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Whether life insurance
will be subject to the Federal estate tax is generally controlled by
Section 2042 of the 1986 Internal Revenue Code, which has two subsections:
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2042. Proceeds of Life Insurance –
The value of the gross estate shall include the value of all
property -
(1) Receivable by the executor.
To the extent of the amount receivable by the executor as insurance
under policies on the life of the decedent.
(2) Receivable by other
beneficiaries. To the extent of the amount receivable by all
other beneficiaries as insurance under policies on the life of the
decedent with respect to which the decedent possessed at his death any
of the incidents of ownership, exercisable either alone or in
conjunction with any other person. |
Receivable By the Executor
This provision seems to be fairly straight
forward, particularly if the term "estate" is substituted for
the term "executor" to read "Receivable by the estate".
In this context, subsection one can be viewed to indicate that any payment
made to the estate from an insurance policy covering the deceased's life
is subject to the Federal estate tax.
Proceeds are most often received by the estate when
the deceased owns a personal life insurance policy that is made payable
directly to the estate or to the estate's executor. The estate is
frequently the 'default' beneficiary of a life insurance policy, meaning
that the policy is paid to the estate when there aren't any named
beneficiaries or when all of the named beneficiaries are deceased.
It is important to note that payments received by the
executor are taxable to the extent they are received by that person in his
or her capacity as executor, which does not include proceeds that are
otherwise received by the same person.
For instance, Ralph has one policy made
payable to his business partner Edward and a second policy made payable to
the executor of his estate. Ralph's will names Edward executor.
Although Ed is the same person and is named to receive both policies, the
first policy is not granted to him in his capacity as executor and is not
available to the estate. the first policy will not be subject to the
estate tax based upon Ed's receipt of the proceeds.
Benefit Received By Estate
Life insurance is also subject to the tax
under subsection one when the estate receives a benefit from the policy's
proceeds, which can occur even though the executor does not actually
receive those proceeds.
For example, Ralph owes the Bensonhurst
Building & Loan Association $1,000,000. As a condition of his loan,
BBL required him to purchase a life insurance policy that would cover the
full amount owing at his death. When Ralph dies, the insurance
company makes direct payment to BBL as the beneficiary.
Although the proceeds of this policy were not
receivable by the executor, Ralph's estate gained a benefit from their
application and the amount paid to satisfy the debt is subject to the
Federal estate tax under subsection one. (However, the $1,000,000
debt will also typically be deductible from the gross estate as an estate obligation
or debt.)
Another example with includible proceeds that does not involve a debt to
the estate is found when the proceeds are used to satisfy the estate's tax
obligations.
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Payable To Other Beneficiaries
The full text of subsection two is actually:
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(2) Receivable by other
beneficiaries. To the extent of the amount receivable by all
other beneficiaries as insurance under policies on the life of the
decedent with respect to which the decedent possessed at his death any
of the incidents of ownership, exercisable either alone or in
conjunction with any other person. For purposes of the preceding
sentence, the term "incident of ownership" includes a reversionary
interest (whether arising by the express terms of the policy or other
instrument or by operation of law) only if the value of such
reversionary interest exceeded 5 percent of the value of the policy
immediately before the death of the decedent. As used in this
paragraph, the term "reversionary interest" includes a possibility
that the policy, or the proceeds of the policy, may return to the
decedent or his estate, or may be subject to a power of disposition by
him. The value of a reversionary interest at any time shall be
determined (without regard to the fact of the decedent's death) by
usual methods of valuation, including the use of tables of mortality
and actuarial principles, pursuant to regulations prescribed by the
Secretary. In determining the value of a possibility that the policy
or proceeds thereof may be subject to a power of disposition by the
decedent, such possibility shall be valued as if it were a possibility
that such policy or proceeds may return to the decedent or his estate. |
The operative definition of this subsection is "incidents
of ownership" which the deceased owned at death. Although "incidents
of ownership" may include outright ownership, its definition is different
and encompasses more than the rights that come with outright ownership.
For instance, incidents of ownership may include the right
borrow from or to 'cash out' the policy. The power to change a
beneficiary of the policy is also an incident of ownership that can cause
the policy's value to be included in the gross estate.
What may be the most important factor to note is that these
incidents of ownership are defined upon the basis of rights and do not
rely upon the actual exercise of any rights.
For instance, if Ralph had the ability to change his life
insurance beneficiary from Edward, the value of that policy would be
included in his gross estate. This will be true even if Ralph
purchased the policy, named Edward as the beneficiary, and never thought
about the policy again before his death.
Intestacy
A policy that is paid to an intestate estate is subject to
the laws of intestacy and will be distributed according to the laws which
are applicable to the deceased's state of domicile.
Although policies typically have instructions to avoid an
intestate distribution (such as instructing payment
Per Stirpes), any policy which does
not have operative instructions for its payment will be distributed to the
estate, including a policy that names a beneficiary who predeceases the
insured.
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Intestacy CalculatorsTM
You can see the intestate share that will be
given to each of your family members by opening the Intestacy CalculatorTM
for your state of permanent residence and each state where you own any real estate.
(If you live and own real estate in the same state, the same program
performs both calculations.)
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