A deceased client’s son walks into your office. His father’s life was insured for $10 million and he had $10 million in other assets in his estate at the time of death.

A deceased client’s son walks into your office. His father’s life was insured for $10 million and he had $10 million in other assets in his estate at the time of death. Assuming the client had used none of his unified credit, had no deductions, and left his entire estate to his son, what should the client’s estate tax liability be? The client had purchased the policy many years ago and has been paying the premiums himself.

What facts would have to change in order for the $10 million insurance proceeds to not be included in the father’s estate? For example, what specific incidents of ownership would the son need to have in his father’s policy?

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Answer

When a person dies, the properties and funds that belong to that person are transferred to the heirs. But that property may be taxed by the government, and the tax is called the Estate Tax (the property left to us by our loved ones is called an ‘Estate’). The estate tax in the United States is one part of the Unified Gift and Estate Tax system.

1.In the United State, there is a basic exclusion from the Federal Estate tax, which is $5.45 million per person for 2016. Once above the exclusion, estates are taxed at 40 percent. However, most people who even have funds above that amount don’t wind up paying any estate tax at all according to the Urban-Brookings Tax Policy Center.

In current scenario the federal estate tax amounts to $0

2. life insurance benefits may be included in the gross estate (even though the proceeds arguably were not “owned” by the decedent and were never received by the decedent). Life insurance proceeds are generally included in the gross estate if the benefits are payable to the estate, or if the decedent was the owner of the life insurance policy or had any “incidents of ownership” over the life insurance policy (such as the power to change the beneficiary designation).

One of the benefits of owning life insurance is the ability to generate a large sum of money payable to your heirs in the event of your death. An even greater advantage is the federal income-tax free benefit that life insurance proceeds receive when they are paid to your beneficiary. However, although the proceeds are income-tax free, they may still be included as part of your taxable estate for estate tax purposes. Section 2042 of the Internal Revenue Code states that the value of life insurance proceeds insuring your life are included in your gross estate if the proceeds are payable: (1) to your estate, either directly or indirectly; or (2) to named beneficiaries, if you possessed any incidents of ownership in the policy at the time of your death.

Ownership Transfer

For those estates that will owe taxes, whether life insurance proceeds are included as part of the taxable estate depends on the ownership of the policy at the time of the insured’s death. If you want your life insurance proceeds to avoid federal taxation, you’ll need to transfer ownership of policy to another person or entity. Here are a few guidelines to remember when considering an ownership transfer:

• Choose a competent adult/entity to be the new owner (it may be the policy beneficiary), then call your insurance company for the proper assignment, or transfer of ownership, forms.
• New owners must pay the premiums on the policy. However, you can gift up to $14,000 per person, so the recipient could use some of this gift to pay premiums.
• You will give up all rights to make changes to this policy in the future. However, if a child, family member or friend is named the new owner, changes can be made by the new owner at your request.
• Obtain a written confirmation from your insurance company as proof of the ownership change.

Life Insurance Trusts

A second way to remove life insurance proceeds from the taxable estate is to create an irrevocable life insurance trust. In order to complete an ownership transfer, deceased cannot be the trustee of the trust and may not retain any rights to revoke the trust. In this case, the policy is held in trust and deceased will no longer be considered the owner. Therefore, the proceeds are not included as part of the deceased’s estate.