Ch 9 Iicle Post Mortem Planning 9 7 09 (2)

9 Insurance

STUART J. KOHN
Levenfeld Pearlstein, LLC
Chicago
NATALIE M. PERRY
JPMorgan Chase Bank, N.A.
Chicago

©COPYRIGHT 2009 BY STUART J. KOHN AND NATALIE M. PERRY.

I. [9.1] Introduction

II. [9.2] Claims and Payment Options

III. Taxation of Life Insurance Proceeds

A. [9.3] Income Tax Considerations
B. [9.4] Estate Tax Considerations
1. [9.5] Inclusion in Gross Estate Pursuant to Code §2042
a. [9.6] Proceeds Paid to Executor
b. [9.7] Incidents of Ownership
3. [9.9] Inclusion of Insurance on the Life of Another (Including Second-to-Die
Insurance)
4. Reporting Requirements and Payment of Estate Tax
a. [9.10] Schedule D of Form 706
b. [9.11] Amount Includible in Taxable Estate
c. [9.12] Alternate Valuation
d. [9.13] Marital Deduction
e. [9.14] Charitable Deduction
f. [9.15] Payment of Tax

IV. [9.16] Irrevocable Life Insurance Trusts

V. Buy-Sell Arrangements

A. [9.17] Introduction
B. [9.18] Cross-Purchase Agreements
1. [9.19] Estate Tax Considerations
2. [9.20] Income Tax Considerations
C. [9.21] Redemption Agreements

VI. [9.24] Split-Dollar Arrangements

VII. Employee Benefit and Retirement Arrangements

B. [9.26] Group Term Life Insurance
C. [9.27] Life Insurance in Qualified Retirement Plans

I. [9.1] INTRODUCTION

Insurance is an important tool in preparing for unexpected losses. Life insurance is designed
to manage financial risk by protecting against a financial loss that can arise from an untimely
death. If a family were to lose income due to the death of the principal earner, it would face
financial hardship. Therefore, life insurance is often purchased by family members seeking to
minimize the financial impact of lost earnings resulting from a premature death. In addition, life
insurance also can be an effective tool to offset the impact of the estate tax that is imposed on the
death of the insured. The death benefit of life insurance can also provide a source of funds
available to assist with administration of specific assets or the estate itself, and can also provide
the liquidity necessary to equalize intended bequests among beneficiaries when a business
interest, real estate or some other illiquid assets is left to one of the beneficiaries.

Life insurance is actually a contract, usually entered into between the insured and the
insurance company. In exchange for premium payments, the insurance company agrees to pay an
agreed sum upon the occurrence of a specific event to any one or more individuals or
organizations selected by the insured.

While there is significant estate and financial planning that can and should be implemented
during the life of the insured in order to minimize the tax impact of the insurance while
maximizing the benefit that will pass to the intended beneficiaries, there are also significant
postmortem planning issues and opportunities that must be considered by the practitioner
involved in the estate and trust administration process.

II. [9.2] CLAIMS AND PAYMENT OPTIONS

As mentioned in §9.1 above, a life insurance policy is a contract between the owner of the
policy and the insurance company. A part of that contract is the beneficiary designation, which
the owner of the policy completes in order to direct to whom payment of the proceeds is to be
made upon the death of the insured. Even if the insured executed a will, the payment of the
insurance proceeds will not be governed by that will unless no beneficiary designation was made
or unless the designated beneficiary is the insured’s estate.

The first step for collecting the proceeds of a life insurance policy is to initiate the
process by contacting the insurance company. Some companies have the necessary forms online.
After the insurance company has been notified of the death, the company will typically send out
claim forms to be completed by the beneficiary or beneficiaries. Once all of the paperwork has
been submitted, the insurance provider will begin processing the claim. The insurance company
will check to see that the policy is still in good standing.

Depending on the circumstances of the insured’s death, some insurance companies may
choose to investigate the claim, especially if the death occurred during the contestability period.
The contestability period refers to an approximately two-year time frame after the life insurance
policy is purchased. If a claim is made during the contestability period, life insurance companies
will typically launch an investigation into the claim, checking for any fraud or deception. The
company will request medical records, financial information and other relevant documents. It is a
good idea to arrange for appropriate legal representation if an investigation is opened.

Upon the death of an insured, a claim must be filed by the designated beneficiary with the
insurance carrier in order to receive the proceeds. An original death certificate also must be
submitted with the claim form. If the beneficiary is the insured’s estate, then the executor will
submit the claim and also will be required to submit a copy of the executor’s letters of office in
order to establish the executor’s authority. Letters of office must be issued to the executor by the
appropriate probate court. The process for initiating a probate proceeding in Illinois is discussed
in IICLE’s Publication “_____________”. If a trust is the beneficiary, the trustee should file the
claim and submit a copy of the pertinent trust document.

If a minor child is designated as a beneficiary of the policy, an insurance carrier may require
that a guardian be appointed by the local court to receive the proceeds on the minor child’s
behalf. The court will oversee the distribution of the funds on the minor’s behalf until the minor
reaches age 18. The remaining balance then will be paid directly to the child upon his or her
attaining age 18.

If the insured executed a will that created trusts for the benefit of any minor children who are
designated beneficiaries, the insurance proceeds can be paid to the trustee of any such trust. The
trustee of the trust will administer the funds according to the terms of the trust and distribute the
income and principal as directed by the terms of the governing instrument.

Issues do arise occasionally if the beneficiary actually designated on an insurance policy is
not the intended recipient of the death benefit. For example, a former spouse may have been
designated as the beneficiary of a policy during marriage and the policy owner may have
neglected to change the beneficiary to his current spouse after remarriage. In Illinois, there is no
law which removes a former spouse as beneficiary of a life insurance policy upon divorce. One
solution may be to have the former spouse disclaim his or her interest in the policy.

Prior to having a disclaimer executed, several issues should be considered. First, the terms of
the contract for the insurance should be reviewed to determine who would receive the proceeds if
no beneficiary is designated. The policy may direct that the proceeds be distributed to the
surviving spouse which may be the desired result. Alternatively, the policy may require that the
proceeds be paid to the executor of the insured’s estate. If no probate estate has been opened, then
a probate estate would have to be opened to receive the proceeds. If the insured had creditors
which have not been paid, using a disclaimer may not make sense. If creditors have filed claims
against the estate, the proceeds would be part of the estate and would be available to satisfy
creditor claims. For a more in depth discussion on disclaimers in connection with post mortem
planning, see Chapter 3.

Finally, if it is clear from extrinsic evidence that the designation of the beneficiary was not
what the insured’s intended, a declaratory judgment action may be filed with the local circuit
court seeking the appropriate relief depending on the circumstances surrounding the beneficiary
designation.

When filing a claim for insurance proceeds, the beneficiary may be presented with different
payout options. The selection of a payment option is an important decision, and the available
options should be reviewed carefully. There may be tax implications that will impact the choice
of payout option. For example, the option selected may result in the loss of the marital deduction

for federal estate tax purposes. See 9.13 below for a more complete discussion of the applicability
of the marital deduction.

The basic payout options that are usually offered are (a) lump-sum payout; (b) life annuity;
(c) life annuity with guaranteed payments; (d) payment for a term of years; (e) fixed amount; and
(f) interest.

The most commonly selected option is a lump-sum payout. Under this option, the beneficiary
receives a one-time payment that is generally free from income tax. More recently, in order to
retain funds as long as possible, the insurance companies now create a money market type
account, providing the beneficiary with a checkbook to access the funds rather than providing the
beneficiary with a check for the full proceeds.

The life-annuity option enables the beneficiary to receive guaranteed, fixed monthly
payments for the remainder of his or her life. The amount of the annuity is determined based on
the beneficiary’s age and gender. The payments cease when the beneficiary dies.

The life-annuity-with-guaranteed-payments option enables the beneficiary to receive a
guaranteed portion of the death benefit for life or a certain period of time, whichever is longer.
The longer the period selected, the lower the annual payment. If the primary beneficiary dies
within the guaranteed term, then the remaining payments are made to the contingent beneficiary.

When the payment-for-term-of-years option is selected, the beneficiary receives payment of a
certain sum for a fixed term of years regardless of whether the beneficiary survives the expiration
of the fixed period. If the beneficiary does not survive the fixed term, payment is made to the
contingent beneficiaries.

Under the fixed-amount option, the beneficiary can choose how much money he or she wants
to receive as well as how frequently, such as quarterly or annually, until the death benefit is
completely paid out. The beneficiary receives periodic installments, and the remaining proceeds
earn interest at a fixed rate. Payments are made to the beneficiary until the entire balance of the
proceeds plus earned interested are paid. The contingent beneficiary receives the remainder of the
payments if the primary beneficiary dies prior to complete distribution of the proceeds.

With the interest option, the beneficiary can choose to have all or a portion of the insurance
proceeds remain with the insurance company while earning interest. The interest earned is paid to
the beneficiary on a regular basis. The beneficiary should ask whether the proceeds will earn a
fixed or variable rate of interest. The beneficiary may be able to withdraw some of the principal
under certain conditions. Upon the beneficiary’s death, the actual benefit is paid to the contingent
beneficiary.

III. TAXATION OF LIFE INSURANCE PROCEEDS

A. [9.3] Income Tax Considerations

Generally, life insurance proceeds received by a beneficiary are not subject to income tax
upon the death of the insured. Section 101(a)(1) of the Internal Revenue Code provides:

(a) Proceeds of life insurance contracts payable by reason of death. —

(1) General rule. — Except as otherwise provided in paragraph (2),
subsection (d), and subsection (f), and subsection (j), gross income does not
include amounts received (whether in a single sum or otherwise) under a life
insurance contract, if such amounts are paid by reason of the death of the
insured.

However, there is an important exception to this general rule. Code §101(a)(2) provides that
when a life insurance policy is transferred for valuable consideration, the income tax exclusion is
lost and a portion of the death benefits are subject to federal income tax. This provision is referred
to as the “transfer-for-value rule.” Specifically, Code §101(a)(2) provides:

(2) Transfer for valuable consideration. — In the case of a transfer for a
valuable consideration, by assignment or otherwise, of a life insurance contract or
any interest therein, the amount excluded from gross income by paragraph (1) shall
not exceed an amount equal to the sum of the actual value of such consideration and
the premiums and other amounts subsequently paid by the transferee. The
preceding sentence shall not apply in the case of such a transfer —

(A) if such contract or interest therein has a basis for determining gain or
loss in the hands of a transferee determined in whole or in part by reference to
such basis of such contract or interest therein in the hands of the transferor, or

(B) if such transfer is to the insured, to a partner of the insured, to a
partnership in which the insured is a partner, or to a corporation in which the
insured is a shareholder or officer.

Code §101 will not apply to a transfer of an insurance policy that is either a gift or a tax-free
exchange of an insurance policy pursuant to Code §1035, as these are not considered transfers for
valuable consideration.

In order to avoid subjecting insurance policy proceeds to income taxation if a transfer for
valuable consideration will be made during the insured’s lifetime, the transfer must be to a person
or entity included in the list of exceptions to the transfer-for-value rule. If the transfer is not to
one of the permitted individuals or entities, Code §101(a)(2) provides that a portion of the policy
proceeds will be subject to income tax. Specifically, the amount subject to income tax will be the
amount of the proceeds received less the consideration paid as part of the transfer, plus any
subsequent premiums or other amount paid by the transferee.

If a transfer of a life insurance policy will take place during the insured’s lifetime, the
transfer-for-value rule and its exceptions must be taken into account while the insured is alive.
After the insured’s death, a transfer for value to a recipient that does not qualify for one of the
exceptions to the rule cannot be corrected.

The exceptions to the transfer-for-value rule found in Code §101(a)(2) provide that certain
transfers will not cause the proceeds of the policy transferred to be subject to income tax. There
are two categories of exceptions: the basis-carryover exception, and the permitted-transferee
exception.

The basis-carryover exception applies when the transferee’s basis would be determined in
whole or in part with reference to the transferor’s basis. An example of a transfer that qualifies
under the basis-carryover exception is a transfer to the insured’s spouse. Transfers of a life
insurance policy to a spouse, whether or not for consideration, do not cause taxation under the
transfer-for-value rule. Code §§101(a)(2)(A), 1041(b). In addition, transfers to or from former
spouses pursuant to a qualified domestic relations order also qualify under this exception. Finally,
it is important to note that transfers for valuable consideration to family members other than a
spouse do not qualify under the basis-carryover exception.

The permitted-transferee exception pursuant to Code §101(a)(2)(B) contains a specific list of
individuals and entities to whom a policy can be transferred for valuable consideration without
triggering the income taxation of the pertinent portion of the policy proceeds. The first permitted
transferee listed is the insured. For these purposes, a transfer to the insured also includes a
transfer to a trust of which the grantor is treated as the owner for income tax purposes pursuant to
Code §§671 – 679. See Pvt.Ltr.Ruls. 200518061 (May 6, 2005), 200514001 (Apr. 8, 2005),
200228019 (July 12, 2002).

A detailed discussion of the other permitted transferees listed in Code §101(a)(2)(B) is set
forth below in §§9.20 and 9.23 below with respect to insurance policies transferred as part of
cross-purchase and redemption arrangements in the buy-sell context.

Upon an insured’s death, the practitioner should, as part of his or her post mortem planning
checklist, request a transcript of the policy history from the insurance company to determine
whether any transfer of the policy was ever made. The attorney should also ask the decedent’s
family for any documentation relating to the insurance policy, request that the insurance agent
review the file, and review gift tax returns, in order to determine whether the insured had ever
transferred the policy. If in fact the insured had transferred the policy, the attorney will then need
to determine whether the transfer-for-value rule or one of its exceptions will apply.

There soon may be additional reporting requirements with respect to the transfer-for-value
rule and its exceptions. The Treasury Department’s GENERAL EXPLANATIONS OF THE
ADMINISTRATION’S FISCAL YEAR 2010 REVENUE PROPOSALS (also known as the
“Green Book”) was released on May 11, 2009, and is available online at
www.treas.gov/offices/tax-policy/library/grnbk09.pdf. The Green Book describes in detail the
revenue proposals contained in the President’s budget for fiscal year 2010.

The Green Book published by the Obama Administration includes a proposed change to the
transfer-for-value rule. If enacted, this proposal would apply to sales or assignments of interests
in life insurance policies and payments of death benefits for taxable years beginning after
December 31, 2010. The proposed modification is intended to ensure that none of the safe-harbor
exceptions to the transfer-for-value rule would apply to “buyers of policies.” Green Book, p. 112.
There is no policy size limitation included in the proposal. When policy benefits are paid to a
buyer, the insurer would be required to report to both the IRS and the payee (1) the gross benefit
payment; (2) the buyer’s taxpayer identification number; and (3) the insurer’s estimate of the
buyer’s basis.

B. [9.4] Estate Tax Considerations

Life insurance proceeds generally are includible in the estate of the insured for estate tax
purposes. The estate tax treatment of life insurance is governed by Code §2042. In addition, Code
§2035 may require inclusion for estate tax purposes of the proceeds of a life insurance policy that
was not owned by the insured.


Code §2042 provides:

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. 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.

a. [9.6] Proceeds Paid to Executor

While inclusion of policy proceeds in the insured’s gross estate pursuant to Code §2042(1)
would appear to be straightforward, there are actually several situations in which proceeds are
included even if they are not payable to the insured’s estate.

The Treasury Regulations provide that the estate of the insured need not be the designated
beneficiary of the policy in order for Code §2042 to apply. For example, if the proceeds are
payable to a beneficiary but are required to be used to pay debts, taxes, or other charges
enforceable against the estate due to a legally binding obligation of the beneficiary, then the
amount of such proceeds (to the extent of the beneficiary’s obligation) is includible in the gross
estate. Treas.Reg. §20.2042-1(b)(1) provides that proceeds of a policy will be included in the
insured’s estate if the proceeds are subject to a “legally binding” obligation to pay estate

obligations. Similarly, if the policy was purchased by the decedent as security for a loan and the
beneficiary is a corporation or third party, the proceeds are treated as receivable for the benefit of
the estate.

Code §2042(1) may result in inclusion of insurance proceeds in the insured’s gross estate
when the policy was held by an irrevocable life insurance trust (ILIT) if certain provisions are
found in the trust agreement. Treas.Reg. §20.2042-1(b)(1) specifically provides that if the
proceeds of the policy are payable to someone other than the insured’s estate but are subject to an
obligation to pay the insured’s debts and taxes, the proceeds will be deemed to have been payable
to the insured’s estate. Therefore, the trustee of an ILIT must be cautious when receiving life
insurance proceeds that are intended to create liquidity to pay estate tax as well as other
administration expenses. In order to avoid inadvertent estate tax inclusion that could result from
using policy proceeds to pay these expenses, the trust agreement that creates the ILIT should not
require the trustee to use trust assets to satisfy debts and taxes, but should instead permit the
trustee to make loans to the insured’s estate in order to allow the policy proceeds to be used to
satisfy these expenses without creating an obligation. The insured’s will should include a similar
provision. Alternatively, the trustee of the ILIT may be given the power to purchase assets from
the insured’s estate. Such power to purchase assets will not trigger estate tax inclusion under
Code §2042(1).

If the trust agreement under which the ILIT was created does not include a provision allowing
the trustee to loan funds to the insured’s estate, the trust agreement may give the trustee of the
ILIT the discretion to pay taxes and expenses of the insured’s estate. If the trustee has this
discretion, then to the extent life insurance proceeds are actually used to pay taxes and expenses,
Code §2042 will cause inclusion of such proceeds in the decedent’s taxable estate. Treas.Reg.
§20.2042-1(b)(1).

b. [9.7] Incidents of Ownership

Pursuant to Code §2042(2), the proceeds of all life insurance on a decedent’s life receivable
by beneficiaries other than the executor of the decedent’s estate must be included in the gross
estate to the extent that the decedent possessed at his or her death any incidents of ownership
exercisable either alone or in conjunction with any other person.

The concept of incidents of ownership reaches beyond actual legal ownership of the policy.
Incidents of ownership can cause estate tax inclusion even if the insured’s right is strictly limited.
Examples of incidents of ownership are described in Treas.Reg. §20.2042-1(c)(2) and include (1)
the power to change the beneficiary; (2) the power to surrender or cancel the policy; (3) the
power to assign the policy; (4) the power to revoke an assignment; and (5) the power to pledge
the policy for a loan or to obtain from the insurer a loan against the surrender value of the policy.
Incidents of ownership exist whether the insured has the right to exercise the incidents of
ownership alone or in conjunction with any other person. Treas.Reg. §20.2042-1(c)(1). Payment
of premiums alone is not an incident of ownership for purposes of Code §2042(2).

Code §2042(2) will apply to include insurance proceeds in the decedent’s gross estate even if
the proceeds are receivable by beneficiaries other than the insured and are not designated as for
the estate’s benefit. This can include a reversionary interest if the interest exceeds five percent of
the value of the policy immediately before the death of the decedent. The value of a reversionary

interest is determined in accordance with recognized valuation principles for determining the
value for estate tax purposes of future or conditional interests in property.

In Estate of Jordahl v. Commissioner, 65 T.C. 92 (1975), acq., 1977-2 Cum.Bull. 1, the Tax
Court found no incidents of ownership existed when the insured, who was also the grantor of an
irrevocable insurance trust, had the power to substitute one or more policies of equal value for
those owned by the trust. Pursuant to the terms of the trust in Jordahl, exercise of the power
would have required the grantor to purchase new policies of equal cash surrender and face value,
comparable premiums, and similar form. The Tax Court held that the grantor’s possession of the
right to substitute assets of equivalent value was not an incident of ownership under Code
§2042(2) even though it could be exercised to reacquire the trust property.

The Tax Court also addressed the issue of whether the grantor had retained control over an
irrevocable trust of which she was not the trustee in Estate of Wall v. Commissioner, 101 T.C.
300 (1993). In Wall, the trustee possessed broad discretionary powers of distribution. The
decedent reserved the right to remove and replace the corporate trustee with another corporate
trustee. The court concluded that the retained power was not equivalent to a power to affect the
beneficial enjoyment of the trust property pursuant to Code §§2036 and 2038.

The Service issued Rev.Rul. 95-58, 1995-2 Cum.Bull. 191, in response to the decision in
Wall. Rev.Rul. 95-58 provides that if the grantor’s power to remove the trustee and appoint a
successor trustee was limited to appointing an individual or corporate successor trustee that was
not related or subordinate to the grantor within the meaning of Code §672(c), then the decedent
would not be treated as having retained discretionary control over the trust’s income. Although
the trust in this ruling did not own an insurance policy, the rationale of the ruling can be applied
to an analysis of retained incidents of ownership when an insurance policy is held in an
irrevocable trust. Beverly R. Budin, 826-2d T.M., Life Insurance (2006).

Finally, if a corporation owns an insurance policy on the life of its controlling shareholder
and a portion of the proceeds are payable to anyone other than the corporation or a third party for
a valid business purpose, then incidents of ownership as to that part of the proceeds will be
attributed to the decedent through his or her stock ownership. See §§9.22 – 9.23 below on
redemption agreements for additional discussion of the taxation of corporate-owned life insurance


The proceeds of an insurance policy that was no longer owned by the insured at death also
may be includible in the insured’s gross estate if certain conditions occur. Code §2035, also
known as the “three-year rule,” may cause estate tax inclusion of insurance proceeds from an
insurance policy transferred by the insured during his or her lifetime. Code §2035(a) provides:

(a) Inclusion of certain property in gross estate. — If —

(1) the decedent made a transfer (by trust or otherwise) of an interest in any
property, or relinquished a power with respect to any property, during the 3-
year period ending on the date of the decedent’s death, and

(2) the value of such property (or an interest therein) would have been
included in the decedent’s gross estate under section 2036, 2037, 2038, or 2042 if
such transferred interest or relinquished power had been retained by the
decedent on the date of his death,

the value of the gross estate shall include the value of any property (or interest
therein) which would have been so included.

Therefore, if the insured owns a life insurance policy on his or her life and transfers the
policy within three years of death, the policy proceeds will be includible in his or her gross estate.

However, Code §2035 does contain an exception. If the transfer was a bona fide sale for
adequate and full consideration in money or money’s worth, then Code §2035 will not apply.
Code §2035(d). However, as described in §9.3 above, when a policy is transferred for valuable
consideration, the transfer-for-value rule may cause a portion of the proceeds received by the
purchaser to be subject to income tax.

3. [9.9] Inclusion of Insurance on the Life of Another (Including Second-to-Die
Insurance)

Pursuant to Code §2033, a decedent’s gross estate must include all assets owned by the
decedent at the time of his or her death, including an insurance policy on the life of someone else.
The value of the policy on the death of the owner will not be the face value of the policy since the
insured is still alive. Instead, the value of the policy is determined by ascertaining the replacement
value of the policy in question. Treas.Reg. §20.2031-8(a)(1) provides that “[t]he value of a
contract for the payment of an annuity, or an insurance policy on the life of a person other than
the decedent, issued by a company regularly engaged in the selling of contracts of that character
is established through the sale by that company of comparable contracts.” If the replacement
value is not readily ascertainable, then “the value may be approximated by adding to the
interpolated terminal reserve at the date of the decedent's death the proportionate part of the gross
premium last paid before the date of the decedent’s death which covers the period extending
beyond that date.” Treas.Reg. §20.2031-8(a)(2).

Life insurance policies on more than one life are a popular estate planning tool, typically on
the lives of a husband and wife, due in part to the lower cost of insuring two lives jointly rather
than insuring each life separately. Second-to-die policies mature at the time when the need for
liquidity is the greatest — at the death of the surviving spouse. For most married couples, estate
tax liability will not arise until the death of the surviving spouse due to the unlimited marital
deduction for property passing to a spouse.

On the death of the first spouse to die, the value of the policy will be included in that spouse’s
gross estate pursuant to Code §2033 if that spouse was the owner of the policy. The value of the
policy will be as set forth in Treas.Reg. §20.2031-8(a). If, however, the first spouse to die was not
the owner of the policy, nothing will be included in that spouse’s gross estate.

A second-to-die policy may be transferred after purchase to a third party such as an
irrevocable life insurance trust. Code §2035 may require that the proceeds of the policy be
brought back into the transferor’s estate if the transferor does not survive the three-year period

following the transfer. If a second-to-die life insurance policy is owned by a third party, the
proceeds of the insurance will not be included in the estate of either insured. As long as the
second to die passes away more than three years after the policy was transferred to the third-party
owner, the three-year rule will not bring the proceeds back into the prior owner’s estate.

4. Reporting Requirements and Payment of Estate Tax

a. [9.10] Schedule D of Form 706

All life insurance policies on the decedent’s life, whether or not includible in the decedent’s
gross estate, are reported on Schedule D of IRS Form 706, United States Estate (and Generation-
Skipping Transfer) Tax Return. Schedule D should include insurance on the life of the decedent
receivable by or for the benefit of the estate as well as insurance on the decedent’s life receivable
by beneficiaries other than the estate when the decedent possessed incidents of ownership
exercisable alone or in conjunction with any other person. The description to be included on
Schedule D for each policy should include the name of the insurance company and the policy
number. In addition, a Form 712, Life Insurance Statement, for each policy must be attached to
Schedule D. Form 712, which should be requested from the insurance company that issued the
policy, will include the date-of-death value to be reported on the return as well as the face amount
of the policy, any accumulated dividends, and any returned premiums. Schedule D also must
include a description of any policies on the life of the decedent that are not includible in the
decedent’s gross estate, as well as an explanation as to why the proceeds are not includible in the
gross estate.

b. [9.11] Amount Includible in Taxable Estate

Treas.Reg. §20.2042-1(a)(3) provides that, except in the case of insurance owned by a
corporation, the amount to be included in the gross estate pursuant to Code §2042 is the full
amount receivable under the policy. If the proceeds of the life insurance policy are made payable
to a beneficiary in the form of an annuity or for a term of years, the amount to be included in the
gross estate will be the one sum payable at death under an option that could have been exercised
either by the insured or by the beneficiary or, if no option was granted, the sum used by the
insurance company in determining the amount of the annuity.

c. [9.12] Alternate Valuation

Code §2032 allows the executor to elect to value the assets of the decedent’s estate at their
value on the six month anniversary of the decedent’s death if such an election will decrease the
value of the decedent’s taxable estate and will decrease the amount of federal estate tax due. If a
decedent’s estate owns life insurance on the life of another and alternate valuation is elected, the
value of the insurance policy will increase if the insured dies during the six month period. The
IRS has ruled that the full face value of the policy will be included in the taxable estate if the
election to use alternate valuation is made. Rev.Rul. 63-52, 1963-1 Cum.Bull. 173; Beverly R.
Budin, 826-2d, T.M., Life Insurance (2006). In addition, an election to use alternate valuation
could also cause inclusion of the entire face value of the policy if the decedent owns a second-to-
die policy and the surviving insured dies during the six-month period.

d. [9.13] Marital Deduction

Generally, life insurance proceeds payable to a surviving spouse or to a trust that qualifies for
the marital deduction will qualify for an estate tax marital deduction pursuant to Code §2056.
However, if the spouse or the trustee of such a trust for the spouse’s benefit elects payment of the
proceeds in a form other than a lump sum, the marital deduction may be lost because the payment
stream may fail to qualify as a “terminable interest” pursuant to Code §2056(b). Therefore,
caution must be taken when selecting a payment option. If a payment option is selected that
allows property to pass from the decedent to anyone other than the surviving spouse or the
spouse’s estate, then the interest also will not be deductible for federal estate tax purposes
because it will not qualify as a terminable interest for purposes of Code §2056. Beverly R. Budin,
826-2d, T.M., Life Insurance (2006).

e. [9.14] Charitable Deduction

Proceeds of life insurance that are paid to an organization that is exempt from income tax
pursuant to Code §501(c)(3) will qualify for an estate tax charitable deduction pursuant to Code
§2055. If the insured-owner of a life insurance policy designates a charitable organization as the
beneficiary of his or her life insurance policy and retains incidents of ownership over the policy,
then the proceeds will be included in the insured’s gross estate under Code §2042 and the
insured’s taxable estate will receive an offsetting deduction pursuant to Code §2055 for the entire
amount that passes to the charity. Unlike the income tax provisions of the Code, there is no limit
on the amount of the estate tax charitable deduction that can be taken.

f. [9.15] Payment of Tax

As described in more detail in Chapter 4, the Internal Revenue Code imposes the federal
estate tax while, as a general rule, state law dictates the apportionment of the federal estate tax
liability. Code §2206, however, is one exception to this general rule.

Code §2206 imposes liability for a proportionate share of the estate tax liability on
beneficiaries who receive life insurance proceeds. The insured-decedent can waive this right of
recovery in his or her will. Specifically, Code §2206 provides:

Unless the decedent directs otherwise in his will, if any part of the gross estate
on which tax has been paid consists of proceeds of policies of insurance on the life of
the decedent receivable by a beneficiary other than the executor, the executor shall
be entitled to recover from such beneficiary such portion of the total tax paid as the
proceeds of such policies bear to the taxable estate. If there is more than one such
beneficiary, the executor shall be entitled to recover from such beneficiaries in the
same ratio. In the case of such proceeds receivable by the surviving spouse of the
decedent for which a deduction is allowed under section 2056 (relating to marital
deduction), this section shall not apply to such proceeds except as to the amount
thereof in excess of the aggregate amount of the marital deductions allowed under
such section.

This right of recovery generally is waived in most standard estate planning documents.
However, the executor should be aware that this right exists under the Code. If the right of
recovery is not waived, the executor should take action to recover the applicable amount of tax.

IV. [9.16] IRREVOCABLE LIFE INSURANCE TRUSTS

Life insurance trusts frequently are used in estate planning when the insured’s estate tax
situation calls for planning beyond the implementation of traditional A/B trust planning. A life
insurance trust is an excellent tool for removing value from an individual’s taxable estate. A life
insurance trust generally can be created at little or no gift tax cost, particularly if a new insurance
policy can be purchased directly by the trust. An existing policy also may be used to fund an
irrevocable life insurance trust, but if the policy is transferred to an ILIT for less than full and
adequate consideration, the insured will be treated as having made a taxable gift of the value of
the policy.

When a life insurance policy is held by an irrevocable trust, the insurance proceeds generally
will not be subject to estate tax upon the death of the insured. If, however, the insurance policy
was transferred to the trust by the insured within three years of the insured’s death, then, as
described in §9.8 above, the proceeds of the policy will be includible in the insured’s gross estate
pursuant to Code §2035.

As discussed in §9.7 above, even when the insured is not the owner of a life insurance policy,
estate tax inclusion may result if the insured is found to have “incidents of ownership” over the
policy. Accordingly, when an insured dies, while the life insurance policy on his or her life is
owned by an irrevocable trust, the trust must be reviewed carefully to determine whether the
insured held any incidents of ownership over the trust that could cause inclusion under Code
§2042(2).

As discussed in §9.6 above, the insurance proceeds are often used to provide liquidity to the
estate in the form of a loan to the deceased insured’s estate. The trustee of the insurance trust that
owns the policy will generally be granted the authority to make loans to the grantor’s estate. The
trustee may also be empowered to purchase assets from the grantor’s estate in order to provide
liquidity at the insured’s death.

V. BUY — SELL ARRANGEMENTS


Life insurance is often an integral component of the buy-sell arrangements contained in
shareholder, partnership, and limited liability operating agreements. In the typical buy-sell
scenario, the owners of a business provide in the applicable agreement for the purchase of a
deceased owner’s interest in the business in order to maintain ownership within the desired group
while also providing liquidity for the deceased owner’s estate. By addressing the situation in the
buy-sell agreement, the parties provide for a smoother transition in the event of the death of one
of them while avoiding potential disputes over, among other things, how the business is to be
valued or how the purchase price will be paid.

A well-drafted buy-sell agreement not only will contain the mechanics for the purchase of the
interest by the surviving owners, but also will detail how the deceased owner’s interest is to be
valued (and, therefore, how the purchase price is to be calculated). With respect to valuation, the
agreement can contain either the methodology to be used to value the business at the time of an
owner’s death (e.g., “the fair market value as determined by ABC accountants”) or the actual

formula to be used (e.g., the book value of the business, or a multiple of the business’ prior year’s
earnings). Often the buy-sell agreement will provide for the annual valuation of the company, a
copy of which is to then be attached to the agreement, and the most recent of which would then
be used for purposes of determining the purchase price for the deceased owner’s interest.

The parties to the buy-sell agreement not only are interested in determining the value of their
interests in the event of death, but they invariably want to ensure that their intended beneficiaries
receive payment for that interest in the most efficient way possible. The purchase price for a
deceased owner’s interest in a standard buy-sell agreement will be paid in a lump sum, over time
(as evidenced by a promissory note), or by a combination of the two.

Life insurance policies often are purchased on the lives of the business owners in order to
provide at least a portion, if not all, of the funds needed to purchase the deceased owner’s interest.
Thus, the applicable purchase price for each owner’s interest in the business will dictate the
amount of life insurance to be purchased. The taxation of the proceeds of the life insurance as
well as the postmortem handling of this insurance will depend on the ownership of the policy.
There are several alternatives to the structuring of the ownership of life insurance and, as a result,
the buy-sell arrangement itself — the two most common of which are the cross-purchase and the
redemption. See §§9.18 – 9.23 below.

B. [9.18] Cross-Purchase Agreements

The cross-purchase arrangement can be an effective structure for a buy-sell agreement,
particularly when the business has only a few owners. If an owner dies, the surviving owners are
required by the buy-sell arrangement to purchase their pro rata share of the deceased owner’s
interest in the business. Typically, each owner purchases and maintains a separate life insurance
policy on the life of each of the other owners to fund the purchase in the event of a death (in order
to avoid being required to use personal funds or to give a personal promissory note to meet the
contractual purchase obligation).

If in fact life insurance is used to fund the cross-purchase agreement, upon the death of an
owner, the remaining owners will submit the necessary claim forms and accompanying
documentation in order to receive the applicable death benefits. Once the death benefits are
received and the applicable purchase price calculated, the surviving owners close on the purchase
of the deceased owner’s interest.


The fair market value of the interest in the business owned by the decedent will be included
in his or her gross estate for estate tax purposes. Code §§2031, 2033. As mentioned in §9.17
above, buy-sell agreements often will establish the value of a deceased owner’s interest in the
business for purposes of the buy-out upon death. While a complete discussion regarding the
valuation of business interests is beyond the scope of this publication, it should be noted that such
buy-sell agreement provisions may or may not be determinative in the valuation of the business
interest for federal estate tax purposes. See Code §2703.

Generally, the decedent’s gross estate also will include the proceeds of a life insurance policy
on his or her life if they are receivable by the executor of his or her estate (Code §2042(1)) or if

the decedent, at the time of death, possessed incidents of ownership in the policy (Code
§2042(2)).

In the conventional cross-purchase arrangement, the life insurance policy of each business
owner is payable to the other business owners, not to the insured’s estate. The insured business
owner does not own, pay for, or in any other way control the life insurance policy and therefore
does not have incidents of ownership. As a result, the proceeds of the policy on the life of a
deceased owner will not be includable in his or her gross estate for federal estate tax purposes.
Rev.Rul. 56-397, 1956-2 Cum.Bull. 599; First National Bank of Birmingham, Alabama v. United
States, 358 F.2d 625 (5th Cir. 1966); Estate of Ealy v. Commissioner, 10 T.C.M. (CCH) 431
(1951); Wilson v. Crooks, 52 F.2d 692 (W.D.Mo. 1931).

Even though the insurance proceeds ultimately will be paid to the insured’s estate by the
other business owner(s) pursuant to the buy-sell agreement, they will not be included in his or her
gross estate under Code §2042(1). (See, for example, Pvt.Ltr.Rul. 9511009 (Mar. 17, 1995), in
which the Service determined that, even though the death benefit of a life insurance policy on the
life of a shareholder was ultimately paid to his estate in satisfaction of the other shareholder’s
obligation to purchase the decedent’s shares under a buy-sell agreement, the proceeds were not
includible in the decedent’s gross estate because they were actually payable to a trust that was
then required to utilize the proceeds to facilitate the buy-sell arrangement.) However, if the
insured’s estate is named as beneficiary of the policy and the insurance proceeds are to be used to
reduce the purchase price required under the buy-sell agreement, the proceeds will be included in
the decedent’s gross estate. Estate of Mitchell v. Commissioner, 37 B.T.A. 1 (1938). The Tax
Court has also ruled that when the insurance agent erroneously issued ownership of insurance
policies purchased to fund a cross-purchase agreement in the name of the insured and the parties
to the agreement were unaware of the error, the nature of the error and the obligations of the
cross-purchase agreements would not cause inclusion of the death benefit in the deceased
partner’s gross estate. Estate of Fuchs v. Commissioner, 47 T.C. 199 (1966).

Even though in the typical cross-purchase scenario the business owners purchase and
maintain similar insurance policies on each others’ lives, the reciprocal nature of the ownership
will not fall under the reciprocal trust doctrine first espoused in Lehman v. Commissioner, 109
F.2d 99 (2d Cir. 1940), and therefore will not result in inclusion of the insurance proceeds in the
deceased owner’s gross estate. Rev.Rul. 56-397, 1956-2 Cum.Bull. 599.

In a cross-purchase arrangement, the insured business owner does not own the insurance
policies on his or her own life, but the cross-purchase agreement will, in certain situations, grant
that insured business owner veto rights over his or her partners’ ability to change the beneficiary
on the policies, surrender the policies, or the like. When these contractual veto rights over the
partners’ rights to change the beneficiary or surrender the insurance policy on the life of the veto
holder are granted solely to ensure compliance with the buy-sell agreement, such veto rights will
not be deemed an incident of ownership causing inclusion of the death benefit in the decedent-
veto holder’s gross estate. Estate of Infante v. Commissioner, 29 T.C.M. (CCH) 903 (1970).
However, in Schwager v. Commissioner, 64 T.C. 781 (1975), the Tax Court ruled that insurance
policy proceeds were includible in the decedent’s gross estate under Code §2042(2) when the
owner of the policy (the employer pursuant to a split-dollar arrangement) could not change the
beneficiary without the decedent’s consent. See also Rev.Rul. 75-70, 1975-1 Cum.Bull. 301;
Estate of Tomerlin v. Commissioner, 51 T.C.M. (CCH) 831 (1986).

In a cross-purchase arrangement, the deceased business owner will have owned policies on
the lives of the other business owners, and, therefore, the value of those policies will be included
in the deceased owner’s gross estate. Code §§2031, 2033. The deceased business owner’s
executor can obtain date-of-death valuations of those policies by requesting IRS Form 712s from
the insurance carriers. The practitioner should keep in mind that ownership of policies on the
lives of a deceased business owner’s associates could end up in the hands of the decedent’s
family and should therefore include provisions in the buy-sell agreement to ensure that ownership
of the policies is required to be transferred along with the ownership interest in the business.


Once a business owner dies, the income taxation of the life insurance policies on his or her
life, as well as the policies that he or she owned on the lives of others, is an issue that must be
examined closely. As detailed in §9.3 above, ordinarily the death benefit of a life insurance policy
is not subject to income tax. Code §101(a)(1). If an insurance policy is transferred during the
lifetime of the insured for valuable consideration, the portion of the death benefit in excess of the
consideration paid for the policy plus the premiums paid by the transferee will be subject to
income taxation. Code §101(a)(2). There are, however, several exceptions to the transfer-for-
value rule, as also detailed in §9.3, several of which have application in the buy-sell context.
Specifically, the transfer of the policy to a partner of the insured, to a partnership in which the
insured is a partner, or to a corporation in which the insured is a shareholder generally will not
cause a portion of the death benefit to be subject to income taxation on the death of the transferor.
Code §101(a)(2)(B).

Application of the transfer-for-value rule often arises, sometimes unexpectedly, when
business owners enter into a buy-sell agreement to dictate the transfer of a deceased owner’s
interest, funding the purchase price called for with insurance. If new insurance policies are
purchased for the buy-sell arrangement and they are purchased directly by one business owner on
the life of another, the transfer-for-value rule will not apply. However, in the corporate context, if
a shareholder in a corporation conveys a policy on his or her life to another shareholder, the
transfer-for-value rule will apply. This will be the case even if no purchase price is actually paid
for the policy. Monroe v. Patterson, 197 F.Supp. 146 (N.D.Ala. 1961).

As described in §9.18 above, in the prototypical cross-purchase arrangement, each
shareholder of a corporation owns insurance policies on the lives of the other shareholders. When
a shareholder dies, if the policies that the deceased shareholder owned on the surviving
shareholders’ lives are conveyed to the surviving shareholders, the transfer-for-value rule will
apply (unless each surviving shareholder receives the policy on his or her own life, which then
would negate the benefit of using that policy to fund the continued buy-sell arrangement with the
other surviving shareholders). However, if those policies are conveyed to the corporation
pursuant to the buy-sell agreement, then an exception under Code §101(a)(2)(B) permits the
transfer of the insurance policy to a corporation in which the insured is a shareholder.

The Code §101(a)(2)(B) exception with respect to the transfer of an insurance policy to a
partner of the insured or to a partnership in which the insured is a partner is quite useful in
avoiding the otherwise harsh result of the transfer-for-value rule in the corporate buy-sell context.
Specifically, if the shareholders of a corporation transfer the policies on their lives to a

partnership or limited liability company (taxed as a partnership) and that entity will then facilitate
the buy-sell arrangement, the transfer-for-value rule will not apply as a result of the transfers of
the policies to the partnership or limited liability company. (See for example, Pvt.Ltr.Rul.
9309021 (Mar. 5, 1993), in which the corporation that owned the insurance policies on the lives
of the shareholders planned to convey the policies to a partnership to be formed by the
shareholders for the purpose of facilitating the cross-purchase, and the Service ruled that the Code
§101(a)(2)(B) exception would apply, and Pvt.Ltr.Ruls. 9328010 (July 16, 1993), 9328012 (July
16, 1993), 9328017 (July 16, 1993), 9328019 (July 16, 1993), and 9328020 (July 16, 1993), all
applying to the same situation in which a corporation planned to convey policies on the lives of
its shareholders to an existing partnership of which the shareholders were the partners. The
partnership then planned to convey the policies equally among the partners, who would then
convey the policies to a series of trusts that would be treated as grantor trusts as to the partners.
The Service ruled that each step of the proposed transaction would meet the Code §101(a)(2)(B)
exception to the transfer-for-value rule — the first transfer to the partnership and to the partners,
the next transfer from the partners to the grantor trusts, and the transfer from a trust on the death
of a partner to the remaining partners. See also Pvt.Ltr.Rul. 9347016 (Nov. 26, 1993), in which a
corporation conveyed policies on the life of a shareholder to the other shareholders, who then
conveyed the policies to each other, and because the shareholders were also partners in a
partnership, Code §101(a)(2)(B) applied to prevent the application of the transfer-for-value rule,
even though the partnership was not actually involved in the conveyances, and Pvt.Ltr.Rul.
9701026 (Jan. 3, 1997), in which the three shareholders in a corporation, who were also the three
partners in a partnership, planned to enter into a cross-purchase agreement and have the
corporation transfer an existing split-dollar life insurance policy to the noninsured shareholders
and the Service ruled that, since the transfer was to partners of the insured, Code §101(a)(2)(B)
applied.)

In the cross-purchase arrangement involving a C corporation, an S corporation, or a
partnership, the cost basis of the deceased owner’s interest in the business will be stepped up
pursuant to Code §1014. The sale of the interest pursuant to the cross-purchase agreement should
then result in no gain being recognized by the seller of the interest.

The beneficiary designation and ultimate payout of insurance policy death benefits can affect
the surviving business owners’ tax basis in the purchased interests. Generally, if a partnership
receives the proceeds of a life insurance policy on the life of a partner (presumably pursuant to
the buy-sell arrangement), the surviving partners’ basis in the partnership is increased
accordingly. Treas.Reg. §1.753-1. The proceeds will instead be paid to the surviving partners to
be used to facilitate the cross-purchase arrangement, and the surviving partners’ basis in the
purchased interest will be increased accordingly.

In Legallet v. Commissioner, 41 B.T.A. 294 (1940), two partners in a partnership took out
insurance on the life of each other, but each partner had retained the right to change the
beneficiary of the policy on his own life. They also entered into a cross-purchase agreement that
required that the proceeds of the policies, even though payable to the deceased partner’s family,
be applied toward the purchase price of the partnership interest. When one partner died, the
insurance proceeds were paid to the decedent’s wife. The Tax Court found that the partners
intended that the insurance proceeds should be paid only to the surviving spouse, and no one else,
and therefore the proceeds were not received by the surviving partner. As a result, the Tax Court
determined that the proceeds were not to be included in the surviving partner’s cost basis in the

deceased partner’s partnership interest that was acquired pursuant to the cross-purchase
agreement.

In contrast, in Mushro v. Commissioner, 50 T.C. 43 (1969), the Tax Court was presented with
similar facts and determined that the purchasing partners received an increased cost basis in the
deceased partner’s interest. In this case, the insurance proceeds were also payable to the surviving
wife. The Tax Court, distinguishing this case from Legallet, concluded that the intent of naming
the wife as beneficiary was only to provide the widow with a security device — that it was the
surviving partners who were intended to receive the proceeds and then use them to purchase the
interest.

C. [9.21] Redemption Agreements

The redemption agreement is a very useful form of buy-sell arrangement, particularly when
the business has several owners. In this arrangement, if life insurance will be used to fund the
purchase of an interest on the death of one of the business’s owners, the business owns one policy
on the life of each business owner, rather than each owner maintaining policies on each of the
other owners. The business entity is named as the beneficiary of the life insurance policies. If an
owner dies, the business entity receives the death benefit and is required by the buy-sell
arrangement to purchase (redeem) the deceased owner’s interest in the business. The insurance
proceeds are used to facilitate all, or at least a portion, of the purchase price called for in the
redemption agreement.


As noted in §9.19 above and discussed further below, the fair market value of the interest in
the business owned by the decedent will be included in his or her gross estate for estate tax
purposes. Code §§2031, 2033, 2703.

The purchase of a deceased business owner’s interest pursuant to a redemption agreement is
often funded with life insurance. Whether the death benefit of the policy will be included in the
gross estate of the deceased business owner pursuant to Code §2042(1) or Code §2042(2)
depends on the type of entity that owns the policy, as well as to whom the proceeds are to be paid.

If a partnership owns an insurance policy on the life of one of its partners, and the policy is
payable on death to a beneficiary other than the partnership, the death benefit will be includible in
the decedent’s gross estate under Code §2042(2). Rev.Rul. 83-147, 1983-2 Cum.Bull. 158.

If a corporation holds all incidents of ownership over a life insurance policy and is the
beneficiary of the policy, the death benefit will not be included in the gross estate of the insured
shareholder even if the insured is the sole or controlling shareholder (that is, owns more than 50
percent of the total combined voting power of the corporation). Treas.Reg. §20.2042-1(c)(6). In
this situation, however, the death benefit of the insurance will affect the valuation of the
shareholder’s interest in the business that will be included in his or her gross estate. Treas.Reg.
§20.2031-2(f). (See additional discussion below regarding the effect of life insurance proceeds on
the valuation of a corporation.) If the corporation holds incidents of ownership over the insurance
policy but is not the beneficiary (such that the proceeds will not be taken into account in valuing
the corporation), incidents of ownership of the policy will be attributed to the insured controlling

shareholder, resulting in inclusion of the proceeds in the deceased controlling shareholder’s gross
estate for estate tax purposes. Treas.Reg. §20.2042-1(c)(6).

Treas.Reg. §20.2042-1(c)(6) details what stock ownership will be attributed to the decedent.
For purposes of this regulation, the decedent will be considered the owner of the stock that, at the
time of death, he or she held jointly (proportionately to the extent of the consideration paid by the
decedent) and that was held by a trust that was treated as a grantor trust pursuant to Code §671, et
seq., at the time of his or her death.

While the proceeds of corporate-owned life insurance on the life of a deceased controlling
shareholder will not be included in the decedent’s gross estate under Code §2042 if the proceeds
are payable to the corporation, the proceeds of the policy will be taken into account in valuing the
decedent’s stock. Treas.Reg. §20.2031-2(f); Rev.Rul. 82-85, 1982-1 Cum.Bull. 137. In Estate of
Huntsman v. Commissioner, 66 T.C. 861 (1976), acq., 1977-2 Cum.Bull. 1, the Service argued
that the decedent’s shares in his corporation should first be valued without regard to the life
insurance proceeds that were paid to the corporation, and then the full amount of the insurance
proceeds added to the value, thereby including the full amount of the insurance proceeds in the
decedent’s gross estate. The Tax Court rejected this argument, stating that the Service’s position
was contrary to Treas.Reg. §§20.2042-1(c)(6) and 20.2031-2(f). The court concluded that the
insurance proceeds should be viewed as just one of the nonoperating assets of the corporation to
be considered in the valuation of the stock. See also Estate of Feldmar v. Commissioner, 56
T.C.M. (CCH) 118 (1988).

In Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005), the Eleventh Circuit
overturned the Tax Court’s determination that life insurance proceeds should be added to the
valuation of the subject corporation. The court explained that Treas.Reg. §20.2031-2(f) provides
that “consideration shall also be given to nonoperating assets, including proceeds of life insurance
policies payable to or for the benefit of the company, to the extent that such nonoperating assets
have not been taken into account in the determination of net worth.” 428 F.3d at 1345. The court,
citing the Ninth Circuit’s decision in Cartwright v. Commissioner, 183 F.3d 1034 (9th Cir. 1999),
as well as the Tax Court’s decision in Huntsman, supra, concluded that the phrase “to the extent
that such nonoperating assets have not been taken into account in the determination of net worth”
precluded the inclusion of the insurance proceeds in the valuation because the proceeds were
offset by the corporation’s contractual obligation to use the proceeds to purchase the decedent’s
stock. 428 F.3d at 1345.

Even when a life insurance policy on the life of a shareholder is owned by a corporation, the
three-year rule of Code §2035 may apply to cause inclusion of the death benefit in the gross
estate of the shareholder on death. If the corporation transfers the life insurance policy to a third
party gratuitously (not pursuant to a bona fide sale for adequate and full consideration), and the
insured shareholder dies within three years of the transfer, the proceeds will be included in the
shareholder’s gross estate pursuant to Code §2035(a) if the shareholder was the controlling
shareholder pursuant to Treas.Reg. §20.2042-1(c)(6). Rev.Rul. 82-141, 1982-2 Cum.Bull. 209;
Tech.Adv.Mem. 8806004 (Nov. 4, 1987). If the shareholder transfers his or her stock within three
years of death, the death benefit of the corporate-owned life insurance policy may or may not be
includible in his or her gross estate. If a controlling shareholder of a corporation transfers his or
her stock within three years of death and the corporation owns an insurance policy on his or her
life, the beneficiary of which is the corporation, the shareholder does not hold any incidents of

ownership in the policy pursuant to Treas.Reg. §20.2042-1(c)(6), and therefore Code §2035(a)
will not cause inclusion of the death benefit in the decedent’s gross estate. Tech.Adv.Mem.
8906002 (Feb. 10, 1989). If, however, the controlling shareholder of a corporation transfers his or
her stock within three years of death and the corporation owns an insurance policy on his or her
life, the beneficiary of which is someone other than the corporation, the shareholder will be
treated as holding incidents of ownership pursuant to Treas.Reg. §20.2042-1(c)(6), and therefore
Code §2035(a) will cause inclusion of the death benefit in the decedent’s gross estate.

The guidelines discussed in §9.19 above in the cross-purchase context regarding the inclusion
of insurance proceeds in a decedent’s gross estate when the decedent holds veto rights or other
powers pursuant to a buy-sell agreement that are deemed to be incidents of ownership also may
apply with respect to redemption agreements. For example, see Tech.Adv.Mem. 9349002 (Dec.
10, 1993). In addition, to the extent that a redemption agreement provides that any insurance
proceeds in excess of those required to fund the redemption are to be paid as designated by the
beneficiary, such excess proceeds will be included in the decedent’s gross estate. See, e.g.,
Pvt.Ltr.Rul. 8943082 (Oct. 27, 1989).


The transfer-for-value rule discussed in §§9.3 and 9.20 above will be less of an issue in the
redemption setting, as the transfer of the existing insurance policy by the business owner to the
business entity (for later use in the redemption) generally will fall into one of the exceptions set
out in Code §101(a)(2)(B) (a transfer to a corporation in which the insured is a shareholder, or a
transfer to a partnership in which the insured is a partner).

As discussed in §9.20 in the cross-purchase context involving a C corporation, an S
corporation, or a partnership, the cost basis of the deceased owner’s interest in the business will
be stepped up pursuant to Code §1014. The redemption of the interest pursuant to the redemption
agreement should then result in no gain being recognized by the seller of the interest, whether or
not insurance is used to fund the redemption.

VI. [9.24] SPLIT-DOLLAR ARRANGEMENTS

Split-dollar insurance arrangements originated as a mechanism to allow an employer to
provide executives and other key employees the benefit of permanent life insurance coverage
while sharing in the payment of the required premiums. A number of different ways of structuring
the payment of premiums, ownership of the policy itself, sharing of the cash value, and sharing of
the premium payments developed over the years, all aimed at providing income tax benefits to the
employer (expense deduction) and the employee-business owner (payment of premium via either
an interest-free loan or tax-free employee benefit), while also providing the insurance coverage
itself. The split-dollar arrangement became an even more useful estate planning tool when
insurance trusts were incorporated into the structures.

Beginning in 2001, the Service issued a series of notices that addressed, and tightened, the
income taxation of split-dollar arrangements. The Service’s focus on the taxation of split-dollar
insurance culminated with the issuance of final regulations in 2003, which defined “split-dollar”
as “any arrangement between an owner of a life insurance contract and a non-owner of a life

insurance contract” under which either party to the arrangement pays, directly or indirectly, all or
any portion of the premiums and one of the parties paying the premiums is entitled to recover all
or any portion of the premiums. Treas.Reg. §1.61-22(b). As a result of those regulations, split-
dollar arrangements fall into one of two different income tax regimes, the economic benefit
regime and the loan regime, and are taxed accordingly. Treas.Reg. §§1.61-22, 1.7872-15.

While detailed descriptions and discussion of the taxation of the various split-dollar structures
is beyond the scope of this publication, the postmortem handling of the split-dollar insurance is
relatively straightforward, particularly in light of the fact that the split-dollar arrangement is most
often documented in a written contract that dictates the actual handling of the policy proceeds on
death. In addition, the insurance policies are typically owned by irrevocable trusts in the split-
dollar arrangement.

Many times, however, an exit strategy will have been implemented in order to avoid the
continued income taxation of the arrangement. These exit strategies often involve the transfer of
the insurance policy. Therefore, the transfer-for-value rule, as well as its exceptions, as detailed in
§§9.3 and 9.20 above, may come into play to cause income taxation of a portion of policy
proceeds on the death of the insured.

The analysis outlined in §9.22 above for the inclusion of an insurance policy’s death benefit
in the gross estate of the insured for federal estate tax purposes, pursuant to Code §§2042(1) and
2042(2), also applies in the split-dollar context. Particular attention ought to be paid to the
applicability of Treas.Reg. §20.2042-1(c)(6) if, pursuant to the split-dollar arrangement, the
corporation retains incidents of ownership over the insurance policy but is not the beneficiary of
the policy.

VII. EMPLOYEE BENEFIT AND RETIREMENT ARRANGEMENTS


Insurance often constitutes a key component of employee benefit packages provided by many
employers, from group term life insurance to bonus plans and deferred compensation
arrangements. While the transfer-for-value rule set forth in Code §101(a)(2) regarding the income
taxation of the death benefits and the general rules regarding the inclusion of the insurance
proceeds in a decedent’s gross estate pursuant to Code §§2042 and §2035 will apply to these
insurance policies, there are also specific issues that will come into play with respect to the
postmortem handling of group term policies as well as those held in retirement plans.

B. [9.26] Group Term Life Insurance

As described in §9.19 above, if the life insurance policy on the life of the employee is payable
to the insured’s estate or is otherwise treated as being receivable by the employee’s executor, then
the proceeds of the policy will be includible in the employee’s gross estate for federal estate tax
purposes. Code §2042(1); Treas.Reg. §20.2042-1(b)(1). In addition, if the death benefit of a
group term life insurance policy is payable to a beneficiary other than the employee’s estate and
the employee retains incidents of ownership, then the proceeds of the policy will be includible in

the employee’s gross estate for federal estate tax purposes under Code §2042(2). In the group
term life insurance context, determining what constitutes incidents of ownership can be tricky.

Even if an employee signs an irrevocable beneficiary designation and otherwise relinquishes
all other perceived incidents of ownership, the death benefit still may be includible in his or her
gross estate pursuant to Code §2042(2). As noted in §9.7 above, if an insured retains the right to
cancel the insurance policy, he or she has retained an incident of ownership. Treas.Reg.
§20.2042-1(c)(3). Could the employee’s ability to terminate his or her employment, thereby
cancelling the group term policy, constitute an incident of ownership? The Service, through a
series of Revenue Rulings, has clarified that an employee’s right to terminate will not cause
inclusion of the death benefit if all other incidents of ownership have been relinquished. Rev.Rul.
69-54, 1969-1 Cum.Bull. 221; Rev.Rul. 72-307, 1972-1 Cum.Bull. 307.

In the partnership context, if the partnership has a group term life insurance policy on the life
of one of its partners and retains the right to cancel the policy, and the insured partner otherwise
irrevocably assigns his or her interest in the policy, the insured partner will not be deemed to hold
incidents of ownership in the policy that would cause inclusion of the death benefit in his or her
gross estate. Rev.Rul. 83-148, 1983-2 Cum.Bull. 157. In that situation, however, if the policy is
payable to a beneficiary other than the partnership, the death benefit will be includible in the
partner’s gross estate. Rev.Rul. 83-147, 1983-2 Cum.Bull. 158.

The Service also has ruled that if the only right retained by an employee at the time of his or
her death is the right to convert the group term policy to an individual policy upon termination of
employment, the employee will not have incidents of ownership that would cause the proceeds to
be subject to estate tax on his or her death. Rev.Rul. 84-130, 1984-2 Cum.Bull. 194. See also
Estate of Smead v. Commissioner, 78 T.C. 43 (1982), acq., 1984-2 Cum.Bull. 1.

Just as there are several Code §2042(2) issues that are unique to group term life insurance
policies, there are also several twists on the three-year rule under Code §2035 with respect to
group term policies. These issues generally present themselves when the employer, in the
ordinary course of its business, changes the insurance providers or the types of policies involved.
See, for example, Rev.Rul. 80-289, 1980-2 Cum.Bull. 270, in which the Service ruled that the
proceeds of a group term life insurance policy would not be included in the decedent’s gross
estate under Code §2035 when the decedent was required to assign rights in a group policy
(which he had previously irrevocably assigned) because the employer had switched insurance
providers.

In Rev.Rul. 82-13, 1982-1 Cum.Bull. 132, the Service addressed the applicability of Code
§2035 to the annual renewal of group term life insurance. Specifically, the Service considered a
group term policy that had an option for automatic renewal upon payment of the premium, which
was accomplished without providing evidence of insurability, and the rights and obligations of
the parties continued without interruption from the policy’s inception as long as the policy was
renewed on each anniversary date. As a result, the Service ruled that even though a decedent
would be considered to have made premium payments until death, the value of a renewable group
term life insurance policy is not includible in a decedent’s gross estate under Code §2035 when
the decedent assigned the policy more than three years before death.

C. [9.27] Life Insurance in Qualified Retirement Plans

Life insurance is often promoted as a valuable investment to be made by a qualified
retirement plan because, among other reasons, pretax dollars can be used to pay the premiums
and no out-of-pocket payments are required of the insured, leveraging the funds in the plan.
However, these arrangements can have extremely harsh results if they do not have a properly
structured exit strategy that is implemented before death. Just as with any other assets held in a
qualified plan, the death benefit of the life insurance policy that is held inside a plan will be both
subject to income tax (it will be considered income in respect of a decedent) and included in the
decedent’s gross estate for federal estate tax purposes (while Code §2039(a) will cause the
retirement plan assets to be included in the gross estate of a decedent, that section specifically
excludes life insurance policy proceeds; Code §2042 will cause inclusion of the proceeds as the
decedent most often retains incidents of ownership, such as the right to change beneficiaries).

Therefore, the successful completion of an exit strategy will result in the insurance policy
being transferred out of the qualified retirement plan, sometimes to the insured (who may then
gift the policy to an irrevocable life insurance trust), or even directly to an ILIT. In any event, if at
the time of the insured’s death a policy is in existence that had been held in a qualified plan, as
outlined above, the transfer-for-value rule in Code §101(a)(2) may apply. In addition, as
described generally in §§9.7 – 9.8 above, Code §§2042 and 2035 will cause inclusion of the
policy proceeds, when applicable.

Conclusion

The financial burden created by the death of a family member is often addressed by the
purchase of a life insurance policy. Life insurance can play a vital role in the estate planning and
administration process. When engaging in estate planning for high net worth individuals, the
estate planner will find that their estates often consist primarily of illiquid assets such as a closely
held business interest or significant real estate. In these types of situations, the beneficiaries of
the estate could be forced to liquidate assets immediately at "fire sale" prices in order to generate
cash to pay taxes and expenses. Life insurance can be used to provide liquidity for such estates.

It is important to consider all of the income and estate tax issues surrounding life insurance
policies. Upon the death of an insured, the proper reporting and review of a life insurance policy
is an essential part of post mortem planning.

Ch 9 Iicle Post Mortem Planning 9 7 09 (2)

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