How can you make sure the life insurance death benefits your family (or other beneficiaries) will receive after your death avoid the federal estate tax? This is an important issue because, once the federal estate tax applies to a decedent’s estate, the rates are high (beginning at 37% and going up to 55%; although the top rate drops to 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45% in 2007, 2008, and 2009).
Insurance on your life will be included in your taxable estate if either (1) your estate is the beneficiary of the insurance proceeds, or (2) you possessed certain economic ownership rights (“incidents of ownership”) in the policy at your death (or within three years of your death).
Avoiding the first situation is easy. Just make sure your estate is not designated as beneficiary of the policy. The second rule is more complex. Clearly, if you are the owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is. However, simply having someone else possess legal title to the policy will not prevent this result if you keep so-called “incidents of ownership” in the policy. Those rights which, if retained and held by you, will cause the proceeds to be taxed in your estate include:
Keep in mind that merely having any of the above powers will cause the proceeds to be taxed in your estate even if you never exercise the power.
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 your estate (unless the estate is named as beneficiary). For example, say Jim and Ralph 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, Jim buys a life insurance policy on Ralph's life. Jim pays all the premiums, retains all incidents of ownership, and names himself beneficiary. Ralph does the same regarding Jim. When the first partner dies, the insurance proceeds are not taxed in his estate.
Irrevocable Life Insurance Trusts. An Irrevocable Life Insurance Trust (“ILIT”)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 Trustee of the ILIT along with assets that can be used to pay future premiums. Alternatively, the Trustee of the ILIT buys the insurance itself with funds contributed by the insured. As long as the ILIT agreement gives the insured none of the ownership rights described above, the proceeds will not be included in his estate. The Trustee can not be the insured, or some person or entity controlled by the insured.
The three-year rule. If you are considering setting up an ILIT with a policy you own currently or simply assigning away your ownership rights in such a policy, please obtain sound legal advice before effecting these moves. Unless you live for at least three years after these steps are taken, the proceeds will be taxed in your estate. For policies in which you never held incidents of ownership, the three-year rule does not apply.