Life Insurance (Portfolio 826)

Part of Tax

Tax Management Portfolio, Life Insurance, No. 826-3rd, analyzes in detail the federal estate and gift tax treatment of life insurance policies. 

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Tax Management Portfolio, Life Insurance, No. 826-3rd, analyzes in detail the federal estate and gift tax treatment of life insurance policies. After outlining the general principles involved, the Portfolio applies the concepts to both personal and business insurance in various contexts, such as group term insurance, split-dollar insurance, and buy-sell insurance. The Portfolio reviews the application of life insurance to other transfer tax and planning areas, such as the marital deduction, §2035 (the three-year rule), and retirement planning.
The Portfolio also discusses special issues in estate planning with life insurance, including policy transfers, charitable giving, and the treatment of policy proceeds held in a qualified retirement plan. In addition, the folio provides a general overview of the major types of life insurance products.
This Portfolio may be cited as Mezzullo, 826-3rd T.M., Life Insurance.


Louis A. Mezzullo, Esq.

Louis A. Mezzullo, University of Maryland (B.A. 1967, M.A. 1976), University of Richmond (J.D. 1976); Consulting Partner, Withers Bergman LLP, Rancho Santa Fe, California (2014–present); Member, McKenna Long & Aldridge LLP (formerly Luce, Forward, Hamilton & Scripps LLP), Rancho Santa Fe, California (2006–2013); Member, McGuireWoods LLP, Richmond, Virginia (2004–2006); Founding Member, Mezzullo & Guare, PLC, Richmond, Virginia (2000–2003); Founding Member, Mezzullo & McCandlish, Richmond, Virginia (1982–2000); Former Adjunct Professor, University of Richmond Law School; Author, 722 T.M. and 812 T.M., Family Limited Partnerships and Limited Liability Companies; 378 T.M. and 814 T.M., Estate and Gift Tax Issues for Employee Benefit Plans; 809 T.M., Estate Planning for Owners of Closely Held Business Interests; 831 T.M., Valuation of Corporate Stock; 835 T.M., Transfers of Interests in Family Entities Under Chapter 14: Sections 2701, 2703 and 2704; 803 T.M., The Mobile Client: Tax, Community Property, and Other Considerations; An Estate Planner's Guide to Buy-Sell Agreements (ABA); An Estate Planner's Guide to Life Insurance (ABA); An Estate Planner's Guide to Qualified Retirement Plan Benefits (ABA); An Estate Planner's Guide to Family Business Entities (ABA); Valuation Rules Under Chapter 14 (ABA); Co-author, Limited Liability Companies in Virginia (Virginia Law Foundation); Advising the Elderly Client (Clark Boardman Callaghan); Fellow and Former Chair, American College of Tax Counsel; Immediate Past President, American College of Trust and Estate Counsel (2012–2013); Charter Fellow, American College of Employee Benefits Counsel; Chair, ABA Section of Real Property, Probate and Trust Law (2000–2001); Former Vice Chair of Publications and Chair of the Business Planning Subcommittee of the Estate and Gift Taxes Committee of the ABA Section of Taxation; Academician and Vice President, International Academy of Trust and Estate Law; and Member, Heckerling Estate Planning Institute Advisory Council.

Table of Contents

Detailed Analysis

I. Estate Taxation

A. Historical Introduction

1. 1916–1942

2. 1942–1954

3. 1954 and 1986 Codes

B. When Are Proceeds “Receivable by the Executor”?

1. Code and Regulations

2. Applicability to Irrevocable Life Insurance Trusts

3. Noninsured Owner of Policy as Slayer

C. “Incidents of Ownership” Test

1. Retention vs. Later Acquisition

2. Impossibility of Exercise

3. Joint Powers

4. “Policy Facts” Doctrine

a. Statement of Problem

b. Major Cases Involving “Policy Facts”

c. Agent's Mistake Exception

d. Quasi-Trust Exception

e. Court Order/State Law Exception

f. Documentary Evidence Exception

g. Conclusions

5. Reversionary Interests

a. Power of Disposition

b. Power in Another

c. Possibility of Inheritance and Elective Rights

d. Reversionary Interest in Divorce Context

e. Reversionary Interest in Business Context

f. Similarity to 2037

6. Special Situations Concerning Incidents of Ownership

a. Insured as Beneficiary of Residuary Estate

b. Insurance Owned by Noninsured, Payable to Insured's Revocable Trust

c. Power of Insured to Borrow Against Policy

d. Assignment of Policy to Secure Loans of Insured

e. Insured with Option to Purchase Policy

f. Power in Insured to Reacquire Assets

g. Divorce by Insured Eliminates Spouse as Trust Beneficiary

h. Insurance Incidental to Stock Exchange Seat

i. Insurance Acquired by Spouse with Community Property

7. Reciprocal Trust Doctrine

a. Background

(1) Lehman

(2) Grace: No Requirement of Consideration

(3) Bischoff: No Requirement of Economic Interest

b. When Are Trusts Interrelated?

(1) In General

(2) Similarity of Trust Provisions

(3) PLR 200426008

c. How Much Is Included?

(1) In General

(2) Possible Impact of Later Additions

d. Impact on Life Insurance Trusts

8. Business Insurance

D. Special Issues in Trust-Owned Insurance: Application of Incidents of Ownership Test

1. What Are Consequences of Decedent Serving as Trustee of Trust Holding Insurance Policy on Decedent's Life?

a. Decedent Is Not Transferor of Policy and Has No Beneficial Interest in Trust

(1) Case Law

(2) Rev. Rul. 84-179

b. Decedent Has Beneficial Interest in Trust

(1) In General: Section 2042 Will Apply

(2) Exception: Trustee's Powers Limited

(3) Exception: Trustee Renounces or Resigns

c. Decedent Is Transferor

d. Decedent as Trustee Improperly Uses Trust Funds for Personal Benefit

e. Practical Application of Rules

2. What Are Consequences if Decedent Is Beneficiary (But Not Trustee) of Trust Holding Insurance Policy on Decedent's Life?

a. Statement of Problem

b. Analysis of Interests of Beneficiary/Insured

c. Authorities

d. PLR 9602010

e. Other Private Letter Rulings

f. Legal Principles

g. Guidelines

3. What Are Consequences of Decedent Having Power to Change Trustees?

a. Prior Law

b. Current Law

4. What Are Consequences of Decedent Serving as Executor of Estate Owning Insurance Policies on Decedent's Life?

5. What Are Consequences of Decedent Holding Insurance Policy on Decedent's Life as Custodian Under Uniform Transfers to Minors Act?

a. Custodian as Transferor

b. Custodian Not Transferor

6. What Are Consequences of Decedent Serving as Agent Under Power of Attorney Granted by Principal Who Owns Insurance Policies on Decedent's Life?

a. Does Attorney-in-Fact Have a “Power”?

b. Analysis If Attorney-in-Fact Has a “Power”

c. Suggested Approach

E. Decedent's Power to Select Settlement Option as Incident of Ownership

1. Lumpkin

2. Connelly

3. IRS's Position

4. Conclusion

F. Estate Taxation and Business Insurance

1. Corporate Owned Insurance - Attribution in General

a. Illustration of Problem

b. Summary of Regulations

c. Potential Trap: Distribution Powers and Withdrawal Rights May Create Attribution

(1) In General

(2) PLR 9037012: Distribution Rights Equal “Ownership”

(3) PLR 9848011: Distribution Rights Do Not Create “Ownership”

d. Potential Trap: Qualified Subchapter S Trust

2. Applicability of 2035 to “Controlling” Shareholder

a. Corporation Transfers Policy Within Three-Year Period Before Death

b. Corporation Transfers Policy Within Three-Year Period for “Full and Adequate Consideration”

(1) Problem 1: What Is “Adequate and Full Consideration”?

(2) Problem 2: “Transfer for Value” Rule

c. Decedent Transfers Stock Within Three-Year Period Before Death

(1) TAM 8906002: Corporation as Beneficiary

(2) Rev. Rul. 90-21: Third Party as Beneficiary

3. Corporate-Owned Life Insurance Payable to Third Party - Some Special Problems

a. Split-Dollar Insurance

(1) General Observations

(2) Controlling Shareholder Rules in Split-Dollar Insurance

(3) Corporation's Power to Terminate Split-Dollar Arrangement

b. Change of Ownership

c. Income Tax Consequences

4. Treatment of “Includible” Split-Dollar Insurance in Gross Estate of Decedent

5. Insurance Owned by and Payable to Corporation

a. Keyperson Insurance

b. Buyout Insurance

(1) Redemption of Some of Decedent's Shares

(2) Redemption of All of Decedent's Shares

(a) Background

(b) Blount - Tax Court Says Insurance Proceeds Considered

(c) Blount - Appeals Court Says Insurance Proceeds Ignored

(3) Payment to Escrow Agent or Trustee

6. Partnership-Owned Insurance

a. Insurance Payable to Third Party

b. Insurance Payable to or for Benefit of Partnership

7. Insurance Owned by Business Associates

8. Decedent's Contingent Option to Purchase Corporate-Owned Insurance

a. Employment Context

b. Shareholder Context

9. Decedent's Indirect Power, as Shareholder, to Change Beneficiary of Insurance Policy; Act of Independent Significance

G. Transfers Within Three Years of Death

1. Introduction

a. Section 2035 Before Tax Reform Act of 1976 (“1976 TRA”)

b. Section 2035 After 1976 TRA and Before Economic Recovery Tax Act of 1981 (“ERTA”)

c. Section 2035 After ERTA

2. Application of Three-Year Rule Where Decedent Named as Original Owner

a. Insured Transfers Policy and Dies Within Three Years

b. Insured Transfers Policies, Continues to Pay Premiums, and Dies More than Three Years After Transfer

c. How Is Transfer of Policy Effected?

3. Application of Three-Year Rule Where Person Other than Insured Named as Original Owner

a. Results Under 2035 Before 1981 Revisions

b. Pre-ERTA Variations on Bel: Owner Makes Payments

c. Results Under 2035 After 1981 Revisions

(1) Leder

(2) Headrick and Perry

(3) IRS Recommends Acquiescence

(4) Remaining Issues

(a) Relation of New Policy to Old Policy: TAM 9141007

(b) Involvement of Insured in Application Process: TAM 9323002

4. Group Term Life Insurance

5. Transfer of Policy for “Adequate and Full Consideration” to Avoid 2035

a. Valuation Issues

b. Income Tax Implications: “Transfer for Value” Rule

c. Sale to Spouse

d. Sale Technique to “Cure” a “Bad” Trust

e. Conclusions

f. Insured Transfers Policy to LLC

6. Estate Tax Inclusion Under 2035 vs. Estate Tax inclusion Under 2042

H. Availability of Estate Tax Marital Deduction

1. Settlement Options

a. Life Annuity Option

b. Life Annuity with Guaranteed Payments

c. Payment for Term of Years

d. Fixed Amount Option

e. Interest Option

2. Marital Deduction Principles - Deductible and Nondeductible Terminable Interests

3. Exceptions to Terminable Interest Rule

4. Life Insurance with General Power of Appointment

5. Qualified Terminable Interest Property

a. Section 2056(b)(7)(B)(ii)

b. Proposed Regulations

c. 1992 Amendment

d. Final Regulations

6. Miscellaneous

a. Disclaimers

b. Delay Clauses

c. Separate Shares

d. Simultaneous Death

I. Estate and Gift Tax Consequences to Someone Other than Insured

1. Owner of Policy Predeceases Insured

2. Insured Predeceases Owner of Policy

a. Proceeds Payable to Owner in Lump Sum

b. Proceeds Payable to Owner Under Settlement Option

c. Proceeds Payable to Someone Other than Owner of Policy

(1) Gift Tax

(2) Estate Tax

3. Applicability of 2035 to Estate of Someone Other than Insured

4. Will Premium Payments by Someone Other than Insured Make Payor a “Transferor” at Death of Insured?

5. Power of Appointment

J. Amount Taxed

1. Estate of Insured - In General

2. Estate of Insured - Insurance Company Rejects Claim

3. Estate of Someone Other than Insured

a. Regular Valuation Date

b. Alternate Valuation Date

(1) Death of Insured

(2) Continued Premium Payments; Interest Earned

(3) Changes in Value Due to Mere Lapse of Time

c. Simultaneous Death of Insured and Owner

(1) Owner Presumed to Have Died Before Insured

(2) Insured Presumed to Have Died Before Owner

K. Apportionment of Federal Estate Tax

1. Decedent's Direction

2. Disclaimer of Benefit of Tax Clause

3. Effect of State Law

4. Special Problem - Insurance Payable in Installments

II. Gift Taxation and Estate Planning

A. Introduction

1. In General

2. Special Advantages of Gifts of Life Insurance

3. To Whom Should Transfer Be Made?

a. Spouse-Owned Life Insurance

b. Individual Other than Spouse as Owner

c. Trust as Owner

B. Transfer of Policy or Payment of Premiums as Taxable Gift

C. Amount of Gift

1. Newly Issued Policy

2. Paid-Up Policy/Single Premium Policy

3. Policy Neither Newly Issued Nor Paid Up

4. Special Circumstances

D. Annual Exclusion

1. In General

2. Outright Gift to Two Donees

3. Gifts to Minors

4. Gifts in Trust

5. Payment of Premium

E. Gift Tax Marital Deduction

F. Split Gifts

G. Potential Traps in Transferring Life Insurance Policies

1. Making Effective Transfer

2. Beneficiary Designation on Transferred Policy - Possible Pitfall

3. Avoiding More than One Owner of Policy

4. Transfer for Value Rule

a. Personal Insurance - In General

b. Personal Insurance - Trust-to-Trust Transfers

(1) Basis Exception

(2) Transferee Exception

c. Business Insurance

(1) Exception for Transfers to Corporation

(2) Exception for Transfers to Partnership or Partner

III. Special Issues in Estate Planning with Life Insurance

A. Group Term Life Insurance

1. Estate Tax Issues with Group Term Insurance Policies

a. Assignability Under State Law and Under Terms of Policy

b. Effectiveness of Assignment for Estate Tax Purposes

c. Insured as Major Shareholder

d. Section 2035

(1) Renewable Group Term

(2) Change in Insurance Carrier

(a) Rev. Rul. 80-289

(b) Variation on Rev. Rul. 80-289

(3) Section 2035 and Group Insurance

2. Gift Tax Issues with Group Term Life Insurance Policies

a. Rev. Rul. 76-490

b. Developments After Rev. Rul. 76-490

(1) Availability of Annual Exclusion

(2) Valuation of Gift

B. Private Split-Dollar Arrangements

1. Background

a. IRS Position re Estate Tax Treatment

b. Estate Tax Exclusion in Arrangement Between Spouse and Insurance Trust

c. Arrangement Between Insured and Insurance Trust

2. Notice 2002-59

3. Impact of 2003 Split-Dollar Regulations

C. Survivorship Insurance

1. Federal Estate Tax

a. Husband Dies First

b. Wife Dies First

2. Policy Owned by Third Party - Application of 2035

D. Charitable Gifts

1. Testamentary Gift

2. Inter Vivos Gift

a. Amount of Deduction

b. Policy Subject to Loan

c. Premium Payments

d. Potential Trap in Inter Vivos Gift - Lack of Insurable Interest

3. Wealth Replacement

E. Insurance Company Disputes Claim

F. Insurance in Qualified Retirement Plans

1. Background of Estate Taxation of Qualified Plans

2. Relationship of 2039 and 2042 Under Prior Law

3. Treatment of Proceeds of Life Insurance Policy Held in Retirement Plan After Tax Reform Act of 1984

a. Gift Tax Implications

b. Generation-Skipping Transfer Tax Implications

c. Income Tax Implications

d. Estate Tax Implications - 2042

e. Estate Tax Implications - Regs. 20.2042-1(c)(6)

f. Estate Tax Implications - 2035

4. Removing Life Insurance Policy from Qualified Retirement Plan

a. Qualified Plan Requirements

b. Income Tax Results

G. Life Insurance Products

1. Universal Life

2. Single Premium Life Insurance

H. What Is Life Insurance?

1. Significance

2. Background

3. Section 7702

4. Modified Endowment Contracts

a. Consequences of Classification as “Modified Endowment Contract”

b. Definition of “Modified Endowment Policy”

c. Ten Percent Additional Tax

d. Loans Treated as “Amounts Received”

5. Section 101(f)

6. Nonstatutory Definition

a. Applicability

b. Basic Definition

c. Endowment Policy

d. Distinguishing Between Insurance Under 2042 and Payments Under 2039

e. “Insurance” Without Commercial Insurance Company

(1) Stock Exchange Death Benefit

(2) Survivor Benefits Relating to Employment

f. Life Insurance vs. Liability Insurance; Payments Under No-Fault Automobile Insurance

g. Tax-Free Receipt of Life Insurance Proceeds During Life

I. State Death Taxes

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Form 712 - Life Insurance Statement

Worksheet 2 Revenue Act of 1918 - H.R. Rep. No. 767, 65th Cong., 2d Sess., 101-2 (1918)

Worksheet 3 Revenue Act of 1942 - H.R. Rep. No. 2333, 77th Cong., 2d Sess., 490-2 (1942)

Worksheet 4 Internal Revenue Code of 1954 - H.R. Rep. No. 1337, 83d Cong., 2d Sess. (1954); S. Rep. 1622, 83d Cong., 2d Sess. (1954)

Worksheet 5 H.R. Rep. No. 736, Conference Report to Accompany H.R. 3103 - Health Insurance Portability and Accountability Act of 1996 (H.R. 3103), 104th Cong., 2d Sess. 305 (1996) (Excerpts)

Worksheet 6 The American Law Institute, Federal Income, Estate and Gift Tax Statute Tentative Draft No. 11, April 24, 1956

Worksheet 7 The American Law Institute Comments on Section X2013 of A.L.I. Statute

Worksheet 8 Summary of the 2003 Split-Dollar Insurance Regulations

Worksheet 9 Treatment of Grandfathered Split-Dollar Policies Under Notice 2002-8





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