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Estate Planning With Existing Life Insurance Jan. 22, 2001 (Principal Financial Group) As clients age and accumulate wealth, their life insurance needs often evolve from survivorship income to estate liquidity. Continued ownership of life insurance policies on themselves when no longer needed to financially protect the surviving spouse needlessly subjects the proceeds to estate tax. Changing policy ownership may allow existing policies to serve estate liquidity needs. This Advisor Update discusses issues to consider when transferring existing life insurance. Estate Inclusion
Generally, insurance proceeds will be included in the insured's estate if the insured owns or transfers an "incident of ownership" in the policy at or within three years of death. Incidents of ownership are defined broadly and include virtually any right or power in the policy. Thus the insured must live for three years after the transfer to exclude policy proceeds from the estate.
Who Should Receive the Policy?
Clients may want to transfer policies directly to children to avoid the cost of creating a trust. If there is only one child and that child is a responsible adult, this approach may work. However, clients should be apprised of the potential problems with this method and some alternatives.
If the child is a minor, transfers under the Uniform Transfers to Minors Act (UTMA) require a custodian. To avoid estate inclusion, the custodian should be someone other than the grantor/insured. Under the UTMA, the child receives unrestricted access to policy cash values (and eventually death benefits) at the relatively young age of majority. Regardless of age, some children may have neither the maturity nor the financial skills to handle large sums of money.
Where there are two children or more, naming one as owner and all of the children as beneficiaries is frequently proposed. The problem with this arrangement is that upon the insured's death, the child/owner is deemed to make a taxable gift of the pro rata share of death benefit to the other children. If the gift exceeds the annual exclusion, a portion of the owner's unified credit will be used.
A transfer to all of the grantor's children in joint tenancy will not qualify for the annual exclusion. In joint tenancy, each tenants' ownership of the property is limited by the requirement that all tenants must agree to any exercise of policy rights. This limitation prevents the gift from qualifying for the annual exclusion.
If subsequent premium payments are made directly to the insurance company by the grantor, joint tenancy again prevents those gifts from qualifying for the annual exclusion. The grantor must gift the premium amount directly to each joint tenant who will in turn pay the premium personally. Finally, joint tenancy can be cumbersome because multiple signatures are required to take action on the policy.
Trusts
The best option in many cases is to transfer the policy to an irrevocable trust designed to own life insurance (ILIT). The original transfer to the trust and subsequent gifts to pay premiums qualify for the annual exclusion if Crummey powers are used. A properly drafted ILIT insulates the policy from the creditor problems, death or divorce of the beneficiaries.
Another trust advantage is that the non-insured spouse can be made a trust income beneficiary without including the entire policy in the estate. The trust also can be drafted so that if the policy is included in insured's estate, it can still qualify for the marital deduction.
Limited liability companies (LLC) and family limited partnerships (FLP) are increasingly used as a flexible alternative to ILITs. A comparison of LLCs and FLPs to ILITs is beyond the scope of this article.
Policies with Loans
Gifting a policy subject to a loan may have extremely negative tax implications and should be carefully considered. Such a transfer discharges the grantor from debt and he is considered to receive income equal to the loan. The transfer is treated as part gift and part sale.
The grantor must recognize income on the transfer to the extent the loan exceeds his basis.
More significantly, the policy has been transferred for value (TFV). The Internal Revenue Code provides that the proceeds of a policy that has been transferred for value are taxable income to the extent the proceeds exceed the owner's basis in the policy.
This result can be avoided if the loan does not exceed the grantor's basis in the policy. The donee's basis will equal that of the grantor thus qualifying the transfer for the carry over basis exception to the TFV rules.
Summary
Existing life insurance can provide cost effective estate liquidity, but policy ownership must be appropriate to avoid estate tax inclusion. All options should be examined to maximize policy benefits and avoid unforeseen tax and legal implications.
2001, Principal Financial Group. All Rights Reserved.
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