For the individual who will not live more than three years, a transfer of an existing policy to an irrevocable trust or a third person will be ineffective to avoid inclusion of the policy in the gross estate at death. For example, an individual who owns a $500,000 life insurance policy on his life and whose estate is in the 60 percent estate tax bracket will only pass on $300,000 to the beneficiaries of the policy (.40 × $500,000 = $200,000; $500,000 − $200,000 = $300,000).
A sale of the policy avoids the three-year rule because the viatication is a sale for fair market value in money or money’s worth. This could provide additional value to the insured’s family and reduce estate taxes because the conversion into cash converts the intangible asset into cash that can be given to family members in the form of tax-free annual exclusion gifts, spent down by the individual, or a combination of the two.
For example, the same individual who owns a $500,000 policy on his life will leave his beneficiaries only $225,000 if he dies owning the policy. Instead, the individual sells the policy and receives $350,000 (70 percent of the face amount). The individual can make annual exclusion gifts of the $350,000 to his four children, their spouses, and ten grandchildren over his remaining assumed life expectancy of two years. Under the viatical settlement, the individual has transferred $350,000 to his family tax-free, providing them an additional $125,000 ($350,000 − $225,000). (In addition, the estate can pass the after-estate tax value of the premiums not spent in maintaining the policy as well as the after-income-and-estate tax on the earnings on the declining balance of the $350,000 viatical proceeds over his remaining life.)
Getting a life insurance policy out of the insured’s estate can sometimes save the estate administration costs of having to file an estate tax return.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM