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.
Although the proceeds of this policy were not receivable by the executor, Ralph’s estate gained a benefit from their application and the amount paid to satisfy the debt is subject to the Federal estate tax under subsection one. (However, the $1,000,000 debt will also typically be deductible from the gross estate as an estate obligation or debt.) Another example with includible proceeds that does not involve a debt to the estate is found when the proceeds are used to satisfy the estate’s tax obligations.
Payable To Other Beneficiaries
The full text of subsection two is actually:
(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.
The operative definition of this subsection is “incidents of ownership” which the deceased owned at death. Although “incidents of ownership” may include outright ownership, its definition is different and encompasses more than the rights that come with outright ownership.
For instance, incidents of ownership may include the right borrow from or to ‘cash out’ the policy. The power to change a beneficiary of the policy is also an incident of ownership that can cause the policy’s value to be included in the gross estate.
What may be the most important factor to note is that these incidents of ownership are defined upon the basis of rights and do not rely upon the actual exercise of any rights.
For instance, if Ralph had the ability to change his life insurance beneficiary from Edward, the value of that policy would be included in his gross estate. This will be true even if Ralph purchased the policy, named Edward as the beneficiary, and never thought about the policy again before his death.
Intestacy
A policy that is paid to an intestate estate is subject to the laws of intestacy and will be distributed according to the laws which are applicable to the deceased’s state of domicile. Although policies typically have instructions to avoid an intestate distribution (such as instructing payment Per Stirpes), any policy which does not have operative instructions for its payment will be distributed to the estate, including a policy that names a beneficiary who predeceases the insured.