| April 26 2010
Life insurance is often the best way to provide liquidity for payment of estate taxes. However, if the insured owns the policy, the proceeds will be includable in the insured’s estate for federal estate tax purposes, thereby compounding the problem.
Advisors sometimes recommend that, to avoid this problem, the children own the policy jointly on the life of the parent (or, in the case of a married couple, on the joint lives of the parents). However, while joint ownership is relatively simple, it presents at least two potential problems:
1. Insurance companies nearly always require joint ownership to be “joint and survivor.” As a result, if a child dies before the parent(s), the child’s ownership rights pass to the surviving children, not to the deceased child’s heirs as is normally the parents’ intent.
2. Payment of premiums can be unwieldy, generally requiring separate gifts to the children, who must then consolidate the funds. If the parents pay the premiums directly, the payments will likely not qualify for the gift tax annual exclusion (see Skouras v. Commissioner, 188 F.2d 183) and will be taxable gifts requiring use of the parent’s lifetime gift tax exclusion and bringing the gifts back into the parent’s estate as “adjusted taxable gifts.”
A better alternative may be to have each child own a separate policy. Each child can name a successor owner and contingent beneficiary, and direct payment of premiums by the parent qualifies for the gift tax annual exclusion. Reg. §25.2503-3(c), Ex. (6).
An even better alternative may be an irrevocable life insurance trust (ILIT). An ILIT avoids the risk that a child may inappropriately borrow on or surrender the policy during the parent’s lifetime, or fail to make the death proceeds available when needed for payment of estate taxes. Also, with an ILIT, the “three-year rule,” which causes estate inclusion of the proceeds if death occurs within three years of a gift of a policy, is more easily avoided. Selling, rather than gifting, a policy to children to avoid the three-year rule results in a “transfer-for-value,” which subjects a portion of the death benefit to income taxation. Selling the policy to an ILIT structured as a “grantor trust,” on the other hand, is treated as a sale to the insured, one of the exceptions to the transfer-for-value rule.
