ESTATES AND TRUSTS
Insurance And The Three-Year Rule
By Lawrence M. Lipoff, CEBS, CPA, Rogoff & Company, P.C.
Beginners to estate planning are often surprised that the tax-free life insurance investment that they have made will be included in their taxable estate. A way to avoid estate taxation (with its high marginal rates) is to irrevocably transfer legal ownership and benefits to a newly established trust which will become the policy's new owner and beneficiary. Individuals can be established as the beneficiaries of the trust.
Estate planners regularly warn their clients that if they transfer ownership and benefits of an experienced policy (i.e., a policy already in force) to an irrevocable life insurance trust, they must live for a period of three years to avoid inclusion in the client's estate. Under IRC section 2042, one of the sections referred to in IRC section 2035, proceeds of life insurance shall be included in the value of a decedent's gross estate "to the extent of the amount receivable by all other beneficiaries as insurance under policies on the life of the decedent with respect to which the decedent possessed at death any of the incidents of ownership, exercisable either alone or in conjunction with any other person.... In determining the value of a possibility that the policy or proceeds thereof may be subject to a power of disposition by the decedent, such possibility shall be valued as if it were a possibility that such policy or proceeds may return to the decedent or estate."
Furthermore, an irrevocable life insurance trust should not be required to pay estate taxes. Under Treasury regulations section 20.2042-1, this legal obligation would bring the insurance proceeds back into the decedent's taxable estate. However, if the trust is allowed to either lend money to or buy assets from the estate, then 1) the life insurance proceeds will not be included in the decedent's taxable estate, and 2) the estate will have the liquidity to pay taxes.
The trust's drafter must ensure that no incidents of ownership remain with the insured when the life insurance policy is transferred to the trust.
All insurance policies, whether whole life, variable life, universal life, or a combination of the above are really term insurance policies with a separate investment feature encased in a single contract. Since they are sold as one investment package, they are presumably subject to the three-year rule. However, what about term insurance policies? Is term insurance subject to the three-year rule under IRC section 2035(d)?
Under the IRC and the Treasury regulations promulgated thereunder, the three-year rule is discussed in terms of the transfer of a policy. However, term insurance is really a year-to-year coverage: Each year that term insurance is renewed, new coverage is purchased. Term is really a one-year rental of life insurance coverage. If so, each year's coverage should be considered a new policy.
For example, assume that a policy year began January 1, 1998, the policy was irrevocably transferred by the insured into an irrevocable life insurance trust in March 1998, and the insured died in January 1999. Based upon the above scenario, the term policy should not be subject to the three-year rule, i.e., the insurance proceeds received by the irrevocable life insurance trust would not be included in the decedent's estate.
A reason that this may not be true is that most term insurance policies have a renewal rider. This guarantees that the insured will be able to have the same amount of insurance purchased each year, irrespective of health condition. In fact, this guarantee causes coverage to be extended to people that have become insurance risks. Therefore, purchasers of term insurance are often advised to apply for new coverage every five years since coverage rates are established to spread the risk of "adverse selection." It is known that rates are preestablished based upon the presumption that these poor health risks will renew coverage.
Therefore, for those insureds where 1) the coverage is needed with a different insurance company, 2) the policy number is obtained when renewing the old policy with the same company, or 3) the policy does not have a renewal rider, in theory, the three-year rule should not apply.
Those covered by the AICPA life insurance trust are guaranteed renewal coverage within certain preestablished guidelines. At certain ages, less insurance may be purchased and at other ages, no coverage is available. Still, the ability to renew is not dependent upon a particular insured. Rather it is dependent upon the entire AICPA membership. Some may conclude that the three-year rule may not apply to irrevocable transfers of AICPA coverage. Still, it would be advisable for the trustee to attempt to have a different policy number assigned to the next policy year's coverage. *
Eric M. Kramer, JD, CPA
Alan D. Kahn, CPA
The AJK Financial Group
Richard H. Sonet, JD, CPA
Marks Shron & Company LLP
Frank G. Colella, LLM, CPA
Lawrence M. Lipoff, CEBS, CPA
Rogoff & Company, P.C.
Jerome Landau, JD, CPA
James B. McEvoy, CPA
The Chase Manhattan Bank
Nathan H. Szerlip, CPA
Edward Isaacs & Company LLP
Lenore J. Jones, CPA
Jacobs Evall & Blumenfeld LLP
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