What Are Incidents of Ownership in Life Insurance?

Life insurance is often obtained to provide financial security, and many assume the death benefit passes to beneficiaries free from tax. While proceeds are not subject to income tax, they can be included in the deceased’s gross estate for federal estate tax purposes. Whether a policy’s value is swept into the taxable estate depends on who holds specific powers over the policy. These rights are known as “incidents of ownership,” and they dictate whether a policy’s proceeds become a taxable asset for the government.

Defining Incidents of Ownership

The term “incidents of ownership” refers to any right to the economic benefits of a life insurance policy, not just technical ownership. It encompasses a bundle of powers giving the holder control. If an individual possesses any of these incidents of ownership in a policy on their own life at death, the full death benefit is included in their gross estate, whether the power is held alone or with someone else.

This principle is codified in Internal Revenue Code Section 2042. The law states that life insurance proceeds are includable in the gross estate if the decedent held any incidents of ownership at death. Adding a large life insurance payout can increase an estate’s total value, potentially pushing it over the exemption threshold or into a higher tax bracket.

A “reversionary interest” is a specific type of incident of ownership. This occurs if there is a possibility that the policy or its proceeds could return to the decedent or their estate. For this interest to trigger estate inclusion, its value must exceed five percent of the policy’s value immediately before the decedent’s death.

Actions That Create Incidents of Ownership

Several specific actions and retained rights are defined by the Internal Revenue Service (IRS) as incidents of ownership. Retaining any of the following powers can cause the policy’s proceeds to be included in an estate:

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

Ownership can also be held indirectly. If an individual is the controlling stockholder (owning more than 50% of voting power) in a corporation that owns a policy on their life, the corporation’s powers may be attributed to them. This attribution can occur if the proceeds are payable to a third party for non-business reasons. Incidents of ownership can also be held in a fiduciary capacity, such as when an individual is the trustee of a trust that holds a policy on their own life and has the power to alter the policy’s benefits.

Transferring Policy Ownership to Avoid Estate Tax

To remove life insurance proceeds from a taxable estate, the insured must relinquish all incidents of ownership. This is accomplished by making a complete and irrevocable transfer of the policy to another person or entity. The transfer must be an “absolute assignment,” a legal process that permanently gives away all rights associated with the policy. Once completed, the original owner can no longer change the beneficiary or exercise any other control.

A component of this strategy is the “three-year look-back rule” detailed in IRC Section 2035. This rule states that if the insured dies within three years of transferring ownership of a life insurance policy, the full death benefit is brought back into their gross estate. This provision is to prevent individuals from avoiding estate tax by giving away policies shortly before death. To successfully remove the policy from the estate, the insured must survive for more than three years from the transfer date.

When transferring a policy that has accumulated cash value, the transfer may be considered a taxable gift. If the value of this gift exceeds the annual gift tax exclusion amount, the donor may be required to file a federal gift tax return, Form 709. This filing may use a portion of the donor’s lifetime gift and estate tax exemption, but it is a way to exclude a much larger death benefit from the estate.

Utilizing an Irrevocable Life Insurance Trust (ILIT)

A structured method for holding a life insurance policy outside of an estate is the Irrevocable Life Insurance Trust (ILIT). An ILIT is a trust that cannot be amended, modified, or revoked by its creator, the grantor. Its primary function is to be the owner and beneficiary of a life insurance policy. Because the trust owns the policy, the insured grantor does not possess any incidents of ownership, and the death benefit is not included in their gross estate.

The participants in an ILIT are the grantor, the trustee, and the beneficiaries. The grantor establishes the trust and is the insured person. The trustee is an independent party responsible for managing the trust, paying policy premiums, and distributing the proceeds. The beneficiaries are the individuals who will receive the financial benefit after the grantor’s death.

Funding an ILIT to pay for policy premiums is done through annual gifts from the grantor to the trust. To ensure these gifts qualify for the annual gift tax exclusion, the trust must grant beneficiaries a temporary right to withdraw the contributed funds. This is done through a notification process using “Crummey letters.” These letters inform each beneficiary of their right to withdraw a portion of the gift for a limited period, such as 30 days. This withdrawal right converts the gift into a “present interest,” which is a requirement for it to qualify for the annual exclusion.