Life Insurance in Estate Planning

In my experience, every one should have life insurance. The only questions are:

  • how much,
  • what type,
  • who should own it, and
  • who should be the beneficiaries

Life insurance is often an important element of an estate plan. Most commonly, life insurance is used for the following purposes:

  • Estate liquidity. It can provide liquidity to the insured’s estate to pay estate taxes and other expenses.
  • Family support. It can be used to supplement or create an estate to support the insured’s family when the insured dies.
  • Financing buyout. In closely held businesses, life insurance is often used to provide the business or co-owners funds to buy a decedent’s interest under a buy-sell or other agreement among the owners.
  • Fringe employment benefit. Employers sometimes use life insurance as a fringe benefit for employees.a. Planning Goals and Techniques

In the most general terms, the goal of life insurance planning is to avoid estate, income, gift, and generation-skipping transfer (GST) tax consequences for the insured, the policy owner, and the beneficiaries.

1) Estate tax goals.
To avoid inclusion of the insurance proceeds in the insured’s gross estate and potentially be subject to estate taxes, the planner must work around the definition of “gross estate” in the Internal Revenue Code.. Under the Code, the insurance proceeds will be included in the insured’s gross estate if

  • The insured owns the policy (IRC §2031),
  • The proceeds are payable to or for the benefit of the estate (IRC §2042(1)),
  • The insured possesses any incidents of ownership in the policy at death (IRC §2042(2)), or
  • The insured transfers any incidents of ownership in the policy within 3 years of death (IRC §2035(a)(2)).

Through proper planning, inclusion in the insured’s estate can be avoided if a trust or someone other than the insured owns the policy. Also, the insured’s estate must not be a beneficiary of the policy, and no beneficiary must be obligated to use the proceeds to pay the insured’s estate taxes or other expenses.

Irrevocable life insurance trust (ILIT).
A commonly used technique to avoid inclusion in the insured’s estate is for the insured to create an irrevocable life insurance trust (ILIT) to own the policy. The ILIT beneficiaries are often the insured’s spouse and issue.

ILITs often give the beneficiaries what are called “Crummey withdrawal powers” so that contributions to the trust to pay premiums will qualify for the present interest annual gift tax exclusion.
ILITs also often provide contingent beneficiaries with Crummey withdrawal powers to take advantage of Estate of Maria Cristofani (1991) 97 TC 74, acq 1992-1 Cum Bull 1, acq 1996-2 Cum Bull 1, in which the Tax Court allowed gift tax exclusions because of withdrawal powers held by contingent remainder beneficiaries.

Partnership owned life insurance
As an alternative to an ILIT, a partnership may be used. A partnership has the following advantages over an ILIT:

  • The partnership is revocable and amendable.
  • There is no gift on transfer of the policy to the partnership (since the insured receives partnership interests in exchange for the policy or the insured sells the policy to the partnership). Therefore, there is no IRC §2035 3-year-rule problem.
  • There is no IRC §101 transfer-for-value problem since the insured is a partner in the partnership.
  • There is no need for Crummey notices.

2) Income tax goals.
As a general rule, life insurance proceeds payable as a result of the insured’s death are not subject to income tax. IRC §101(a)(1). Income earned by the policy investments is not taxable for income tax purposes. Increase in cash value, even though accessible by the owners of the policy is not taxable until taken out. Even then, if taken out as a loan from the policy, it is generally not taxable at that time.

About the Author
D. Steven Yahnian has been a member of the California Bar and a practicing Attorney since 1980. He has also been a California CPA since 1984. Mr. Yahnian also holds the CFP® designation.

Mr. Yahnian practices in the following areas of law through YAHNIAN LAW CORPORATION:

  • Estate Planning & Administration
  • Asset Protection Planning
  • Tax Planning, Tax Debt Resolution and Tax Litigation
  • Business & Corporate Law and Planning
  • Real Property Law & Planning

As a CPA/CFP, Mr. Yahnian also has a separate accounting and tax return preparation practice called DSA ACCOUNTING.

Mr. Yahnian is a California State Bar Certified Specialist in the following
• Taxation Law and
• Estate Planning, Trust & Probate Law.

Mr. Yahnian received a B.S. degree in Accounting from USC, a J.D. from Loyola University of Los Angeles School of Law and an LL.M. in Taxation from New York University Law School. He also has a Certificate in Taxation from UCLA (with distinction). Mr. Yahnian also has an MS in Taxation* from UCLA (with Distinction).


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