IRS Code 811: Estate Tax Rules for Life Insurance

While many individuals search for information on life insurance and estate taxes under “IRS Code 811,” this section was part of the older Internal Revenue Code of 1939. The governing principles are now found within Section 2042 of the current Internal Revenue Code. This law outlines the specific circumstances under which the value of a life insurance policy becomes part of a decedent’s estate for federal tax purposes.

Conditions for Including Life Insurance in an Estate

The Internal Revenue Code establishes two primary conditions that result in life insurance proceeds being included in a decedent’s gross estate. The first condition occurs when the policy’s proceeds are receivable by the decedent’s executor or are made payable to the decedent’s estate. If the proceeds are legally available to pay the estate’s taxes, debts, or other administration expenses, the IRS will include them in the gross estate calculation.

A more complex condition involves the decedent holding “incidents of ownership” in the policy at the time of their death. This term refers to the economic benefits and control rights associated with the policy, which the tax code views as equivalent to ownership. If the deceased individual retained certain powers over the policy, exercisable alone or with another person, the proceeds are included in their estate regardless of the named beneficiary.

Common examples of these ownership rights include:

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

Even a reversionary interest can trigger inclusion if its value exceeds five percent of the policy’s value immediately before death. A reversionary interest is a possibility that the policy or its proceeds could return to the decedent or their estate. The presence of any of these rights can cause the entire death benefit to be counted in the decedent’s gross estate, potentially increasing the estate’s tax liability.

The Three-Year Look-Back Rule

Even if a person does not possess any incidents of ownership at death, life insurance proceeds may still be included in their gross estate. This occurs under a provision detailed in Section 2035 of the tax code, often called the “three-year look-back rule.” The rule is designed to prevent individuals from avoiding estate tax by making last-minute gifts of their policies.

If a policy is transferred and the original owner dies within this three-year window, the full value of the death benefit is pulled back into the gross estate. This applies to transfers of policies that would have been included in the estate had the transfer not occurred. The look-back period is a strict timeline and does not consider the decedent’s intent or health at the time of the transfer.

Role of an Irrevocable Life Insurance Trust

A common planning structure is the Irrevocable Life Insurance Trust (ILIT), which is created to own a life insurance policy. Because the trust is irrevocable, the person who creates it, known as the grantor, cannot easily amend or terminate it. This arrangement is designed to hold the policy so that the proceeds are not considered part of the grantor’s estate upon death.

The primary function of an ILIT is to remove incidents of ownership from the insured individual. When the trust is established, the trustee applies for and purchases a new policy, ensuring the grantor never personally owns it. The trust owns the policy, and the trustee manages it, paying the premiums from funds gifted to the trust by the grantor.

The three-year look-back rule directly impacts how existing policies are handled with an ILIT. If a grantor transfers a policy they already own into an ILIT, they must survive for more than three years from the date of the transfer. If the grantor dies within that period, the life insurance proceeds are brought back into the taxable estate.