This inclusion rule captures transfers involving more that just direct policy ownership

The Internal Revenue Code contains a “three-year inclusion rule” with regard to life insurance that states as follows: If an insured who owns a policy on his/her life gives the policy to another person, trust or entity and then dies within three years of the transfer, the policy proceeds will be included in the estate of the insured and will be subject to estate tax inclusion.

Another provision of the Code provides that if the decedent/owner possessed any “incidents of ownership” in the policy at the time of his or her death, the death benefit is subject to estate tax. Incidents of ownership include the right to:

(1) Change the beneficiary, (2) Surrender or cancel the policy, (3) Assign the policy, (4) Revoke an assignment, (5) Pledge the policy for a loan, or (6) Obtain a policy loan.

Because of the interaction of these two Code sections, when the insured transfers the policy, these rights must be relinquished, and the transferring owner must live more than three years after the relinquishment or transfer in order for the policy proceeds to escape estate tax inclusion.

The “three-year inclusion rule” does not apply to a bona fide sale for adequate and valuable consideration. However, if the transaction is structured as a sale, it may become ensnared by another trap may, known as the transfer-for-value rule. This rule may apply unless the transfer is structured to fit within one of the allowable “transfer for value” exceptions. (A topic for an article in a later Brokerage Briefs)

How can a non-gift transfer of the policy and all incidents of ownership be a solution to the three-year inclusion rule? The three-year rule often comes into play when an owner/insured gives an existing policy to an irrevocable life insurance trust (ILIT). Since the three-year inclusion rule impacts only gifts, the transfer can be structured to be a sale to the trust as long as the trust is wholly owned by the policy owner/insured. Many legal experts feel that this transaction will avoid both the “three-year inclusion rule” and the “transfer-for-value” rule because the trust and the policy owner are viewed as the same person; hence, the owner is, in effect, selling it to himself.

Another solution is to purchase term insurance to cover the three-year period during which the transferred policy would be subject to estate taxation. The term death benefit would pay the estate tax due to the proceeds that were brought back into the estate.

Insure With the People You Trust

The options and rules involved in purchasing and understanding life insurance can be tough. We have already learned from the costly mistakes of others and are happy to pass that knowledge on to you. Contact Kasmann Insurance and let our trained life insurance experts help you navigate through the myriad of concerns, companies, and questions you may have.

These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matter addressed in this document. The taxpayer should seek advice from an independent tax advisor.

In addition to this annual per person exclusion, every individual has a lifetime gift tax exemption of $1,000,000. This means that the first million dollars of the gift, after applying the annual exclusion, will also be tax-free. That helps, but it does not eliminate the tax. In the example, the gift that the wife made, after applying https://onedayloan.net/payday-loans-pa/ the annual exclusion, was two times $988,000 or $1,976,000. After subtracting the $1,000,000 exemption, $976,000 will needlessly be subject to gift tax.

Failure to Name a Successor Owner

However, if an insured’s estate is large enough to be subject to estate taxation, ownership of his or her policy will trigger unnecessary estate taxation. What does the owner/insured do when he/she discovers that ownership of the policy creates a tax problem? The most obvious solution is to give the ownership of the policy to another person or to a trust. That sounds like a quick and easy solution, but it could have unintended consequences.