Section 2042 of the Internal Revenue Code of 1986 provides that the value of a gross estate includes all life insurance policies (1) receivable by the executor of your estate; and (2) all policies over which you owned any "incidents of ownership." IRS regulations define "incidents of ownership" to include the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy. See Regulation 20.2042-1(c)(2). It also includes a reversionary interest in the policy or its proceeds if the reversionary interest exceeds 5% of the policy value.
Pursuant to Section 2035, your estate also includes life insurance policies that would have been included in your estate if you transferred an interest or relinquished power over the policy within three (3) years of your death.
The IRS defines the term "life insurance" broadly to cover virtually every insurance product payable upon your death. Regulation 20.2042-1(a)(1) includes the following definition: "The term ``insurance'' refers to life insurance of every description, including death benefits paid by fraternal beneficial societies operating under the lodge system."
If a policy is included in your gross estate, its value is "the full amount receivable under the policy." See Reg. 20-2042-1(a)(3).
With appropriate estate planning, it is possible to remove a policy of life insurance from your gross estate for Estate Tax purposes. Often this is done with an irrevocable insurance trust. So, what is a life insurance trust?
1. You must give up your right to change the beneficiary.
After a trustee is designated, the trustee alone has the right to change the beneficiary and you cannot serve as the trustee of your life insurance trust. Of course, you may designate the beneficiaries of the trust, but after the life insurance trust has been set up, you will lack the flexibility to deal with changed family circumstances.
2. No borrowing against the policy.
You no longer own the policy so you can't borrow against it. The right to borrow against the policy is an incident of ownership.
3. You may need to purchase a new policy.
Because Section 2035 pulls policies back into your estate if you die within three years after making a transfer, you will be treated as the owner of the policy and it will be taxed in your estate if you transfer an existing policy within that time frame. You could also be deemed to have made a taxable gift in the amount of the cash value of the policy if you transfer an existing policy. For this reason, it may be preferable to have the trust take a new policy on your life so its one you never owned.
4. The trust must be irrevocable.
This is a one way path. Once you set up and fund the trust, you can't get it back. If you could, then you still have an incident of ownership.
5. You can use your annual estate tax exemption to make the premium payments.
If the policy has not yet endowed (paid-up), then someone has to make the premium payments. You can do this by setting your trust up as a Crummey Trust. A Crummey Trust is one where you place money into the trust and give the beneficiaries the right to withdraw those funds for up to 30 days after each annual gift is made. Although there is some risk involved, most beneficiaries won't exercise this right, believing you wouldn't fund the trust next if they drain the trust this year. The right to withdraw the funds causes the gift to be deemed a present interest, which is eligible for the annual gift exclusion. If the beneficiary does not withdraw the gift within the 30 days, the withdrawal right lapses and the money remains in the trust until the beneficiary reaches a designated distribution age. In the meantime, the funds are used to pay the premium payments on the life insurance policy.
6. You will need a trustee.
You cannot serve as trustee of your life insurance trust. That means that he will have to find or hire a third party trustee.
Given the complexity of the tax rules, we suggest that you do structure transactions of this type with the advice of a professional.