10 Estate Planning Tax Facts You Need to Know + 12 More You Need to Know About Life Insurance

10 estate planning tax facts you need to know

By Tax Facts Online
The fiscal cliff deal cleared up every estate planning tax question ever, right? Or not. Because for as much fanfare as the new estate tax received, there are still a lot of sticky tax-related questions out there. Like what, exactly, constitutes an estate? Do life insurance proceeds count? What about employer-provided income benefits? How are annuities treated? Here are 10 big estate planning tax questions, answered.

1. If life insurance proceeds are payable to an insured’s estate, is their value includable in the insured’s estate?
2. Yes. The entire value of the proceeds must be included in the insured’s gross estate even if the insured possessed no incident of ownership in the policy, and paid none of the premiums.^[1] But proceeds payable to an executor in his or her individual capacity rather than as executor for the insured’s estate were not treated as payable to the insured’s estate by the Tax Court.^[2]

[1] .IRC Sec. 2042(1); Est. of Bromley v. Comm., 16 BTA 1322 (1929).

[2] .Est. of Friedberg v. Comm., TC Memo 1992-310.

1. When are life insurance proceeds that are payable to a beneficiary other than the insured’s estate includable in the insured’s estate?
2. Proceeds are includable in an insured’s gross estate if the insured legally possessed and could legally exercise any incidents of ownership at the time of the insured’s death. It does not matter that the insured did not have possession of the policy and therefore was unable to exercise his or her ownership rights at the time of his or her death,^[1] or that the insured was unable as a practical matter to effect any change in the policy because the policy was collaterally assigned.^[2]

The proceeds are includable even if the insured cannot exercise his or her ownership rights alone, but only in conjunction with another person.^[3] It has been held that an insured did not possess incidents of ownership where the insured had paid no premiums, did not regard the policy as the insured’s own, and had made an irrevocable designation of beneficiary and mode of payment of proceeds.^[4] But even if the proceeds are payable to a beneficiary other than the insured’s estate, and the insured possesses no incidents of ownership in the policy, the proceeds are nevertheless includable in the insured’s gross estate if they are receivable for the benefit of the insured’s estate. Even though the insured retains no incidents of ownership in the policy, the proceeds may be includable in the insured’s estate if the insured has transferred the policy within three years before the insured’s death.

[1] .Comm. v. Est. of Noel, 380 U.S. 678 (1965).

[2] .Est. of Goodwyn v. Comm., TC Memo 1973-153.

[3] .IRC Sec. 2042(2); Goldstein’s Est. v. U.S., 122 F. Supp. 677 (Ct. Cl. 1954).

[4] .Morton v. U.S., 29 AFTR 2d 72-1531 (4th Cir. 1972).

1. If an employer provides, under a nonqualified agreement or plan, an income benefit only for certain survivors designated by family or marital relationship to the employee, how is the benefit treated for estate tax purposes in the employee’s estate?
2. The threshold issue is whether the survivor income benefit plan is treated as insurance or as an annuity.

If it is treated as life insurance, includability of the value of the survivor benefit in the employee’s estate is determined under the rules applicable to death proceeds of insurance. The controlling statute in this case is usually IRC Section 2042, although IRC Section 2035 comes into play if the decedent insured has assigned any of his or her rights in the benefit within three years of death. If the plan is treated as an annuity, includability is usually determined under IRC Section 2039(a), but not under IRC Section 2042.

Case law and IRS rulings dealing with the estate taxation of survivor income benefits tend to support the view of the Second Circuit. In All v. McCobb,^[1] the Second Circuit held that a survivor income benefit plan that was uninsured and unfunded lacked the necessary insurance elements of risk-shifting and risk-distribution to be treated as insurance. Est. of Lumpkin v. Comm.,^[2] Est. of Connelly v. U.S.,^[3] and Est. of Smead v. Comm.^[4]all involve insured plans that the courts treated as group insurance.

In Let. Rul. 8046110, a plan funded by group life insurance was treated as insurance. Following Rev. Rul. 69-54, the IRS ruled that because the decedent insured died possessing the right to convert his group life insurance into individual insurance, an incident of ownership, the sum used by the insurance company in determining the amount of the survivor annuity payable was includable in the decedent’s estate.^[5] Rev. Rul. 77-183,^[6] Est. of Schelberg v. Comm.,^[7] and Est. of Van Wye v. U.S.,^[8] all involved uninsured and unfunded plans that the courts treated as annuities.

No estate tax cases or rulings have been found that deal with uninsured funded plans.

[1] .321 F.2d 633 (2nd Cir. 1963).

[2] .474 F.2d 1092 (5th Cir. 1973).

[3] .551 F.2d 545 (3rd Cir. 1977).

[4] .78 TC 43 (1982), acq. in result, 1984-2 CB 2.

[5] .See Treas. Reg. §20.2042-1(a)(3).

[6] .1977-1 CB 274.

[7] .70 TC 690 (1978), rev’d on other grounds, 79-2 USTC ¶13,321 (2nd Cir. 1979).

[8] .82-2 USTC ¶13,485 (6th Cir. 1982).

1. Can an insured remove existing life insurance from his or her gross estate by an absolute assignment of the policy?
2. Yes, assuming the insured lives for at least three years after the assignment, the insured assigns all incidents of ownership, and the assignee is not legally obligated to use the proceeds for the benefit of the insured’s estate.^[1]

If the form of the assignment reserves any incidents of ownership to the insured, the proceeds may be included in the insured’s gross estate despite the insured’s clear intention to transfer all ownership rights.^[2] It has been held that where the insured had paid no premiums and had never treated the policy as his or her own, the insured’s irrevocable designation of beneficiaries and mode of payment of proceeds was an effective assignment of all of the insured’s incidents of ownership in the policy.^[3] The amount of any premiums paid on the assigned policy by the insured may be included to the extent they are paid within three years of death.

A reversionary interest in a policy is an incident of ownership if, immediately before the insured’s death, the value of the reversionary interest is worth more than five percent of the value of the policy.^[4] The insured will have no such reversionary interest, however, if the policy is purchased and owned by another person, or if the policy is absolutely assigned to another person by the insured. Regulations state that the term “reversionary interest” does not include the possibility that a person might receive a policy or its proceeds by inheritance from another person’s estate, by exercising a surviving spouse’s statutory right of election, or under some similar right. They also state that, in valuing a reversionary interest, interests held by others that would affect the value must be taken into consideration. For example, a decedent would not have a reversionary interest in a policy worth more than five percent of the policy’s value, if, immediately before the decedent’s death, some other person had the unrestricted power to obtain the cash surrender value of the policy; the value of the reversionary interest would be zero.^[5]

An insured was treated as holding a reversionary interest in a policy held in a trusteed buy-sell arrangement where the insured was considered to have transferred the policy to the trust and retained the right to purchase the policy for its cash surrender value upon termination of the buy-sell agreement.^[6] However, a policy held in a trusteed buy-sell arrangement would not be includable in an insured’s estate under IRC Section 2042 where (1) proceeds would be received by a partner’s estate only in exchange for purchase of the partner’s stock, and (2) all incidents of ownership would be held by the trustee of the irrevocable life insurance trust.^[7]

[1] .Treas. Regs. §§20.2042-1(b)(1), 20.2042-1(c)(1); Lamade v. Brownell, 245 F. Supp. 691 (M.D. Pa. 1965).

[2] .Est. of Piggott v. Comm., 340 F.2d 829 (6th Cir. 1965).

[3] .Morton v. U.S., 29 AFTR 2d 72-1531 (4th Cir. 1972).

[4] .IRC Sec. 2042(2).

[5] .Treas. Reg. §20.2042-1(c)(3).

[6] .TAM 9349002.

[7] .Let. Rul. 9511009.

 

1. Are life insurance proceeds includable in the insured’s estate if someone other than the insured took out the policy and owns it at the insured’s death?
2. Proceeds ordinarily are not includable in the insured’s gross estate if the insured has never owned the policy and the proceeds are not payable to or for the benefit of his estate.^[1] If the terms of the policy give the insured any legal incidents of ownership, however, the proceeds may be included in the insured’s gross estate even though a third party purchased the policy and always has retained physical possession of it.^[2]

Even though a policy says clearly that incidents of ownership belong to the insured, if it also is clear from facts outside the policy that it was the intention and belief of the parties involved in purchasing the insurance that these ownership rights were to be, and were, placed in another, courts may allow the “intent facts” to override the “policy facts.” That is, they may find that the insured did not actually possess the incidents of ownership the policy said were exercisable by the insured.^[3]

On the other hand, even though the policy does not give the insured any incidents of ownership, an incident of ownership may be given to the insured by an outside document, such as a corporate resolution, a trust indenture, or another agreement between the insured and the third party.^[4] The fact that the insured has had no opportunity to exercise the legal incidents of ownership is immaterial.^[5] Also, if the insured causes insurance to be bought on his or her life by another with funds supplied by the insured and then dies within three years of the purchase, the proceeds may be includable in the insured’s estate. In Est. of Margrave v. Comm.,^[6] the Eighth Circuit affirmed a 9-7 decision of the Tax Court holding that the proceeds of a wife-owned policy, payable revocably to the trustee of a revocable trust created by the insured husband, were not includable in the insured’s estate under either IRC Section 2042 or IRC Section 2041 (general power of appointment). The IRS has agreed to follow the holding in Margrave.^[7]

[1] .IRC Sec. 2042.

[2] .U.S. v. Rhode Island Hosp. Trust Co., 355 F.2d 7 (1st Cir. 1966).

[3] .National Metropolitan Bank v. U.S., 87 F. Supp. 773 (Ct. Cl. 1950); Schongalla v. Hickey, 149 F.2d 687 (2d Cir. 1945), cert. denied 326 U.S. 736; Watson v. Comm., TC Memo 1977-268; First Nat’l Bank of Birmingham v. U.S., 358 F.2d 625 (5th Cir. 1966); Let. Rul. 8610068.

[4] .Est. of Thompson v. Comm., TC Memo 1981-200; St. Louis Union Trust Co. (Orthwein) v. U.S., 262 F. Supp. 27 (E.D. Mo. 1966); Est. of Tomerlin v. Comm., TC Memo 1986-147.

[5] .Comm. v. Est. of Noel, 380 U.S. 678 (1965).

[6] .71 TC 13 (1978), aff’d 45 AFTR 2d ¶148,393 (8th Cir. 1980).

[7] .Rev. Rul. 81-166, 1981-1 CB 477.

1. If partners or stockholders enter into a buy-sell agreement and each purchases life insurance on each other’s lives to fund the agreement, are proceeds includable in an insured’s gross estate?
2. If, under a cross-purchase arrangement, proceeds are not payable to an insured’s estate, and an insured has no incidents of ownership in the policies on his or her life, proceeds are not includable in his or her gross estate.^[1]

The Tax Court has held that a provision in an agreement prohibiting a policy owner from surrendering the policy, borrowing against the policy, or changing the beneficiary of the policy without the insured’s consent did not give the insured incidents of ownership in the policy.^[2] The value of an insured’s partnership interest or corporate stock is includable.^[3] The value of any unmatured policies an insured owns on the life of his or her associates also will be includable.

If proceeds are payable to an insured’s estate, or if an insured has incidents of ownership in a policy on his or her life, proceeds are includable in his or her gross estate.

Where proceeds are includable in the gross estate but the estate is obligated to apply them to the purchase price of the insured’s business interest, the value of the business interest will be includable in the gross estate only to the extent that it exceeds the value of the proceeds. In other words, there will be no double taxation.^[4]

There is some legal authority to the effect that terms of a policy can be modified by terms of a business agreement. Thus, where an agreement gives all beneficial ownership in proceeds to an insured’s co-partners and obligates the parties to apply them to the purchase of the insured’s business interest, proceeds are not included in the insured’s gross estate despite a policy provision giving the insured the right to change the beneficiary.^[5]

[1] .IRC Sec. 2042; Rev. Rul. 56-397, 1956-2 CB 599.

[2] .Est. of Infante v. Comm., TC Memo 1970-206 (appeal dismissed).

[3] .Est. of Riecker v. Comm., 3 TCM 1293 (1944).

[4] .Est. of Mitchell v. Comm., 37 BTA 1 (1938), acq.; Est. of Tompkins v. Comm., 13 TC 1054 (1949), acq.; Est. of Ealy v. Comm.,10 TCM 431; Dobrzensky v. Comm., 34 BTA 305 (1936), nonacq. 1936-2 CB 39; Boston Safe Deposit & Trust Co. v. Comm., 30 BTA 679 (1934), nonacq. 1934-2 CB 34.

[5] .Est. of Fuchs v. Comm., 47 TC 199 (1966), acq. 1967-2 CB 2; First Nat’l Bank of Birmingham v. U.S., 358 F.2d 625 (5th Cir. 1966).

1. How is a closely held business interest valued for federal estate tax purposes where there is no purchase agreement?
2. Valuation of closely held corporate stock requires a determination of fair market value. Estate tax regulations define this as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under compulsion to buy or sell and both having reasonable knowledge of the relevant facts.”^[1]

Factors that should be considered when determining fair market value include the company’s net worth, prospective earnings and dividend paying capacity, goodwill, the economic outlook in the particular industry and its management, the degree of control of the business represented by the block of stock to be valued, and the value of securities of corporations engaged in the same or similar lines of business that are listed on a stock exchange.^[2]

If a block of stock represents a controlling interest in a corporation, a control premium generally adds to the value of the stock. If, however, shares constitute a minority ownership interest, a minority discount often is used. A premium also may attach for swing vote attributes where one block of stock may exercise control by joining with another block of stock.^[3] One memorandum valued stock included in a gross estate at a premium as a controlling interest, while applying a minority discount to a marital deduction portion that passed to a surviving spouse.^[4]

Just because an interest being valued is a minority interest does not mean that a minority discount is available.^[5] One case, however, valued stock with voting rights at no more than stock without voting rights.^[6]

The Tax Court has held that if real estate is specially valued for estate tax purposes under IRC Section 2032A, an estate may not take a minority discount with respect to stock in a corporation that held the real estate.^[7]

In a split decision, however, the Tenth Circuit Court of Appeals has ruled that minority discounts and special use valuation under IRC Section 2032A are not mutually exclusive; it would apply the minority discount to the fair market value of the real estate as owned through a partnership and then apply the $750,000 cap on special use valuation to the difference between fair market value as discounted and special use value of the real estate.^[8]

The Fifth Circuit Court of Appeals has ruled that shares of stock in a decedent’s estate were to be valued as a minority interest when the decedent owned less than 50 percent, despite the fact that control of the corporation was within the decedent’s family. This was true even when, immediately before death, the decedent and the decedent’s spouse owned more than 50 percent of the stock as community property. The court also ruled that family attribution (Q 225) would not apply to lump a decedent’s stock with that of related parties for estate tax valuation purposes both because of prior case law and because applying attribution would be inconsistent with the willing buyer-willing seller rule.^[9]

A minority discount will not be disallowed solely because a transferred interest would be part of a controlling interest if the interest were aggregated with interests held by family members.^[10]

A minority discount was allowed even when the person to whom the interest was transferred already was a controlling shareholder.^[11]

A couple of deathbed transactions, however, were aggregated into a single integrated transfer to which a control premium attached rather than minority discounts where a parent, a 60 percent shareholder, sold a 30 percent interest in a corporation to a child, a 20 percent shareholder and the parent had the corporation redeem the remaining 30 percent interest in the corporation held by the parent.^[12]

The Tax Court has determined that an estate would not be allowed a minority discount where a decedent transferred a small amount of stock immediately prior to death for the sole purpose of reducing her interest from a controlling interest to a minority interest for valuation purposes.^[13]

Similarly, the IRS has disallowed minority discounts while disregarding partnerships or limited liability companies created on a decedent’s deathbed presumably to obtain minority discounts.^[14]

A couple of courts have rejected the idea that a partnership can be ignored for purposes of IRC Section 2703.

A partnership or LLC entity may be included in a gross estate under IRC Section 2036 without the benefit of discounts under a number of circumstances. For example, if a decedent puts everything he or she owns into the entity, retains complete control over the income of the entity, uses the entity as a personal pocket book, or fails to follow entity formalities, the entity may be included in his or her gross estate.^[15]

One case has held that IRC Section 2036 did not apply because the court concluded that the transfer to a partnership was a bona fide sale for adequate consideration.^[16]

[1] .Treas. Reg. §20.2031-1(b).

[2] .Treas. Reg. §20.2031-2. See also Rev. Rul. 59-60, 1959-1 CB 237.

[3] .TAM 9436005.

[4] .TAM 9403005.

[5] .Godley v. Comm., 2002-1 USTC ¶60,436 (4th Cir. 2002) (partnerships held housing projects subject to long term government contracts).

[6] .Est. of Simplot v. Comm., 2001-1 USTC ¶60,405 (9th Cir. 2001).

[7] .Est. of Maddox v. Comm., 93 TC 228 (1989).

[8] .Est. of Hoover v. Comm., 95-2 USTC ¶60,217 (10th Cir. 1995) (acq. 1998-2 CB xix), rev’g 102 TC 777 (1994).

[9] .Est. of Bright v. Comm., 658 F.2d 999 (5th Cir. 1981).

[10] .Rev. Rul. 93-12, 1993-1 CB 202.

[11] .TAM 9432001.

[12] .TAM 9504004.

[13] .Est. of Murphy v. Comm., TC Memo 1990-472.

[14] .TAMs 9719006, 9723009, 9725002, 9730004, 9735003, 9736004, 9842003.

[15] .Est. of Strangi v. Comm., 2005-2 USTC ¶60,506 (5th Cir. 2005), aff’g TC Memo 2003-145; Est. of Bongard v. Comm., 124 TC 95 (2005); Est. of Bigelow v. Comm., 2007-2 USTC ¶60,548 (9th Cir. 2007), aff’g TC Memo 2005-65; Kimbell v. U.S., 2003-1 USTC ¶60,455 (N.D. Tex. 2003), rev’d 2004-1 USTC ¶60,486 (5th Cir. 2004); Est. of Abraham v. Comm., TC Memo 2004-39; Est. of Hilgren v. Comm., TC Memo 2004-46 (discount for business loan agreement was allowed); Est. of Thompson v. Comm., 2004-2 USTC ¶60,489 (3rd Cir. 2004), aff’g TC Memo 2002-246.

[16] .Kimbell v. U.S., 2004-1 USTC ¶60,486 (5th Cir. 2004), rev’g 2003-1 USTC ¶60,455 (N.D. Tex. 2003).

1. How is a closely held business interest valued for federal estate tax purposes where there is a purchase agreement?
2. For purchase agreements entered into after October 8, 1990, or substantially modified after that date, the value of a closely held business interest is to be determined without regard to any purchase agreement exercisable at less than fair market value, determined without regard to the purchase agreement, unless the purchase agreement:

(1)is a bona fide business arrangement;

(2)is not a device to transfer property to members of the decedent’s family for less than full or adequate consideration in money or money’s worth; and

(3)has terms comparable to those entered into by persons in an arm’s length transaction.^[1]

Whether or not an agreement is subject to IRC Section 2703, case law has established the additional following rules:

(1)an estate must be obligated to sell at death under either a mandatory purchase agreement or an option held by the business or survivors;

(2)the price must be fixed by the terms of the agreement or the agreement must contain a formula or method for determining the price;

(3)the agreement must prohibit an owner from disposing of his or her interest during life without first offering it to the other party or parties at no more than the contract price;

(4)the price must be fair and adequate when the agreement is made.^[2]

If a business purchase agreement calls for shares to be purchased from an estate with installment purchase notes bearing a rate of interest lower than the market rate at the date of death, an executor may be allowed to discount the value of the shares by the difference between the interest rate called for in the buy-sell agreement and the prevailing rate at the date of death.^[3]

A first-offer agreement, under which survivors have no enforceable right to purchase the business interest and can purchase the interest only if the executor wishes to sell and does not fix the value of the interest for estate tax purposes.^[4]

If an agreement is between closely related persons and is merely a scheme for avoiding estate taxes, the price set in the agreement will not control.^[5]

A buy-sell agreement is not binding unless it represents a bona fide business agreement and is not testamentary in nature.^[6] An agreement may be found to be a scheme for avoiding estate taxes even where it serves a bona-fide business purpose.^[7]

No effect will be given to an option or contract under which a decedent is free to dispose of the interest or shares at any price he or she chooses during life.^[8]

On the other hand, an agreement that restricts sale during life, but not at death, also will fail to fix the estate tax value.^[9]

[1] .See IRC Sec. 2703.

[2] .May v. McGowan, 194 F.2d 396 (2nd Cir. 1952); Comm. v. Child’s Est., 147 F.2d 368 (3rd Cir. 1945); Comm. v. Bensel, 100 F.2d 639 (3rd Cir. 1938); Lomb v. Sugden, 82 F.2d 166 (2nd Cir. 1936); Wilson v. Bowers, 57 F.2d 682 (2nd Cir. 1932); Est. of Littick v. Comm., 31 TC 181 (1958), acq. in result 1984-2 CB 1; Est. of Salt v. Comm., 17 TC 92 (1951), acq.; Brodrick v. Gore, 224 F.2d 892 (10th Cir. 1955); Fiorito v. Comm., 33 TC 440 (1959), acq.; Est. of Weil v. Comm., 22 TC 1267 (1954), acq.; Est. of Bischoff v. Comm., 69 TC 32 (1977); see also Treas. Reg. §20.2031-2(h); Treas. Reg. §20.2031-3.

[3] .Let. Rul. 8245007.

[4] .Worcester County Trust Co. v. Comm., 134 F.2d 578 (1st Cir. 1943); City Bank Farmers Trust Co. v. Comm., 23 BTA 663 (1931), acq. 1932-1 CB 2; Michigan Trust Co. v. Comm., 27 BTA 556 (1933).

[5] .Slocum v. U.S., 256 F. Supp. 753 (S.D.N.Y. 1966).

[6] .Est. of True v. Comm., 2004-2 USTC ¶60,495 (10th Cir. 2004).

[7] .St. Louis County Bank v. U.S., 49 AFTR 2d ¶1509 (8th Cir. 1982).

[8] .Est. of Caplan v. Comm., TC Memo 1974-39; Est. of Gannon v. Comm., 21 TC 1073 (1954); Est. of Trammell v. Comm., 18 TC 662 (1952), acq. 1953-1 CB 6; Est. of Mathews v. Comm., 3 TC 525 (1944); Hoffman v. Comm., 2 TC 1160 (1943); Est. of Tompkins v. Comm., 13 TC 1054 (1949); Rev. Rul. 59-60, 1959-1 CB 237; Rev. Rul. 157, 1953-2 CB 255.

[9] .Land v. U.S., 303 F.2d 170 (5th Cir. 1962).

1. What benefits payable at death are included in the term “life insurance” for estate tax purposes?

IRC Section 2042 deals with the estate taxation of proceeds from insurance on the life of a decedent. According to regulations, the term “insurance,” as used in IRC Section 2042, means life insurance of every description, including death benefits paid by fraternal societies operating under the lodge system.^[1] In the case of a retirement income endowment, the death proceeds are treated as insurance proceeds under IRC Section 2042 if the insured dies before the terminal reserve value equals or exceeds the face value; if the insured dies after that time, the proceeds are treated as death proceeds of an annuity contract.^[2]

With respect to the proceeds of “no-fault” automobile liability insurance, the IRS has ruled on three categories of benefits:

(1)Survivors’ loss benefits. These are benefits payable only to certain named dependent survivors of the insured; if the insured dies leaving no such eligible dependents, no benefits are paid. The value of any such benefit is not includable in the insured’s gross estate under IRC Section 2033 or under IRC Section 2042(2) because if the proceeds are life insurance (an issue the ruling did not decide) the insured would not have owned any incidents of ownership at his or her death.^[3]

(2)Basic economic loss benefit. This benefit covers the insured’s medical expenses and loss of income arising from the insured’s injury while operating an automobile. The value of this benefit is includable in the insured’s gross estate under IRC Section 2033, but not under IRC Section 2042(1) (life insurance proceeds payable to or for the insured’s estate).^[4]

(3)Death benefit. This is a benefit payable unconditionally to the estate of the insured and to the estate of any passenger in the insured’s car killed in a covered accident. The value of this benefit is includable under IRC Section 2042(1) in the estate of each insured receiving the benefit.^[5]

[1] .Treas. Reg. §20.2042-1(a).

[2] .Treas. Reg. §20.2039-1(d).

[3] .Rev. Rul. 82-5, 1982-1 CB 131.

[4] .Rev. Rul. 83-44, 1983-1 CB 228.

[5].Rev. Rul. 83-44, above.

1. When are annuities or annuity payments includable in a decedent’s gross estate under IRC Section 2039?
2. IRC Section 2039 deals with annuities or other payments receivable by any beneficiary under any form of contract or agreement by reason of surviving the decedent. Subsections (a) and (b) of that section state the circumstances under which such an annuity or payment is includable in the decedent’s gross estate. Thus, IRC Section 2039 applies to death and survivor benefits under annuity contracts and under optional settlements of living proceeds from life insurance policies and endowment contracts.

Exclusions under various provisions of IRC Section 2039 may apply to employee annuities which are part of qualified pension and profit sharing plans; to employee annuities payable under nonqualified deferred compensation plans, including death benefit only plans; to certain tax sheltered annuity plans; and to individual retirement savings plans.

12 more estate planning tax facts you need to know about life insurance

By Robert Bloink, William H. Byrnes

January 24, 2014 • Reprints

Estate planning is a complicated business. Before you sit down with clients, find out what Uncle Sam will demand if a life insurance policy or an annuity is part of their estate, or part of a recent inheritance.

See also: 10 estate planning tax facts you need to know

1. When are death proceeds of life insurance includable in an insured’s gross estate?

They are includable in the following four situations:

(1) The proceeds are payable to the insured’s estate, or are receivable for the benefit of the insured’s estate.

(2) The proceeds are payable to a beneficiary other than the insured’s estate but the insured possessed one or more incidents of ownership in the policy at the time of the insured’s death, whether exercisable by the insured alone or only in conjunction with another person.

(3) The insured has made a gift of the policy on his or her life within three years before his or her death.

(4) The insured has transferred the policy for less than an adequate consideration (i.e., the transaction was not a bona fide sale) and the transfer falls within one of the rules for includability contained in IRC Sections 2035, 2036, 2037, 2038, or 2041. Under these circumstances, the value of the proceeds in excess of the value of the consideration received is includable in an insured’s estate. A grantor may retain the power to substitute property of an equivalent value. Such a power, in and of itself, generally does not cause the trust corpus to be includable under IRC Section 2036 or 2038.

 

2. What are the incidents of ownership that, if held by an insured, will cause life insurance proceeds to be includable in the insured’s estate?

Proceeds are includable in an insured’s gross estate if the insured possesses any of the following incidents of ownership at his or her death:

• the right to change the beneficiary;
• the right to surrender or cancel the policy;
• the right to assign the policy;
• the right to revoke an assignment;
• the right to pledge the policy for a loan; or
• the right to obtain a policy loan.

The reservation of a right to make premium loans has been held to be an incident of ownership. A right to change contingent beneficiaries, who are to receive benefits after the primary beneficiary’s death, also is an incident of ownership.

The mere right to change the time or manner of payment of proceeds to the beneficiary, as by electing, changing, or revoking settlement options, has been held an incident of ownership, but the Tax Court and the U.S. Court of Appeals for the Third Circuit have held to the contrary. (In 1981, the IRS reiterated its opposition to the Third Circuit’s holding in Connelly, and indicated its intent to continue to oppose that result in all circuits except the Third (Pa., Del., N.J., Virgin Islands).

According to a Technical Advice Memorandum, trust provisions that changed the beneficial interest from a decedent’s spouse to the decedent’s children if the decedent and the decedent’s spouse became divorced were not the equivalent to a retained incident of ownership that would bring the life insurance proceeds into the decedent’s estate. The memorandum implies that the result would have been different if the trust had provided that the beneficial interest would revert to the decedent upon divorce.

The right to receive disability income is an incident of ownership if payment of disability benefits would reduce the face amount payable at death. But where an employer corporation owned the policy and the insured employee was entitled to benefits under a disability income rider, the IRS did not claim that the right to the disability income was an incident of ownership that would cause the proceeds to be includable in the insured’s gross estate.

A more than 5 percent reversionary interest in the proceeds is an incident of ownership. When a wife, who owned insurance on her husband’s life and who was the primary beneficiary, changed the contingent beneficiary from her estate to whomever the insured named in his will, the IRS ruled that the insured did not possess at his death an incident of ownership.

3. What are the incidents of ownership of employer-paid death benefits that would cause life insurance proceeds to be includable in the insured’s estate?

An employee insured’s right to designate the beneficiary of an employer-paid death benefit is not treated as an incident of ownership in the insurance funding the benefit if the employer is sole owner of the policy and sole beneficiary for its exclusive use. The IRS has taken the position that if the insured under a corporation-owned policy has an agreement with the corporation giving the insured the first right to purchase the policy for its cash surrender value if the corporation decides to discontinue the coverage, the purchase option is an incident of ownership. The Tax Court has held, however, that the insured’s contingent purchase option as described in Revenue Ruling 79-46 is not an incident of ownership within the meaning of IRC Section 2042(2).

The IRS also has ruled that where, under an insured stock redemption agreement, a stockholder had the right to purchase the policies the corporation owned on the insured’s life if the insured ceased being a stockholder, such contingent purchase option was not an incident of ownership in the insurance. An insured who held the right to purchase a policy upon termination of a buy-sell agreement did not possess incidents of ownership so long as the contingency had not occurred, but would possess incidents once the agreement was terminated.

Also, a shareholder was not treated as holding incidents of ownership in a life insurance policy where the shareholder could purchase a corporate-owned policy upon disability, or upon a cross-purchase of the shareholder’s stock if the shareholder dissented to sale of the corporation to a third party or a public offering. However, an insured was treated as holding incidents of ownership in a policy held in a trusteed buy-sell arrangement where the insured was considered to have transferred the policy to the trust and retained the right to purchase the policy for its cash surrender value.

The right to receive dividends has been held not to be an incident of ownership in the policy. It has been held that if the insured has the power to terminate the interest of the primary beneficiary with only the consent of the secondary beneficiary, the insured has an incident of ownership. However, a sole shareholder would not be treated as holding incidents of ownership in a life insurance policy on the shareholder’s own life where a collateral consequence of a termination of an employee’s employment would be a termination of the employee’s option agreement to purchase the shareholder’s stock with a corresponding change in beneficiary of the insurance proceeds held in an irrevocable life insurance trust created by the employee.

The assignment of a life insurance policy by a third-party owner as an accommodation to the insured to cover the insured’s debts does not in itself create in the insured an incident of ownership. But if a policy owner collaterally assigns a policy as security for a loan and then makes a gift of the policy subject to the assignment, the donor will be deemed to have retained an incident of ownership.

Where an insurance funded buy-sell agreement prohibited each partner from borrowing against, surrendering, or changing the beneficiary on the policy each owned on the life of the other partner without the insured’s consent, the Tax Court held that the decedent-insured did not possess an incident of ownership in the policy insuring the decedent-insured’s life. However, it has been reported that the IRS, citing an internal ruling dated January 7, 1971, has declined to follow the decision.

An insured was treated as holding incidents of ownership in a policy held in a trusteed buy-sell arrangement where the trust could only act as directed by the shareholders through the buy-sell agreement and the insured could thus withhold consent to the exercise of policy rights.

Where an insured absolutely assigned a policy that required the insured’s consent before the policy could be assigned, or the beneficiary changed, to someone who had no insurable interest in the insured’s life, IRS ruled that the insured had retained an incident of ownership.

Similarly, the Tax Court has held that an employee’s right to consent to a change of beneficiary on a split dollar policy owned by the employee’s employer on the employee’s life is an incident of ownership. The Tax Court also has held that where the insured assigned policies, retaining the right to consent to the assignee’s designating as beneficiary, or assigning the policies to, anyone who did not have an insurable interest in the insured’s life, the assignee’s act of designating an irrevocable beneficiary did not eliminate the insured’s retained incidents of ownership. The Third Circuit reversed the Tax Court in this case, however, taking the position that because under the facts presented the insured could not have enjoyed any economic benefit from exercising the insured’s veto power over the designation of beneficiaries or assignees, the insured’s retained power did not amount to an incident of ownership. The insured’s right to purchase the policy from an assignee was treated as equivalent to the right to revoke an assignment, which is an incident of ownership.

4. Can an insured remove existing life insurance from his or her gross estate by an absolute assignment of the policy but retaining a reversionary interest?

A reversionary interest in a policy is an incident of ownership if, immediately before the insured’s death, the value of the reversionary interest is worth more than five percent of the value of the policy. The insured will have no such reversionary interest, however, if the policy is purchased and owned by another person, or if the policy is absolutely assigned to another person by the insured. Regulations state that the term “reversionary interest” does not include the possibility that a person might receive a policy or its proceeds by inheritance from another person’s estate, by exercising a surviving spouse’s statutory right of election, or under some similar right. They also state that, in valuing a reversionary interest, interests held by others that would affect the value must be taken into consideration. For example, a decedent would not have a reversionary interest in a policy worth more than 5 percent of the policy’s value, if, immediately before the decedent’s death, some other person had the unrestricted power to obtain the cash surrender value of the policy; the value of the reversionary interest would be zero.

An insured was treated as holding a reversionary interest in a policy held in a trusteed buy-sell arrangement where the insured was considered to have transferred the policy to the trust and retained the right to purchase the policy for its cash surrender value upon termination of the buy-sell agreement. However, a policy held in a trusteed buy-sell arrangement would not be includable in an insured’s estate under IRC Section 2042 where (1) proceeds would be received by a partner’s estate only in exchange for purchase of the partner’s stock, and (2) all incidents of ownership would be held by the trustee of the irrevocable life insurance trust.

5. If life insurance proceeds are required under the terms of a property settlement agreement or a divorce decree to be paid to certain beneficiaries, are the proceeds includable in the insured’s estate?

Includability of Proceeds or Premiums

The IRS has ruled that where a divorced wife had an absolute right, under terms of a property settlement agreement incorporated by reference in a divorce decree, to annuity payments after the death of her former husband, and such payments were to be provided by insurance on his life maintained by him for that purpose, the former husband possessed no incidents of ownership in the insurance at his death. As a result, no part of the insurance proceeds was includable in his estate. Also, the Tax Court has held that where a divorced husband was required under a property settlement agreement to maintain insurance on his life payable to his former wife, if living, but otherwise to their surviving descendants or to his former wife’s estate if there were no surviving descendants, the insured possessed no incidents of ownership in the insurance. The insurance, in other words, was not merely security for other obligations. In another case, the Tax Court held that where an insured was subject to a court order requiring the insured to maintain insurance on his life payable to his minor children, such court order, operating in conjunction with other applicable state law, effectively nullified incidents of ownership the insured would otherwise possess by policy terms.

When, on the other hand, the divorced husband was merely required to maintain a stated sum of insurance on his life payable to his former wife so long as she lived and remained unmarried, the insured was held to have retained a reversionary interest sufficient in value to make the proceeds includable in his estate It also has been held that where, pursuant to a divorce decree, the proceeds of insurance maintained by a divorced husband on his own life to secure alimony payments are paid following the insured’s death directly to the former wife, the proceeds are includable in the insured’s estate. The Board of Tax Appeals reasoned that because the proceeds satisfy a debt of the decedent or his estate, the result is the same as if the proceeds are received by the decedent’s executor.

6. May a charitable contribution deduction be taken for the gift of a life insurance policy or premium? May a charitable contribution deduction be taken for the gift of a maturing annuity or endowment contract?

Yes, subject to the limits on deductions for gifts to charities.

The amount of any charitable contribution must be reduced by the amount of gain that would have represented ordinary income to the donor had the donor sold the property at its fair market value. Gain realized from the sale of a life insurance contract is taxed to the seller as ordinary income. Therefore, the deduction for a gift of a life insurance policy to a charity is restricted to the donor’s cost basis in the contract when the value of the contract exceeds the premium payments. Thus, if a policy owner assigns the policy itself to a qualified charity, or to a trustee with a charity as irrevocable beneficiary, the amount deductible as a charitable contribution is either the value of the policy or the policy owner’s cost basis, whichever is less. It is not necessary, however, to reduce the amount of the contribution when, by reason of the transfer, ordinary income is recognized by the donor in the same taxable year in which the contribution is made. Letter Ruling 9110016, which denied a charitable deduction when a policy was assigned to a charity that had no insurable interest under state law, was revoked after the taxpayer decided not to proceed with the transaction.

Premium payments also are deductible charitable contributions if a charitable organization or a trustee of an irrevocable charitable trust owns the policy. It is not settled whether premium payments made by the donor to the insurer to maintain a policy given to the charity, instead of making cash payments directly to the charity in the amount of the premiums, are gifts to the charity or merely gifts for the use of the charity. The difference is important when the donor wishes to take a charitable deduction of more than 30 percent of the donor’s adjusted gross income. When the policy is merely assigned to a charitable organization as security for a note, the premiums are not deductible even though the note is equal to the face value of the policy and is payable from the proceeds at either the insured’s death or the maturity of the policy. The reason is that the note could be paid off and the policy recovered after the insured has obtained charitable deductions for the premium payments. A corporation, as well as an individual, can take a charitable contribution deduction for payment of premiums on a policy that has been assigned to a charitable organization.

Planning Point: For a number of reasons, including concerns over the rules limiting a tax deduction to the lesser of fair market value or basis and because of the uncertainty regarding tax consequences of premium payments made by the donor directly to the insurance company on a policy owned by a charity, it is generally preferable for a donor to make cash gifts to a charity and allow the charity to pay premiums on policies owned by the charity. It is important, however, not to require that the cash gifts be used for premium payments.

7. When can death proceeds of community property life insurance payable to someone other than the surviving spouse be includable in the surviving spouse’s gross estate?

If the insured elects to have death proceeds held under an interest or installment option for the insured’s surviving spouse with proceeds remaining at the surviving spouse’s death payable to another, a portion of such remaining proceeds may be includable in the surviving spouse’s gross estate under IRC Section 2036 as a transfer by the surviving spouse of his or her community property interest with life income retained. Such a transfer will be imputed to the surviving spouse if under state law the insured’s death makes the transfer absolute. The amount includable is the value of the surviving spouse’s community half of the remaining proceeds going to the beneficiary of the remainder interest, less the value (at the insured’s death) of the surviving spouse’s income interest in the insured’s community half of the proceeds. In states where the noninsured spouse has a vested interest in the proceeds of community property life insurance (e.g., California and Washington), a gift of the surviving spouse’s community property interest should not be imputed to the surviving spouse unless the surviving spouse has consented to or has acquiesced in the insured’s disposition of the proceeds. But see, Est. of Bothun v. Comm., decided under California law, where an IRC Section 2036 transfer was imputed to the surviving spouse-primary beneficiary when, because the surviving spouse failed to survive a fifteen-day delayed payment clause, proceeds were paid to the contingent beneficiary. The opinion contained no suggestion of any evidence that the noninsured spouse had consented to the delayed payment clause.

The IRS has ruled that where community property life insurance is payable to a named beneficiary other than the noninsured spouse, if deaths of the insured and the insured’s spouse occur simultaneously when both possess the power to change the beneficiary in conjunction with the other, one-half of the proceeds is includable in each spouse’s estate without regard to whether local law provides a presumption as to survivorship.

8. How is community property life insurance taxed when the spouse who is not the insured dies first?

One-half of the value of the unmatured policy is includable in the non-insured spouse’s gross estate. The value of the policy is determined under Treasury Regulation Section 20.2031-8. The amount includable in the estate of the surviving insured spouse upon his or her subsequent death is determined by applying state law to the facts presented to ascertain the extent to which the proceeds are treated as community property or as separate property of the insured.

9. What are the estate tax results when a decedent has been receiving payments under an annuity contract?

If a decedent was receiving a straight life annuity, there is no property interest remaining at the decedent’s death to be included in the decedent’s gross estate.

If a contract provides a survivor benefit (as under a refund life annuity, joint and survivor annuity, or installment option), tax results depend on whether the survivor benefit is payable to a decedent’s estate or to a named beneficiary and, if payable to a named beneficiary, on who paid for the contract.

If payable to a decedent’s estate, the value of the post-death payment or payments is includable in the decedent’s gross estate under IRC Section 2033 as a property interest owned by the decedent at the time of his or her death. If payable to a named beneficiary, the provisions of IRC Section 2039(a) and IRC Section 2039(b) generally apply and inclusion in the gross estate is determined by a premium payment test. Thus, if a decedent purchased the contract (after March 3, 1931), the value of the refund or survivor benefit is includable in the decedent’s gross estate.

In the event a decedent furnished only part of the purchase price, the decedent’s gross estate includes only a proportional share of this value.

The foregoing rules do not apply to death proceeds of life insurance on the life of a decedent. In addition, special statutory provisions apply to employee annuities under qualified pension and profit-sharing plans, to certain other employee annuities, and to individual retirement plans.

10. In the case of a joint and survivor annuity, what value is includable in the gross estate of the annuitant who dies first?

The value of a survivor’s annuity is includable in the deceased annuitant’s gross estate in proportion to his or her contribution to the purchase price of the contract. (This rule applies to contracts purchased after March 3, 1931).

Thus, if a deceased annuitant purchased the contract, the full value of the survivor’s annuity is includable in his or her gross estate. If the survivor purchased the contract, no part of the value is includable in the deceased annuitant’s estate. If both contributed to the purchase price, only a proportionate part of the value is includable in the deceased’s estate.

For example, suppose that the decedent and his wife each contributed $15,000 to the purchase price of a joint and survivor annuity payable for their joint lives and the life of the survivor. If the value of the survivor’s annuity is $20,000 at the decedent’s death, the amount to be included in his gross estate is one-half of $20,000 ($10,000) since he contributed one-half of the cost of the contract.

In accord with this rule, if a joint and survivor annuity is purchased with community funds, only one-half of the value of the survivor’s annuity is includable in the gross estate of the spouse who dies first.

Where a joint and survivor annuity between spouses is treated as qualifying terminable interest property for gift tax purposes and the donee spouse dies before the donor spouse, nothing is included in the donee spouse’s estate by reason of the qualifying interest. Where the survivor is the deceased annuitant’s spouse, the value of the survivor’s annuity will qualify for the marital deduction if the contract satisfies applicable conditions.

See also: Legacy planning for the uninsurable client

Planning Point: A joint and survivor annuity between spouses usually will escape estate tax in both spouse’s estates because of the marital deduction and because the annuity ends at the survivor’s death.

11. Are death proceeds payable under a single premium annuity and life insurance combination includable in an annuitant’s gross estate?

Yes.

Even though an insured-annuitant holds no incidents of ownership in a life insurance policy at death, the proceeds of the policy nevertheless are includable in his or her gross estate under IRC Section 2039 as a payment under an annuity contract purchased by the insured-annuitant.

In a case decided before IRC Section 2039 was enacted, the U.S. Supreme Court held that the proceeds were not includable in the insured-annuitant’s gross estate under IRC Section 2036 as property transferred by the insured-annuitant in which he retained a right to income for life.

If an insured-annuitant transfers a life insurance policy within three years before his or her death, the proceeds may be includable in the insured-annuitant’s gross estate under IRC Section 2035.

If an insured-annuitant owns a life insurance policy at death, the proceeds are includable in his or her gross estate either as property owned at the time of death or as a payment under an annuity contract purchased by the insured-annuitant.

12. If a decedent purchased an annuity on the life of another person, will the value of the contract be includable in his or her gross estate?

If a decedent purchased an annuity as a gift for another person and retained no interest in the annuity payments, incidents of ownership, or refunds, the value of the annuity ordinarily will not be includable in the decedent’s gross estate.

If a decedent has named him or herself as refund beneficiary, the value of the refund may be taxable in the decedent’s estate as a transfer intended to take effect at death. This rule is not applicable, however, unless the value of the refund exceeds 5 percent of the value of the annuity immediately before the donor’s death. Moreover, if the donee-annuitant has the power to surrender the contract or to change the refund beneficiary, it would appear that such a power would preclude taxation in the donor’s estate as a transfer to take effect at death.

Where a decedent retains ownership of a contract until death, the value in the decedent’s gross estate apparently would be the cost of a comparable contract at the time of the decedent’s death. In one case, however, where a decedent and his wife paid one-half the cost of an annuity for their son, reserving to themselves the right to surrender the contract, only one-half the surrender value was included in the decedent’s gross estate.

 

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