Whether life insurance will be subject to the Federal estate tax is generally controlled by Section 2042 of the 1986 Internal Revenue Code, which has two subsections:
2042. Proceeds of Life Insurance – 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.
Receivable By the Executor
This provision is fairly straight forward, particularly if the term “estate” is substituted for the term “executor” to read “Receivable by the estate”. In this context, subsection one can be viewed to indicate that any payment made to the estate from an insurance policy covering the deceased’s life is subject to the Federal estate tax.
Proceeds are most often received by the estate when the deceased owns a personal life insurance policy that is made payable directly to the estate or to the estate’s executor. The estate is frequently the ‘default’ beneficiary of a life insurance policy, meaning that the policy is paid to the estate when there aren’t any named beneficiaries or when all of the named beneficiaries are deceased.
It is important to note that payments received by the executor are taxable to the extent they are received by that person in his or her capacity as executor, which does not include proceeds that are otherwise received by the same person.
For instance, Ralph has one policy made payable to his business partner Edward and a second policy made payable to the executor of his estate. Ralph’s will names Edward executor. Although Ed is the same person and is named to receive both policies, the first policy is not granted to him in his capacity as executor and is not available to the estate. The first policy will not be subject to the estate tax based upon Ed’s receipt of the proceeds.
Benefit Received By Estate
Life insurance is also subject to the tax under subsection one when the estate receives a benefit from the policy’s proceeds, which can occur even though the executor does not actually receive those proceeds. For example, Ralph owes the Bensonhurst Building & Loan Association $1,000,000. As a condition of his loan, BBL required him to purchase a life insurance policy that would cover the full amount owing at his death. When Ralph dies, the insurance company makes direct payment to BBL as the beneficiary.