Irrevocable Life Insurance Trust
What is it?

An irrevocable life insurance trust (ILIT), sometimes referred to as a wealth replacement trust, is a trust that is funded, at least in part, by life insurance policies or proceeds. If properly implemented, an ILIT can help minimize estate taxes and provide a source of liquid funds to your estate for the payment of taxes, debts, and expenses.

Generally, assets you own at death are subject to federal estate tax. This includes life insurance policies and proceeds. Estates in excess of the exemption equivalent amount (in 2016, $5,450,000 plus any deceased spousal unused exclusion amount) may have to pay estate tax at rates as high as 40 percent. If you’re an insured individual whose estate will have to pay estate tax, your family may receive less money from your life insurance than you originally planned for.

An ILIT can solve this problem, and may be especially appropriate if your estate would not have to pay estate taxes were it not for the inclusion of the policy proceeds.

Although this discussion concerns federal estate taxes only, an ILIT can also help minimize state death taxes.

How does it work?

Because an ILIT is an irrevocable trust, policies and proceeds (and any other assets) held by the trust are considered owned by the trust entity and not owned by you. Since you won’t own the policy at your death, the proceeds will not be included in your estate. They will be received by the ILIT and ultimately pass to your family members undiminished by estate taxes. Your family members can use the proceeds to pay estate expenses. This may save your family members from having to sell assets at fire sale prices, and allow them to keep assets that may generate needed income or are valued family keepsakes. One key to this strategy is that you must relinquish all power over and benefits from the property in the trust.

In a typical scenario, an insurable person (the grantor) first creates an ILIT, names an independent trustee (e.g., a bank trust department), and names the beneficiaries of the trust (usually his or her spouse and/or children). The trustee then applies for life insurance on the grantor’s life and designates the ILIT as the sole beneficiary. The trustee also opens a checking account for the ILIT. The grantor gives the trustee funds for the initial premium, which the trustee deposits into the ILIT checking account. The trustee writes a check from the ILIT checking account, pays the premium to the insurance company, and coverage becomes effective. As premiums come due, the grantor and trustee repeat the same procedure. Whenever the ILIT receives funds from the grantor, the trustee provides a special notice (a Crummey notice) to each of the beneficiaries. This Crummey notice lets the beneficiaries know that they have a right to withdraw the recently deposited funds, but only within a certain limited time frame (e.g., 30 to 60 days). The trustee waits until this time frame passes before remitting the funds to the insurance company. This notice procedure serves to qualify the gift for the annual gift tax exclusion (see the section on Crummey withdrawal rights). At the grantor’s death, the ILIT trustee collects the total proceeds and distributes them to the beneficiaries according to the terms of the trust.

An ILIT can hold almost any type of life insurance policy, including a second-to-die (survivorship) policy. A second-to-die policy covers the lives of yourself and your spouse, and pays off at the death of the survivor. If your ILIT will hold this type of policy, extra care must be taken when drafting and funding the trust.
Why use an ILIT?

There are many reasons to use a trust rather than have an individual own your life insurance policy. For example, having your spouse own the policy may defeat the purpose of the ILIT, as the proceeds will be subject to estate taxes in his or her estate. Having an adult child or any other individual own the policy may expose the policy or proceeds to that individual’s creditors, or may create disharmony among family members. An ILIT can accomplish some or all of the following:

  • Avoid inclusion of the proceeds in your (and your spouse’s) estate
  • Make the cash liquidity provided by the total proceeds available to the estate of the insured
  • Insulate the proceeds from estate taxes over multiple generations
  • Provide professional management of the proceeds
  • Protect the policy and proceeds from future creditors and potential ex-spouses
  • Provide incentives to beneficiaries

Creating the ILIT

Trust must be irrevocable

To enjoy its benefits, a life insurance trust must be irrevocable. That means you (the grantor) can’t change the terms of the trust or the beneficiaries, end the trust, or retain any power over or interest in the trust. Further, any property transfers made to the trust must be complete and permanent. This also applies to your spouse if the ILIT is funded with a second-to-die policy.

Because it will be difficult, or even impossible, for you to make changes to the trust without adverse tax consequences, it’s important to build flexibility into the trust document. Be sure to consult an attorney experienced with ILITs.

Naming a trustee

Your choice of trustee, the person who will administer the trust, is an important decision. For the ILIT to be effective, you cannot serve as trustee, and you shouldn’t even retain the power to name yourself as trustee. The IRS has clearly stated that proceeds will be included in an insured’s estate if the insured serves as trustee. If the ILIT holds a second-to-die policy, your spouse cannot serve as trustee for the same reason.

The trust document should expressly prohibit the insured(s) from serving as trustee. Further, the trust document should contain language that limits your power to change the trustee. You can change the trustee so long as the successor trustee is not related or subordinate. The term “related or subordinate” includes spouses, parents, descendants, siblings, and employees, but not nieces, nephews, in-laws, or partners.

A noninsured spouse can serve as trustee, but it is not recommended. Remember, one key to an ILIT is relinquishing all control over and interest in the trust property. If your spouse is administering the trust, you may be regarded as retaining some control, albeit indirectly. If you choose this course, however, your spouse must not make any gifts to the trust. If your spouse is also a beneficiary, a co-trustee is recommended to handle distributions to your spouse, or a successor trustee should assume all duties at your death.

Other beneficiaries can serve without adverse tax consequences, but this is generally not a good idea because there may be conflicts of interest.

Other non-beneficiary family members or friends can serve as long as you trust them to perform their duties competently. A professional trustee may be the best choice because a professional will have the experience to properly administer your ILIT, and you can be fairly assured of competent asset management and impartiality.

The key duties of an ILIT trustee include:

  • Opening and maintaining a trust checking account
  • Obtaining a taxpayer identification number for the trust entity, if necessary
  • Applying for and purchasing life insurance policies
  • Accepting funds from the grantor
  • Sending Crummey withdrawal notices (see the section on Crummey withdrawal rights)
  • Paying premiums to the insurance company
  • Making cash value investment decisions
  • Claiming insurance proceeds at your death
  • Distributing trust assets according to the terms of the trust
  • Filing tax returns, if necessary

Naming the beneficiaries

To keep the proceeds out of your estate, do not name your executor, your estate, your creditors, or the creditors of your estate as beneficiaries of the trust. The proceeds will be considered payable to your estate if your ILIT requires the trustee to use the proceeds to pay your estate’s debts, taxes, or other obligations. If the ILIT merely gives the trustee the authority to pay such expenses, however, the proceeds will not be included in your estate unless the trustee actually uses them to satisfy such obligations. To make the proceeds available to your estate, the ILIT should include language that permits the trustee to buy property from your estate or make loans to the estate. If the trustee does either, the transaction must be completed in a reasonable, arm’s-length manner.

If you want to name your spouse as a beneficiary and also keep the proceeds out of your spouse’s estate, the ILIT must be drafted so that access by your spouse to the proceeds is limited. Your spouse can receive some or all of the annual income from the ILIT, but access to trust principal must be limited to ascertainable standards (i.e., for support, health, or education only). Further, your spouse can hold a right of withdrawal not to exceed the greater of five percent of the trust balance or $5,000 each year. Your spouse can also be given a limited (or special) power of appointment, but not a general power of appointment. In other words, your spouse can name subsequent beneficiaries, but cannot name himself/herself, his/her creditors, or the creditors of his/her estate.

Funding the ILIT

You can create an ILIT and leave it unfunded during your lifetime. An unfunded ILIT is one that holds a life insurance policy only, and does not hold any other assets. With an unfunded ILIT, you will need to gift money to the trust so the trustee can pay policy premiums. If the trust holds a permanent life insurance policy and the policy allows it, premiums can be paid with accumulated cash values or dividends, and you may not need to gift additional funds.

Alternatively, you can fund an ILIT during your lifetime with assets in addition to your life insurance policy. Funding an ILIT with income-producing assets can provide the trustee with the money needed to pay the policy premiums. An additional benefit of funding your ILIT is that any future appreciation in the assets will be sheltered from estate taxes, again because the trust is irrevocable. Funding your ILIT also allows you to coordinate the asset’s final disposition with the insurance proceeds.

After you die, the ILIT (unfunded or funded) will receive the policy proceeds and the trustee will administer them according to the terms of the trust. The trust can receive other assets at your death along with the insurance proceeds, such as assets poured over from your will, or death benefits paid by your employer or employer benefit plan. The trust terms can direct that the proceeds be distributed to the beneficiaries immediately, or the trust terms can direct that the proceeds remain in the trust and under the trustee’s management for a period of time before being distributed. The latter option may be desirable if you anticipate that your heirs might mismanage the funds or if your heirs are minor children.

Funding an ILIT with assets in addition to your life insurance policy may trigger gift tax and income tax consequences (see the section on Tax Considerations).

If you live in a community property state and your spouse is a beneficiary, do not fund the trust with community property. If you do, half of the insurance proceeds will be included in your spouse’s estate. To avoid this situation, be sure to initially fund the trust and make any subsequent contributions with separate property only.

The three-year rule

You may have existing life insurance policies you want to transfer to an ILIT. While this is possible (merely execute an absolute assignment of ownership form provided by the issuing insurer), it is not advisable because transferring existing policies triggers the three-year rule. This rule states that, if you transfer a life insurance policy to an ILIT within the three years preceding your death, all the proceeds will be brought back into your estate for estate tax purposes. Because of the three-year rule, it is not advisable to transfer policies unless you’re no longer insurable or can’t afford the cost of replacement policies.

Funding an ILIT with policies that have accumulated cash values may trigger gift tax consequences (see the section on Tax considerations).

You can avoid the three-year rule by allowing the trustee, on behalf of the trust, to apply for and purchase a new policy. If the trust owns the policy from the outset, the three-year rule will not apply. Because the purchase must be purely discretionary, be sure the trustee is not obligated to buy the policy, but is permitted to do so.

The ownership problem

To keep the proceeds out of your estate and your spouse’s estate, you and your spouse must not retain any incidents of ownership in the policies held by the trust. Though the IRS doesn’t specifically define incidents of ownership, the phrase generally refers to any rights you retain that might benefit you economically. Those rights include:

  • The right to transfer, or to revoke the transfer, of ownership rights
  • The right to change certain policy provisions
  • The right to surrender or cancel the policy
  • The right to pledge the policy for a loan or to borrow against its cash value
  • The right to name and to change a beneficiary
  • The right to determine how beneficiaries will receive the death proceeds

You must not retain any of these rights. Further, the trust document should expressly state that the trust is irrevocable and that the insured is retaining no rights to the policies held by the trust.

You can, however, retain the power to change the trustee so long as the successor trustee is not related or subordinate.

Crummey withdrawal rights

Transfers of cash (or any other property, including cash values accumulated in existing policies) to your ILIT may be subject to gift tax. However, you can minimize or eliminate your actual gift tax liability by structuring the transfer so that it qualifies for the annual gift tax exclusion (currently $14,000 per beneficiary).

Generally, a gift must be a present interest gift in order to qualify for the exclusion, which allows you to gift $14,000 (in 2015 and 2016) per beneficiary gift-tax free. A present interest gift means that the recipient is able to immediately use, possess, or enjoy the gift. Gifts made to a trust are usually considered gifts of future interests and do not qualify for the exclusion unless they fall within an exception. One such exception is when the beneficiaries are given the right to demand, for a limited period of time, any amounts transferred to the trust. This is referred to as Crummey withdrawal rights or powers.

The beneficiaries (or their parents/guardians) must also be given notice of their rights to withdraw whenever you transfer funds to the ILIT, and they must be given reasonable time to exercise their rights. The basic requirement is that actual written notice must be made in a timely manner. It is best to give written notice at least 30 to 60 days before the expiration of the withdrawal period. It is the duty of the trustee to provide notice to each beneficiary.

Of course, so as not to defeat the purpose of the trust, your beneficiaries should not actually exercise their Crummey withdrawal rights, but should let their rights lapse. Lapsed withdrawal rights, however, are considered gifts to the other trust beneficiaries, and are generally includable in a beneficiary’s estate. To address this problem, the Internal Revenue Code provides an exception, referred to as the five or five power. The Code states that the lapse of rights to withdraw will not be treated as a gift, and will not be included in the beneficiary’s estate, to the extent it does not exceed the greater of five percent of the trust balance or $5,000 each year.

Because the beneficiaries’ withdrawal powers are limited to five percent or $5,000 of the trust’s assets each year, your annual gift tax exclusion is also limited to the five or five amount. If you need to contribute more than this to cover the policy premium, the excess will be subject to gift tax. You may be able to avoid this result with the use of hanging powers. The hanging power throws the excess into future years, until all of it is used.

Tax considerations

Income Tax

Trust’s income generally attributed to the grantor

If you fund your ILIT with income-producing assets and the trust is a grantor trust, income from the trust will be taxed to you, and you can use any gains, losses, deductions, and credits realized by the trust (most ILITs are grantor trusts). If the trust is not a grantor trust, the income tax rules are generally as follows:

  • Income used to pay premiums is taxed to you (the grantor)
  • Income paid to the beneficiaries is taxed to them
  • Income retained by the trust is taxed to the trust

If the trust is not a grantor trust, the trustee must obtain a taxpayer identification number (TIN), which can be obtained online, over the phone, or by mail. If the trust is a grantor trust, a TIN is not required while you are alive, but the trust will need one upon your death. That being the case, it may make sense to obtain a TIN at the outset.

Gift Tax

Transfers to an ILIT are taxable gifts

Transfers to an ILIT are taxable gifts. Crummey rights of withdrawal held by the beneficiaries, however, allow the transfers to qualify for the annual gift tax exclusion. Transfers that do not qualify for the annual gift tax exclusion are exempt from gift tax to the extent of your lifetime gift and estate tax exemption ($5,450,000 in 2016, $5,430,000 in 2015), which is automatically applied.

If existing life insurance policies are transferred to your ILIT, they will be valued at the interpolated terminal reserve value (which is approximately the same as the cash surrender value of the policy). Upon request, your insurance company can give you the exact terminal reserve value. Depending on the size of the policy, your health, and the length of time that the policy has been in place, this terminal reserve value may be quite large.

One possible strategy to reduce the size of the gift is to take out a loan against the cash value of the policy prior to the gift. Such a loan will reduce the interpolated terminal reserve value.

Community property considerations

If you live in a community property state, special attention should be paid to the drafting and funding of your ILIT. For example, you should create a separate property agreement and fund the trust with separate property.

Beneficiaries may incur gift tax or estate tax due to withdrawal right lapses

When a beneficiary allows his or her right to withdraw money gifted to the trust to lapse, he or she is considered to have made a taxable gift to the remaining beneficiaries of the trust and the funds are includable in the beneficiary’s estate. Five percent of the trust balance or $5,000, whichever is greater, is exempted. Gift tax consequences on lapses in excess of this so-called five or five power can be avoided using hanging powers, or by giving the beneficiaries the right to appoint the unwithdrawn amounts in their wills (those amounts will still be includable in their estates, however).

This is an extremely technical area. You will need to consult your accountant or tax attorney.

Estate Tax

Proceeds from life insurance policy not included in grantor’s estate

If the ILIT is drafted, funded, and administered properly, the proceeds from insurance policies held by the trust will not be included in your estate. This is one of the main benefits of setting up this type of trust.

If an existing insurance policy is transferred to the trust and you die within three years of the transfer, however, the proceeds will be included in your estate.
Generation-Skipping Transfer Tax
Transfers to trust with beneficiaries two or more generations below grantor are subject to generation-skipping transfer tax

An ILIT can be an excellent vehicle for generation-skipping transfer (GST) tax planning for life insurance proceeds. If your ILIT has beneficiaries that are two or more generations below you (your grandchildren, for example), gifts to the trust may be subject to both gift tax and GST tax. The GST tax rate is a flat rate at the highest estate tax rate in effect. Fortunately, there is an annual exclusion ($14,000 per skip beneficiary) similar to the annual gift tax exclusion, and a lifetime exemption ($5,450,000 in 2016).

Your ILIT can be designed as a dynasty trust meant to last for several generations, leveraging your GST tax exemption, and avoiding successive generations of taxes. This is a complicated strategy, however, requiring careful planning.

Unlike the gift tax exemption, which is allocated automatically, you may have to explicitly allocate your GST tax exemption on Form 709.

How do you implement an ILIT?

Contact your insurance professional

Your insurance professional will help you decide what kind of policy is best for you. Do not purchase the policy, however.

Hire an attorney

For an ILIT to work according to your intentions, careful drafting of the trust document is essential. One error can negate all your planning. In addition, there are many complex legal issues that can arise when you set up a trust. You should hire an experienced attorney to draft the trust document and advise you on the complex legal issues.

Fund the trust

You must transfer cash to the ILIT trustee so the trustee can purchase the policy (and additional amounts as premiums come due). As noted before, the trustee should buy the policy in order to avoid the three-year rule. In addition, you may want to transfer other assets to the trust. Your attorney should assist you in properly transferring ownership.

Serve Crummey notice to the beneficiaries

The ILIT trustee must fulfill the Crummey notice requirements to keep the ILIT effective. This means that when the trust is initially funded, and whenever you make any subsequent contributions, the trustee must give actual written notice to each beneficiary at least 30 to 60 days prior to the expiration of the withdrawal period.

The trustee should consider sending the notices so that the recipient’s signature is required, and should keep the signatures on file.

File federal gift tax return (Form 709), if necessary

If the transfers you make to the trust exceed the annual gift tax exclusion and you have used up your exemption, you may have to file a federal gift tax return (Form 709) and pay gift tax. If you want to allocate a portion of your generation-skipping transfer tax exemption, you will also need to file Form 709. Another important step is view pan card eligibility, many people skip this step and regret it afterwards. You may want to consult your accountant or tax attorney prior to making any gifts.

If your state imposes gift tax, you may also need to file a state gift tax return.

Include trust income on your personal annual income tax return, if required

Income earned by the trust that is taxable to you (the grantor) must be included on your personal income tax return for the year in which it is earned.

The Fool and His Estate Tax

There’s no two ways about it: only a fool pays 45% estate tax upon his death. With simple life insurance and trust tools, anyone can easily reduce their estate tax to nearly zero. In the article, “Only the Foolish Pay 45% Estate Tax,” author Barry Ritholtz writes, “Only if you are an idiot [would you pay 45% estate tax]. Or, perhaps, if you were on the way to your lawyer’s office when you got hit by a bus, and died intestate (without a will), then that makes sense as well. Short of those things occurring, no one in America actually pays ’45 percent’ in estate taxes. It is simply too easy to avoid paying estate taxes.”

Read the article below and contact us to learn more about how you can save your clients from paying exorbitant estate tax.

Only the Foolish Pay the 45% Estate Tax

By Barry Ritholtz  Jan 30, 2014 9:07 AM CT

By now, you must have heard about Tom Perkins’s letter to the Wall Street Journal (Progressive Kristallnacht Coming?), where he made a foolish comparison to the “parallels of fascist Nazi Germany to its war on its ‘one percent,’ namely its Jews, to the progressive war on the American one percent, namely the ‘rich.’ “

The PR disaster Perkins ignited — yeah, he is that Perkins from venture capital firm Kleiner Perkins — ignited a firestorm. The reaction was so intense he had to go on Bloomberg TV to sort of, but not quite, apologize. In the course of his comments, he said several other really dumb things (you may be detecting a pattern here) on unrelated subjects.

But the thing which really stood out to me was his plea for lower taxes. Perkins said: “Upon my death the government will take 45 percent” of my estate.

To which I am compelled to respond: Only if you are an idiot. Or, perhaps, if you were on the way to your lawyer’s office when you got hit by a bus, and died intestate (without a will), then that makes sense as well. Short of those things occurring, no one in America actually pays “45 percent” in estate taxes. It is simply too easy to avoid paying estate taxes. (The top federal rate currently is 40 percent, although in some states the total bill can easily reach the Perkins 45 percent level.)

First, some numbers: About 314 million people live in the U.S. Each year, a bit fewer than 2.5 million people shuffle off this mortal coil, according to the Centers for Disease Control and Prevention. The first $5.25 million is exempt from estate taxes (double that for married spouses). In other words, only the wealthiest 0.14 percent of Americans pay any estate tax. That’s fewer than two out of every 1,000 people who die.

But here’s where things get interesting: With a little planning, those folks don’t pay anywhere near a 45 percent rate. As the Center on Budget and Policy Priorities has observed, a more typical tax rate on large estates is about 17 percent.

Estate taxes. Source: Center on Budget and Policy Priorities
Estate taxes. Source: Center on Budget and Policy Priorities

Take a guy like Perkins, who said “I am not a billionaire.” Let’s assume he has a net worth of $100 million dollars (or some multiple of that). It is a rather simple thing to reduce his estate taxes to almost zero.

I am not referring to any complex or exotic tax strategies like the “Double Irish” or “Dutch Sandwich” that so many American companies have used to great effect. Rather, all that is required is some basic planning using run-of-the-mill insurance policies and trusts. Nothing cutting edge or daring, just put a few well-paid lawyers, accountants, and financial planners to work using existing policies and tax laws.

If you don’t want to pay a 45 percent estate tax, consider these four basic strategies:

Second-to-die life insurance is a very effective tool. Combined with an irrevocable life insurance trust (ILIT), this allows a fortune to pass to the next generation effectively tax-free. Uncle Sam still gets his cut paid out by the insurer, but to the estate it looks and feels like there are no taxes to be paid. The costs are the premiums (which vary by the age and health of the insured), plus whatever your lawyer charges you to set up the trust. Figure that two 60 year olds in good health will pay about $20,000 per $1 million for the insurance; the trust costs less than $10,000. For Perkins’s $100 million dollar estate, avoiding a 45 percent tax would cost about $750,000 per year. Not cheap, but that avoids $45 million in estate taxes right off the top.

Grantor retained annuity trust, or GRAT, is another commonly used tool. It not only avoids the estate tax, but sidesteps any gift taxes as well. This trust’s donor (that’s you) receives annual payments during a fixed period of time (that’s the annuity part). Once this term ends, the remaining value gets passed on to the named beneficiary as a tax-free gift. No worries if you aren’t around to see that; this trust allows the balance to pass to the beneficiary free of estate tax also.

Charitable giving with a charitable remainder unit trust (CRUT) is a similar mechanism. Similarly to the GRAT, the CRUT pays out income over the lifetime of the donor, then provides your selected charities with the remaining principal. The inverse of the GRUT is the charitable lead trust (CLT). Income during your lifetime goes to your favorite charity, and the principal at your death goes to your beneficiaries. (Note: the CLT has some complications to it).

Of course, the easiest way to avoid estate taxes is to give it all away. Warren Buffett decided to put his entire $60 billion fortune in the Bill & Melinda Gates Foundation, run by his pal Bill Gates. Uncle Sam’s take is precisely zero.

While the formal rate on any estate greater than $10.5 million dollars per couple can reach 45 percent, nobody actually pays that. Not unless they’re an idiot.

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.

12 more estate planning tax facts you need to know

BY  | JANUARY 24, 2014

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).

See also: Taxing life insurance would be bad — up to a point

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.

See also: 10 more life insurance tax facts you need to know

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.

See also: Legacy planning for the uninsurable client

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.

If there’s one thing we’ve learned from the latest season of Downton Abbey, it’s that death taxes (AKA estate taxes) have the power to destroy a family’s estate. Without proper planning, the untimely death of a family’s primary bread winner could leave its surviving members 40% of the breadwinner’s worth in debt. This is why early and well thought out planning is key. While Downton Abbey is just a fictional creation, the woes of death and death taxes are more real than any of us care to admit. In the article below, author Candice Boyer, draws a stark comparison between the fictional arena of Downton Abbey and the unpredictable realities of life, death and death taxes. In the end, Boyer, like most reasonable viewers, saw the lessons to be learned from this season of Downton and advocates for proper estate planning.

Downton and the death tax

Downton and the death tax

6:50 PM 01/14/2014
Candice Boyer, Director of Scheduling and Outreach, ATR

Whether or not you were one of the 10.2 million viewers who tuned into the season premiere of Downton Abbey, know that the post-Edwardian period drama shows that sometimes art imitates life. The dulcet-toned and ill-tempered eldest daughter, Lady Mary, has been widowed, losing her husband Matthew Crawley. Fortunately, Lady Mary seems to have bounced back from her extreme state of grief and malaise in just over an hour only to discover she is co-owner of a grand estate that owes inheritance taxes.

The “death duties,” a shockingly blasé term for inheritance taxes, could potentially bankrupt the estate. Should the Crawleys sell land to pay them all at once or find another solution? What will happen when Mary eventually dies and her son becomes the heir? As Crawley patriarch Lord Robert points out, “the estate will now be hit with death duties twice.” The best drama always has a touch of reality so it may come as no surprise to find out that the real-life Downton Abbey has been through this before.

Highclere Castle, nestled in Hampshire, England, is the setting for the “upstairs” portion of Downton Abbey and is regarded as one of England’s finest historic houses. Its beautiful vaulted ceilings and grand rooms have been the seat of the aristocratic Carnarvon family since 1679. In October of 2013, the Daily Telegraph reported that when the Fifth Earl of Carnarvon died in the mid 1920s the estate was taxed at £500,000. That is the equivalent of £30 million today or approximately $51 million U.S. dollars. In 1926, his son, the Sixth Earl and his wife were forced to sell off many valuable family possessions and personal heirlooms to pay off the debt and keep the grand manor house.

To most of us living in 2014 this seems like a fluke of history or the trappings of a bygone age. Knowing that the Carnarvons benefited from a severe and antiquated British class system makes crying about the death tax seem like a pastime for the uber-rich and underworked.

Coincidently, Downton Abbey isn’t the only showbiz death tax twist of late. When the actor James Gandolfini (star of the HBO hit TV series The Sopranos) passed away suddenly in June of 2013 it was discovered that his $70 million fortune was subject to an estimated $30 million in estate taxes.

Certainly some will argue, “He was rich, why shouldn’t the estate be taxed?” But should he be taxed twice? James Gandolfini earned his money from his job and he paid taxes on those wages at the time he earned them. If his estate has to pay inheritance taxes, then the wages he earned will be taxed twice. He was born in 1961, the son of a high school lunch lady and a bricklayer, in Westwood, New Jersey. He was hardly landed gentry and it seems unlikely that the Gandolfinis had a manor house stashed somewhere and simply neglected to inform the IRS.

If you are comfortable with the idea of stealing honestly earned wages that the IRS has already taken a slice of, then it is easy to assume that with the current $5 million-plus exemption the death tax targets only the extremely wealthy. Yet one of the most important and overlooked facts about the inheritance tax is that is slows down the economy for all Americans regardless of income level. Economist Steve Entin, currently with the Tax Foundation, estimated in a 2011 study that full death-tax repeal would increase economic output by nearly $3 trillion over the following decade. In short, small businesses are spending energy and capital to pay for and comply with double taxation rather than create jobs.

In May 2012, small employer Karen Madonia (CFO, Illco, Inctestified before the Small Business Subcommittee on Economic Growth, Tax and Capital Access that the estate tax was a burden on her family-owned air-conditioning and refrigeration business that employs 90 people and generates $40 million in revenue. She stated, “The reality is that we’re not talking about passing down bank accounts with million dollar balances. These are businesses, where most of the net worth is tied up in inventory, equipment, and real-estate.” She spoke of the time and money her father continually puts into navigating the complexity of the death tax to make sure that if he dies their family business will be able to keep their doors open.

It is doubtful that fictional Lady Mary, swanning around Downton Abbey, has any concern for the expenses of a refrigeration business, but the point is clear. In time, money, or agony, the death tax affects us all.

Candice Boyer is director of outreach for Americans for Tax Reform.