a third-party owner as an accommodation to the insured to cover the insured’s debts does not in itself create in the insured an incident of ownership. But if a policy owner collaterally assigns a policy as security for a loan and then makes a gift of the policy subject to the assignment, the donor will be deemed to have retained an incident of ownership.
Where an insurance funded buy-sell agreement prohibited each partner from borrowing against, surrendering, or changing the beneficiary on the policy each owned on the life of the other partner without the insured’s consent, the Tax Court held that the decedent-insured did not possess an incident of ownership in the policy insuring the decedent-insured’s life. However, it has been reported that the IRS, citing an internal ruling dated January 7, 1971, has declined to follow the decision.
An insured was treated as holding incidents of ownership in a policy held in a trusteed buy-sell arrangement where the trust could only act as directed by the shareholders through the buy-sell agreement and the insured could thus withhold consent to the exercise of policy rights.
Where an insured absolutely assigned a policy that required the insured’s consent before the policy could be assigned, or the beneficiary changed, to someone who had no insurable interest in the insured’s life, IRS ruled that the insured had retained an incident of ownership.
Similarly, the Tax Court has held that an employee’s right to consent to a change of beneficiary on a split dollar policy owned by the employee’s employer on the employee’s life is an incident of ownership. The Tax Court also has held that where the insured assigned policies, retaining the right to consent to the assignee’s designating as beneficiary, or assigning the policies to, anyone who did not have an insurable interest in the insured’s life, the assignee’s act of designating an irrevocable beneficiary did not eliminate the insured’s retained incidents of ownership. The Third Circuit reversed the Tax Court in this case, however, taking the position that because under the facts presented the insured could not have enjoyed any economic benefit from exercising the insured’s veto power over the designation of beneficiaries or assignees, the insured’s retained power did not amount to an incident of ownership. The insured’s right to purchase the policy from an assignee was treated as equivalent to the right to revoke an assignment, which is an incident of ownership.
4. Can an insured remove existing life insurance from his or her gross estate by an absolute assignment of the policy but retaining a reversionary interest?
A reversionary interest in a policy is an incident of ownership if, immediately before the insured’s death, the value of the reversionary interest is worth more than five percent of the value of the policy. The insured will have no such reversionary interest, however, if the policy is purchased and owned by another person, or if the policy is absolutely assigned to another person by the insured. Regulations state that the term “reversionary interest” does not include the possibility that a person might receive a policy or its proceeds by inheritance from another person’s estate, by exercising a surviving spouse’s statutory right of election, or under some similar right. They also state that, in valuing a reversionary interest, interests held by others that would affect the value must be taken into consideration. For example, a decedent would not have a reversionary interest in a policy worth more than 5 percent of the policy’s value, if, immediately before the decedent’s death, some other person had the unrestricted power to obtain the cash surrender value of the policy; the value of the reversionary interest would be zero.
An insured was treated as holding a reversionary interest in a policy held in a trusteed buy-sell arrangement where the insured was considered to have transferred the policy to the trust and retained the right to purchase the policy for its cash surrender value upon termination of the buy-sell agreement. However, a policy held in a trusteed buy-sell arrangement would not be includable in an insured’s estate under IRC Section 2042 where (1) proceeds would be received by a partner’s estate only in exchange for purchase of the partner’s stock, and (2) all incidents of ownership would be held by the trustee of the irrevocable life insurance trust.
5. If life insurance proceeds are required under the terms of a property settlement agreement or a divorce decree to be paid to certain beneficiaries, are the proceeds includable in the insured’s estate?
Includability of Proceeds or Premiums
The IRS has ruled that where a divorced wife had an absolute right, under terms of a property settlement agreement incorporated by reference in a divorce decree, to annuity payments after the death of her former husband, and such payments were to be provided by insurance on his life maintained by him for that purpose, the former husband possessed no incidents of ownership in the insurance at his death. As a result, no part of the insurance proceeds was includable in his estate. Also, the Tax Court has held that where a divorced husband was required under a property settlement agreement to maintain insurance on his life payable to his former wife, if living, but otherwise to their surviving descendants or to his former wife’s estate if there were no surviving descendants, the insured possessed no incidents of ownership in the insurance. The insurance, in other words, was not merely security for other obligations. In another case, the Tax Court held that where an insured was subject to a court order requiring the insured to maintain insurance on his life payable to his minor children, such court order, operating in conjunction with other applicable state law, effectively nullified incidents of ownership the insured would otherwise possess by policy terms.
When, on the other hand, the divorced husband was merely required to maintain a stated sum of insurance on his life payable to his former wife so long as she lived and remained unmarried, the insured was held to have retained a reversionary interest sufficient in value to make the proceeds includable in his estate It also has been held that where, pursuant to a divorce decree, the proceeds of insurance maintained by a divorced husband on his own life to secure alimony payments are paid following the insured’s death directly to the former wife, the proceeds are includable in the insured’s estate. The Board of Tax Appeals reasoned that because the proceeds satisfy a debt of the decedent or his estate, the result is the same as if the proceeds are received by the decedent’s executor.
6. May a charitable contribution deduction be taken for the gift of a life insurance policy or premium? May a charitable contribution deduction be taken for the gift of a maturing annuity or endowment contract?
Yes, subject to the limits on deductions for gifts to charities.
The amount of any charitable contribution must be reduced by the amount of gain that would have represented ordinary income to the donor had the donor sold the property at its fair market value. Gain realized from the sale of a life insurance contract is taxed to the seller as ordinary income. Therefore, the deduction for a gift of a life insurance policy to a charity is restricted to the donor’s cost basis in the contract when the value of the contract exceeds the premium payments. Thus, if a policy owner assigns the policy itself to a qualified charity, or to a trustee with a charity as irrevocable beneficiary, the amount deductible as a charitable contribution is either the value of the policy or the policy owner’s cost basis, whichever is less. It is not necessary, however, to reduce the amount of the contribution when, by reason of the transfer, ordinary income is recognized by the donor in the same taxable year in which the contribution is made. Letter Ruling 9110016, which denied a charitable deduction when a policy was assigned to a charity that had no insurable interest under state law, was revoked after the taxpayer decided not to proceed with the transaction.
Premium payments also are deductible charitable contributions if a charitable organization or a trustee of an irrevocable charitable trust owns the policy. It is not settled whether premium payments made by the donor to the insurer to maintain a policy given to the charity, instead of making cash payments directly to the charity in the amount of the premiums, are gifts to the charity or merely gifts for the use of the charity. The difference is important when the donor wishes to take a charitable deduction of more than 30 percent of the donor’s adjusted gross income. When the policy is merely assigned to a charitable organization as security for a note, the premiums are not deductible even though the note is equal to the face value of the policy and is payable from the proceeds at either the insured’s death or the maturity of the policy. The reason is that the note could be paid off and the policy recovered after the insured has obtained charitable deductions for the premium payments. A corporation, as well as an individual, can take a charitable contribution deduction for payment of premiums on a policy that has been assigned to a charitable organization.
Planning Point: For a number of reasons, including concerns over the rules limiting a tax deduction to the lesser of fair market value or basis and because of the uncertainty regarding tax consequences of premium payments made by the donor directly to the insurance company on a policy owned by a charity, it is generally preferable for a donor to make cash gifts to a charity and allow the charity to pay premiums on policies owned by the charity. It is important, however, not to require that the cash gifts be used for premium payments.
7. When can death proceeds of community property life insurance payable to someone other than the surviving spouse be includable in the surviving spouse’s gross estate?
If the insured elects to have death proceeds held under an interest or installment option for the insured’s surviving spouse with proceeds remaining at the surviving spouse’s death payable to another, a portion of such remaining proceeds may be includable in the surviving spouse’s gross estate under IRC Section 2036 as a transfer by the surviving spouse of his or her community property interest with life income retained. Such a transfer will be imputed to the surviving spouse if under state law the insured’s death makes the transfer absolute. The amount includable is the value of the surviving spouse’s community half of the remaining proceeds going to the beneficiary of the remainder interest, less the value (at the insured’s death) of the surviving spouse’s income interest in the insured’s community half of the proceeds. In states where the noninsured spouse has a vested interest in the proceeds of community property life insurance (e.g., California and Washington), a gift of the surviving spouse’s community property interest should not be imputed to the surviving spouse unless the surviving spouse has consented to or has acquiesced in the insured’s disposition of the proceeds. But see, Est. of Bothun v. Comm., decided under California law, where an IRC Section 2036 transfer was imputed to the surviving spouse-primary beneficiary when, because the surviving spouse failed to survive a fifteen-day delayed payment clause, proceeds were paid to the contingent beneficiary. The opinion contained no suggestion of any evidence that the noninsured spouse had consented to the delayed payment clause.
The IRS has ruled that where community property life insurance is payable to a named beneficiary other than the noninsured spouse, if deaths of the insured and the insured’s spouse occur simultaneously when both possess the power to change the beneficiary in conjunction with the other, one-half of the proceeds is includable in each spouse’s estate without regard to whether local law provides a presumption as to survivorship.
8. How is community property life insurance taxed when the spouse who is not the insured dies first?
One-half of the value of the unmatured policy is includable in the non-insured spouse’s gross estate. The value of the policy is determined under Treasury Regulation Section 20.2031-8. The amount includable in the estate of the surviving insured spouse upon his or her subsequent death is determined by applying state law to the facts presented to ascertain the extent to which the proceeds are treated as community property or as separate property of the insured.
9. What are the estate tax results when a decedent has been receiving payments under an annuity contract?
If a decedent was receiving a straight life annuity, there is no property interest remaining at the decedent’s death to be included in the decedent’s gross estate.
If a contract provides a survivor benefit (as under a refund life annuity, joint and survivor annuity, or installment option), tax results depend on whether the survivor benefit is payable to a decedent’s estate or to a named beneficiary and, if payable to a named beneficiary, on who paid for the contract.
If payable to a decedent’s estate, the value of the post-death payment or payments is includable in the decedent’s gross estate under IRC Section 2033 as a property interest owned by the decedent at the time of his or her death. If payable to a named beneficiary, the provisions of IRC Section 2039(a) and IRC Section 2039(b) generally apply and inclusion in the gross estate is determined by a premium payment test. Thus, if a decedent purchased the contract (after March 3, 1931), the value of the refund or survivor benefit is includable in the decedent’s gross estate.
In the event a decedent furnished only part of the purchase price, the decedent’s gross estate includes only a proportional share of this value.
The foregoing rules do not apply to death proceeds of life insurance on the life of a decedent. In addition, special statutory provisions apply to employee annuities under qualified pension and profit-sharing plans, to certain other employee annuities, and to individual retirement plans.
See also: 8 annuity tax facts you need to know
10. In the case of a joint and survivor annuity, what value is includable in the gross estate of the annuitant who dies first?
The value of a survivor’s annuity is includable in the deceased annuitant’s gross estate in proportion to his or her contribution to the purchase price of the contract. (This rule applies to contracts purchased after March 3, 1931).
Thus, if a deceased annuitant purchased the contract, the full value of the survivor’s annuity is includable in his or her gross estate. If the survivor purchased the contract, no part of the value is includable in the deceased annuitant’s estate. If both contributed to the purchase price, only a proportionate part of the value is includable in the deceased’s estate.
For example, suppose that the decedent and his wife each contributed $15,000 to the purchase price of a joint and survivor annuity payable for their joint lives and the life of the survivor. If the value of the survivor’s annuity is $20,000 at the decedent’s death, the amount to be included in his gross estate is one-half of $20,000 ($10,000) since he contributed one-half of the cost of the contract.
In accord with this rule, if a joint and survivor annuity is purchased with community funds, only one-half of the value of the survivor’s annuity is includable in the gross estate of the spouse who dies first.
Where a joint and survivor annuity between spouses is treated as qualifying terminable interest property for gift tax purposes and the donee spouse dies before the donor spouse, nothing is included in the donee spouse’s estate by reason of the qualifying interest. Where the survivor is the deceased annuitant’s spouse, the value of the survivor’s annuity will qualify for the marital deduction if the contract satisfies applicable conditions.
Planning Point: A joint and survivor annuity between spouses usually will escape estate tax in both spouse’s estates because of the marital deduction and because the annuity ends at the survivor’s death.
11. Are death proceeds payable under a single premium annuity and life insurance combination includable in an annuitant’s gross estate?
Even though an insured-annuitant holds no incidents of ownership in a life insurance policy at death, the proceeds of the policy nevertheless are includable in his or her gross estate under IRC Section 2039 as a payment under an annuity contract purchased by the insured-annuitant.
In a case decided before IRC Section 2039 was enacted, the U.S. Supreme Court held that the proceeds were not includable in the insured-annuitant’s gross estate under IRC Section 2036 as property transferred by the insured-annuitant in which he retained a right to income for life.
If an insured-annuitant transfers a life insurance policy within three years before his or her death, the proceeds may be includable in the insured-annuitant’s gross estate under IRC Section 2035.
If an insured-annuitant owns a life insurance policy at death, the proceeds are includable in his or her gross estate either as property owned at the time of death or as a payment under an annuity contract purchased by the insured-annuitant.
12. If a decedent purchased an annuity on the life of another person, will the value of the contract be includable in his or her gross estate?
If a decedent purchased an annuity as a gift for another person and retained no interest in the annuity payments, incidents of ownership, or refunds, the value of the annuity ordinarily will not be includable in the decedent’s gross estate.
If a decedent has named him or herself as refund beneficiary, the value of the refund may be taxable in the decedent’s estate as a transfer intended to take effect at death. This rule is not applicable, however, unless the value of the refund exceeds 5 percent of the value of the annuity immediately before the donor’s death. Moreover, if the donee-annuitant has the power to surrender the contract or to change the refund beneficiary, it would appear that such a power would preclude taxation in the donor’s estate as a transfer to take effect at death.
Where a decedent retains ownership of a contract until death, the value in the decedent’s gross estate apparently would be the cost of a comparable contract at the time of the decedent’s death. In one case, however, where a decedent and his wife paid one-half the cost of an annuity for their son, reserving to themselves the right to surrender the contract, only one-half the surrender value was included in the decedent’s gross estate.