Estate and Gift Tax Considerations

While life insurance death benefits are generally income tax-free, they may still be subject to estate or gift taxes. Understanding these implications is crucial for proper estate planning.

Estate Tax and Incidents of Ownership

Life insurance proceeds are included in the insured's taxable estate if the insured possessed any incidents of ownership at the time of death.

What Are Incidents of Ownership?

Key Concept: If the insured has ANY incidents of ownership, the ENTIRE death benefit is included in their taxable estate.

Federal Estate Tax Thresholds (2025)

Portability: Unused exemption can be transferred to a surviving spouse.

Example: Estate Tax Impact

Scenario:

• Insured's total estate: $10 million
• Life insurance death benefit: $5 million (insured owned the policy)
• Total taxable estate: $15 million
• Estate tax exemption: $13.99 million
• Taxable amount: $1.01 million
• Estate tax at 40%: $404,000

Important: The estate tax exemption is scheduled to be reduced significantly in 2026 when the Tax Cuts and Jobs Act provisions sunset.

Irrevocable Life Insurance Trusts (ILITs)

An Irrevocable Life Insurance Trust (ILIT) is the primary tool for removing life insurance from the taxable estate.

How an ILIT Works

1. Grantor creates the trust - An irrevocable trust is established
2. Trust owns the policy - The ILIT is the owner AND beneficiary
3. Grantor makes gifts to trust - Cash gifts fund premium payments
4. Trustee pays premiums - Using Crummey withdrawal powers
5. Death benefit paid to trust - Not included in insured's estate
6. Trustee distributes to beneficiaries - Per trust instructions

Key ILIT Requirements

The Three-Year Rule

If an existing life insurance policy is transferred to an ILIT (or any other party), and the insured dies within three years of the transfer, the death benefit is included in the taxable estate.

Avoiding the Three-Year Rule

1. Have the ILIT purchase a new policy - No transfer means no 3-year rule
2. Wait it out - If transferred, insured must survive 3 years
3. Gift to spouse first - Spouse then gifts to ILIT (aggressive strategy)

Example:

• John transfers his $2 million policy to an ILIT on January 1, 2024
• John dies on June 15, 2026 (within 3 years)
• Result: The $2 million is included in John's taxable estate

Exam Tip: The 3-year rule applies to transfers of policies with incidents of ownership. If the ILIT purchases a new policy from the beginning, the 3-year rule does not apply.

Gift Tax Considerations

Premium Payments as Gifts

When someone other than the policyowner pays premiums, those payments are gifts:

Annual Gift Tax Exclusion (2025)

• $19,000 per donee per year
• $38,000 if gift-splitting with spouse
• Unlimited for direct payment of medical or educational expenses

Crummey Withdrawal Powers

For ILIT premium gifts to qualify for the annual exclusion, beneficiaries must have Crummey powers - the right to withdraw their share of the gift for a limited time (typically 30-60 days).

Example:

• ILIT has 4 beneficiaries
• Annual premium: $60,000
• Each beneficiary has Crummey power: $15,000
• Total annual exclusion: 4 × $19,000 = $76,000
• Gift tax on premium: $0 (fully covered by exclusions)

Gift of Policy

When a policy is gifted, the gift value depends on the policy status:

*The actual calculation is complex and may require professional appraisal.

Split-Dollar Arrangements

Split-dollar life insurance involves two parties sharing the costs and benefits of a policy, commonly used in executive compensation:

Split-Dollar Tax Considerations

• Economic benefit: Employee taxed on cost of insurance protection
• Loan regime: Interest must be charged at AFR or imputed
• Equity interest: Subject to Section 83 rules

Summary: Estate Planning with Life Insurance