Why Your Life Insurance May Get Taxed…

By Chuck Crouse

Few people realize that, even though they may have a modest estate, their families may owe hundreds of thousands of dollars in estate taxes because they own a life insurance policy with a substantial death benefit. This is so because life insurance proceeds, while not subject to federal income tax, are considered part of your taxable estate and are subject to federal estate tax. Even though federal tax legislation enacted in 2001 repeals the estate tax, the repeal is not effective until 2010 and is likely to change. In the meantime, the rules on the estate tax taxation of life insurance benefits remain in force.

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 (“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 so-called “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.

Buy-sell agreements. Life insurance obtained to fund a buy-sell 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 A and B 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, A buys a life insurance policy on B's life. A pays all the premiums, retains all incidents of ownership, and names himself beneficiary. B does the same regarding A. When the first partner dies, the insurance proceeds are not taxed in his estate.

Life insurance trusts. A life insurance trust 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 estate.

A properly drafted life insurance trust keeps the insurance proceeds from being taxed in the estate as well as in the estate of the surviving spouse. It also protects the trust beneficiaries from their own “excesses”, against their creditors, and in the event of divorce. Moreover, the trust also provides reliable management for the trust assets. Here's how the irrevocable life insurance trust works.

You create an irrevocable life insurance trust to be the owner and beneficiary of one or more life insurance policies on your life. You contribute cash to the trust to be used by the trustee to make premium payments on the life insurance policies. If the trust is properly drafted, the contributions you make to the trust for premium payments will qualify for the annual gift tax exclusion, so you won't have to pay gift tax on the contributions.

The life insurance trust typically provides that, during your lifetime, principal and income, in the trustee's discretion, may be paid or applied to or for the benefit of your spouse and descendants. This allows indirect access to the cash surrender value of the life insurance policies owned by the trust, and permits the trust to be terminated if desired despite its being irrevocable. On your death, the trust continues for the benefit of your spouse during his or her lifetime. Your spouse is given certain beneficial interests in the trust, such as the right to income, limited invasion rights, and eligibility to receive principal. On the death of your spouse, the trust assets are paid outright to, or held in further trust for the benefit of, your descendants.

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, do so  as soon as you reasonably can. Unless you live for at least three years after these steps are taken, the proceeds will be taxed in your estate. For policies in which you never held incidents of ownership, the three-year rule doesn't apply.

If you own a life insurance policy with a significant death benefit, an irrevocable life insurance trust may be of substantial benefit to you.

Kingery & Crouse, P.A.

About the Author
Chuck Crouse, CPA, is a share partner with Kingery & Crouse, P.A., Certified Public Accountants, located in Tampa, Florida. Chuck has nineteen years of public accounting experience during which time he has garnered extensive experience in taxation and auditing. Kingery & Crouse, P.A. is a full service public accounting firm with a staff of dedicated professionals providing tax and accounting services, including audits of SEC companies. You may contact Kingery & Crouse at (813) 874-1280. Find us on the web at www.tampacpa.com.