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Frequently Asked Questions and Issues regarding Life Insurance

Orlando, FL Estate Planning Law Firm


How Does Life Insurance Play a Unique Role in Your Estate Planning?

There can be no question that life insurance is a unique financial asset. Many of the unique features of life insurance are well known. Most people realize that life insurance is unique in its ability to provide liquidity at death. Not many realize some of the other positive features of life insurance. Amongst those features are the fact that the proceeds of a life insurance contract are paid to the designated beneficiary outside of the probate process and, as a general rule, life insurance proceeds are paid to the beneficiary free from the claims of creditors. Even less understood, but still a positive feature of life insurance is the unique treatment it is afforded under the current income tax and estate tax rules.

What are the Steps of Probate Avoidance?

Life insurance proceeds are paid to the designated beneficiary of such policy pursuant to the terms of a contract. As such, there is no probate proceeding required. There are exceptions to this general rule. Obviously, if insurance proceeds are payable to the decedent’s estate, then such proceeds will be subject to the probate process. Sometimes, this may happen inadvertently. Many times the decedent will fail to properly complete some portion of the beneficiary designation with respect to a policy. In such an instance, most insurance companies provide that the default beneficiary on such policy will be the decedent’s estate. For example, suppose the decedent named his or her spouse as the primary beneficiary and did not designate a contingent or alternate beneficiary. If the decedent’s spouse predeceases, then the insurance proceeds will likely be paid to the decedent’s estate.

What is the Creditor Protection Advantages of Life Insurance?

Florida Statute Section 222.13 provides that whenever any person residing in this state dies leaving insurance on his or her life, said insurance shall exclusively benefit the person designated as a beneficiary under such policy. This means that the proceeds of any such life insurance policy shall be exempt from the claims of creditors of the insured unless the policy provides otherwise or there is a valid assignment of the policy proceeds. If, however, the policy is payable to the insured, his estate, or the executors of his estate, then the proceeds shall become a part of the probate estate and shall be administered in the same manner as all other probate assets.

Florida Statute Section 222.14 provides that the cash surrender value of life insurance policies issued upon the lives of citizens or resident of the state shall not in any case be liable to attachment, garnishment or legal process in favor of any creditor of the person whose life is so insured unless the policy was effected for the benefit of such creditor.

General Income Tax Rules regarding Life Insurance

Section 101(a)(1) of the Internal Revenue Code sets forth the general rule that amounts paid under a life insurance contract by reason of the death of the insured are excluded from the gross income of the beneficiary – 3 – of such policy. [Unless otherwise specified, all section references are to the Internal Revenue Code of 1986 (the “IRC”), as amended.] As with any general rule, there are a number of exceptions. First, the exclusion applies only to amounts paid pursuant to a life insurance contract. The definition of a life insurance contract is set forth in §7702 of the IRC. A thorough examination of that definition is beyond the scope of this outline. It will suffice to say, however, that the minimum standards for finding a valid life insurance contract will not be met if the investment component in the contract is too large relative to the insurance element. A further exception to the general rule that grants an income tax exclusion for life insurance proceeds deals with “transfers for value.”

Transfer for Value Rules

The Transfer for Value Rules are an exception to the general rule that the proceeds of an insurance contract are received by the beneficiary income tax free. If a Transfer for Value occurs, IRC §101(a)(2) provides that the exclusion from gross income will be limited to the total of the amount of consideration and other amounts (including premium payments) paid by the transferee of the insurance policy. A Transfer for Value occurs upon any transfer of an insurance contract for valuable consideration.

There are two exceptions to the Transfer for Value Rules. The first applies to transfers following which the transferee determines his or her basis in the insurance contract in whole or in part by reference to the transferor’s basis. This most often applies to transfers which are considered part gift/part sale. (Remember that if the transfer occurred purely by gift then it would not be considered a Transfer for Value). A part gift/part sale transaction often occurs in a divorce context. IRC §1041(b) provides that property transferred to a former spouse incident to a divorce receives a carryover basis (i.e., a basis determined by reference to the transferor’s basis). The second exception to the Transfer for Value Rules applies to transfers of an insurance policy to the insured, a partner of the insured, a partnership in which the insured is a partner and a corporation in which the insured is a shareholder or officer. The members of this group of persons who form the exception to the rule are sometimes referred to as the “Exempt Persons”. You will notice that omitted from the list of Exempt Persons are shareholders and officers of a corporation in which the insured is a shareholder or officer. This means that the transfer of insurance policies from an insured shareholder to another shareholder in the same corporation to fund a cross purchase agreement constitutes a Transfer for Value not within the exception. A transfer to an Exempt Person, however, will cleanse the transaction of all problems with the Transfer for Value Rules.

General Estate Tax Rules

The basic rules regarding the estate tax treatment of the proceeds of life insurance policies are contained in Section 2042 of the IRC. The two basic rules that determine when the proceeds of insurance policies on a decedent’s life are to be included in the gross estate are as follows:

  1. If the proceeds are receivable by the decedent’s personal representative or are payable to or for the benefit of the estate; or
  2. If the proceeds are receivable by other beneficiaries and the decedent retains certain rights, referred to as “incidents of ownership,” over the policy at the time of his or her death.

It should be stressed that IRC Section 2042 deals only with insurance policies on the life of the decedent. If a decedent dies owning an insurance policy on the life of another person, Section 2042 is not applicable. That does not, of course, mean that the value of such policy will escape taxation in the decedent’s estate. Rather, it simply means that estate tax inclusion, if any, will result under other sections of the IRC besides Section 2042.

Amounts Receivable By or For the Estate

IRC Section 2042(1) states that the value of the gross estate shall include the proceeds of all life insurance policies that are receivable by the personal representative of the estate. This does not mean, however, that the proceeds of a policy must be explicitly payable to the person named in the will as personal representative of the estate. If no will is executed and the insurance proceeds come into the hands of the personal representative, the requirements of Section 2042(1) are satisfied. See, for example, Treasury Regulation Section 20.2042-1(b)(1). Some examples of the operation of Section 2042(1) are set forth below:

  1. Aaron, a single individual, is provided with a life insurance on his life as part of his employment package. He cannot decide who he would like to name as his beneficiary, so he names his estate. The policy proceeds are included in Aaron’s estate at his death.
  2. Bob, another single individual, supports his elderly mother. He purchases a life insurance policy on his life in order to provide money to support her in the event that he predeceases her. He does not name a contingent beneficiary. Bob’s mother dies several years later. Bob dies the following year without changing the beneficiary designation under the policy. In this situation, it is the practice of most insurance companies to pay the policy proceeds to the decedent’s estate. The proceeds are therefore included in Bob’s estate.
  3. Carl’s attorney told him that if life insurance is placed in an irrevocable life insurance trust the policy proceeds will not be taxed in his gross estate. On his attorney’s suggestion, Carl forms such a trust to hold title to his insurance policy. His attorney drafted the trust with the requirement that trust principal be used to pay estate taxes and other death costs. Under Section 2042(1), a clause such as this would defeat the purpose of the trust and the full amount of the insurance proceeds would be included in Carl’s gross estate. If payment of estate taxes and other death costs is mandated under the terms of the Trust, Section 2042(1) will require such inclusion. Note, however, that this does not preclude the Trustee from loaning funds to the estate. In addition, the Trustee can be given the right (but not the requirement), to purchase assets from the decedent’s estate at fair market value.
  4. Dalton names his wife as the beneficiary of his life insurance policy. He does not name a contingent beneficiary. Dalton and his wife are killed in a car accident. Under the simultaneous death statutes in effect in Florida where he resides, in a situation where the insured and the primary beneficiary die simultaneously, a presumption is created that the insured has survived the primary beneficiary. If no other living beneficiary is named, the proceeds will then be payable to the insured’s estate. This will result in the inclusion of the policy proceeds in the insured’s gross estate.
  5. Pursuant to the terms of a loan at his local bank, Earvin purchases a life insurance policy and names the bank as the beneficiary. Earvin dies three months later. Under Section 2042(1), the policy proceeds are included in Earvin’s gross estate because the proceeds are used to satisfy a valid and enforceable claim against Earvin’s estate.

Amounts Receivable By Other Beneficiaries

Under Section 2042(2), amounts receivable by beneficiaries other than the decedent’s estate are includable in the decedent’s gross estate if, at the time of his death (or within three years prior to death), the decedent had any of the “incidents of ownership” in the policy, exercisable alone or in conjunction with any other person. Some examples of “incidents of ownership” are the following:

  • the power to change the beneficiary,
  • the power to surrender or cancel the policy,
  • the power to assign the policy,
  • the power to revoke an assignment,
  • the power to pledge the policy for a loan, or the right to change or receive any of the economic benefits of the policy.

Has the Insured Retained any Incidents of Ownership?

In determining whether or not a decedent had incidents of ownership in an insurance policy, the “policy facts” will control. This means that the determination of whether or not the decedent had any incidents of ownership will be made by looking at the policy terms. Rarely will the determination be based on extrinsic evidence which might indicate that control was held in a manner other than as indicated in the insurance contract. See, Commissioner v. Estate of Noel, 380 U.S. 678 (1965) and United States v. Rhode Island Hospital Trust Company, 355 F.2d 7 (1st Cir. 1966). Occasionally, however, a taxpayer can avoid the generally accepted rule regarding policy facts by arguing that there was a mistake made in the insurance contract. See, Watson v. Commissioner, 36 T.C.M. 1084 (1977) and Estate of Fuchs v. Commissioner, 47 T.C. 199 (1966), acq. 1967-1 C.B.2. In both of those cases, however, one of the key points was the fact that the insurance agent testified that he completed the insurance application incorrectly and that the parties never intended for the decedent to have any incidents of ownership. In other words, the only reason that the policy facts did not control was because the insurance agent testified under oath that he committed malpractice!! In addition to an examination of the policy facts, there are several other factors to consider in determining whether or not the decedent had any incidents of ownership in an insurance policy. Some of the other factors to consider are as follows:

  • Reversionary Interests – A reversionary interest deals with a situation where there the decedent does not possess the incidents of ownership in a policy but there is a chance that they will revert back to the decedent. This typically occurs where the decedent retains an interest in a trust or where the decedent is a successor in interest after the demise of the power holder. A reversionary interest will be considered an incident of ownership only if the value of the reversionary interest exceeds five percent (5%) of the value of the policy immediately before the decedent’s death.

  • Incidents of Ownership Held in a Fiduciary Capacity – An oft occurring question in dealing with an irrevocable life insurance trust is the issue of who may serve as trustee. Under Treasury Regulations §20.2042-1(c)(4), a decedent is considered to have an “incident of ownership” in a policy if, under the terms of the policy, the decedent has the power (as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment thereof, even though the decedent has no beneficial interest in the trust. A number of cases have considered this broad language to determine whether or not there is inclusion in the gross estate of a decedent who acts as the trustee of a trust holding life insurance on his life. A number of cases have considered this issue. See, for example, Fruehauf v. Commissioner, 50 T.C. 915 (1968), Skifter v. Commissioner, 56 T.C. 1190 (1971), affirmed 468 F.2d 699 (2nd Cir. 1972) and see also, Revenue Ruling 84-179, 1984-2 C.B. 195. The current view seems to be that powers held by a decedent as fiduciary with respect to an insurance policy on his life will not constitute incidents of ownership in the policy so long as:

    1. the powers are not exercisable for the decedent’s personal benefit;
    2. the decedent did not directly transfer the policy to the trust; and
    3. the decedent’s powers were exercisable solely in his capacity as a fiduciary and not as settlor of the trust.
  • Near Death Transfers – If a transfer occurs with respect to a life insurance policy within three (3) years Of the date of the decedent’s death, IRC §2035(d)(2) will require inclusion in the decedent’s gross estate of the value of any interest in a life insurance policy transferred within three (3) years of death, but only if such policy would have been included under IRC §2042 if such interest had been retained by the decedent. What if the decedent transfers a policy within 3 years of death but the beneficiary pays all post-transfer premiums? Under generally accepted principles, it appears that a proportion of the policy proceeds equal to that proportion of the total premiums paid by the decedent will be includable in his or her gross estate. The remaining portion, however, will not be included in the gross estate.

Possible Owners of Policy Other than the Insured

We have examined some of the estate tax perils that may result if the insured is the owner of a life insurance policy. The next question that often arises is who else should be the owner of the policy? What are the income, gift and estate tax implications of vesting ownership in the insured’s spouse? What about the insured’s children? The issues that arise in this situation are briefly considered below:

  1. Policy Ownership by Spouse. Generally speaking, policy proceeds received by a spouse on the death of the insured are received income tax free. The transfer of a policy to a spouse (or the payment by the insured of premiums on a policy owned by a spouse) is technically a taxable gift. Under IRC §2523, however, there is an unlimited gift tax marital deduction which will shield such transfers from taxation as a gift. (*Note that this presumes that the insured’s spouse is a U.S. citizen. See IRC §2523(i) for the applicable limitations where a spouse is not a U.S. citizen.) In addition, the receipt of the policy proceeds by the spouse on the death of the insured will not result in inclusion of the policy proceeds in the decedent’s estate (unless the decedent retained some incidents of ownership). The problem, of course, is that the policy proceeds will be included in the surviving spouse’s gross estate and will, unless consumed by the spouse, by subject to estate tax at his or her death.
  2. Policy Ownership by One Child Once again, receipt of the policy proceeds by a child of the insured should be income tax free. The transfer of a policy to a child (or the payment by the insured of premiums on a policy owned by a child) is a potentially taxable gift. Under IRC §2503(b), however, there is an annual gift tax exclusion for gifts of a present interest of up to $13,000 per year per donee under tax laws in effect in 2009 (the annual exclusion can be increased to $26,000 per year per donee if the insured is married and, together with his or her spouse, they elect marital gift splitting under IRC §2513). An insurance policy owned outright by a child is considered a present interest, so as long as the value of the policy transferred plus the amount of the annual premium payments does not exceed the amount of the annual exclusion, no taxable gift will result. The receipt of the policy proceeds by the child on the death of the insured, will not result in inclusion of the policy proceeds in the decedent’s estate. The policy proceeds will be included in the child’s gross estate unless consumed prior to his or her death.
  3. Policy Ownership by Multiple Children As in the other situations mentioned above, the receipt of the policy proceeds on the death of the insured should be income tax free. There are, however, a number of potential gift and estate tax problems that may arise which causes this area to be a trap for the unwary. If multiple children own the policy, then the transfer of a policy to the children (or the payment by the insured of premiums on a policy owned by his children) is a potentially taxable gift. This gift is generally not eligible for the annual gift tax exclusion under IRC §2503(b), however, because it is not a gift of a present interest. The reason that the gift is not of a present interest is because where there are multiple owners of a policy, the consent of all owners is required to obtain cash from the policy. Therefore, a taxable gift is created upon the transfer of the policy or the payment of premiums by the insured. There are two solutions to this dilemma (although both solutions have their disadvantages): first, the insured can simply gift money to his children. He or she must then hope that the children use the gifted money to pay the insurance premiums. The second solution is to simply name one child as the owner and name all of the children as beneficiaries. Besides the obvious risk that such child will not survive the insured, there are gift tax problems with this solution as well. At the death of the insured, the child owning the policy will be treated as making a gift of that portion of the policy proceeds which are payable to the other children/beneficiaries.

    An oft-sited problem with ownership of a policy by multiple children is the issue of what happens if one child predeceases the insured. Typically, there is a survivorship element associated with ownership of policies. This means that where there are multiple owners, the surviving owners receive the interest of a deceased joint owner. This may or may not coincide with the intent of the insured.

    Another issue that often arises is with respect to the cash surrender value of the policy. If there are multiple owners, who will have the right to borrow the cash surrender value? If any one of the owners can borrow, then what would prevent one child from borrowing all of the funds? The interest on such borrowing is typically charged against the policy. In essence, this means that all of the children are paying for the amounts borrowed by one. In addition, on the death of the insured, the amount borrowed will be offset against the policy proceeds. How will this be settled amongst the children? Even if no child ever borrows against the cash surrender value, what will happen upon the divorce of a child? Will such child’s share of the cash surrender value be considered a marital asset for purposes of the divorce proceeding?

Possible Beneficiaries of the Policy

To a large extent, many of the income, estate and gift tax issues associated with designating the beneficiary of a policy were previously discussed in the section above entitled Possible Owners of a Policy. Those issues will not be repeated here. Instead, non-tax considerations associated with choice of beneficiary of a policy will be considered below:

  1. Surviving Spouse as Beneficiary. For many people, this seems the obvious choice of beneficiary. Clearly, many people obtain insurance coverage to benefit and provide for a surviving spouse’s financial needs after the death of the insured. If children are involved, many people also assume that the surviving spouse will provide for the minor children. There are some risks associated with this strategy. First, in most cases, the surviving spouse is totally unprepared to handle the amount of money that is paid upon the death of the insured. For many spouses, they have never previously handled such sums of liquid assets in their life. To complicate matters, the funds are paid at a time of personal loss when the spouse is not necessarily focused on financial matters. The potential exists for both misuse and abuse of the funds. Naming the spouse as an outright beneficiary provides him or her with no investment guidance. There is no protection provided against the unscrupulous. Nor is their protection against the surviving spouse’s own poor financial decisions, the possible incapacity of the spouse, or the spouse’s creditor problems (although the policy proceeds are exempt from the claims of the insured’s creditors). If the surviving spouse ever remarries, the policy proceeds may become part of the marital estate and a portion of the insurance proceeds could wind up in the hands of a second spouse. There is also no assurance that on the death of the surviving spouse that any of the remaining proceeds will be distributed to the insured’s children.
  2. Surviving Children as Beneficiary. Many of the comments stated above with respect to a surviving spouse also apply to the direct payment of insurance benefits to children. The additional issue with respect to children is the issue of minority. Generally speaking, an insurance company will not pay policy proceeds directly to a minor. Florida Statutes Section 710.108 permits the payment of policy proceeds to a minor to be paid in accordance with the Uniform Transfers to Minors Act, but only if the amount of proceeds are under $10,000. If the proceeds are in excess of this amount, then a guardianship proceeding for the benefit of the minor child must be commenced. This proceeding must be commenced under the jurisdiction of the Probate Court (guardianship division) of the county in which the minor child resides. Typically, the insurance company will then pay the policy proceeds pursuant to an order of the guardianship court.
  3. The Insured’s Estate as Beneficiary. Naming the insured’s estate as beneficiary can have numerous implications. Almost all of those implications are negative. As mentioned above, the provisions of IRC §2042(1) mandate that the policy proceeds be included in the decedent’s gross estate for estate tax purposes if policy proceeds are payable to the estate. Proceeds that are payable to an insured’s estate will also be a part of the probate estate for state law purposes. Florida Statute Section 222.13 makes it clear, however, that once policy proceeds are payable to the estate they become part of the probate process for all purposes and the exemption from creditor claims is lost.

What is an Irrevocable Life Insurance Trust?

The use of an irrevocable life insurance trust (“ILIT”) is one of the most useful estate planning tools available to a practitioner. The concept is relatively simple. By forming a trust which is both the owner and the beneficiary of a life insurance policy, the insured retains no incidents of ownership sufficient to bring the policy proceeds within the provisions of Section 2042.

On the decedent’s death, the policy proceeds are payable to the trust. The trust then maintains and/or distributes the policy proceeds according to the terms of the trust document. Obviously, the insured will have the ILIT drafted in such a manner as to achieve the post-mortem family planning goals which prompted him or her to procure life insurance in the first place.

A key advantage to an ILIT is that it provides flexibility with regard to the pay-out of policy proceeds. The Settlor may choose to have the proceeds retained in trust for a certain period of time or until a beneficiary attains a certain age. He may choose to have the proceeds distributed only for certain needs or according to certain ascertainable standards. The possibilities are endless, although typically, the trust document is carefully drafted so as to avoid causing estate tax inclusion (at a minimum) in the estate of the decedent’s surviving spouse and, in many cases, in the estates of the decedent’s children as well.

What are some of the Advantages and Disadvantages of an Irrevocable Life Insurance Trust?

Besides the obvious estate tax saving advantages, an ILIT may also provide an excellent source of estate liquidity and/or family income after the death of the Settlor. It also provides an insured with the ability to exercise a measure of control over the use of the insurance proceeds after his death. It is not, however, without its drawbacks. One should always bear in mind that an ILIT is irrevocable and will result in the grantor’s loss of control over the life insurance policy, including the loss of the right to borrow against the policy’s cash surrender value. Particularly in the case of young families, this complete loss of control may be a significant factor to consider in the future. Once the grantor establishes the trust, he gives up the power to make any changes. Some flexibility may be drafted into the trust document to allow the trustee certain discretionary powers, but those powers will belong to the trustee and not the grantor.

What Steps are involved in Forming and Operating a Life Insurance Trust?

An ILIT is formed by the execution of a trust document. Since it is an irrevocable trust, it is treated as a new taxpayer and accordingly, must obtain a tax identification number. This is accomplished by filing a Form SS- 4, Application for Employer Identification Number. Once this number is received, a separate bank account is typically opened to handle gifts or contributions made by the insured which are intended to fund premium payments. Signature authority over the bank account is vested with the Trustee(s) of the Trust. Premium payments on the insurance policy are made from the trust bank account.

An ILIT must file an annual income tax return (Form 1041). The gross income of a trust is determined in the same manner as that of an individual. See Regulations Section 1.641(a)-2. The taxable year of an ILIT is the calendar year, as required under Section 645(a).

Generally speaking, ILIT’s do not have much income during the life of the grantor. This is because most amounts contributed to the ILIT are used to pay premiums on life insurance. Nonetheless, if the trust document provides that trust income, if any, may be used for the payment of premiums on the policies of insurance on the life of the grantor or the grantor’s spouse, then the trust will be treated as a grantor trust, pursuant to Section 677(a)(3). If that is the case, then all trust income will be taxed to the grantor.

What are the Methods of Placing the Policy into the Trust?

In an ideal situation, the ILIT will The ILIT, by and through the trustee, follow the following procedures:

  1. The trust should be fully executed and in existence on or before the date of application for the life insurance policy;
  2. The trustee should be the original applicant of the policy and the ILIT should be named as both the owner and beneficiary; and
  3. The grantor should make cash gifts to the trust which are then deposited in a trust checking account. The trustee then uses these funds to pay the initial (and subsequent) life insurance premiums.

What if a life insurance policy is in force prior to the execution of the trust? If the grantor transfers an existing policy insuring his own life to the trust, the provisions of Section 2035 will apply. In order for the policy proceeds to be excluded from the grantor’s gross estate, he must survive three years from the date of such transfer. Further, the transfer of a policy into an ILIT is deemed to be a gift of the value of the policy to the trust beneficiaries.

There are many issues associated with the use of a life insurance trust. Who may serve as the Trustee of an ILIT? Is the gift of funds to an ILIT eligible for the annual gift tax exclusion? Isn’t such a gift a gift of a future interest? How can a future interest be converted into a present interest? What if the insured changes his mind about a policy that is already placed in an ILIT? What options are available to him? Are there any other viable alternatives to the ILIT? Please feel free to contact the attorneys at Kane and Koltun. We will be glad to assist you with these and other issues.