As is the case with any other gift tax analysis, when life insurance is the subject of a transfer, the planner must ask four questions. In this article, we will review those four questions, and what each of them means. They are:
- Was there a gift, a gratuitous transfer for less than adequate and full consideration?
- Was the gift completed?
- What is the value of the gift?
- Is there an exclusion (such as the annual exclusion) or a deduction (such as the marital or charitable deduction) that can reduce or eliminate the taxable gift or a credit (such as the lifetime exemption) that can reduce or eliminate the tax on the gift?
To qualify a transfer of a life insurance policy for the gift tax marital deduction, the assignment to the insured’s spouse must be: (a) outright; or (b) consist of the transfer of a life interest coupled with a general power of appointment vested in the spouse; or (c) meet qualified terminable interest property (QTIP) rules.
Typically, a gift of a life insurance policy to charity will qualify for the charitable deduction and therefore no gift tax will be payable regardless of the size of the policy or its value.
However, the gift tax charitable deduction is allowed only if the client assigns his entire interest (or an undivided portion of the donor’s entire interest). Thus, if a client gives a charity the right to the death benefit but keeps the policy cash values or gives the charity the right to policy cash values and retains the right to name the beneficiary of the death benefit, no gift tax (or income tax) deduction would be allowed.
A further tax trap pertains to insurable interest. If the law in the state of the donor’s domicile doesn’t recognize that the charity has an insurable interest in the donor’s life, the IRS may argue that the insured’s estate may have rights in the policy or its proceeds. This in turn could thwart both the income tax deduction and the gift tax deduction since the donor’s gift to charity would be considered a transfer of a partial interest rather than a gift of the donor’s entire interest. A lack of insurable interest may also result in the disallowance of a charitable gift tax deduction for future premium payments made by the client to charity after the transfer of an existing policy or purchase by the charity of a new one.1
Typically, most gift tax problems with respect to life insurance arise where a client makes a gratuitous transfer of a policy. But several other situations can also trigger gift tax problems. The first is the case where a policy on one person’s life is owned by a second person and payable to a third.2 Another scenario that triggers gift tax is where one party pays premiums on behalf of another. Each of these and other gift tax generating types of transactions will be covered in detail in the following section.
Note that while the 2017 Tax Cuts and Jobs Act increased the amount of the unified estate and gift tax exemption to $11 million ($11,400,000 in 2019 after inflation adjustments), it did not otherwise change the mechanics of gift or estate tax calculation with respect to life insurance. Also, the TCJA is currently scheduled to sunset on December 31, 2025 taking with it the elevated exemption amount.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM