I. [9.1] Introduction II. [9.2] Claims and Payment OptionsIII. Taxation of Life Insurance Proceeds A. [9.3] Income Tax Considerations B. [9.4] Estate Tax Considerations 1. [9.5] Inclusion in Gross Estate Pursuant to Code §2042 a. [9.6] Proceeds Paid to Executor b. [9.7] Incidents of Ownership 2. [9.8] Inclusion in Gross Estate Pursuant to Code §2035 3. [9.9] Inclusion of Insurance on the Life of Another (Including Second-to-Die Insurance) 4. Reporting Requirements and Payment of Estate Tax a. [9.10] Schedule D of Form 706 b. [9.11] Amount Includible in Taxable Estate c. [9.12] Alternate Valuation d. [9.13] Marital Deduction e. [9.14] Charitable Deduction f. [9.15] Payment of TaxIV. [9.16] Irrevocable Life Insurance Trusts V. Buy-Sell Arrangements A. [9.17] Introduction B. [9.18] Cross-Purchase Agreements 1. [9.19] Estate Tax Considerations 2. [9.20] Income Tax Considerations C. [9.21] Redemption Agreements 1. [9.22] Estate Tax Considerations 2. [9.23] Income Tax ConsiderationsVI. [9.24] Split-Dollar ArrangementsVII. Employee Benefit and Retirement Arrangements A. [9.25] Introduction B. [9.26] Group Term Life Insurance C. [9.27] Life Insurance in Qualified Retirement Plans
I. [9.1] INTRODUCTION Insurance is an important tool in preparing for unexpected losses. Life insurance is designedto manage financial risk by protecting against a financial loss that can arise from an untimelydeath. If a family were to lose income due to the death of the principal earner, it would facefinancial hardship. Therefore, life insurance is often purchased by family members seeking tominimize the financial impact of lost earnings resulting from a premature death. In addition, lifeinsurance also can be an effective tool to offset the impact of the estate tax that is imposed on thedeath of the insured. The death benefit of life insurance can also provide a source of fundsavailable to assist with administration of specific assets or the estate itself, and can also providethe liquidity necessary to equalize intended bequests among beneficiaries when a businessinterest, real estate or some other illiquid assets is left to one of the beneficiaries. Life insurance is actually a contract, usually entered into between the insured and theinsurance company. In exchange for premium payments, the insurance company agrees to pay anagreed sum upon the occurrence of a specific event to any one or more individuals ororganizations selected by the insured. While there is significant estate and financial planning that can and should be implementedduring the life of the insured in order to minimize the tax impact of the insurance whilemaximizing the benefit that will pass to the intended beneficiaries, there are also significantpostmortem planning issues and opportunities that must be considered by the practitionerinvolved in the estate and trust administration process.II. [9.2] CLAIMS AND PAYMENT OPTIONS As mentioned in §9.1 above, a life insurance policy is a contract between the owner of thepolicy and the insurance company. A part of that contract is the beneficiary designation, whichthe owner of the policy completes in order to direct to whom payment of the proceeds is to bemade upon the death of the insured. Even if the insured executed a will, the payment of theinsurance proceeds will not be governed by that will unless no beneficiary designation was madeor unless the designated beneficiary is the insured’s estate. The first step for collecting the proceeds of a life insurance policy is to initiate theprocess by contacting the insurance company. Some companies have the necessary forms online.After the insurance company has been notified of the death, the company will typically send outclaim forms to be completed by the beneficiary or beneficiaries. Once all of the paperwork hasbeen submitted, the insurance provider will begin processing the claim. The insurance companywill check to see that the policy is still in good standing. Depending on the circumstances of the insured’s death, some insurance companies maychoose to investigate the claim, especially if the death occurred during the contestability period.The contestability period refers to an approximately two-year time frame after the life insurancepolicy is purchased. If a claim is made during the contestability period, life insurance companieswill typically launch an investigation into the claim, checking for any fraud or deception. Thecompany will request medical records, financial information and other relevant documents. It is agood idea to arrange for appropriate legal representation if an investigation is opened.
Upon the death of an insured, a claim must be filed by the designated beneficiary with theinsurance carrier in order to receive the proceeds. An original death certificate also must besubmitted with the claim form. If the beneficiary is the insured’s estate, then the executor willsubmit the claim and also will be required to submit a copy of the executor’s letters of office inorder to establish the executor’s authority. Letters of office must be issued to the executor by theappropriate probate court. The process for initiating a probate proceeding in Illinois is discussedin IICLE’s Publication “_____________”. If a trust is the beneficiary, the trustee should file theclaim and submit a copy of the pertinent trust document. If a minor child is designated as a beneficiary of the policy, an insurance carrier may requirethat a guardian be appointed by the local court to receive the proceeds on the minor child’sbehalf. The court will oversee the distribution of the funds on the minor’s behalf until the minorreaches age 18. The remaining balance then will be paid directly to the child upon his or herattaining age 18. If the insured executed a will that created trusts for the benefit of any minor children who aredesignated beneficiaries, the insurance proceeds can be paid to the trustee of any such trust. Thetrustee of the trust will administer the funds according to the terms of the trust and distribute theincome and principal as directed by the terms of the governing instrument. Issues do arise occasionally if the beneficiary actually designated on an insurance policy isnot the intended recipient of the death benefit. For example, a former spouse may have beendesignated as the beneficiary of a policy during marriage and the policy owner may haveneglected to change the beneficiary to his current spouse after remarriage. In Illinois, there is nolaw which removes a former spouse as beneficiary of a life insurance policy upon divorce. Onesolution may be to have the former spouse disclaim his or her interest in the policy. Prior to having a disclaimer executed, several issues should be considered. First, the terms ofthe contract for the insurance should be reviewed to determine who would receive the proceeds ifno beneficiary is designated. The policy may direct that the proceeds be distributed to thesurviving spouse which may be the desired result. Alternatively, the policy may require that theproceeds be paid to the executor of the insured’s estate. If no probate estate has been opened, thena probate estate would have to be opened to receive the proceeds. If the insured had creditorswhich have not been paid, using a disclaimer may not make sense. If creditors have filed claimsagainst the estate, the proceeds would be part of the estate and would be available to satisfycreditor claims. For a more in depth discussion on disclaimers in connection with post mortemplanning, see Chapter 3. Finally, if it is clear from extrinsic evidence that the designation of the beneficiary was notwhat the insured’s intended, a declaratory judgment action may be filed with the local circuitcourt seeking the appropriate relief depending on the circumstances surrounding the beneficiarydesignation. When filing a claim for insurance proceeds, the beneficiary may be presented with differentpayout options. The selection of a payment option is an important decision, and the availableoptions should be reviewed carefully. There may be tax implications that will impact the choiceof payout option. For example, the option selected may result in the loss of the marital deduction
for federal estate tax purposes. See 9.13 below for a more complete discussion of the applicabilityof the marital deduction. The basic payout options that are usually offered are (a) lump-sum payout; (b) life annuity;(c) life annuity with guaranteed payments; (d) payment for a term of years; (e) fixed amount; and(f) interest. The most commonly selected option is a lump-sum payout. Under this option, the beneficiaryreceives a one-time payment that is generally free from income tax. More recently, in order toretain funds as long as possible, the insurance companies now create a money market typeaccount, providing the beneficiary with a checkbook to access the funds rather than providing thebeneficiary with a check for the full proceeds. The life-annuity option enables the beneficiary to receive guaranteed, fixed monthlypayments for the remainder of his or her life. The amount of the annuity is determined based onthe beneficiary’s age and gender. The payments cease when the beneficiary dies. The life-annuity-with-guaranteed-payments option enables the beneficiary to receive aguaranteed portion of the death benefit for life or a certain period of time, whichever is longer.The longer the period selected, the lower the annual payment. If the primary beneficiary dieswithin the guaranteed term, then the remaining payments are made to the contingent beneficiary. When the payment-for-term-of-years option is selected, the beneficiary receives payment of acertain sum for a fixed term of years regardless of whether the beneficiary survives the expirationof the fixed period. If the beneficiary does not survive the fixed term, payment is made to thecontingent beneficiaries. Under the fixed-amount option, the beneficiary can choose how much money he or she wantsto receive as well as how frequently, such as quarterly or annually, until the death benefit iscompletely paid out. The beneficiary receives periodic installments, and the remaining proceedsearn interest at a fixed rate. Payments are made to the beneficiary until the entire balance of theproceeds plus earned interested are paid. The contingent beneficiary receives the remainder of thepayments if the primary beneficiary dies prior to complete distribution of the proceeds. With the interest option, the beneficiary can choose to have all or a portion of the insuranceproceeds remain with the insurance company while earning interest. The interest earned is paid tothe beneficiary on a regular basis. The beneficiary should ask whether the proceeds will earn afixed or variable rate of interest. The beneficiary may be able to withdraw some of the principalunder certain conditions. Upon the beneficiary’s death, the actual benefit is paid to the contingentbeneficiary.III. TAXATION OF LIFE INSURANCE PROCEEDSA. [9.3] Income Tax Considerations Generally, life insurance proceeds received by a beneficiary are not subject to income taxupon the death of the insured. Section 101(a)(1) of the Internal Revenue Code provides:
(a) Proceeds of life insurance contracts payable by reason of death. — (1) General rule. — Except as otherwise provided in paragraph (2), subsection (d), and subsection (f), and subsection (j), gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. However, there is an important exception to this general rule. Code §101(a)(2) provides thatwhen a life insurance policy is transferred for valuable consideration, the income tax exclusion islost and a portion of the death benefits are subject to federal income tax. This provision is referredto as the “transfer-for-value rule.” Specifically, Code §101(a)(2) provides: (2) Transfer for valuable consideration. — In the case of a transfer for a valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by paragraph (1) shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee. The preceding sentence shall not apply in the case of such a transfer — (A) if such contract or interest therein has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such contract or interest therein in the hands of the transferor, or (B) if such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. Code §101 will not apply to a transfer of an insurance policy that is either a gift or a tax-freeexchange of an insurance policy pursuant to Code §1035, as these are not considered transfers forvaluable consideration. In order to avoid subjecting insurance policy proceeds to income taxation if a transfer forvaluable consideration will be made during the insured’s lifetime, the transfer must be to a personor entity included in the list of exceptions to the transfer-for-value rule. If the transfer is not toone of the permitted individuals or entities, Code §101(a)(2) provides that a portion of the policyproceeds will be subject to income tax. Specifically, the amount subject to income tax will be theamount of the proceeds received less the consideration paid as part of the transfer, plus anysubsequent premiums or other amount paid by the transferee. If a transfer of a life insurance policy will take place during the insured’s lifetime, thetransfer-for-value rule and its exceptions must be taken into account while the insured is alive.After the insured’s death, a transfer for value to a recipient that does not qualify for one of theexceptions to the rule cannot be corrected. The exceptions to the transfer-for-value rule found in Code §101(a)(2) provide that certaintransfers will not cause the proceeds of the policy transferred to be subject to income tax. Thereare two categories of exceptions: the basis-carryover exception, and the permitted-transfereeexception.
The basis-carryover exception applies when the transferee’s basis would be determined inwhole or in part with reference to the transferor’s basis. An example of a transfer that qualifiesunder the basis-carryover exception is a transfer to the insured’s spouse. Transfers of a lifeinsurance policy to a spouse, whether or not for consideration, do not cause taxation under thetransfer-for-value rule. Code §§101(a)(2)(A), 1041(b). In addition, transfers to or from formerspouses pursuant to a qualified domestic relations order also qualify under this exception. Finally,it is important to note that transfers for valuable consideration to family members other than aspouse do not qualify under the basis-carryover exception. The permitted-transferee exception pursuant to Code §101(a)(2)(B) contains a specific list ofindividuals and entities to whom a policy can be transferred for valuable consideration withouttriggering the income taxation of the pertinent portion of the policy proceeds. The first permittedtransferee listed is the insured. For these purposes, a transfer to the insured also includes atransfer to a trust of which the grantor is treated as the owner for income tax purposes pursuant toCode §§671 – 679. See Pvt.Ltr.Ruls. 200518061 (May 6, 2005), 200514001 (Apr. 8, 2005),200228019 (July 12, 2002). A detailed discussion of the other permitted transferees listed in Code §101(a)(2)(B) is setforth below in §§9.20 and 9.23 below with respect to insurance policies transferred as part ofcross-purchase and redemption arrangements in the buy-sell context. Upon an insured’s death, the practitioner should, as part of his or her post mortem planningchecklist, request a transcript of the policy history from the insurance company to determinewhether any transfer of the policy was ever made. The attorney should also ask the decedent’sfamily for any documentation relating to the insurance policy, request that the insurance agentreview the file, and review gift tax returns, in order to determine whether the insured had evertransferred the policy. If in fact the insured had transferred the policy, the attorney will then needto determine whether the transfer-for-value rule or one of its exceptions will apply. There soon may be additional reporting requirements with respect to the transfer-for-valuerule and its exceptions. The Treasury Department’s GENERAL EXPLANATIONS OF THEADMINISTRATION’S FISCAL YEAR 2010 REVENUE PROPOSALS (also known as the“Green Book”) was released on May 11, 2009, and is available online atwww.treas.gov/offices/tax-policy/library/grnbk09.pdf. The Green Book describes in detail therevenue proposals contained in the President’s budget for fiscal year 2010. The Green Book published by the Obama Administration includes a proposed change to thetransfer-for-value rule. If enacted, this proposal would apply to sales or assignments of interestsin life insurance policies and payments of death benefits for taxable years beginning afterDecember 31, 2010. The proposed modification is intended to ensure that none of the safe-harborexceptions to the transfer-for-value rule would apply to “buyers of policies.” Green Book, p. 112.There is no policy size limitation included in the proposal. When policy benefits are paid to abuyer, the insurer would be required to report to both the IRS and the payee (1) the gross benefitpayment; (2) the buyer’s taxpayer identification number; and (3) the insurer’s estimate of thebuyer’s basis.B. [9.4] Estate Tax Considerations
Life insurance proceeds generally are includible in the estate of the insured for estate taxpurposes. The estate tax treatment of life insurance is governed by Code §2042. In addition, Code§2035 may require inclusion for estate tax purposes of the proceeds of a life insurance policy thatwas not owned by the insured. 1. [9.5] Inclusion in Gross Estate Pursuant to Code §2042 Code §2042 provides: The value of the gross estate shall include the value of all property — (1) Receivable by the executor. — To the extent of the amount receivable by the executor as insurance under policies on the life of the decedent. (2) Receivable by other beneficiaries. — To the extent of the amount receivable by all other beneficiaries as insurance under policies on the life of the decedent with respect to which the decedent possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person. For purposes of the preceding sentence, the term “incident of ownership” includes a reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent. As used in this paragraph, the term “reversionary interest” includes a possibility that the policy, or the proceeds of the policy, may return to the decedent or his estate, or may be subject to a power of disposition by him. The value of a reversionary interest at any time shall be determined (without regard to the fact of the decedent’s death) by usual methods of valuation, including the use of tables of mortality and actuarial principles, pursuant to regulations prescribed by the Secretary. In determining the value of a possibility that the policy or proceeds thereof may be subject to a power of disposition by the decedent, such possibility shall be valued as if it were a possibility that such policy or proceeds may return to the decedent or his estate. a. [9.6] Proceeds Paid to Executor While inclusion of policy proceeds in the insured’s gross estate pursuant to Code §2042(1)would appear to be straightforward, there are actually several situations in which proceeds areincluded even if they are not payable to the insured’s estate. The Treasury Regulations provide that the estate of the insured need not be the designatedbeneficiary of the policy in order for Code §2042 to apply. For example, if the proceeds arepayable to a beneficiary but are required to be used to pay debts, taxes, or other chargesenforceable against the estate due to a legally binding obligation of the beneficiary, then theamount of such proceeds (to the extent of the beneficiary’s obligation) is includible in the grossestate. Treas.Reg. §20.2042-1(b)(1) provides that proceeds of a policy will be included in theinsured’s estate if the proceeds are subject to a “legally binding” obligation to pay estate
obligations. Similarly, if the policy was purchased by the decedent as security for a loan and thebeneficiary is a corporation or third party, the proceeds are treated as receivable for the benefit ofthe estate. Code §2042(1) may result in inclusion of insurance proceeds in the insured’s gross estatewhen the policy was held by an irrevocable life insurance trust (ILIT) if certain provisions arefound in the trust agreement. Treas.Reg. §20.2042-1(b)(1) specifically provides that if theproceeds of the policy are payable to someone other than the insured’s estate but are subject to anobligation to pay the insured’s debts and taxes, the proceeds will be deemed to have been payableto the insured’s estate. Therefore, the trustee of an ILIT must be cautious when receiving lifeinsurance proceeds that are intended to create liquidity to pay estate tax as well as otheradministration expenses. In order to avoid inadvertent estate tax inclusion that could result fromusing policy proceeds to pay these expenses, the trust agreement that creates the ILIT should notrequire the trustee to use trust assets to satisfy debts and taxes, but should instead permit thetrustee to make loans to the insured’s estate in order to allow the policy proceeds to be used tosatisfy these expenses without creating an obligation. The insured’s will should include a similarprovision. Alternatively, the trustee of the ILIT may be given the power to purchase assets fromthe insured’s estate. Such power to purchase assets will not trigger estate tax inclusion underCode §2042(1). If the trust agreement under which the ILIT was created does not include a provision allowingthe trustee to loan funds to the insured’s estate, the trust agreement may give the trustee of theILIT the discretion to pay taxes and expenses of the insured’s estate. If the trustee has thisdiscretion, then to the extent life insurance proceeds are actually used to pay taxes and expenses,Code §2042 will cause inclusion of such proceeds in the decedent’s taxable estate. Treas.Reg.§20.2042-1(b)(1). b. [9.7] Incidents of Ownership Pursuant to Code §2042(2), the proceeds of all life insurance on a decedent’s life receivableby beneficiaries other than the executor of the decedent’s estate must be included in the grossestate to the extent that the decedent possessed at his or her death any incidents of ownershipexercisable either alone or in conjunction with any other person. The concept of incidents of ownership reaches beyond actual legal ownership of the policy.Incidents of ownership can cause estate tax inclusion even if the insured’s right is strictly limited.Examples of incidents of ownership are described in Treas.Reg. §20.2042-1(c)(2) and include (1)the power to change the beneficiary; (2) the power to surrender or cancel the policy; (3) thepower to assign the policy; (4) the power to revoke an assignment; and (5) the power to pledgethe policy for a loan or to obtain from the insurer a loan against the surrender value of the policy.Incidents of ownership exist whether the insured has the right to exercise the incidents ofownership alone or in conjunction with any other person. Treas.Reg. §20.2042-1(c)(1). Paymentof premiums alone is not an incident of ownership for purposes of Code §2042(2). Code §2042(2) will apply to include insurance proceeds in the decedent’s gross estate even ifthe proceeds are receivable by beneficiaries other than the insured and are not designated as forthe estate’s benefit. This can include a reversionary interest if the interest exceeds five percent ofthe value of the policy immediately before the death of the decedent. The value of a reversionary
interest is determined in accordance with recognized valuation principles for determining thevalue for estate tax purposes of future or conditional interests in property. In Estate of Jordahl v. Commissioner, 65 T.C. 92 (1975), acq., 1977-2 Cum.Bull. 1, the TaxCourt found no incidents of ownership existed when the insured, who was also the grantor of anirrevocable insurance trust, had the power to substitute one or more policies of equal value forthose owned by the trust. Pursuant to the terms of the trust in Jordahl, exercise of the powerwould have required the grantor to purchase new policies of equal cash surrender and face value,comparable premiums, and similar form. The Tax Court held that the grantor’s possession of theright to substitute assets of equivalent value was not an incident of ownership under Code§2042(2) even though it could be exercised to reacquire the trust property. The Tax Court also addressed the issue of whether the grantor had retained control over anirrevocable trust of which she was not the trustee in Estate of Wall v. Commissioner, 101 T.C.300 (1993). In Wall, the trustee possessed broad discretionary powers of distribution. Thedecedent reserved the right to remove and replace the corporate trustee with another corporatetrustee. The court concluded that the retained power was not equivalent to a power to affect thebeneficial enjoyment of the trust property pursuant to Code §§2036 and 2038. The Service issued Rev.Rul. 95-58, 1995-2 Cum.Bull. 191, in response to the decision inWall. Rev.Rul. 95-58 provides that if the grantor’s power to remove the trustee and appoint asuccessor trustee was limited to appointing an individual or corporate successor trustee that wasnot related or subordinate to the grantor within the meaning of Code §672(c), then the decedentwould not be treated as having retained discretionary control over the trust’s income. Althoughthe trust in this ruling did not own an insurance policy, the rationale of the ruling can be appliedto an analysis of retained incidents of ownership when an insurance policy is held in anirrevocable trust. Beverly R. Budin, 826-2d T.M., Life Insurance (2006). Finally, if a corporation owns an insurance policy on the life of its controlling shareholderand a portion of the proceeds are payable to anyone other than the corporation or a third party fora valid business purpose, then incidents of ownership as to that part of the proceeds will beattributed to the decedent through his or her stock ownership. See §§9.22 – 9.23 below onredemption agreements for additional discussion of the taxation of corporate-owned life insurance 2. [9.8] Inclusion in Gross Estate Pursuant to Code §2035 The proceeds of an insurance policy that was no longer owned by the insured at death alsomay be includible in the insured’s gross estate if certain conditions occur. Code §2035, alsoknown as the “three-year rule,” may cause estate tax inclusion of insurance proceeds from aninsurance policy transferred by the insured during his or her lifetime. Code §2035(a) provides: (a) Inclusion of certain property in gross estate. — If — (1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3- year period ending on the date of the decedent’s death, and
(2) the value of such property (or an interest therein) would have been included in the decedent’s gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death, the value of the gross estate shall include the value of any property (or interest therein) which would have been so included. Therefore, if the insured owns a life insurance policy on his or her life and transfers thepolicy within three years of death, the policy proceeds will be includible in his or her gross estate. However, Code §2035 does contain an exception. If the transfer was a bona fide sale foradequate and full consideration in money or money’s worth, then Code §2035 will not apply.Code §2035(d). However, as described in §9.3 above, when a policy is transferred for valuableconsideration, the transfer-for-value rule may cause a portion of the proceeds received by thepurchaser to be subject to income tax. 3. [9.9] Inclusion of Insurance on the Life of Another (Including Second-to-Die Insurance) Pursuant to Code §2033, a decedent’s gross estate must include all assets owned by thedecedent at the time of his or her death, including an insurance policy on the life of someone else.The value of the policy on the death of the owner will not be the face value of the policy since theinsured is still alive. Instead, the value of the policy is determined by ascertaining the replacementvalue of the policy in question. Treas.Reg. §20.2031-8(a)(1) provides that “[t]he value of acontract for the payment of an annuity, or an insurance policy on the life of a person other thanthe decedent, issued by a company regularly engaged in the selling of contracts of that characteris established through the sale by that company of comparable contracts.” If the replacementvalue is not readily ascertainable, then “the value may be approximated by adding to theinterpolated terminal reserve at the date of the decedents death the proportionate part of the grosspremium last paid before the date of the decedent’s death which covers the period extendingbeyond that date.” Treas.Reg. §20.2031-8(a)(2). Life insurance policies on more than one life are a popular estate planning tool, typically onthe lives of a husband and wife, due in part to the lower cost of insuring two lives jointly ratherthan insuring each life separately. Second-to-die policies mature at the time when the need forliquidity is the greatest — at the death of the surviving spouse. For most married couples, estatetax liability will not arise until the death of the surviving spouse due to the unlimited maritaldeduction for property passing to a spouse. On the death of the first spouse to die, the value of the policy will be included in that spouse’sgross estate pursuant to Code §2033 if that spouse was the owner of the policy. The value of thepolicy will be as set forth in Treas.Reg. §20.2031-8(a). If, however, the first spouse to die was notthe owner of the policy, nothing will be included in that spouse’s gross estate. A second-to-die policy may be transferred after purchase to a third party such as anirrevocable life insurance trust. Code §2035 may require that the proceeds of the policy bebrought back into the transferor’s estate if the transferor does not survive the three-year period
following the transfer. If a second-to-die life insurance policy is owned by a third party, theproceeds of the insurance will not be included in the estate of either insured. As long as thesecond to die passes away more than three years after the policy was transferred to the third-partyowner, the three-year rule will not bring the proceeds back into the prior owner’s estate. 4. Reporting Requirements and Payment of Estate Tax a. [9.10] Schedule D of Form 706 All life insurance policies on the decedent’s life, whether or not includible in the decedent’sgross estate, are reported on Schedule D of IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. Schedule D should include insurance on the life of the decedentreceivable by or for the benefit of the estate as well as insurance on the decedent’s life receivableby beneficiaries other than the estate when the decedent possessed incidents of ownershipexercisable alone or in conjunction with any other person. The description to be included onSchedule D for each policy should include the name of the insurance company and the policynumber. In addition, a Form 712, Life Insurance Statement, for each policy must be attached toSchedule D. Form 712, which should be requested from the insurance company that issued thepolicy, will include the date-of-death value to be reported on the return as well as the face amountof the policy, any accumulated dividends, and any returned premiums. Schedule D also mustinclude a description of any policies on the life of the decedent that are not includible in thedecedent’s gross estate, as well as an explanation as to why the proceeds are not includible in thegross estate. b. [9.11] Amount Includible in Taxable Estate Treas.Reg. §20.2042-1(a)(3) provides that, except in the case of insurance owned by acorporation, the amount to be included in the gross estate pursuant to Code §2042 is the fullamount receivable under the policy. If the proceeds of the life insurance policy are made payableto a beneficiary in the form of an annuity or for a term of years, the amount to be included in thegross estate will be the one sum payable at death under an option that could have been exercisedeither by the insured or by the beneficiary or, if no option was granted, the sum used by theinsurance company in determining the amount of the annuity. c. [9.12] Alternate Valuation Code §2032 allows the executor to elect to value the assets of the decedent’s estate at theirvalue on the six month anniversary of the decedent’s death if such an election will decrease thevalue of the decedent’s taxable estate and will decrease the amount of federal estate tax due. If adecedent’s estate owns life insurance on the life of another and alternate valuation is elected, thevalue of the insurance policy will increase if the insured dies during the six month period. TheIRS has ruled that the full face value of the policy will be included in the taxable estate if theelection to use alternate valuation is made. Rev.Rul. 63-52, 1963-1 Cum.Bull. 173; Beverly R.Budin, 826-2d, T.M., Life Insurance (2006). In addition, an election to use alternate valuationcould also cause inclusion of the entire face value of the policy if the decedent owns a second-to-die policy and the surviving insured dies during the six-month period.d. [9.13] Marital Deduction
Generally, life insurance proceeds payable to a surviving spouse or to a trust that qualifies forthe marital deduction will qualify for an estate tax marital deduction pursuant to Code §2056.However, if the spouse or the trustee of such a trust for the spouse’s benefit elects payment of theproceeds in a form other than a lump sum, the marital deduction may be lost because the paymentstream may fail to qualify as a “terminable interest” pursuant to Code §2056(b). Therefore,caution must be taken when selecting a payment option. If a payment option is selected thatallows property to pass from the decedent to anyone other than the surviving spouse or thespouse’s estate, then the interest also will not be deductible for federal estate tax purposesbecause it will not qualify as a terminable interest for purposes of Code §2056. Beverly R. Budin,826-2d, T.M., Life Insurance (2006). e. [9.14] Charitable Deduction Proceeds of life insurance that are paid to an organization that is exempt from income taxpursuant to Code §501(c)(3) will qualify for an estate tax charitable deduction pursuant to Code§2055. If the insured-owner of a life insurance policy designates a charitable organization as thebeneficiary of his or her life insurance policy and retains incidents of ownership over the policy,then the proceeds will be included in the insured’s gross estate under Code §2042 and theinsured’s taxable estate will receive an offsetting deduction pursuant to Code §2055 for the entireamount that passes to the charity. Unlike the income tax provisions of the Code, there is no limiton the amount of the estate tax charitable deduction that can be taken. f. [9.15] Payment of Tax As described in more detail in Chapter 4, the Internal Revenue Code imposes the federalestate tax while, as a general rule, state law dictates the apportionment of the federal estate taxliability. Code §2206, however, is one exception to this general rule. Code §2206 imposes liability for a proportionate share of the estate tax liability onbeneficiaries who receive life insurance proceeds. The insured-decedent can waive this right ofrecovery in his or her will. Specifically, Code §2206 provides: Unless the decedent directs otherwise in his will, if any part of the gross estate on which tax has been paid consists of proceeds of policies of insurance on the life of the decedent receivable by a beneficiary other than the executor, the executor shall be entitled to recover from such beneficiary such portion of the total tax paid as the proceeds of such policies bear to the taxable estate. If there is more than one such beneficiary, the executor shall be entitled to recover from such beneficiaries in the same ratio. In the case of such proceeds receivable by the surviving spouse of the decedent for which a deduction is allowed under section 2056 (relating to marital deduction), this section shall not apply to such proceeds except as to the amount thereof in excess of the aggregate amount of the marital deductions allowed under such section. This right of recovery generally is waived in most standard estate planning documents.However, the executor should be aware that this right exists under the Code. If the right ofrecovery is not waived, the executor should take action to recover the applicable amount of tax.
IV. [9.16] IRREVOCABLE LIFE INSURANCE TRUSTS Life insurance trusts frequently are used in estate planning when the insured’s estate taxsituation calls for planning beyond the implementation of traditional A/B trust planning. A lifeinsurance trust is an excellent tool for removing value from an individual’s taxable estate. A lifeinsurance trust generally can be created at little or no gift tax cost, particularly if a new insurancepolicy can be purchased directly by the trust. An existing policy also may be used to fund anirrevocable life insurance trust, but if the policy is transferred to an ILIT for less than full andadequate consideration, the insured will be treated as having made a taxable gift of the value ofthe policy. When a life insurance policy is held by an irrevocable trust, the insurance proceeds generallywill not be subject to estate tax upon the death of the insured. If, however, the insurance policywas transferred to the trust by the insured within three years of the insured’s death, then, asdescribed in §9.8 above, the proceeds of the policy will be includible in the insured’s gross estatepursuant to Code §2035. As discussed in §9.7 above, even when the insured is not the owner of a life insurance policy,estate tax inclusion may result if the insured is found to have “incidents of ownership” over thepolicy. Accordingly, when an insured dies, while the life insurance policy on his or her life isowned by an irrevocable trust, the trust must be reviewed carefully to determine whether theinsured held any incidents of ownership over the trust that could cause inclusion under Code§2042(2). As discussed in §9.6 above, the insurance proceeds are often used to provide liquidity to theestate in the form of a loan to the deceased insured’s estate. The trustee of the insurance trust thatowns the policy will generally be granted the authority to make loans to the grantor’s estate. Thetrustee may also be empowered to purchase assets from the grantor’s estate in order to provideliquidity at the insured’s death.V. BUY — SELL ARRANGEMENTSA. [9.17] Introduction Life insurance is often an integral component of the buy-sell arrangements contained inshareholder, partnership, and limited liability operating agreements. In the typical buy-sellscenario, the owners of a business provide in the applicable agreement for the purchase of adeceased owner’s interest in the business in order to maintain ownership within the desired groupwhile also providing liquidity for the deceased owner’s estate. By addressing the situation in thebuy-sell agreement, the parties provide for a smoother transition in the event of the death of oneof them while avoiding potential disputes over, among other things, how the business is to bevalued or how the purchase price will be paid. A well-drafted buy-sell agreement not only will contain the mechanics for the purchase of theinterest by the surviving owners, but also will detail how the deceased owner’s interest is to bevalued (and, therefore, how the purchase price is to be calculated). With respect to valuation, theagreement can contain either the methodology to be used to value the business at the time of anowner’s death (e.g., “the fair market value as determined by ABC accountants”) or the actual
formula to be used (e.g., the book value of the business, or a multiple of the business’ prior year’searnings). Often the buy-sell agreement will provide for the annual valuation of the company, acopy of which is to then be attached to the agreement, and the most recent of which would thenbe used for purposes of determining the purchase price for the deceased owner’s interest. The parties to the buy-sell agreement not only are interested in determining the value of theirinterests in the event of death, but they invariably want to ensure that their intended beneficiariesreceive payment for that interest in the most efficient way possible. The purchase price for adeceased owner’s interest in a standard buy-sell agreement will be paid in a lump sum, over time(as evidenced by a promissory note), or by a combination of the two. Life insurance policies often are purchased on the lives of the business owners in order toprovide at least a portion, if not all, of the funds needed to purchase the deceased owner’s interest.Thus, the applicable purchase price for each owner’s interest in the business will dictate theamount of life insurance to be purchased. The taxation of the proceeds of the life insurance aswell as the postmortem handling of this insurance will depend on the ownership of the policy.There are several alternatives to the structuring of the ownership of life insurance and, as a result,the buy-sell arrangement itself — the two most common of which are the cross-purchase and theredemption. See §§9.18 – 9.23 below.B. [9.18] Cross-Purchase Agreements The cross-purchase arrangement can be an effective structure for a buy-sell agreement,particularly when the business has only a few owners. If an owner dies, the surviving owners arerequired by the buy-sell arrangement to purchase their pro rata share of the deceased owner’sinterest in the business. Typically, each owner purchases and maintains a separate life insurancepolicy on the life of each of the other owners to fund the purchase in the event of a death (in orderto avoid being required to use personal funds or to give a personal promissory note to meet thecontractual purchase obligation). If in fact life insurance is used to fund the cross-purchase agreement, upon the death of anowner, the remaining owners will submit the necessary claim forms and accompanyingdocumentation in order to receive the applicable death benefits. Once the death benefits arereceived and the applicable purchase price calculated, the surviving owners close on the purchaseof the deceased owner’s interest. 1. [9.19] Estate Tax Considerations The fair market value of the interest in the business owned by the decedent will be includedin his or her gross estate for estate tax purposes. Code §§2031, 2033. As mentioned in §9.17above, buy-sell agreements often will establish the value of a deceased owner’s interest in thebusiness for purposes of the buy-out upon death. While a complete discussion regarding thevaluation of business interests is beyond the scope of this publication, it should be noted that suchbuy-sell agreement provisions may or may not be determinative in the valuation of the businessinterest for federal estate tax purposes. See Code §2703. Generally, the decedent’s gross estate also will include the proceeds of a life insurance policyon his or her life if they are receivable by the executor of his or her estate (Code §2042(1)) or if
the decedent, at the time of death, possessed incidents of ownership in the policy (Code§2042(2)). In the conventional cross-purchase arrangement, the life insurance policy of each businessowner is payable to the other business owners, not to the insured’s estate. The insured businessowner does not own, pay for, or in any other way control the life insurance policy and thereforedoes not have incidents of ownership. As a result, the proceeds of the policy on the life of adeceased owner will not be includable in his or her gross estate for federal estate tax purposes.Rev.Rul. 56-397, 1956-2 Cum.Bull. 599; First National Bank of Birmingham, Alabama v. UnitedStates, 358 F.2d 625 (5th Cir. 1966); Estate of Ealy v. Commissioner, 10 T.C.M. (CCH) 431(1951); Wilson v. Crooks, 52 F.2d 692 (W.D.Mo. 1931). Even though the insurance proceeds ultimately will be paid to the insured’s estate by theother business owner(s) pursuant to the buy-sell agreement, they will not be included in his or hergross estate under Code §2042(1). (See, for example, Pvt.Ltr.Rul. 9511009 (Mar. 17, 1995), inwhich the Service determined that, even though the death benefit of a life insurance policy on thelife of a shareholder was ultimately paid to his estate in satisfaction of the other shareholder’sobligation to purchase the decedent’s shares under a buy-sell agreement, the proceeds were notincludible in the decedent’s gross estate because they were actually payable to a trust that wasthen required to utilize the proceeds to facilitate the buy-sell arrangement.) However, if theinsured’s estate is named as beneficiary of the policy and the insurance proceeds are to be used toreduce the purchase price required under the buy-sell agreement, the proceeds will be included inthe decedent’s gross estate. Estate of Mitchell v. Commissioner, 37 B.T.A. 1 (1938). The TaxCourt has also ruled that when the insurance agent erroneously issued ownership of insurancepolicies purchased to fund a cross-purchase agreement in the name of the insured and the partiesto the agreement were unaware of the error, the nature of the error and the obligations of thecross-purchase agreements would not cause inclusion of the death benefit in the deceasedpartner’s gross estate. Estate of Fuchs v. Commissioner, 47 T.C. 199 (1966). Even though in the typical cross-purchase scenario the business owners purchase andmaintain similar insurance policies on each others’ lives, the reciprocal nature of the ownershipwill not fall under the reciprocal trust doctrine first espoused in Lehman v. Commissioner, 109F.2d 99 (2d Cir. 1940), and therefore will not result in inclusion of the insurance proceeds in thedeceased owner’s gross estate. Rev.Rul. 56-397, 1956-2 Cum.Bull. 599. In a cross-purchase arrangement, the insured business owner does not own the insurancepolicies on his or her own life, but the cross-purchase agreement will, in certain situations, grantthat insured business owner veto rights over his or her partners’ ability to change the beneficiaryon the policies, surrender the policies, or the like. When these contractual veto rights over thepartners’ rights to change the beneficiary or surrender the insurance policy on the life of the vetoholder are granted solely to ensure compliance with the buy-sell agreement, such veto rights willnot be deemed an incident of ownership causing inclusion of the death benefit in the decedent-veto holder’s gross estate. Estate of Infante v. Commissioner, 29 T.C.M. (CCH) 903 (1970).However, in Schwager v. Commissioner, 64 T.C. 781 (1975), the Tax Court ruled that insurancepolicy proceeds were includible in the decedent’s gross estate under Code §2042(2) when theowner of the policy (the employer pursuant to a split-dollar arrangement) could not change thebeneficiary without the decedent’s consent. See also Rev.Rul. 75-70, 1975-1 Cum.Bull. 301;Estate of Tomerlin v. Commissioner, 51 T.C.M. (CCH) 831 (1986).
In a cross-purchase arrangement, the deceased business owner will have owned policies onthe lives of the other business owners, and, therefore, the value of those policies will be includedin the deceased owner’s gross estate. Code §§2031, 2033. The deceased business owner’sexecutor can obtain date-of-death valuations of those policies by requesting IRS Form 712s fromthe insurance carriers. The practitioner should keep in mind that ownership of policies on thelives of a deceased business owner’s associates could end up in the hands of the decedent’sfamily and should therefore include provisions in the buy-sell agreement to ensure that ownershipof the policies is required to be transferred along with the ownership interest in the business. 2. [9.20] Income Tax Considerations Once a business owner dies, the income taxation of the life insurance policies on his or herlife, as well as the policies that he or she owned on the lives of others, is an issue that must beexamined closely. As detailed in §9.3 above, ordinarily the death benefit of a life insurance policyis not subject to income tax. Code §101(a)(1). If an insurance policy is transferred during thelifetime of the insured for valuable consideration, the portion of the death benefit in excess of theconsideration paid for the policy plus the premiums paid by the transferee will be subject toincome taxation. Code §101(a)(2). There are, however, several exceptions to the transfer-for-value rule, as also detailed in §9.3, several of which have application in the buy-sell context.Specifically, the transfer of the policy to a partner of the insured, to a partnership in which theinsured is a partner, or to a corporation in which the insured is a shareholder generally will notcause a portion of the death benefit to be subject to income taxation on the death of the transferor.Code §101(a)(2)(B). Application of the transfer-for-value rule often arises, sometimes unexpectedly, whenbusiness owners enter into a buy-sell agreement to dictate the transfer of a deceased owner’sinterest, funding the purchase price called for with insurance. If new insurance policies arepurchased for the buy-sell arrangement and they are purchased directly by one business owner onthe life of another, the transfer-for-value rule will not apply. However, in the corporate context, ifa shareholder in a corporation conveys a policy on his or her life to another shareholder, thetransfer-for-value rule will apply. This will be the case even if no purchase price is actually paidfor the policy. Monroe v. Patterson, 197 F.Supp. 146 (N.D.Ala. 1961). As described in §9.18 above, in the prototypical cross-purchase arrangement, eachshareholder of a corporation owns insurance policies on the lives of the other shareholders. Whena shareholder dies, if the policies that the deceased shareholder owned on the survivingshareholders’ lives are conveyed to the surviving shareholders, the transfer-for-value rule willapply (unless each surviving shareholder receives the policy on his or her own life, which thenwould negate the benefit of using that policy to fund the continued buy-sell arrangement with theother surviving shareholders). However, if those policies are conveyed to the corporationpursuant to the buy-sell agreement, then an exception under Code §101(a)(2)(B) permits thetransfer of the insurance policy to a corporation in which the insured is a shareholder. The Code §101(a)(2)(B) exception with respect to the transfer of an insurance policy to apartner of the insured or to a partnership in which the insured is a partner is quite useful inavoiding the otherwise harsh result of the transfer-for-value rule in the corporate buy-sell context.Specifically, if the shareholders of a corporation transfer the policies on their lives to a
partnership or limited liability company (taxed as a partnership) and that entity will then facilitatethe buy-sell arrangement, the transfer-for-value rule will not apply as a result of the transfers ofthe policies to the partnership or limited liability company. (See for example, Pvt.Ltr.Rul.9309021 (Mar. 5, 1993), in which the corporation that owned the insurance policies on the livesof the shareholders planned to convey the policies to a partnership to be formed by theshareholders for the purpose of facilitating the cross-purchase, and the Service ruled that the Code§101(a)(2)(B) exception would apply, and Pvt.Ltr.Ruls. 9328010 (July 16, 1993), 9328012 (July16, 1993), 9328017 (July 16, 1993), 9328019 (July 16, 1993), and 9328020 (July 16, 1993), allapplying to the same situation in which a corporation planned to convey policies on the lives ofits shareholders to an existing partnership of which the shareholders were the partners. Thepartnership then planned to convey the policies equally among the partners, who would thenconvey the policies to a series of trusts that would be treated as grantor trusts as to the partners.The Service ruled that each step of the proposed transaction would meet the Code §101(a)(2)(B)exception to the transfer-for-value rule — the first transfer to the partnership and to the partners,the next transfer from the partners to the grantor trusts, and the transfer from a trust on the deathof a partner to the remaining partners. See also Pvt.Ltr.Rul. 9347016 (Nov. 26, 1993), in which acorporation conveyed policies on the life of a shareholder to the other shareholders, who thenconveyed the policies to each other, and because the shareholders were also partners in apartnership, Code §101(a)(2)(B) applied to prevent the application of the transfer-for-value rule,even though the partnership was not actually involved in the conveyances, and Pvt.Ltr.Rul.9701026 (Jan. 3, 1997), in which the three shareholders in a corporation, who were also the threepartners in a partnership, planned to enter into a cross-purchase agreement and have thecorporation transfer an existing split-dollar life insurance policy to the noninsured shareholdersand the Service ruled that, since the transfer was to partners of the insured, Code §101(a)(2)(B)applied.) In the cross-purchase arrangement involving a C corporation, an S corporation, or apartnership, the cost basis of the deceased owner’s interest in the business will be stepped uppursuant to Code §1014. The sale of the interest pursuant to the cross-purchase agreement shouldthen result in no gain being recognized by the seller of the interest. The beneficiary designation and ultimate payout of insurance policy death benefits can affectthe surviving business owners’ tax basis in the purchased interests. Generally, if a partnershipreceives the proceeds of a life insurance policy on the life of a partner (presumably pursuant tothe buy-sell arrangement), the surviving partners’ basis in the partnership is increasedaccordingly. Treas.Reg. §1.753-1. The proceeds will instead be paid to the surviving partners tobe used to facilitate the cross-purchase arrangement, and the surviving partners’ basis in thepurchased interest will be increased accordingly. In Legallet v. Commissioner, 41 B.T.A. 294 (1940), two partners in a partnership took outinsurance on the life of each other, but each partner had retained the right to change thebeneficiary of the policy on his own life. They also entered into a cross-purchase agreement thatrequired that the proceeds of the policies, even though payable to the deceased partner’s family,be applied toward the purchase price of the partnership interest. When one partner died, theinsurance proceeds were paid to the decedent’s wife. The Tax Court found that the partnersintended that the insurance proceeds should be paid only to the surviving spouse, and no one else,and therefore the proceeds were not received by the surviving partner. As a result, the Tax Courtdetermined that the proceeds were not to be included in the surviving partner’s cost basis in the
deceased partner’s partnership interest that was acquired pursuant to the cross-purchaseagreement. In contrast, in Mushro v. Commissioner, 50 T.C. 43 (1969), the Tax Court was presented withsimilar facts and determined that the purchasing partners received an increased cost basis in thedeceased partner’s interest. In this case, the insurance proceeds were also payable to the survivingwife. The Tax Court, distinguishing this case from Legallet, concluded that the intent of namingthe wife as beneficiary was only to provide the widow with a security device — that it was thesurviving partners who were intended to receive the proceeds and then use them to purchase theinterest.C. [9.21] Redemption Agreements The redemption agreement is a very useful form of buy-sell arrangement, particularly whenthe business has several owners. In this arrangement, if life insurance will be used to fund thepurchase of an interest on the death of one of the business’s owners, the business owns one policyon the life of each business owner, rather than each owner maintaining policies on each of theother owners. The business entity is named as the beneficiary of the life insurance policies. If anowner dies, the business entity receives the death benefit and is required by the buy-sellarrangement to purchase (redeem) the deceased owner’s interest in the business. The insuranceproceeds are used to facilitate all, or at least a portion, of the purchase price called for in theredemption agreement. 1. [9.22] Estate Tax Considerations As noted in §9.19 above and discussed further below, the fair market value of the interest inthe business owned by the decedent will be included in his or her gross estate for estate taxpurposes. Code §§2031, 2033, 2703. The purchase of a deceased business owner’s interest pursuant to a redemption agreement isoften funded with life insurance. Whether the death benefit of the policy will be included in thegross estate of the deceased business owner pursuant to Code §2042(1) or Code §2042(2)depends on the type of entity that owns the policy, as well as to whom the proceeds are to be paid. If a partnership owns an insurance policy on the life of one of its partners, and the policy ispayable on death to a beneficiary other than the partnership, the death benefit will be includible inthe decedent’s gross estate under Code §2042(2). Rev.Rul. 83-147, 1983-2 Cum.Bull. 158. If a corporation holds all incidents of ownership over a life insurance policy and is thebeneficiary of the policy, the death benefit will not be included in the gross estate of the insuredshareholder even if the insured is the sole or controlling shareholder (that is, owns more than 50percent of the total combined voting power of the corporation). Treas.Reg. §20.2042-1(c)(6). Inthis situation, however, the death benefit of the insurance will affect the valuation of theshareholder’s interest in the business that will be included in his or her gross estate. Treas.Reg.§20.2031-2(f). (See additional discussion below regarding the effect of life insurance proceeds onthe valuation of a corporation.) If the corporation holds incidents of ownership over the insurancepolicy but is not the beneficiary (such that the proceeds will not be taken into account in valuingthe corporation), incidents of ownership of the policy will be attributed to the insured controlling
shareholder, resulting in inclusion of the proceeds in the deceased controlling shareholder’s grossestate for estate tax purposes. Treas.Reg. §20.2042-1(c)(6). Treas.Reg. §20.2042-1(c)(6) details what stock ownership will be attributed to the decedent.For purposes of this regulation, the decedent will be considered the owner of the stock that, at thetime of death, he or she held jointly (proportionately to the extent of the consideration paid by thedecedent) and that was held by a trust that was treated as a grantor trust pursuant to Code §671, etseq., at the time of his or her death. While the proceeds of corporate-owned life insurance on the life of a deceased controllingshareholder will not be included in the decedent’s gross estate under Code §2042 if the proceedsare payable to the corporation, the proceeds of the policy will be taken into account in valuing thedecedent’s stock. Treas.Reg. §20.2031-2(f); Rev.Rul. 82-85, 1982-1 Cum.Bull. 137. In Estate ofHuntsman v. Commissioner, 66 T.C. 861 (1976), acq., 1977-2 Cum.Bull. 1, the Service arguedthat the decedent’s shares in his corporation should first be valued without regard to the lifeinsurance proceeds that were paid to the corporation, and then the full amount of the insuranceproceeds added to the value, thereby including the full amount of the insurance proceeds in thedecedent’s gross estate. The Tax Court rejected this argument, stating that the Service’s positionwas contrary to Treas.Reg. §§20.2042-1(c)(6) and 20.2031-2(f). The court concluded that theinsurance proceeds should be viewed as just one of the nonoperating assets of the corporation tobe considered in the valuation of the stock. See also Estate of Feldmar v. Commissioner, 56T.C.M. (CCH) 118 (1988). In Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005), the Eleventh Circuitoverturned the Tax Court’s determination that life insurance proceeds should be added to thevaluation of the subject corporation. The court explained that Treas.Reg. §20.2031-2(f) providesthat “consideration shall also be given to nonoperating assets, including proceeds of life insurancepolicies payable to or for the benefit of the company, to the extent that such nonoperating assetshave not been taken into account in the determination of net worth.” 428 F.3d at 1345. The court,citing the Ninth Circuit’s decision in Cartwright v. Commissioner, 183 F.3d 1034 (9th Cir. 1999),as well as the Tax Court’s decision in Huntsman, supra, concluded that the phrase “to the extentthat such nonoperating assets have not been taken into account in the determination of net worth”precluded the inclusion of the insurance proceeds in the valuation because the proceeds wereoffset by the corporation’s contractual obligation to use the proceeds to purchase the decedent’sstock. 428 F.3d at 1345. Even when a life insurance policy on the life of a shareholder is owned by a corporation, thethree-year rule of Code §2035 may apply to cause inclusion of the death benefit in the grossestate of the shareholder on death. If the corporation transfers the life insurance policy to a thirdparty gratuitously (not pursuant to a bona fide sale for adequate and full consideration), and theinsured shareholder dies within three years of the transfer, the proceeds will be included in theshareholder’s gross estate pursuant to Code §2035(a) if the shareholder was the controllingshareholder pursuant to Treas.Reg. §20.2042-1(c)(6). Rev.Rul. 82-141, 1982-2 Cum.Bull. 209;Tech.Adv.Mem. 8806004 (Nov. 4, 1987). If the shareholder transfers his or her stock within threeyears of death, the death benefit of the corporate-owned life insurance policy may or may not beincludible in his or her gross estate. If a controlling shareholder of a corporation transfers his orher stock within three years of death and the corporation owns an insurance policy on his or herlife, the beneficiary of which is the corporation, the shareholder does not hold any incidents of
ownership in the policy pursuant to Treas.Reg. §20.2042-1(c)(6), and therefore Code §2035(a)will not cause inclusion of the death benefit in the decedent’s gross estate. Tech.Adv.Mem.8906002 (Feb. 10, 1989). If, however, the controlling shareholder of a corporation transfers his orher stock within three years of death and the corporation owns an insurance policy on his or herlife, the beneficiary of which is someone other than the corporation, the shareholder will betreated as holding incidents of ownership pursuant to Treas.Reg. §20.2042-1(c)(6), and thereforeCode §2035(a) will cause inclusion of the death benefit in the decedent’s gross estate. The guidelines discussed in §9.19 above in the cross-purchase context regarding the inclusionof insurance proceeds in a decedent’s gross estate when the decedent holds veto rights or otherpowers pursuant to a buy-sell agreement that are deemed to be incidents of ownership also mayapply with respect to redemption agreements. For example, see Tech.Adv.Mem. 9349002 (Dec.10, 1993). In addition, to the extent that a redemption agreement provides that any insuranceproceeds in excess of those required to fund the redemption are to be paid as designated by thebeneficiary, such excess proceeds will be included in the decedent’s gross estate. See, e.g.,Pvt.Ltr.Rul. 8943082 (Oct. 27, 1989). 2. [9.23] Income Tax Considerations The transfer-for-value rule discussed in §§9.3 and 9.20 above will be less of an issue in theredemption setting, as the transfer of the existing insurance policy by the business owner to thebusiness entity (for later use in the redemption) generally will fall into one of the exceptions setout in Code §101(a)(2)(B) (a transfer to a corporation in which the insured is a shareholder, or atransfer to a partnership in which the insured is a partner). As discussed in §9.20 in the cross-purchase context involving a C corporation, an Scorporation, or a partnership, the cost basis of the deceased owner’s interest in the business willbe stepped up pursuant to Code §1014. The redemption of the interest pursuant to the redemptionagreement should then result in no gain being recognized by the seller of the interest, whether ornot insurance is used to fund the redemption.VI. [9.24] SPLIT-DOLLAR ARRANGEMENTS Split-dollar insurance arrangements originated as a mechanism to allow an employer toprovide executives and other key employees the benefit of permanent life insurance coveragewhile sharing in the payment of the required premiums. A number of different ways of structuringthe payment of premiums, ownership of the policy itself, sharing of the cash value, and sharing ofthe premium payments developed over the years, all aimed at providing income tax benefits to theemployer (expense deduction) and the employee-business owner (payment of premium via eitheran interest-free loan or tax-free employee benefit), while also providing the insurance coverageitself. The split-dollar arrangement became an even more useful estate planning tool wheninsurance trusts were incorporated into the structures. Beginning in 2001, the Service issued a series of notices that addressed, and tightened, theincome taxation of split-dollar arrangements. The Service’s focus on the taxation of split-dollarinsurance culminated with the issuance of final regulations in 2003, which defined “split-dollar”as “any arrangement between an owner of a life insurance contract and a non-owner of a life
insurance contract” under which either party to the arrangement pays, directly or indirectly, all orany portion of the premiums and one of the parties paying the premiums is entitled to recover allor any portion of the premiums. Treas.Reg. §1.61-22(b). As a result of those regulations, split-dollar arrangements fall into one of two different income tax regimes, the economic benefitregime and the loan regime, and are taxed accordingly. Treas.Reg. §§1.61-22, 1.7872-15. While detailed descriptions and discussion of the taxation of the various split-dollar structuresis beyond the scope of this publication, the postmortem handling of the split-dollar insurance isrelatively straightforward, particularly in light of the fact that the split-dollar arrangement is mostoften documented in a written contract that dictates the actual handling of the policy proceeds ondeath. In addition, the insurance policies are typically owned by irrevocable trusts in the split-dollar arrangement. Many times, however, an exit strategy will have been implemented in order to avoid thecontinued income taxation of the arrangement. These exit strategies often involve the transfer ofthe insurance policy. Therefore, the transfer-for-value rule, as well as its exceptions, as detailed in§§9.3 and 9.20 above, may come into play to cause income taxation of a portion of policyproceeds on the death of the insured. The analysis outlined in §9.22 above for the inclusion of an insurance policy’s death benefitin the gross estate of the insured for federal estate tax purposes, pursuant to Code §§2042(1) and2042(2), also applies in the split-dollar context. Particular attention ought to be paid to theapplicability of Treas.Reg. §20.2042-1(c)(6) if, pursuant to the split-dollar arrangement, thecorporation retains incidents of ownership over the insurance policy but is not the beneficiary ofthe policy.VII. EMPLOYEE BENEFIT AND RETIREMENT ARRANGEMENTSA. [9.25] Introduction Insurance often constitutes a key component of employee benefit packages provided by manyemployers, from group term life insurance to bonus plans and deferred compensationarrangements. While the transfer-for-value rule set forth in Code §101(a)(2) regarding the incometaxation of the death benefits and the general rules regarding the inclusion of the insuranceproceeds in a decedent’s gross estate pursuant to Code §§2042 and §2035 will apply to theseinsurance policies, there are also specific issues that will come into play with respect to thepostmortem handling of group term policies as well as those held in retirement plans.B. [9.26] Group Term Life Insurance As described in §9.19 above, if the life insurance policy on the life of the employee is payableto the insured’s estate or is otherwise treated as being receivable by the employee’s executor, thenthe proceeds of the policy will be includible in the employee’s gross estate for federal estate taxpurposes. Code §2042(1); Treas.Reg. §20.2042-1(b)(1). In addition, if the death benefit of agroup term life insurance policy is payable to a beneficiary other than the employee’s estate andthe employee retains incidents of ownership, then the proceeds of the policy will be includible in
the employee’s gross estate for federal estate tax purposes under Code §2042(2). In the groupterm life insurance context, determining what constitutes incidents of ownership can be tricky. Even if an employee signs an irrevocable beneficiary designation and otherwise relinquishesall other perceived incidents of ownership, the death benefit still may be includible in his or hergross estate pursuant to Code §2042(2). As noted in §9.7 above, if an insured retains the right tocancel the insurance policy, he or she has retained an incident of ownership. Treas.Reg.§20.2042-1(c)(3). Could the employee’s ability to terminate his or her employment, therebycancelling the group term policy, constitute an incident of ownership? The Service, through aseries of Revenue Rulings, has clarified that an employee’s right to terminate will not causeinclusion of the death benefit if all other incidents of ownership have been relinquished. Rev.Rul.69-54, 1969-1 Cum.Bull. 221; Rev.Rul. 72-307, 1972-1 Cum.Bull. 307. In the partnership context, if the partnership has a group term life insurance policy on the lifeof one of its partners and retains the right to cancel the policy, and the insured partner otherwiseirrevocably assigns his or her interest in the policy, the insured partner will not be deemed to holdincidents of ownership in the policy that would cause inclusion of the death benefit in his or hergross estate. Rev.Rul. 83-148, 1983-2 Cum.Bull. 157. In that situation, however, if the policy ispayable to a beneficiary other than the partnership, the death benefit will be includible in thepartner’s gross estate. Rev.Rul. 83-147, 1983-2 Cum.Bull. 158. The Service also has ruled that if the only right retained by an employee at the time of his orher death is the right to convert the group term policy to an individual policy upon termination ofemployment, the employee will not have incidents of ownership that would cause the proceeds tobe subject to estate tax on his or her death. Rev.Rul. 84-130, 1984-2 Cum.Bull. 194. See alsoEstate of Smead v. Commissioner, 78 T.C. 43 (1982), acq., 1984-2 Cum.Bull. 1. Just as there are several Code §2042(2) issues that are unique to group term life insurancepolicies, there are also several twists on the three-year rule under Code §2035 with respect togroup term policies. These issues generally present themselves when the employer, in theordinary course of its business, changes the insurance providers or the types of policies involved.See, for example, Rev.Rul. 80-289, 1980-2 Cum.Bull. 270, in which the Service ruled that theproceeds of a group term life insurance policy would not be included in the decedent’s grossestate under Code §2035 when the decedent was required to assign rights in a group policy(which he had previously irrevocably assigned) because the employer had switched insuranceproviders. In Rev.Rul. 82-13, 1982-1 Cum.Bull. 132, the Service addressed the applicability of Code§2035 to the annual renewal of group term life insurance. Specifically, the Service considered agroup term policy that had an option for automatic renewal upon payment of the premium, whichwas accomplished without providing evidence of insurability, and the rights and obligations ofthe parties continued without interruption from the policy’s inception as long as the policy wasrenewed on each anniversary date. As a result, the Service ruled that even though a decedentwould be considered to have made premium payments until death, the value of a renewable groupterm life insurance policy is not includible in a decedent’s gross estate under Code §2035 whenthe decedent assigned the policy more than three years before death.C. [9.27] Life Insurance in Qualified Retirement Plans
Life insurance is often promoted as a valuable investment to be made by a qualifiedretirement plan because, among other reasons, pretax dollars can be used to pay the premiumsand no out-of-pocket payments are required of the insured, leveraging the funds in the plan.However, these arrangements can have extremely harsh results if they do not have a properlystructured exit strategy that is implemented before death. Just as with any other assets held in aqualified plan, the death benefit of the life insurance policy that is held inside a plan will be bothsubject to income tax (it will be considered income in respect of a decedent) and included in thedecedent’s gross estate for federal estate tax purposes (while Code §2039(a) will cause theretirement plan assets to be included in the gross estate of a decedent, that section specificallyexcludes life insurance policy proceeds; Code §2042 will cause inclusion of the proceeds as thedecedent most often retains incidents of ownership, such as the right to change beneficiaries). Therefore, the successful completion of an exit strategy will result in the insurance policybeing transferred out of the qualified retirement plan, sometimes to the insured (who may thengift the policy to an irrevocable life insurance trust), or even directly to an ILIT. In any event, if atthe time of the insured’s death a policy is in existence that had been held in a qualified plan, asoutlined above, the transfer-for-value rule in Code §101(a)(2) may apply. In addition, asdescribed generally in §§9.7 – 9.8 above, Code §§2042 and 2035 will cause inclusion of thepolicy proceeds, when applicable.Conclusion The financial burden created by the death of a family member is often addressed by thepurchase of a life insurance policy. Life insurance can play a vital role in the estate planning andadministration process. When engaging in estate planning for high net worth individuals, theestate planner will find that their estates often consist primarily of illiquid assets such as a closelyheld business interest or significant real estate. In these types of situations, the beneficiaries ofthe estate could be forced to liquidate assets immediately at "fire sale" prices in order to generatecash to pay taxes and expenses. Life insurance can be used to provide liquidity for such estates. It is important to consider all of the income and estate tax issues surrounding life insurancepolicies. Upon the death of an insured, the proper reporting and review of a life insurance policyis an essential part of post mortem planning.