Is Life Insurance Included in Gross Estate?

A gross estate is the total value of all assets a person owns at death, which is the starting point for determining if federal estate tax is due. While assets like bank accounts and real estate are clearly part of this calculation, the treatment of life insurance is more complex. Whether a policy’s payout becomes part of the taxable estate depends on the circumstances of its ownership and beneficiary designations. The Internal Revenue Service (IRS) has established guidelines that dictate when these proceeds are included in the gross estate.

When Life Insurance is Included in an Estate

Life insurance proceeds are included in a decedent’s gross estate under two primary conditions. The first scenario is when the proceeds are made payable directly to the decedent’s estate. This can happen if the estate is the named beneficiary or if proceeds revert to the estate by default. In these cases, the proceeds become an asset of the estate used for paying debts and taxes.

The second condition involves the rights the deceased held over the policy. Under Section 2042 of the Internal Revenue Code, proceeds are included in the gross estate if the decedent possessed any “incidents of ownership” in the policy at death. This rule applies even if the proceeds are paid to a specific individual. Similarly, if a beneficiary is legally obligated to use the funds to pay the estate’s debts or taxes, those amounts are also includible.

Understanding Incidents of Ownership

The term “incidents of ownership” refers to the rights and economic benefits associated with a life insurance policy. Possessing even one of these rights at the time of death is sufficient to pull the policy’s death benefit into the gross estate. The IRS looks at the practical power a person holds over the policy, not just who is listed as the “owner” on documents.

Some of the most common incidents of ownership include:

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

These rights, whether held alone or with another person, demonstrate a level of control that the tax code equates with ownership. For instance, if a policy is held by a corporation in which the decedent was the controlling stockholder (owning more than 50% of the voting power), the corporation’s incidents of ownership may be attributed to the decedent.

The Three-Year Rule for Policy Transfers

Giving away a life insurance policy or relinquishing incidents of ownership shortly before death does not guarantee the proceeds will be excluded from the gross estate. The IRS uses a “three-year rule” under Section 2035 of the Internal Revenue Code to address this. This rule prevents individuals from making transfers solely to circumvent federal estate taxes.

Under this regulation, if a decedent transfers ownership of a life insurance policy or releases incidents of ownership within three years of death, the death benefit is brought back into their gross estate. For example, if a person transfers ownership to their child two years before passing away, the three-year rule would be triggered. The entire death benefit paid to the child would be included when calculating the parent’s gross estate.

Using Trusts to Exclude Life Insurance

A primary strategy to exclude life insurance proceeds from a gross estate involves using an Irrevocable Life Insurance Trust (ILIT). An ILIT is a legal entity created to own and be the beneficiary of one or more life insurance policies. When structured correctly, an ILIT can remove the death benefit from the insured’s taxable estate, allowing proceeds to pass to heirs without being subject to estate tax.

The core principle is the complete separation of the insured from any control over the policy. The trust is designated as the owner and beneficiary, and the insured cannot change beneficiaries, borrow against the policy, or exercise any other incidents of ownership. Because the decedent holds no such rights at death, the proceeds are not includible in their estate.

An ILIT also helps navigate the three-year rule. If the trust purchases a new policy directly, the insured never holds any incidents of ownership, so there is no transfer to trigger the look-back period. If an existing policy is transferred to the trust, the insured must survive for more than three years after the transfer. The trustee manages the policy, collects the proceeds upon death, and can then distribute them to beneficiaries or use them to provide liquidity to the estate.