If, at the insured’s death, any incidents of ownership in a policy on his life were held by the insured, (regardless of the monetary value of the incident retained, whether exercisable alone or only in conjunction with another, or how the interest was acquired), the proceeds are includable in the insured’s gross estate.
The physical ability of the insured to exercise the ownership right is immaterial; the IRS and the courts generally look to the insured’s legal right to exercise ownership. Mere possession of the incident and not its exercise is all that is necessary for inclusion, but the insured must in fact hold legal right to exercise the power in question.
If section 2042(2) applies, the entire amount receivable by beneficiaries (other than the estate) is includable in the insured’s gross estate. It is important to note that any incident of ownership will trigger inclusion; an insured does not have to possess all of the incidents of ownership nor does the incident of ownership have to be of great value to be fatal.
Incidents of Ownership Defined
Think of an incident of ownership as the right of the insured (or his estate) to one or more economic benefit from the policy. Such a benefit may take the form of the right to:
- cancel the policy;
- assign the policy;
- surrender the policy;
- obtain a policy loan;
- change the beneficiary;
- pledge the policy for a loan;
- change contingent beneficiaries;
- change beneficiaries’ share of proceeds;
- require consent before change of beneficiary; or
- require consent before assignment of the policy.
Whether or not other rights will or will not be considered an incident of ownership is not always clear cut. Some of the more frequently litigated issues (and the typical results) have been:
- The mere possession of the right to alter the time and manner of payment of the proceeds to a beneficiary (with no right to change the beneficiary or alter in any way the total amount of proceeds payable to that party) (includable);
- The right to require consent to the designation of a beneficiary who does not have an insurable interest in the life of the insured (includable);
- The right to receive dividends on a mutual policy (not includable);
- The right to change the beneficiary of a policy held in trust (includable);
- The right to change the terms of a trust that holds a policy (includable);
- The right to exercise ownership rights only in conjunction with another (includable);
- The naming by a third party owner as beneficiary “the person named by my husband (the insured) as the beneficiary of his will” (not includable);
- The inability of the insured to exercise a retained power (includable);
- The absence of intention on the part of the insured to retain an incident of ownership (includable);
- Instructions to the insurance agent/and or insurer to divest the insured of any incident (not includable);
- The right to designate or make a change of beneficiary on a policy on the insured’s life owned by the insured’s employer even though the insured’s employer retains the right to amend or cancel the policies without the insured’s consent (includable);
- The right to terminate a spouse’s interest in a policy by divorcing her (not includable);
- The right to obtain cash values of a policy irrevocably assigned for the benefit of the insured’s children to a trust (includable);
- The right to cancel insurance payable to a trust providing income for life to the insured (including income from the proceeds of surrendered policies) (includable);
- The right to cancel a no-fault auto insurance policy that provided survivors’ loss benefits (not includable);
- The right to purchase the policy from its owner (generally includable);
- The right to convert from term to whole life or from whole life to limited pay (includable);
- The right to substitute policies of equal value for those held by a trust (not includable);
- The right of one partner under a cross purchase buy-sell to veto another partner’s right to borrow, surrender, or change beneficiaries (not includable);
- The insured’s right to alter, amend, or revoke a trust that is named as the beneficiary of a policy on the insured’s life (not includable);
- The right to select settlement options (includable);
- Loans made by the insured to an irrevocable life insurance trust to fund the premiums on a trust-owned life insurance contract were not considered incidents of ownership;
- The continuing power to determine the compensation of a trustee of an irrevocable life insurance trust was not considered the retention of an interest in the trust by the grantor and, therefore, did not cause federal estate tax inclusion of the trust’s assets; and
- The insured-grantor’s right to remove a trustee for cause will not cause inclusion.
Attribution of Ownership
In some cases, the IRS will attribute an entity’s actual ownership of a life insurance policy to an owner of the entity. For instance, if a partnership owns a policy on the life of one of its partners, to the extent that policy is payable to a party other than the partnership or its creditors (for example to a partner’s grandson), the insured partner will be deemed to hold an incident of ownership in the policy.
Because the partnership’s actual incident of ownership is deemed constructively owned by the insured partner, it will be includable in his estate. There is no minimum partnership interest required for this result to occur. On the other hand, as long as the policy proceeds are payable to or for the benefit of the partnership, its incidents of ownership will not be attributed to its partners.
A partnership’s ability to surrender or cancel its group term coverage will not be attributed to its partners. So, if a partner transfers (more than three years prior to his death) all of the incidents of ownership he holds in group term coverage, he will not be considered to constructively hold incidents of ownership through the partnership’s ability to cancel the group term coverage.
When a corporation holds incidents of ownership in a life insurance policy, its ownership rights may be attributed to the insured. Here, the rule for corporations is slightly more formalized than is the case for a partnership: if (at death) the insured owns more than 50 percent of the total combined voting power of all classes of the corporation’s shares entitled to vote, he is deemed to own incidents actually owned by the corporation to the extent proceeds are payable to anyone other than the corporation or its creditors.
Example. Assume a client owns 80 percent of a corporation that owns an insurance policy on his life. If the policy is payable to the corporation (or its creditor), the client will be deemed to hold no incident of ownership in the policy. But if the proceeds of the corporate owned policy are payable to the client’s daughter, then the policy actually owned by the corporation will be deemed to be owned by the client and includable in his estate. (The payment of the proceeds may also be considered a constructive dividend or compensation to the shareholder, followed by a gift from the shareholder to his daughter.)
If, however the proceeds were payable to a bank to which the client’s corporation owed money and the proceeds were accepted in payment of that debt, to that extent the corporation’s incidents of ownership would not be attributed to the client. Naturally, the payoff of the debt would have the effect of increasing the value of the corporation’s stock.
There are at least two reasons why the difference (inclusion of proceeds in insured’s estate as insurance versus inclusion of stock with higher value) is important. First, treating insurance proceeds as a corporate asset may result in a smaller increase than a dollar for dollar inclusion of insurance proceeds and only the decedent’s proportionate share would be includable. For instance, if the decedent only owns 80 percent of the corporation, at worst 80 percent and not 100 percent of the proceeds would be includable. In many cases, since the net asset value of a corporation is not the predominant factor in valuing a going concern, there might not be a dollar for dollar increase in corporate value when insurance proceeds are payable to the corporation.
Second, inclusion of life insurance in the insured’s estate as life insurance makes qualification for a section 303 stock redemption or a section 6166 installment payment of estate tax more difficult.
If corporate owned policy proceeds are used to redeem stock from a shareholder’s estate, will the proceeds be considered payable to or for the benefit of the estate (and therefore includable separately as life insurance) or will the IRS treat the proceeds as payable to the corporation? The answer is that, in a classic stock redemption or section 303 stock purchase, there will be no attribution of ownership even though indirectly the proceeds enhance the estate’s liquidity and make stock held by the estate marketable. But if the decedent was a controlling shareholder of the corporation owning the policy and the proceeds are payable to a second corporate beneficiary to redeem its stock (or for general corporate purposes), the IRS would probably claim that the proceeds are not payable to or for the benefit of the (first) corporation and therefore should be included.
A corporation’s ability to cancel group term life insurance coverage is not considered an incident of ownership held by its shareholder. Therefore, there should be no attribution, even in the case of a controlling stockholder.
Community Property Issues
When life insurance is purchased by community property domiciliaries, federal law usually recognizes it as being owned one half by the wife and one half by the husband. The result is that, where the insured spouse dies first, only half the proceeds are includable in his gross estate, regardless of who the beneficiary is.
Example. If a client and his wife live in a community property state and purchase a $1,000,000 life insurance policy on the client’s life, only $500,000 will be in the client’s estate because the client never owned incidents of ownership over more than one half of the policy. This one half rule applies even if all the proceeds are payable to the insured’s estate.
State community property law determines the extent to which the insured had incidents of ownership in a policy. For example, incidents of ownership do not apply merely because state law gives one spouse the right to manage a community owned policy and thus has the legal power to surrender the contract.
Likewise, regardless of whose name is listed on the policy application as owner, absent strong proof to the contrary, each spouse holds one half of all incidents of ownership. So generally, life insurance acquired by spouses in a community property state is presumed to be community property even if the title is held in only one spouse’s name. However, the parties can establish, through clear and convincing evidence that they intended to hold the property in some form other than all as community.
It is also possible that life insurance will be deemed to have been purchased partially with community property funds and partially with separate property funds. A common example is where the policy itself was purchased prior to marriage or before the couple moved to a community property state. Then, if premiums are paid from community funds, the proceeds have been generated by a mixture of separate and community premiums.
In Texas, Louisiana, New Mexico, and Arizona, the concept of inception of title is used to classify the proceeds; insurance proceeds on a policy purchased prior to the couple’s marriage or move to a community property state remains as it was at inception, separate property, even though community funds were used to pay some premiums. Under state law, the proceeds would therefore be the insured’s separate property, but the surviving spouse would have a right to be reimbursed for half of the community funds used to pay premiums. That, of course, would be the measure of federal estate tax inclusion; the entire proceeds would be includable less the one half of the community funds that were used to pay premiums.
California and Washington use a concept called the premium tracing rule; each spouse is deemed to own his share of the policy proportionate to his share of the premium contribution. Therefore, only the portion that belonged to the insured would be includable.
An unintended and unexpected gift tax trap may await the unwary; if the client names neither his estate nor his spouse as beneficiary of the proceeds, the IRS could argue that the uninsured spouse made a gift to the beneficiary when the proceeds are paid. The gift becomes complete upon the insured’s death and the amount of the gift is one half the amount of the insurance proceeds.
Where the noninsured spouse dies first and the insurance is community property, half the value of the unmatured policy is includable in that spouse’s gross estate. Then, if the insured spouse receives the policy under the noninsured spouse’s will, the entire proceeds will be includable in his estate.
More Than 5 Percent Test
In some situations, a client has made a conditional transfer, i.e., a gift of a policy coupled with a “but if…back to me” string. If certain events did (or did not) occur, the policy would revert (i.e., come back) to the donor insured (or his estate).
Such a reversionary interest in a policy held by the insured or the insured’s estate will be considered an incident of ownership under section 2042 if the actuarial value of that interest exceeds 5 percent of the value of the policy (measured immediately prior to the insured’s death). This reversionary interest must be just that, a right retained by the insured (either in the policy provisions or by some other instrument or operation of law) when the insured transferred the policy. The mere possibility that a policy could return to the insured as a bequest by will at the donee’s death or through the intestacy of the donee (or through the right of the insured to elect against a spouse’s will) is not considered a reversionary interest and will therefore not cause inclusion.
Even if a reversionary interest exists, it must be actuarially (according to current monthly government discount rates) be worth more than 5 percent of the value of the policy as measured immediately before the insured’s death. So, if someone else had an interest that lowered the value of the insured’s interest, the value of the other person’s interest could prevent estate tax inclusion in the insured’s estate.
Example. Suppose a client gave a policy on his life to his son and retained the right to regain the policy if the son died before the insured. Suppose, in the same transfer, the donor insured gave the son the unfettered right to surrender the policy for cash at any time. The son’s power to completely eliminate the insured’s right to regain the policy would reduce the value of the father’s interest to zero.
As a practical matter, if the donee of a policy is the owner and has all rights normally associated with ownership except the right to name a successor owner (the reversionary right held by the insured), the value of the insured’s reversionary right would be well below the more than 5 percent threshold. If the donee had the right to revoke the insured’s successive ownership designation in addition to the ability to surrender the contract, the value of the insured’s reversionary interest should approach zero.
Reversionary Interest and Death of Third Party Owner
What is the result where a third party owner of a policy on the insured’s life dies before the insured does and the policy passes back to the insured? Here, state law must be examined very carefully. The results may be surprising. For example, suppose a client’s wife purchased a $1,000,000 policy on the client’s life. Assume the wife is killed in an automobile accident in which the client dies one hour later. As the beneficiary of his wife’s will, the client becomes (if only for an hour) the owner of the insurance proceeds that are actually paid to the specified contingent beneficiaries.
Did the client have incidents of ownership? The answer will depend on state law. If title and legal right and possession of personal property pass to the estate’s executor and that party is someone other than the client, the client would not have legal power to exercise incidents of ownership in the insurance. Therefore, nothing would be includable in his estate under section 2042. But if he was the personal representative (executor) of the estate, as well as heir, he would have incidents of ownership since he would have immediate legal rights over the insurance. The same result would occur if the insured were named as contingent owner of the policy. Were he merely personal representative but not an heir of the wife’s estate, there would be no inclusion because there would be no personally exercisable incidents of ownership.
Insured as Trustee
Often, insureds have served as a trustee of a trust which held insurance on their lives. Unfortunately, such an arrangement has often led to expensive litigation and often federal estate tax inclusion of policy proceeds on these grounds: the trust owned the policy, the trustee controlled the trust, the insured was trustee, and therefore the insured is deemed to have held incidents of ownership in a policy on his life actually held by the trust. Of course, this argument conveniently overlooks the most basic premise of trust law: a fiduciary is barred from using such funds for personal benefit absent express provision in the governing instrument (assuming the fiduciary is not also a beneficiary).
Although it would appear a sound argument therefore, that incidents held purely and solely in a fiduciary capacity cannot be used except to benefit a trust’s heirs (and therefore should not be included in the decedent’s estate as insurance), the IRS doesn’t see it that way. Fortunately, the courts don’t always agree with the IRS. The result is a confusing and dangerous mix of cases and rulings that vary in result depending more on domicile than on facts.
Two types of situations may trigger the problem: The most common is where the client creates a trust and transfers life insurance to it and insists on being named trustee. But the problem can also occur where the policy on the insured is owned by a third party (such as the insured’s spouse) and, at that third party’s death, the policy passes to a trust over which the insured is trustee.
The following will summarize the section 2042(2) issues with respect to life insurance trusts where the IRS will act aggressively against the deceased taxpayer’s estate:
If the decedent (acting alone or in conjunction with others) had the power as trustee to change the time or manner of enjoyment, even if the decedent had no beneficial interest in the trust, the IRS will treat him as having held an incident of ownership in a policy on his own life held in a trust if he was trustee.
If the decedent transferred the policy to the trust or paid premiums, the IRS will treat him as having held an incident of ownership in a policy on his own life held in a trust if he was trustee.
If the decedent could have exercised his powers as trustee for his own benefit, regardless of how those powers were acquired and regardless of whether or not the decedent transferred property to the trust, the IRS will treat him as having held an incident of ownership in a policy on his own life held in a trust if he was trustee.
The following will summarize the section 2042(2) issues with respect to life insurance trusts where the IRS will not claim the deceased taxpayer held incidents of ownership.
If the decedent held powers only in a fiduciary capacity and could not exercise those powers for his personal benefit;
If he did not transfer the policy or any of the premiums or other consideration for purchasing or maintaining the policy from personal assets; and
If the return of powers to the decedent was not part of a prearranged plan.
The following will summarize the section 2042(2) issues with respect to life insurance trusts where the courts in some jurisdictions are likely to agree with the IRS that the deceased taxpayer had held incidents of ownership:
According to the Fifth Circuit, a decedent has incidents of ownership in a policy on his life held in trust if the decedent is trustee, even if incidents of ownership are possessed only in a fiduciary capacity and the insured made no transfer of the policy to the trust.
The following will summarize the section 2042(2) issues with respect to life insurance trusts where the courts in some jurisdictions are likely to agree with the IRS that the deceased taxpayer had held incidents of ownership:
According to the Second, Sixth, and Eighth Circuits, a decedent does not have incidents of ownership in a policy on his life held in trust if the decedent transfers policies on his life to a trust, even though the decedent is named trustee, as long as he cannot exercise his fiduciary powers for his own benefit.
What is certain is that this confusion and danger can be avoided by naming someone other than the insured as the trustee of a trust that has or could have insurance on his life. As a next best alternative, planners should consider the following provisions:
Specifically forbid an insured serving as trustee from taking any action with respect to a policy on his life held by a trust over which the insured is trustee or co-trustee.24
If a non-grantor insured is a beneficiary of a trust, make sure that the insured does not possess any incidents of ownership in the life insurance policy.
Specify that the insured, as trustee, cannot use trust income or assets to satisfy his or her legal obligation to support his or her children.
Place assets in the trust to generate sufficient income to pay premiums.
Follow the terms of the trust closely and avoid conflict fact patterns which indicate that the insured acting as trustee can use trust property for personal gain.
Insured as Fiduciary Other than Trustee
When the insured becomes the executor or administrator of an estate or the custodian of a minor or otherwise legally incompetent person’s assets, there is a strong possibility that an incident of ownership problem may arise if the estate or custodial account holds a policy on the insured’s life.
Example. Assume a wife purchased a policy on her husband’s life but the wife predeceased her husband. The policy would be considered personal property in her estate. Assume the wife’s will left the entire estate to the husband, if living, otherwise to the couple’s children.
When the insured becomes the administrator or executor of an estate and is also a beneficiary of the estate, as is the case in this example, it is highly likely that should the insured die, even before distribution of the policy, the IRS will claim he had incidents of ownership in a policy on his life held by the estate. It would argue that, as executor, the insured could exercise powers over the insurance for his own benefit.
Inclusion is clear where the husband was the sole beneficiary of the estate. But what if the estate was split in thirds between the insured husband and the couple’s two children? What if the wife’s estate was payable entirely to the three children?
In the authors’ opinion, these two later situations do not meet the three tests the IRS itself set out:
- the insured must have transferred the policy or provided consideration for purchasing or maintaining it from the insured’s personal assets;
- the rights and powers the insured obtained were part of a prearranged plan involving the participation of the insured; and
- the insured can personally benefit from the powers held as fiduciary.
- Even if the first and third tests were met (i.e., if the insured paid premiums from personal funds to keep the policy on his life in force and personally could benefit from the arrangement), it would be difficult for the IRS to argue that the wife and the husband colluded and she died first so that he could obtain control without inclusion of the policy in his estate.
Many states’ version of the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) allows a custodian for a child to purchase and/or maintain life insurance. It is clear that, if a client transfers life insurance on his life to a custodial account for his child and names himself as the custodian, assets in the account will be includable in his estate if he died before the minor child reaches the age where the custodial funds must be paid out under state law. If life insurance is one of the custodial account’s assets, it will be included in the insured-custodian’s estate. Likewise, if the client becomes successor custodian and then dies, the value of the property transferred will be includable in the client’s estate.
There are situations in which an individual gives another person a power of attorney over assets in order to care for and protect the individual. Assume a client’s mother owned a life insurance policy on the client’s life. To protect herself against incompetency, the mother gave her son a general durable power of attorney with wide boilerplate provisions. Would the power given to the son amount to an incident of ownership in the policy on his life?
There appears to be no cases or rulings directly on point. If the insured could exercise power over the life insurance as holder of the power, at the very least, the IRS could engage his estate in costly litigation. The authors conclude that the best course of action is to provide in the power of attorney that the holder of the power is barred from exercising any right whatsoever with respect to a policy of life insurance on his life.
Split Dollar Insurance
In the classic split dollar arrangement in which a corporation makes an outlay equal to the annual increase in policy cash values and a selected employee pays the balance of the premium, if any, the insured is given the power to name and change the beneficiary of the portion of the proceeds not going to the corporation (usually an amount at least equal to its cumulative outlay). That ability to name and change the beneficiary is an incident of ownership and will cause inclusion of the proceeds.
The right to name the beneficiary of proceeds in excess of the cash value (or in the case of reverse split dollar, the right to name the beneficiary of the policy’s cash value) would seem to be sufficient to warrant inclusion of the entire proceeds. All the proceeds would be includable even if the insured possessed only one incident of ownership and even though a portion of the proceeds were payable to someone other than the insured’s beneficiaries.
Example. Assume a client owned 40 percent of the stock of a company that provided $1,000,000 of life insurance on his life. The corporation paid an amount equal to each year’s increase in cash values and the client paid the balance of the premium. At the client’s death, the proceeds were to be paid to the corporation in an amount up to its total outlay and any balance would be paid to the client’s daughter. Assuming the client doesn’t assign the policy to his daughter more than three years prior to his death, the entire proceeds would be included in his estate.
However, a claims against the estate deduction might be allowed for proceeds paid to the corporation (or other party receiving a portion of the proceeds in return for having paid a portion of the premiums). This claim against the estate deduction should apply whenever:
the insured owned 50 percent or less of the corporation (i.e., was not a controlling shareholder);
there was a bona fide written agreement as to the reimbursement arrangement; and
the agreement was entered into initially for full and adequate consideration as part of a business transaction. This implies that the client’s estate may not be allowed an estate tax deduction where the client merely names a family trust as beneficiary.
A much more difficult problem is faced when an individual controls (owns more than 50 percent of the combined voting stock in) a closely held corporation. In that case, to the extent proceeds of a corporate owned policy are payable to or for the benefit of a party other than the corporation, such proceeds are includable as insurance in the insured’s estate (because the insured is deemed to possess incidents of ownership).
As the law stands today, it appears that the only way to remove a split dollar life insurance policy from the gross estate of a controlling shareholder is to insulate all incidents of ownership from the corporation (because once the corporation owns any incident, including the right to borrow against the cash surrender value, that incident is attributed to its controlling shareholder).
But how is it possible to set up a split dollar plan with the corporation advancing the bulk of the premium and yet not providing security for the corporation’s outlays? One answer lies in the problem itself; there is only a problem if the shareholder is controlling (i.e., owns more than 50 percent of the vote). By definition, therefore, that person should be able to persuade the corporation to forgo the customary protection or right to borrow against the policy’s cash value or veto a loan against or surrender of the policy. This can generally be accomplished by having the corporation receive only a restricted collateral interest in the policy. This means that the corporation only has the right to receive back its interest in the event of the death of the insured or the termination of the split dollar arrangement (it should not have the unilateral right to terminate). Thus, it would have no incidents of ownership via the collateral assignment that could be deemed to be possessed by the insured.
If the policy is owned by a third party, such as a trust for the client’s children (or if adult children own the policy), from inception or the policy is assigned to an irrevocable trust (or to adult children) more than three years prior to the client’s death, the insured would hold no incidents of ownership either personally or through the corporation (since the corporation would have no rights whatsoever except the right to receive that portion of the proceeds equal to its premium outlay).
If the insured owned more than 50 percent of the corporation which is splitting the premium and proceed dollars, it is appropriate (but not certain at this point) that since the amount payable to the corporation will already be included in the insured’s gross estate due to the impact it will have increasing corporate value, those proceeds should not again be includable separately as insurance.
Although most split dollar arrangements are between corporations and employees, there are many agreements to split premiums, cash values, and death proceeds of life insurance that are made between individuals. Such an arrangement is often called private split dollar. A father in law, for example, may protect his daughter and grandchildren by entering into a split dollar agreement with his son in law. The father would help the son in law obtain more insurance at a lower cost than might otherwise be possible.
If the insured is given or retains any incident of ownership in the policy, the proceeds will be includable in his estate. Suppose a parent, for instance, sets up a trust for his children and the trust purchases a life insurance policy on the father’s life. To help the trustee pay premiums (and to lower gift tax costs), the father advances amounts equal to the annual increase in the policy’s cash surrender value. The trustee must pay the balance of each year’s premium. The father retains the right to recover an amount equal to his cumulative outlays or to borrow against the policy for up to that amount. That retained right will cause inclusion of the proceeds in his estate. However, if the insured only has a restricted collateral interest in the policy as discussed above, then estate inclusion will not be an issue.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM