Insurance Held Outside the Estate

Two different taxes

The common understanding that life insurance is tax free is half right, and the half that is wrong is expensive.

Death benefit proceeds are generally excluded from the beneficiary's gross income. That is the income tax answer and it is usually correct. The estate tax asks a different question: whether the insured possessed incidents of ownership in the policy at death, or whether the proceeds are payable to the estate. Where either is true, the full death benefit is generally included in the taxable estate.

Incidents of ownership

The phrase is broader than legal title. It reaches the practical powers a policy owner holds, including the right to change the beneficiary, to surrender or cancel the policy, to assign it, to pledge it as security, and to borrow against the cash value.

Retaining any one of them is generally enough. The usual answer is therefore for the policy to be owned from the outset by an irrevocable trust, with the trust as both owner and beneficiary, and with the insured holding no powers over it.

Three years, and why timing decides it

Transferring an existing policy into such a trust works, with one significant qualification. Where the insured transfers a policy and dies within three years, the proceeds are generally pulled back into the estate as though the transfer had not occurred.

There is no way to accelerate the period and no relief for good intentions. The rule is the clearest illustration available of why this work is done in an ordinary year rather than in response to a diagnosis.

Funding the premiums

Cash contributed to the trust to pay premiums is a gift to the trust's beneficiaries. Because a gift to a trust is ordinarily a gift of a future interest, it does not qualify for the annual exclusion without more.

The conventional solution gives beneficiaries a temporary right to withdraw contributions, which converts the gift into a present interest. Two points follow, and both are administrative rather than clever.

1. 01Notice must actually be given, in writing, each time a contribution is made, and the withdrawal window must be real. Trusts where the notices were never sent, or were reconstructed years later, are a recurring audit theme.
2. 02The lapse of an unexercised withdrawal right is itself a transfer by the beneficiary above certain limits, which is why trusts are drafted with provisions addressing the consequence of the lapse.

The trap in restructuring an existing policy

Where a policy changes hands for consideration, the income tax exclusion can be lost. The proceeds then become taxable above the consideration paid plus subsequent premiums, which converts a tax-free death benefit into a largely taxable one.

There are exceptions, including transfers to the insured and certain transfers involving partnerships in which the insured is a partner. They are specific, and they are the reason that moving an existing policy between entities, or between business partners under a buy-sell arrangement, is a transaction to be reviewed before it happens rather than after.