Younger taxpayers often purchase life insurance to care for family members dependent on them if they were to die; but, elderly taxpayers often purchase life insurance to cover estate tax and other financial obligations they are responsible for if they were to die. Are life insurance proceeds taxable? Yes and no. Life insurance policies are often purchased in estate planning to cover debts and tax liabilities. The proceeds are generally included in the gross estate, if not structured properly, though not taxable to the beneficiary as income. The answer as to whether the estate is taxed lies in resolving who is the beneficiary. One way to avoid making the life insurance proceeds as part of the taxable estate is to use an Irrevocable Life Insurance Trust (ILIT) to pay the premiums and become the beneficiary of the life insurance proceeds.
Is the trust allowed to receive money from the grantor to pay the premiums without reporting income? Although the ILIT will generally not have income during the grantor’s lifetime, the grantor will give money to the trust to pay the life insurance premiums. There is a $14,000 exclusion allowed from filing for gifts where the gift is intended as a “present interest gift”. Future interest gifts are not subject to the $14,000 annual exclusion and grantors must file Form 709, even if the gift was under $14,000. Direct gifts to the trust to pay for life insurance proceeds in the future will be seen as “future interest” gifts unless a Crummey Trust is used. Crummey v. Commissioner, CA9 (1968), 397 F.2d 82.
A Crummey provision generally gives a beneficiary a time period (usually 60 days) during which the beneficiary can demand receipt of the cash transferred to the trust, such that the gift becomes a “present interest”. If the beneficiary does not exercise his or her right during that period, the funds enter the trust and become unavailable to the beneficiary. At that point, the funds are generally used to pay the premiums due on the policy such that there are no tax consequences or reporting requirements.
If a married couple is involved, it is typical to have a life insurance second to die policy, since there will be a need at the second death for liquidity to be used to pay the estate tax. To remain out of the decedent’s estate, the trust cannot be required to pay the estate tax, otherwise, the decedent would have effectively retained an interest to pay off his/her estate debts with the funds, such that the funds would be included in the decedent’s estate.
Additionally, the life insurance policy may be included and taxable in the decedent’s estate where there are “incidents of ownership” within three years before the date of death. Such disqualifying “incidents of ownership” may be as slight as the right to borrow against the policy or change beneficiaries.
Where the taxpayer properly creates the ILIT, funds it to pay premiums with gifts using a Crummy Trust (or have an estate below the estate exclusion threshold), and the grantor did not retain “incidents of ownership” before death, the grantor can fund the premiums, and life insurance proceeds can be effectively used to take care of debts and tax liability upon a grantor’s death. Just be sure to properly identify and provide documentation to a trusted party where and how to access the life insurance policies!