Who Should Own a Life Insurance Policy?

A life insurance policy is a contract where an insurer pays a sum of money upon the death of an insured individual. The policy owner holds the contractual rights and control, distinct from the insured (whose life is covered) and the beneficiary (who receives the death benefit). The owner can make decisions about the policy, such as changing beneficiaries, accessing any cash value through loans or withdrawals, or even surrendering the policy for its cash value. Understanding policy ownership is fundamental because it dictates control and significantly impacts financial and tax implications for all parties.

When the Insured Owns the Policy

The most common arrangement for life insurance ownership is when the person whose life is insured also owns the policy. In this setup, the insured maintains direct and complete control over all policy decisions throughout their lifetime. This includes the right to designate or change beneficiaries, assign policy rights, surrender the policy for its cash value, or borrow against any accumulated cash value.

This ownership structure has specific implications for estate planning. Upon the insured’s death, the death benefit proceeds are included in their gross estate for federal estate tax purposes. This inclusion occurs because the insured possessed “incidents of ownership” in the policy, meaning they had the right to control the economic benefits of the policy. Examples of such incidents include the power to change beneficiaries or borrow against the policy.

For estates exceeding the federal estate tax exemption amount, which is $13.61 million per individual in 2024, this inclusion can lead to estate tax liability. The death benefit, although income tax-free to the beneficiary, can increase the total value of the estate, potentially subjecting more assets to taxation. If the estate is illiquid, heirs might face the challenge of needing to sell assets to cover these taxes.

Ownership by Another Individual

An individual other than the insured can also own a life insurance policy. This is a common strategy in personal financial planning, often involving a spouse, adult child, or another family member. A primary reason for this structure is to remove the death benefit from the insured’s taxable estate, potentially reducing estate tax exposure.

For the death benefit to be excluded from the insured’s gross estate, the insured must not possess any “incidents of ownership” in the policy. This means the insured cannot retain rights like changing beneficiaries, surrendering the policy, or taking policy loans. If an existing policy is transferred, the insured must survive for at least three years after the transfer for the proceeds to be excluded from their estate. This three-year rule is an important consideration.

When another individual owns the policy, they typically pay the premiums and control its terms. This setup can provide liquidity for the insured’s estate or specific beneficiaries, ensuring funds are available for purposes like covering estate taxes without forcing the sale of other assets. If an estate primarily consists of non-liquid assets like real estate or a family business, the tax-free life insurance proceeds can provide the necessary cash for tax obligations.

Ownership by an Irrevocable Life Insurance Trust

An Irrevocable Life Insurance Trust (ILIT) is a specialized legal arrangement designed to own one or more life insurance policies. This type of trust is frequently chosen as an ownership vehicle to remove the life insurance proceeds from the insured’s taxable estate. The primary purpose of an ILIT is to minimize potential federal estate taxes and provide long-term control over how and when the death benefit is distributed to beneficiaries.

Establishing an ILIT involves a grantor (the insured) creating the trust and transferring funds, typically for premium payments, to a trustee. The trustee manages the trust and policy, while beneficiaries are the individuals or entities who will receive the policy proceeds upon the insured’s death. The trust must be irrevocable, meaning the grantor cannot modify or terminate it once established. This irrevocability is essential for the death benefit to be excluded from the grantor’s estate.

ILITs involve “Crummey powers,” which allow beneficiaries a temporary right to withdraw gifted funds (premiums) contributed to the trust. This mechanism helps ensure contributions qualify for the annual gift tax exclusion, preventing them from consuming the grantor’s lifetime gift tax exemption. The trustee notifies beneficiaries of these withdrawal rights. Properly structured, an ILIT can provide immediate liquidity for estate expenses or taxes, protect assets from creditors, and ensure distributions align with the grantor’s wishes across multiple generations.

Business Entity Ownership

Life insurance policies can also be owned by business entities, such as corporations, partnerships, or limited liability companies. Businesses leverage life insurance for several strategic reasons, including mitigating financial risks associated with the loss of key personnel, facilitating ownership transitions, and providing employee benefits.

One common application is key person insurance, where the business purchases a policy on a vital employee, pays the premiums, and is the beneficiary. If the key person dies, the business receives the death benefit, which helps offset financial losses, cover recruitment costs, or ensure operational continuity. Premiums for key person insurance are not tax-deductible for the business, but death benefits received are income tax-free.

Another significant use is funding buy-sell agreements, which are contracts outlining how a deceased or exiting owner’s interest will be transferred. Life insurance provides the necessary liquidity to purchase the shares from the deceased owner’s estate, ensuring a smooth transition of ownership and maintaining business stability. The business might own policies on each owner (entity purchase) or individual owners might own policies on each other (cross-purchase). Businesses may also use life insurance in employee benefit programs, such as executive bonus plans or split-dollar arrangements, where the costs and benefits of a policy are shared between the employer and employee.