IRC 2042: Including Life Insurance in a Taxable Estate

While the death benefit from a life insurance policy is not subject to income tax, it can be subject to federal estate tax. The value of a policy can significantly increase a decedent’s gross estate, potentially pushing it above the 2025 federal exemption of $13.99 million per individual. This high exemption is scheduled to revert to approximately half its amount after 2025 unless Congress acts to extend it. Federal tax law contains specific provisions that determine whether life insurance proceeds must be included in an estate, a central consideration in estate planning for individuals with large policies.

Conditions for Including Life Insurance in an Estate

The inclusion of life insurance proceeds in a decedent’s gross estate is governed by Internal Revenue Code Section 2042. This section outlines two primary conditions that determine if the death benefit becomes part of the taxable estate. If either of these conditions is met at the time of death, the full value of the proceeds must be reported on the estate tax return.

The first condition is the “Receivable by the Estate” test. If a life insurance policy explicitly names the decedent’s estate as the beneficiary, the proceeds are automatically included in the gross estate. This test also applies if a named beneficiary is legally obligated to use the insurance proceeds to pay the estate’s debts, taxes, or other administration expenses, as the amount required for those obligations is includable.

A second, and more frequently encountered, condition for inclusion is the “Incidents of Ownership” test. This rule states that if the decedent possessed any control or economic rights over the policy at the time of death, the proceeds are included in their estate, regardless of who the beneficiary is.

Understanding Incidents of Ownership

The term “incidents of ownership” refers to the economic benefits and control a person holds over a life insurance policy, not technical legal ownership. Possessing even one of these rights at death is enough to cause the full death benefit to be included in the taxable estate. These rights can be held directly by the insured or indirectly through another entity.

Common incidents of ownership include:

• The right to change the policy’s beneficiary.
• The ability to surrender the policy for its cash value or to cancel it.
• The power to assign the policy or to revoke an assignment.
• The ability to pledge the policy as collateral for a loan.
• The right to borrow against the policy’s cash surrender value.

These ownership rights can also be held indirectly. For instance, if an individual is the controlling shareholder of a corporation that owns a policy on their life, the corporation’s incidents of ownership may be attributed to the shareholder. This attribution would cause the proceeds to be included in the individual’s estate to the extent they are not payable to the corporation. Holding these powers as a trustee over a policy can also be deemed an incident of ownership.

A reversionary interest is another form of an incident of ownership. This occurs if there is a possibility that the policy or its proceeds could return to the decedent or their estate. This interest only triggers inclusion if its value immediately before death exceeds five percent of the policy’s value.

Planning with Irrevocable Life Insurance Trusts

A primary strategy for preventing life insurance proceeds from being included in a taxable estate is using an Irrevocable Life Insurance Trust (ILIT). An ILIT is a legal entity created to own and be the beneficiary of a life insurance policy, which removes the policy from the insured’s control and gross estate for tax purposes.

The structure involves three parties: the grantor, the trustee, and the beneficiaries. The grantor is the individual who establishes the trust and is the person whose life is insured. The trustee, who must be an independent party, is responsible for managing the trust, paying policy premiums, and eventually distributing the proceeds. The beneficiaries are the individuals who will receive the benefits from the trust after the grantor’s death.

To fund the ILIT, the grantor makes cash gifts to the trust, which the trustee then uses to pay the policy premiums. Because the trust is irrevocable, the grantor gives up all rights to change the trust and relinquishes all incidents of ownership over the policy. As a result, the policy proceeds are paid to the trust upon the grantor’s death and are not considered part of their estate.

These gifts to the trust can be structured to qualify for the annual gift tax exclusion, which is $19,000 per recipient for 2025. This is accomplished by giving beneficiaries a temporary right to withdraw the gifted funds, a power known as a “Crummey” power. This technique allows the grantor to fund premium payments without using their lifetime gift tax exemption.

The Three-Year Rule for Policy Transfers

A consideration in life insurance planning is the “three-year rule” under IRC Section 2035. This provision acts as a look-back period for certain transfers made shortly before death. If an individual transfers an existing life insurance policy in which they held incidents of ownership and then dies within three years of that transfer, the full value of the death benefit is brought back into their gross estate for tax purposes.

This rule is designed to prevent last-minute transfers intended to avoid estate tax. The transfer is essentially disregarded by the IRS, and the situation is treated as if the decedent still possessed incidents of ownership at the time of their death. This can undermine the estate planning benefits of transferring a policy to an ILIT or another individual.

To avoid triggering this three-year look-back period, the preferred method is for the trustee of a newly created ILIT to purchase a new life insurance policy directly. The grantor provides cash to the trust, and the trustee applies for and becomes the original owner of the policy. Because the insured individual never personally held any incidents of ownership in the policy, there is no transfer to which the three-year rule can apply.

Creating a new policy within a trust is often safer than gifting an existing policy to it. When transferring an existing policy is the only option, the three-year clock begins on the date of the transfer, creating a period of risk for the estate.