Internal Revenue Code section §2042 deals with the inclusion in the gross estate, of the proceeds of life insurance policies, payable by reason of the death of the insured. In general, the insurance proceeds are includable in the gross estate if the proceeds are:
(i) receivable by or for the benefit of the decedent's estate, or
(ii) receivable by other named beneficiaries, if the decedent-insured possessed any "incidents of ownership" in the policy at the time of death.
Thus, in order to avoid estate tax on life insurance proceeds, it is critical that the insured's estate not be named as the beneficiary, and the policy must be owned by someone other than the insured.
(The treatment of insurance death benefits for income tax purposes should not be confused with estate tax treatment. Code §2042 deals with the inclusion in the gross estate, of the proceeds of life insurance policies, payable by reason of the death of the insured. I.R.C. §101 deals with the income tax treatment of insurance benefits. Under I.R.C. §101 benefits paid under a contract of insurance by reason of the death of the insured are excluded from gross income. The income tax exclusion is applicable regardless of who paid the premium on the policy or to whom the death benefit is payable. The exclusion may be lost, though, in the case of an existing insurance policy which has been transferred for a valuable consideration during the insured's lifetime (the so-called transfer for value rule).
Clearly, if the insurance policy provides for direct payment of the death benefit to the estate of the insured, the entire amount is includable in the gross estate -- even if the decedent-insured had possessed no incidents of ownership when he died. (However, if the proceeds made payable to the decedent's estate are community assets under local community property law and, as a result, one half of the proceeds belongs to the decedent's spouse, then only one half of the proceeds is considered receivable by or for the benefit of the estate.) However, the general rule goes beyond direct payment to the estate. The gross estate includes policy proceeds paid to beneficiaries other than estate to the extent used to indirectly benefit the estate. Thus, if the proceeds are receivable by another beneficiary but are subject to a legally binding obligation on that beneficiary to pay taxes, debts or other charges enforceable against the estate, then the amount of such proceeds required for satisfaction in full of such obligation is includable in the gross estate. For example, if the insurance proceeds are payable to a trust, and one of the provisions of the trust instrument requires that the trustee pay any estate tax liability of the decedent's estate, the portion of the proceeds so utilized would be includable in the gross estate.
Under I.R.C. §2042, if the proceeds are payable to a beneficiary other than decedent's estate, they may still be includable in the gross estate if the decedent possessed "incidents of ownership" in the policy when he died. Generally speaking, the term "incidents of ownership" refers to the right to the economic benefits of the policy. Thus, it includes the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain a loan against the surrender value. Whether or not a decedent possessed "incidents of ownership" has been the subject of scores of court decisions and IRS rulings involving a broad spectrum of factual circumstances. The following sections discuss some of the facets of this issue.
Reversionary Interest as "Incident of Ownership"
I.R.C. §2042(2) specifically states that if the insured had a reversionary interest in the policy and, as of the date of death, the reversionary interest exceeded 5 percent of the value of the policy, than the decedent is deemed to have held an incident of ownership. The term "reversionary interest" in this context includes a possibility that the policy or its proceeds may return to the decedent or his estate and a possibility that the policy or its proceeds may become subject to a power of disposition by him.
Example: Four years prior to her death Amy transferred all ownership rights in a $200,000 insurance policy on her life to Bob, her son. Bob is the beneficiary of the policy. However, if he should predecease his mother, ownership of the policy reverts to her. Amy died when Bob was 26 years old (as calculated to his nearest birthday). Is any part of this $200,000 policy includable in Amy's gross estate? The proceeds of a life insurance policy insuring Amy's life are included in her gross estate if such proceeds are paid to or for the benefit of her estate or if she held any incidents of ownership in the policy within three years of her death. Although Amy transferred all ownership rights in the policy more than three years prior to her death, the possibility that she might regain such ownership (if Bob predeceased her) is considered an incident of ownership if the value of this reversionary interest (immediately before Amy's death) is more than 5% of the policy's value. Thus, if the value of Amy's reversionary interest is greater than 5%, the entire $200,000 of proceeds are included in her gross estate. The actuarial value of her reversionary interest is determined as of the date of her death using 120% of the federal midterm rate (the "Section 7520 rate") for the month of her death. Assume that the Section 7520 rate for that month is 7.8%. After the appropriate Section 7520 rate is determined, the applicable remainder factor is taken from Table S of IRS Pub.1457. Based on a 7.8% rate and Bob's age of 26 at Amy's death, her remainder interest is valued at $9,830 ($200,000 x .04915). Thus, the policy's proceeds are not included in Amy's gross estate since $9,830 is not greater than 5% of the policy's value.
Incidents of Ownership Requiring Consent of Another Party
The insured is deemed to possess an incident of ownership for purposes of I.R.C. §2042 even if he is unable to utilize it acting alone, but must act in conjunction with another person. §2042(2). For example, if an insured's spouse is the owner of the policy and possesses all of the incidents of ownership, except that the consent of the insured is required for any assignment of the policy or change of beneficiary to anyone having an insurable interest in his life, this control over assignment and beneficiary change is an incident of ownership in the insured. See Rev. Rul. 75-70, 1975-1 CB 301; Schwager v. Commissioner, 64 TC 781 (1975). This is so even though the insured could not himself effect an assignment or beneficiary change without participatory action by the spouse. In effect, the mere right to veto an action with respect to a policy can be an incident of ownership.
Incidents of Ownership Held in Fiduciary Capacity
Would the proceeds of an insurance policy payable to a beneficiary other than the insured be includable in the gross estate of the insured if he had possessed no incidents of ownership in his own right, but possessed powers with respect to the policy solely in his capacity as a trustee or fiduciary for other parties? Although it would seem that possession of rights solely in a fiduciary capacity would not confer upon the decedent-insured the personal economic interest in the policy which should cause it to be taxed as part of his gross estate, the IRS has taken a position requiring inclusion in the gross estate of the fiduciary-insured in either of the following situations:
If the fiduciary's powers may be exercised in any way in favor of himself personally; or
If the insured transferred the policy or at least some of the consideration for purchasing or maintaining the policy to the trust from personal assets and the trust powers devolved upon the insured as part of a prearranged plan involving the participation of the insured.
The Revenue Ruling which sets forth this rule, Rev. Rul. 84-179, 1984-2 CB 195, purports to be consistent with the positions taken in several earlier court cases, most notably in the Tax Court and the Sixth and Second circuit Courts of Appeals, [See Estate of Shafter v. Commissioner, 468 F.2d 699 (2nd Cir. 1972); Estate of Freehauf v. Commissioner, 427 F.2d 80 (6th Cir. 1970). The Revenue Ruling effectively abandons the strict position originally stated in Regs. §20.2042-1(c)(4), and adopted in the Fifth circuit (see, e.g., Rose v. U.S., 511 F.2d 259 (5th Cir. 1975)), to the effect that any incident of ownership possessed by a fiduciary-insured will cause the policy proceeds to be includable in his gross estate, even if it could not be exercised for his own personal benefit.] in which varying (though not necessarily conflicting) rules had been adopted, based upon the respective facts presented.
Incidents of Ownership Held by a Corporation
Reg. §20.2042-1(c)(6) provides, in effect, that if an insurance policy is owned by a corporation, insuring the life of a controlling stockholder, the incidents of ownership are attributed to the stockholder, except to the extent that the policy proceeds are payable to the corporation or to a third party for a valid business purpose (i.e., for the benefit of the corporation). For purposes of this rule, a controlling shareholder is someone who owns stock possessing more than fifty percent (50%) of the total combined voting power of the corporation.
Thus, for example, if S owns 70 percent of the stock of C Corp. and C Corp. owns a $500,000 policy on S's life, the estate tax consequences would depend upon the identity of the beneficiary. If the corporation is the sole beneficiary then none of the incidents of ownership would be attributed to S. The theoretical reason for this is that if the proceeds are payable to the corporation, the value of S's gross estate will be increased by the resulting increase in the value of his stock, so that there would be a duplication of the gross estate impact if the policy proceeds were also includable by attribution of the incident of ownership. (It should be noted that in any case where the controlling stockholder-insured owns less than 100 percent of the corporation's stock, the gross estate impact through increase in stock value would ordinarily be less than inclusion of the entire policy proceeds in the gross estate under the general rule of §2042.) On the other hand, if the death benefit were payable 25 percent to the corporation and 75 percent to the children of the stockholder-insured, then the decedent will be deemed to have possessed incidents of ownership with respect to 75 percent of the policy, and $375,000 (the proceeds payable to the children) will be includable in his gross estate by virtue of the attribution principle.
Incidents of Ownership Held by a Partnership
In the case where a partnership owns an insurance policy on the life of one of its partners, the IRS essentially follows similar rules it applies for corporate ownership (see above). Thus, when proceeds are payable to beneficiaries other than the partnership, the partnership's incidents of ownership will be attributed to the insured partner. Note that, unlike the rule for corporations, it is the view of the IRS that this attribution through partnership operates without regard to whether or not the insured held a controlling interest in the partnership. Rev. Rul. 83-147, 1983-2 CB 145. On the other hand, in the case of group term insurance, the partnership's incidents of ownership will not be attributed to insured partners. Rev. Rul. 83-148, 1983-2 CB 146.
If the proceeds are payable to the partnership, only the decedent's percentage interest is includable (even if the decedent was a general partner). See Estate of Knipp, 25 TC 153 (1955) acq. in result, 1959-1 C.B. 4, aff’d on another issue, 244 F.2d 436 (4th Cir. 1957), cert. den. 355 U.S. 827.
In addition to the property owned outright at the date of death the gross estate for federal estate tax purposes includes certain other property with which the decedent was connected, as discussed in the following blog posts:
Proceeds of Life Insurance - I.R.C. §2042