Life insurance is a contract where an insurance company promises to pay a specified amount to a designated person upon the death of the insured.

Congress has enacted a variety of provisions designed to limit the tax advantages of life insurance to those products that are truly insurance in nature. Section 7702 establishes a definition of life insurance that is applicable to policies issued after 1984. Policies that fail to meet the definition of insurance set out in IRC Section 7702 lose much of the favorable tax treatment given to insurance. In 1998 Congress enacted IRC Section 7702A, introducing the concept of the “modified endowment contract.” This provision adds an additional hurdle for life insurance contracts to meet in order to be taxed under the rules applicable to life insurance.

The Rules require technical actuarial calculations that are beyond the scope of most estate planners’ expertise. The policyholder should obtain written assurances from the insurance company that the policy will be treated as life insurance for tax purposes and will not be treated as a modified endowment contract.

The purchaser of the policy does not have to be the insured, but must have an insurable interest in the insured. An "insurable interest" is a relationship between the purchaser and the insured where the purchaser will experience a loss upon the death of the insured. The insurable interest rule is in place to avoid having life insurance used for gambling purposes.

The beneficiary of a life insurance policy is designated by the owner of the policy. Since the designated beneficiary has no ability to prevent the owner of the policy from changing the designation, the named beneficiary has no property interest in a life insurance policy until the death of the insured.

When dealing with life insurance, there are different parties that are involved: the owner of the policy, the insured, (if done correctly, the owner of the policy will not be the insured), the beneficiary of the policy, and an entity or an individual that is paying the premium of the insurance policy.

There are numerous types of insurance policies. The most significant difference between life insurance policies is that some policies, namely term insurance, provide pure insurance protection against the risk of premature death, where other policies (such as whole life, variable life, and universal life insurance) have an investment component that can provide lifetime benefits to the insured (these types of policies are known as cash value policies).

Term Life Insurance is pure insurance that protects against the risk of death for a specific period of time. If the insured dies during the period, the insurer will pay the face amount of the policy to the beneficiary. All of the premiums go toward the insurance coverage and administration expenses. There is no cash value build up. Term life insurance is popular because it is very affordable. Term Insurance enables an individual with relatively few assets to have a large cash flow for the family in the event of premature death.
Whole life insurance differs from term insurance in that it lasts for the entire life of the insured unless the policy is canceled by the insured or lapses due to failure to pay premiums. It provides for level premium payments throughout the insured’s life. Whole life insurance is more expensive than term insurance. The excess premium creates a reserve, which is accumulated and eventually supports lower premiums in later years. A portion of the reserve is accessible to the owner of the policy by giving the opportunity to borrow against the policy or to cash out the policy.

There are many uses for insurance in estate planning. These include:

1. Income Replacement:

The most common use of insurance is to provide a source of support for the insured’s family in the event of the insured’s premature death. Since insurance proceeds are often the largest asset in the estate. The proceeds may be necessary in order to support the family, educate the children, or satisfy the mortgage.

Life insurance is also valuable because it is paid directly to the beneficiaries and does not have to go through the probate process. Since it avoids probate, it provides an immediate source of support during a time that much of the decedent’s estate may be tied up in probate.

2. Providing Liquidity to Pay Estate Taxes:

Life insurance is a valuable tool for providing liquidity to pay estate taxes and other expenses incurred by reason of the insured’s death and can eliminate the need to sell assets in order to pay this liability.

3. Providing Liquidity to Fund Buy-Sell Agreements:

For clients who own a business, life insurance can play an important role by providing the cash necessary to fund buy-sell agreements. Buy-sell agreements are agreements in which co-owners of a business agree to purchase the interest in the business held by the decedent upon death.

In order for a buy-sell agreement to be effective, the individuals or entity obligated to purchase the decedent’s interest must have the cash necessary to make the purchase. By purchasing life insurance on each other’s lives, the co-owners of the business can be certain to have sufficient assets to carry out the terms in the buy-sell agreement.

4. Equalizing Distributions:

Insurance can be useful in enabling a client to distribute property equitably among family members. If the estate consists largely of an asset that is not easily divisible and the client does not want the beneficiaries to have to sell the asset, life insurance can provide an additional asset to facilitate an equitable distribution of the property.

5. Second Marriage:

One situation in which insurance can be very useful is when the client wants to provide a benefit to a new spouse as well as children from a prior marriage. A common estate planner’s response is the QTIP. If the new spouse and children do not get along well, the QTIP trust can escalate tensions in the relationship since the spouse’s interest is in direct conflict with the children’s interest. If the second spouse is close in age to the children from the prior marriage, the children may not live long enough to enjoy the remainder interest under the QTIP.

Although there are many uses for insurance in estate planning, in order for it to be a successful estate planning tool, care must be taken to ensure the insurance achieves your goal without being included in your gross estate for tax purposes.

§ 2042 of the Internal Revenue Code is the determining section of whether life insurance is deemed to be taxable in the gross estate of the insured. Life insurance is broadly defined under the code and in order for benefits paid at death to be taxable as life insurance under §2042, there must be a sharing of risk.

Typically, the death benefits of a life insurance policy are substantial. Therefore, life insurance policies are often one of the most significant assets that an individual owns, so care must be taken to ensure the proceeds are available to provide liquidity to the estate but are excluded for estate tax purposes.

Generally, the proceeds are included in the insured’s estate if the proceeds are payable to the estate, the insured has incidents of ownership in the policy at the time of death, or the insured transfers the policy within three years of death.

(i) Under §2042 if life insurance proceeds are payable to the decedent’s estate those proceeds are included in the decedent’s estate for estate tax purposes.

(ii) Incidents of ownership. Life insurance proceeds are includible in the estate under §2042(2) if the decedent possessed “incidents of ownership” in the policy. This is true regardless of whether the insured owned the policy alone or in conjunction with another person at the time of death.

According to the Regs §2042.1(c) the term “incidents of ownership” is not limited to ownership of the policy in a technical sense, it includes the following:

(a) a power to change a beneficiary;

(b) the power to assign the policy;

(c) the power to pledge the policy for a loan;

(d) the power to cancel the policy;

(e) the power to revoke an assignment of the policy; or

(f) the power to obtain from the insurer a loan against the surrender value of the policy.

(iii) If the insured has incidents of ownership in the life insurance policy and transfers the policy within three years of death, those proceeds will be included in the gross estate of the decedent according to §2035. This is known as the Three Year Rule.

The Three Year Rule can be avoided by having the trustee of an ILIT purchase a life insurance policy in lieu of the decedent having to survive three years after transferring the policy to the ILIT. Therefore, the three year rule would not apply if the trustee transfers the policy since the decedent never had incidents of ownership in the policy. This is beneficial because the proceeds will be excluded from the gross estate. This is true even if the insured makes annual exclusion gifts to the ILIT to cover the cost of the annual insurance premiums. See Leader Estate v. Commissioner, 893 F.3d 237 (10th Circuit 1989) and Hedrick Estate v. Commissioner, 918 F.2d 1263 (6th Circuit 1990).

Insurance is a valuable estate planning tool. If structured properly, insurance can be used as a source of liquidity for the beneficiaries and be income tax free and free from estate taxes.