An often overlooked component of an estate for the purpose of calculating estate tax are the death benefit of and cash value in a life insurance policy. Even though these benefits may go to a child or other third person designated as a beneficiary on your policy, you and your spouse should take the value of these benefits into consideration in attempting to minimize or eliminate estate tax.
There are ways to be sure that the life insurance benefits your family will receive after your death will not be includible in your estate, so the benefits will not be subject to state or federal estate tax. Under the estate tax rules, insurance on your life will be included in your taxable estate if either:
- (1) your estate is the beneficiary of the insurance proceeds, or
- (2) you possessed certain economic ownership rights (known as “incidents of ownership”) in the policy at your death (or within three years of your death).
Avoiding the first situation is easy: just make sure your estate is not designated as beneficiary of the policy.
The second rule is more complex. Clearly, if you are the owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is. However, simply having someone else possess legal title to the policy will not prevent this result if you keep “incidents of ownership” in the policy. Rights that, if held by you, will cause the proceeds to be taxed in your estate include:
- . . . the right to change beneficiaries,
- . . . the right to assign the policy (or to revoke an assignment),
- . . . the right to pledge the policy as security for a loan,
- . . . the right to borrow against the policy’s cash surrender value, and
- . . . the right to surrender or cancel the policy
Keep in mind that merely having any of the above powers will cause the proceeds to be taxed in your estate even if you never exercise the power.
Other vehicles are available in formulating your estate plan that will remove the benefits of a life insurance policy from being part of your taxable estate:
Buy-sell agreements. Life insurance obtained to fund a buysell agreement for a business interest under a “cross-purchase” arrangement will not be taxed in your estate (unless the estate is named as beneficiary). For example, say Alice and Barb are partners who agree that the partnership interest of the first of them to die will be bought by the surviving partner. To fund these obligations, Alice buys a life insurance policy on Barb’s life. Alice pays all the premiums, retains all incidents of ownership, and names himself or herself as beneficiary. Barb does the same regarding Alice. When the first partner dies, the insurance proceeds are not taxed in the first partner’s estate.
Life insurance trusts. An irrevocable life insurance trust (often referred to as an “ILIT”) is an effective vehicle that can be set up to keep life insurance proceeds from being taxed in the insured’s estate. Typically, the policy is transferred to the trust along with assets that can be used to pay future premiums. Alternatively, the trust buys the insurance itself with funds contributed by the insured. As long as the trust agreement gives the insured none of the ownership rights described above, the proceeds will not be included in the insured’s estate.
The three-year rule. If you are considering setting up a life insurance trust with a policy you own currently or simply assigning away your ownership rights in such a policy, it is important to act early. Unless you live for at least three years after these steps are taken, the proceeds will nevertheless be taxed in your estate. For policies in which you never held incidents of ownership, the three-year rule doesn’t apply.
Andrew Willaert is a partner at Gislason & Hunter and is a true counselor to his clients and believes that strong representation is the product of good listening. For over 36 years, he has helped his clients understand their options and make informed decisions in the areas of finance and banking, real estate, environmental law and land use and trusts and estates. Andrew can be reached at firstname.lastname@example.org or 507-387-1115.