Preventing Estate Tax on Life Insurance

Under current estate tax rules, life insurance proceeds are included in the estate of the policy owner upon his or her death if either:

(1) The owner's estate is the beneficiary of the insurance proceeds, or

(2) The owner possessed certain economic rights (called “incidents of ownership”) in the policy at death (or within three years of death).

Avoiding the first situation is easy:  just make sure the estate is not designated as beneficiary of the policy.

The second rule is more complex.  Insurance proceeds are included in the policy owner's estate regardless of who the beneficiary is.  The result is the same even if the policy is transferred to another person if the original owner keeps any so-called “incidents of ownership” in the policy.  These rights of ownership, if retained by the owner, will cause the proceeds to be taxed in the owner's estate:

... 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 to the owner's estate even if the powers are never exercised.  However, there are a couple of common strategies that can be used to avoid taxation of death benefits to the estate of the policy owner, including buy-sell agreements and life insurance trusts. 

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 the owner's estate (unless his or her estate is named as beneficiary). For example, say Al and Bob 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, Al buys a life insurance policy on Bob's life. Al pays all the premiums, retains all incidents of ownership, and names himself beneficiary.  Bob does the same regarding Al.  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 his estate.

The three-year rule.  A person who gives away or transfers life insurance to avoid estate taxes must live for at least 3 years after the transfer is made.  Otherwise the life insurance proceeds will be taxed as part of his or her estate.  For policies in which a person never held incidents of ownership, the three-year rule doesn't apply.  Also, bear in mind that taxation of life insurance may not be a concern when the value of the owner's estate is less than the "applicable exclusion amount" (currently $5 million per person), which is the threshhold amount that will cause his or her estate to incur any tax.