Use Of Life Insurance In Estate Planning - Estate and Gift Taxation

Estate and Gift Taxation
Whether or not life insurance proceeds are included in the taxable estate depends on who owns the policy when the insured person dies. If the deceased person owned the policy, then the full amount of the proceeds are included in the federal taxable estate. If someone else owned the policy, the proceeds are not included.

To avoid federal estate tax, transfer ownership of a life insurance policy to another person or entity.

There are two ways to do it:

1) You can transfer ownership to another person, including the policy beneficiary, or
2) You can create an irrevocable life insurance trust, and transfer ownership to it.

*Gifts of life insurance policies made within three years of death are disallowed for federal estate tax purposes. This means that the full amount of the proceeds will be included in the decedent's estate, as if no gift was made at all.

Generally, the proceeds of a life insurance policy are entirely free from income tax. However, an often overlooked provision of the tax law known as the "transfer-for-value rule" can result in the loss of that favorable tax treatment. Under the rule, if a policy (or any interest in a policy) is transferred for a valuable consideration, the death proceeds will generally be excludible from income only to the extent of the consideration paid by the transferee, plus the net premiums paid by the transferee after the transfer. The balance of the proceeds will be taxable as ordinary income. Basically, a policy that becomes subject to the rule loses the income tax exemption ordinarily permitted for life insurance proceeds, except to the extent the transferee develops basis in the policy.

Example: ABC Corporation has paid premiums totaling $5,000 for a $100,000 life insurance policy on the life of shareholder A. In 2011, ABC Corp. transfers the policy to shareholder B (the noninsured shareholder) for $6,000. Shareholder B receives the $100,000 proceeds on Shareholder A's death in 2013. During the period Shareholder B owned the policy (2011-2013), and paid premiums totaling $3,000. The amount Shareholder B can exclude from their income is limited to $9,000 (the $6,000 they paid to ABC Corp. for the policy + the $3,000 of premiums they paid after the transfer). The $91,000 balance is taxable to Shareholder B in 2013.

There are five specific exceptions to this rule, thus allowing the death benefit of a policy that has been transferred to be paid tax-free to the beneficiary. They include:Policy transfers to the insured on the policy.

  • Policy transfers to a partner of the insured on the policy.
  • Policy transfers to a partnership in which the insured on the policy is a partner.
  • Policy transfers to a corporation in which the insured on the policy is an officer or shareholder.
  • Policy transfers in which the recipient's cost basis in the policy being transferred is calculated in reference to the cost basis of the transferor.
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