Life Insurance Owned on the Life of Another: Section 2033 Explained

There are many situations in which one party purchases life insurance on the life of one or more other individuals. For instance, a business partner may purchase insurance on the lives of each of her three partners. Assume she dies before the three insureds do. The policies she owned on their lives would be includable in her estate (to the extent of the value of the policy as of the date of the insured’s death) as property in which the decedent had an interest. Likewise, a son may purchase insurance on the life of a parent. If the son predeceases the parent, the value of the unmatured policy will be in the son’s estate.

Estate Tax Value

The estate tax value of third party owned, unmatured policies includable in the estate of someone other than the insured is generally the replacement cost of the policy. Replacement cost is ascertained using the same rules governing valuation of policies for gift tax purposes (the date of death is substituted for the date of the gift in valuing the policy). In most cases, this approximates the sum of: (a) the cash surrender value of the policy (technically, the interpolated terminal reserve of the policy is the amount includable and in early policy years this can significantly exceed the cash surrender value); plus (b) the unearned premium (any premium the insured paid but that was not earned by the insurer as of the date of the policyowner’s death). For more information, please refer to Chapter 26: Life Insurance Valuation.

Common Disaster

Although the IRS has tried to include the entire proceeds in the insured’s estate when the insured and the policy owner were killed in a common disaster, after a number of Circuit Court reversals, the IRS gave up. It now holds, in cases in which the presumption of the Uniform Simultaneous Death Act applies (i.e., that the insured survived the beneficiary), that the policy’s interpolated terminal reserve is the appropriate measure of inclusion rather than the death benefit. If, however, the presumed order of deaths is reversed (i.e., the presumption is that the beneficiary survived the insured), simultaneous deaths of the insured and the policyowner will cause the death proceeds to be includable in the policyowner’s estate.

Excludable Growth

No inclusion is required for the increase in the value of a policy from the date of the policyowner’s death to the valuation date resulting from the estate paying premiums or earning interest on a policy insuring a third party. So, if at the date of death a client owned a $1,000,000 policy insuring the life of a business associate and the interpolated terminal reserve (reflecting income earned by the policy reserve invested with the insurer during the period from the date of death) increased $2,000 from the owner’s death to the valuation date, that increment would be excluded from the policyowner’s gross estate.

Alternate Valuation Date Trap

Planners should beware of this situation: A decedent owns a life insurance policy insuring the life of a third party (such as a spouse or business associate). Within six months of the deceased policyowner’s death, the insured dies. If the policyowner-decedent’s executor uses the alternate valuation date to value assets in the estate, the increase in value caused by the insured’s death, and not merely the interpolated terminal reserve plus any unearned premium, will be includable.

This alternate valuation date trap is especially dangerous with respect to last to die (also called second to die) life insurance in which a policy pays proceeds only when the second insured dies. When the first insured dies, the policy must be included as an asset in the estate of the decedent, at its replacement value (essentially interpolated terminal reserve plus unearned premium). But if the decedent’s executor elects the alternate date and the second insured has died between the first spouse’s death and the alternate valuation date six months later, the entire proceeds will be includable in the first spouse’s estate. The executor of the later dying spouse must include the entire amount of the proceeds again in that spouse’s estate because of the incidents of ownership rules described below.

Beneficiary Who Predeceases Insured

Typically, a primary beneficiary’s rights to policy proceeds expire with his death. So, if the named beneficiary dies before the insured and no rights pass to the beneficiary’s heirs, nothing will be in the beneficiary’s estate. This assumes the beneficiary had no other rights in the policy and all rights in the proceeds terminated (as they usually do) upon predeceasing the insured. Note that state law determines the existence and extent of such ownership rights or interest in proceeds.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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