Incidents Of Ownership

Marguerite owned a 900,000 dollar policy on her own life and named her son directly as beneficiary. At her death the insurer pays him promptly and the money never passes through her will. Her executor nonetheless lists the 900,000 dollars on the federal estate tax return. Is the executor correct?

1. A.Yes; naming a beneficiary avoids probate, but because she OWNED the policy the proceeds are still in her gross estateCorrect. Probate avoidance and estate tax inclusion are separate questions, and ownership drives the latter.
2. B.Yes, but only the cash surrender value immediately before death is included, not the full death benefitWhen the insured owned the policy, the full death benefit is included, not the cash value.
3. C.No; the proceeds are excluded because they are income tax free to the sonIncome tax free receipt under Section 101(a) has no bearing on estate tax inclusion. They are different taxes.
4. D.No; proceeds paid directly to a named beneficiary are excluded from the gross estateDirect payment avoids probate only. Ownership at death brings the proceeds into the gross estate.

Why: Yes, and the two ideas are independent. Naming a living beneficiary means the proceeds pass by contract and avoid PROBATE, which is the court supervised process of retitling assets under a will. That saves time, expense and publicity. It says nothing about the federal ESTATE TAX, which reaches everything the decedent owned or held incidents of ownership over at death, including a policy on her own life. Marguerite owned the policy, so the full 900,000 dollars is in her gross estate even though not a dollar of it went through probate.

Two clients use irrevocable life insurance trusts. Ingram signs an existing 2,000,000 dollar policy over to his newly created trust and dies two years later. Solveig instead has her trustee APPLY FOR and PURCHASE a brand new 2,000,000 dollar policy on her life with trust funds, and she dies two years after issue. How does the three year rule affect each estate?

1. A.Neither is included, because an irrevocable life insurance trust always removes proceeds from the gross estateAn ILIT is effective only if the estate tax rules are satisfied, and a transfer within three years defeats it.
2. B.Solveig proceeds are included and Ingram proceeds are not, because she was the driving force behind the purchaseThis reverses the outcome. Who arranged the purchase does not matter; whether the insured transferred an existing policy does.
3. C.Both are included, because each insured died within three years of the trust acquiring the policyAcquisition by the trust is not the trigger. Only a transfer by the insured starts the three year clock.
4. D.Ingram proceeds are included in his gross estate; Solveig proceeds are not, because there was no transfer of an existing policyCorrect. The three year rule reaches transferred policies. A trust that originally applies for and buys the policy avoids it.

Why: The three year rule pulls a life insurance policy back into the gross estate when the insured TRANSFERS an existing policy and dies within three years of the transfer. Ingram did exactly that, so his 2,000,000 dollars is included. Solveig never owned the policy at any moment. The trustee applied for it, the trust was the original owner and beneficiary, and there was no transfer to claw back, so the three year rule simply has nothing to grip. Her proceeds stay out of the estate even though she died within three years of issue. This is why practitioners insist on having the trust buy the policy at inception rather than transferring one in.

Four insureds each try to keep a policy on their own life out of their gross estate. Wilhelmina gave the policy away but kept the right to change the beneficiary. Osric gave it away but kept the right to borrow against the cash value. Petronella gave it away but kept the right to be paid the death benefit if the named beneficiary predeceases her. Callum gave it away outright and simply continued to pay the premiums by writing checks to the insurer. Whose policy proceeds are NOT included in the gross estate?

1. A.OsricThe right to borrow against cash value is an incident of ownership, so his proceeds are included.
2. B.WilhelminaThe right to change the beneficiary is the classic incident of ownership. Her proceeds are included.
3. C.CallumCorrect. Paying premiums on a policy owned by another is a gift, not an incident of ownership, so the proceeds stay out of his gross estate.
4. D.PetronellaA retained right to receive the proceeds if the beneficiary predeceases her is a reversionary interest and can cause inclusion.

Why: Estate inclusion turns on retained INCIDENTS OF OWNERSHIP, which are the economic rights of ownership: the right to change the beneficiary, the right to borrow against or assign the policy, the right to surrender or cancel it, and any reversionary interest of sufficient value. Wilhelmina, Osric and Petronella each retained one of those rights, so each policy is pulled back into the gross estate. Callum retained none. Merely paying premiums on a policy someone else owns is not an incident of ownership; it is a GIFT of the premium amount each year, with gift tax consequences but no estate inclusion of the death benefit.