Removing Life Insurance from the Taxable Estate

This is the first in a two-part series of articles regarding life insurance and removing it from the taxable estate. This first article examines why life insurance is in the taxable estate and how to remove it. The second article will examine the application of the “Transfer for Value” rule and how to navigate around that rule while keeping the life insurance out of the taxable estate.

First, why is life insurance in the taxable estate? Section 2042 causes inclusion in your estate if the life insurance on your life is either i) paid to your estate, or ii) if you had any significant control over the policy. Even if your estate wasn’t the beneficiary of the policy, if you could change the beneficiary of the policy or pledge the policy, among other things, it would be included in your taxable estate.

For example, Mary had a policy on her life that would pay the beneficiary, John, $5 million at her death. Assuming Mary has “incidents of ownership,” such as the ability to change the beneficiary, the policy on Mary’s life would be included in Mary’s taxable estate even though neither she nor her estate is the beneficiary.

Mary could remove the policy from her taxable estate by transferring it to an irrevocable trust, often called an “Irrevocable Life Insurance Trust” or “ILIT.” Mary should not be the trustee of the ILIT nor retain control over who is the trustee of the ILIT. Further, Mary cannot be the beneficiary nor change the beneficiaries of the ILIT without causing inclusion in her estate. But, at the outset, Mary can choose whomever she wants (other than herself) as the beneficiaries of the ILIT, like her three children.

If Mary makes a gratuitous transfer to the ILIT, then she would be making a gift of the current value of the policy, which would likely be far less than the death benefit. This may not be a concern if the value is low. However, if the policy is gifted, the policy’s death benefit would still be included in Mary’s taxable estate for three years after the transfer due to the application of another code Section, Section 2035, which only comes into play in certain narrow situations, including this.

So, what could Mary do if she wanted to remove the policy from her estate right away? She could sell the policy to the trust for its fair market value. Let’s say the fair market value of the policy is $50,000. If Mary contributes $50,000 to the trust and the trustee of the trust purchases the policy from Mary, Mary wouldn’t have to wait the three years to remove it from her taxable estate. However, while this will solve Mary’s estate tax issue, it may cause the death benefit to be income taxable.

The next article in the series will focus on the Transfer for Value rule and a simple way to navigate around it.

Stephen C. Hartnett, J.D., LL.M.
Director of Education
American Academy of Estate Planning Attorneys, Inc.
9444 Balboa Avenue, Suite 300
San Diego, California 92123
Phone: (858) 453-2128
www.aaepa.com