What Are Incidents of Ownership?
A person (including a trustee) has incidents of ownership if they have the right to change beneficiaries on a life insurance policy, to borrow from the cash value, or to change or modify the policy in any manner. This occurs even if the person chooses not to act on it and even if they don't borrow from the policy. Simply the ability to do so gives the insured incidents of ownership.
Understanding Incidents of Ownership
At times, the Internal Revenue Service (IRS) will look for any incidents of ownership by a person who gifts a life insurance policy to another person or entity. When transferring a policy, the original owner must forfeit all legal rights and must not pay the premiums to keep the policy in force. Also, upon completion of the transfer, if the insured or transferor dies within three years of the date from which the policy was transferred, the life insurance proceeds will be included in the gross value of the original owner's estate (called the three-year rule).
Incidents of Ownership and a Primer on Life Insurance Policies
Stepping back, life insurance policies are numerous and all have a range of special features, such as incidents of ownership. Major types of life insurance policies include whole life, term life, universal life, and variable universal life (VUL) policies.
Whole life, one of the most common types of life insurance, guarantees coverage for the entire life of the insured and includes a death benefit and savings component where cash value may accumulate. Term life only guarantees payment of a death benefit during a specified term. A policyholder has several options when the term expires, including renewing for another term, converting to permanent coverage, or letting the policy to terminate completely. Universal life takes the concept even further and includes an investment element and a flexible premium option.
Finally, variable universal life (VUL) has a built-in savings component that allows for the investment of the cash value into sub-accounts. Similar to mutual funds, these sub accounts allow plan participants to select options with varying market and risk exposure. While VULs can generate significant returns, as with any investment, can also result in substantial losses.
Incidents of Ownership and Gift Taxes
Gift tax regulations can be complex and change regularly. It is always best to check with your respective tax authorities if you have given anyone a gift, including a life insurance policy valued at more than $15,000 on or after January 1, 2018.