Rev. Rul. 83-53: Impact on Shareholder Life Insurance

IRS regulations address the estate tax implications of life insurance owned by a closely held corporation on its controlling shareholder. The core issue is when the death benefit from such a policy must be included in the deceased shareholder’s gross estate for federal estate tax purposes. These rules clarify how corporate control and policy rights interact, causing the policy’s value to be taxed as part of the individual’s estate. This guidance is a consideration in business succession and estate planning for owners of private companies.

Determining a Controlling Shareholder

An individual is considered a controlling shareholder if, at the time of their death, they owned stock possessing more than 50% of the total combined voting power of the corporation. This is a strict, bright-line test, meaning ownership of 51% of the voting stock confers control, while owning 50% or less does not.

For this rule, ownership is not limited to stock held directly in the decedent’s name. It also includes stock held jointly with others, by a nominee, or by certain types of trusts where the decedent is treated as the owner. This broad definition of ownership prevents avoidance of the rule by simply transferring legal title while retaining effective control. The determination is made at the precise moment of death.

Attribution of Incidents of Ownership

A central concept in this area of tax law involves “incidents of ownership,” which are the rights and powers associated with owning a life insurance policy. These rights include the power to:

• Change the policy’s beneficiary
• Surrender or cancel the policy for its cash value
• Assign the policy to another person or entity
• Borrow against the policy’s cash surrender value

When a corporation owns a policy on its controlling shareholder’s life, tax regulations dictate that the incidents of ownership held by the corporation are attributed, or passed through, to that shareholder. This attribution occurs because the shareholder’s voting control over the corporation gives them the indirect power to exercise these policy rights. For example, a 51% shareholder can direct the corporation to change the beneficiary or surrender the policy.

This attribution is the step that triggers potential estate inclusion. The Internal Revenue Code provides that life insurance proceeds are included in a decedent’s gross estate if they possessed any incidents of ownership in the policy at death. By attributing the corporation’s rights to the controlling shareholder, the death benefit is swept into their taxable estate if it is payable to a personal beneficiary.

The Corporate Benefit Exception

An exception exists that prevents automatic estate inclusion. If the proceeds of the corporate-owned life insurance policy are payable to the corporation itself, the incidents of ownership are not attributed to the controlling shareholder. The same exception applies if the proceeds are payable to a third party for a valid business purpose, such as to satisfy a corporate debt. This is because the proceeds are being used to increase the corporation’s net worth.

When the proceeds are paid to the corporation, they are not directly included in the shareholder’s gross estate. Instead, the life insurance payout increases the overall value of the company, which in turn increases the value of the deceased shareholder’s stock included in their estate. This is often a more favorable tax outcome, as the stock’s value may be subject to valuation discounts that are not available when cash proceeds are included directly.

Structuring Policies to Avoid Estate Inclusion

A common planning strategy to avoid these estate tax rules is to house the life insurance policy outside of both the corporation and the shareholder’s personal estate. This is frequently accomplished through an Irrevocable Life Insurance Trust (ILIT). An ILIT is a separate legal entity created specifically to own a life insurance policy.

In this arrangement, the ILIT is established as the owner and beneficiary of the policy on the shareholder’s life. The shareholder makes gifts to the trust, and the trustee uses those funds to pay the policy premiums. Upon the shareholder’s death, the insurance proceeds are paid directly to the ILIT. Because the corporation never owned the policy, there are no incidents of ownership to attribute to the shareholder.

Since the shareholder does not personally own the policy or control the trust, the proceeds are not included in their personal gross estate. The funds held by the trust can then be made available to the shareholder’s heirs outside of the taxable estate, often providing the liquidity needed to pay estate taxes or purchase company stock from the estate.