Take-Away: If an individual possesses and incident of ownership in life insurance at the time of his/her death, the full death benefit will be included in the individual’s taxable estate for federal estate taxation. Incident of ownership is more than just owning the life insurance on one’s life.

Background: Death benefits owned by the insured  on the insured’s life are included in the insured’s taxable estate. [IRC 2033 and IRC 2042.] However, even if the policy is not owned by the insured, if there is an incident of ownership in the policy, the death benefit will be included in the insured’s taxable estate.

Incident of Ownership: Incident of ownership is broadly defined and thus creates an estate tax trap for some insureds. An incident of ownership includes the right to: (i) change the policy beneficiary; (ii) surrender or cancel the policy; (iii) assign the policy or revoke an assignment of the policy; or (iv) borrow against the policy or pledge the policy. Consequently, there can be estate tax exposure even if the insured does not own the life insurance policy. The incident of ownership trap often appears in situations where life insurance is owned by shareholders and used to fund a buy-sell agreement between or among them. [IRC 2042.]

  • Example #1: Rex and his daughter Ruth each own 100 shares of the 200 outstanding shares of RexCo, Inc., an S corporation. Rex and Ruth have a buy-sell agreement which requires the survivor to purchase the shares owned by the estate of the deceased shareholder, and they agree to fund that buy-out obligation with life insurance each owning a policy on the life of the other. Rex and Ruth each purchase a $1.0 million life insurance policy on the life of the other shareholder. Rex gave Ruth $100,000 to purchase the policy on Rex’s life. In exchange for Rex’s generosity, Ruth agreed to allow Rex to borrow against the her insurance policy’s cash surrender value (the policy she owns that insures Rex’s life.). Rex dies. The full $1.0 million policy proceeds paid to Ruth on Rex’s death will be in Rex’s gross taxable estate, since he possessed the right to borrow against the policy. Ruth will receive the death benefit paid on her father’s death tax-free [IRC 101(a)(1)] but Rex’s estate may have to pay an estate tax on $1.0 million that it did not receive, depleting other assets of Rex’s estate.
  • Example #2: Same facts in the Rex-Ruth example. Rex’s attorney advises him that his right to borrow against the cash surrender value of the policy that Ruth holds on his life will cause estate tax problems for the beneficiaries of his estate. Rex wisely releases his right to borrow against Ruth’s life insurance policy on Rex’s life following his lawyer’s advice. Rex, however, dies within three year  of his release of his right to borrow against Ruth’s life insurance policy. The policy proceeds paid to Ruth will still be taxed in Rex’s estate, since Rex, the decedent, released his incident of ownership within three years of his death.[IRC 2035(a)(2) and (d).]
  • Example #3: Ted owns 60% of Chopped, Inc., and Guy owns the other 40%. [Way too much TV watching during this pandemic!] They have a stock redemption agreement that requires Chopped, Inc. to purchase the shares of a deceased shareholder. In order to fund its redemption obligation, Chopped purchases a $300,000  insurance policy on Ted’s life and a $200,000 insurance policy on Guy’s life. On the death of either Ted or Guy, the life insurance proceeds will not be included in their respective taxable estates, since the death benefit is paid to Chopped. However, since the proceeds are payable to Chopped, the federal estate tax implication is that the value of the deceased shareholder’s estate will be increased due to the increase in Chopped’s assets (from its receipt of the death benefit). For example, if Ted dies first, the value of Ted’s gross estate will be increased by $180,000 in the increase in value of his shares in Chopped, i.e., the pro-rata share of the life insurance proceeds attributable to Ted’s 60% ownership interest [60% times $300,000 = $180,000.] Since Ted and Guy are aware of this indirect increase in their taxable estate arising from the stock redemption agreement, they include in that  redemption agreement that the death benefit proceeds will be paid to their respective children, and not to Chopped. With such a provision as part of the stock redemption agreement, on Ted’s death, the insurance proceeds paid to his son (and not in satisfaction of any corporate debt) will cause Ted to be deemed to possess an ownership interest in the life insurance policy on his death, thus triggering the inclusion of the death benefit in Ted’s taxable estate, since Ted controlled the beneficiary of the policy that Chopped owned on his life.

“Beamed Transfer Theory:” At one time the IRS asserted the beamed transfer theory to include the life policy proceeds in the insured’s taxable estate, even when the insured did not own the policy, but within three years of the insured’s death he had directed his children to purchase the policy. In Bel, 452 F.2d 683 (5th Cir., 1971) the death benefits paid under life insurance policies to the insured’s children were nonetheless included in the insured’s taxable estate under IRC 2035 even though he never owned the policies that were initially issued to his children. The death benefit was included in the insured’s taxable estate because: (i) he made all of the premium payments to sustain the life insurance; (ii) he designated his children as the owners of the policies; and (iii) he arranged for the purchase of the policies by his children. Based upon these facts the Court concluded:

“We think our focus should be on the control beam of the word ‘transfer.’ The decedent, and the decedent alone, beamed the accidental death policy at his children, for by paying the premium he designated ownership of the policy and he created in his children all of the contractual rights to the insurance benefits These were acts of transfer…”

This ‘beamed transfer’ theory was later rejected in other court cases. In Leder, 89 Tax Court, 235 (1987), aff’d 893 F. 2d. 237 ( 10th Cir. 1989), the Court held that the “beamed transfer theory” would not apply and the insurance proceeds would not be includible in the insured’s taxable estate unless the insured-decedent ‘actually possessed incidents of ownership in the insurance policy on his life.’

“Agency Theory:” Despite its “beamed transfer” theory having been rejected in Leder, the IRS now asserts the agency theory of estate inclusion for life insurance proceeds. In Estate of Testsuo Kurihara, 83 Tax Court 51 (1989) the Court held that insurance policy proceeds had to be included in the insured’s taxable estate under IRC 2025 and IRC 2042. The Court relied on the fact that the decedent-insured instructed the trustee of an irrevocable trust that he had created to purchase the policy. The decedent-insured then paid the policy premiums within three years of his death. By directing the trustee to acquire the life insurance policy, as well as making the premium payments, the trustee was found by the Court to not act entirely on his own volition, and was thus treated as acting as the decedent–insured’s agent.

Conclusion:  One of the proposed responses to the increased income tax liability of beneficiaries of inherited IRAs and other retirement account assets under the SECURE Act is to ‘buy life insurance’ in order to provide additional income-tax free assets to those beneficiaries to assist them with their increased income tax burden. No surprise, the source of that advice is life insurance companies. That proposed solution tends to ignore that sometimes the death benefit will cause additional estate tax liability for the insured’s estate if an incident of ownership is triggered with the IRS asserting its ‘agency theory’, leaving much less ‘tax-free’ [IRC 101(a)(1)] death benefit available to the beneficiaries of the policy. If the purchase of life insurance is contemplated as one response to the new SECURE Act 10-year distribution rule, be mindful of the incident of ownership rule, and in particular the agency theory that the IRS has successfully used to cause death benefits to be included in the deceased IRA owner’s taxable estate.