Insurance Payable Directly to Estate
Regardless of who purchased the policy, owned the incidents of ownership, or paid premiums, if the proceeds are payable directly to the insured’s estate (executor or administrator), they are includable for federal estate tax purposes. The entire value of the proceeds must be included.
Insurance Payable Indirectly to Estate
Regardless of who purchased the policy, owned incidents of ownership, or paid premiums, if the proceeds are for whatever reason payable for the benefit of the estate, they are includable for federal estate tax purposes.
Insurance proceeds would be considered payable for the benefit of the estate if used to pay:
- federal estate tax;
- state death taxes;
- income or gift or any other taxes; or
- debts or other charges against the estate.
Inclusion of insurance proceeds payable for the benefit of the estate but not payable directly to the estate (executor or administrator) is conditioned on the following two tests.
First, the beneficiary to whom the proceeds are payable must be legally obligated to use the insurance money for one or more of the purposes described in the list of examples above. If there is no legal obligation for the beneficiary to use the money to meet the type of estate obligation described above, there should be no inclusion. So, for example, the mere power or authority to use insurance proceeds to satisfy debts of the insured will not cause inclusion since such a right does not amount to a legal obligation.
This makes the wording in a classic irrevocable life insurance trust crucial; if the trustee is given discretion to use or not use proceeds to purchase assets from the decedent’s estate, the proceeds should not be includable. A loan from the trust to the estate, or even the purchase of assets by the trust from the estate, will not cause inclusion. But if the trustee is directed to pay the insured’s estate taxes, debts, or administrative costs to the extent directed by the estate’s executor, the proceeds required to pay those expenses will be includable to the extent so used.
Second, there must also be actual use of the insurance money to pay taxes or other claims against the estate. To the extent the trustee has the legal right to use the proceeds to pay taxes or other expenses but life insurance policy proceeds are not in fact used to pay off such claims, they will not be includable.
Insurance Payable to Beneficiary Barred from Collecting
What if the named beneficiary is barred by state law from collecting the policy proceeds? For example, what if the beneficiary murdered the insured in a state which provides that where a beneficiary takes the life of the insured and is convicted of a felony in the offense, the killer forfeits his beneficial interest in the insurance and the forfeited interest passes by law to the insured’s other heirs at law unless otherwise disposed of by the insured.
Where state law diverts the proceeds to heirs of the insured’s estate, the proceeds are treated for federal tax law purposes as if they had passed into the insured’s estate first and were then paid out to the insured’s heirs (even if the named beneficiary is convicted of voluntary manslaughter of the insured rather than murder). Thus, if a husband first insured and then murdered his wife and later killed himself, the murdered wife would be deemed to have the equitable right to dictate disposition of the proceeds even though she never owned the policy. The proceeds would probably be distributed according to the terms of the wife’s will (as though her murderer had died first) and, for tax purposes, the IRS would tax the money in her estate as if it were paid to her estate’s administrators.
Insurance Payable to Executor or Testamentary Trustee Payable to Others under Governing Instrument
The implications of state law must be examined: There are a number of cases which hold that insurance should be considered payable to the ultimate beneficiary rather than to the estate even though the instrument itself appears to make the proceeds payable to the estate or its executor. This is particularly true where state law allows insurance on a parent’s life to pass free from the claims against the estate even if payable to the insured’s estate. In such cases, federal law honors state law and treats the insurance as if it had been paid directly to the ultimate beneficiary.
Even more common is the case where insurance is payable to the trustee under a trust established in a will. Insurance payable to a testamentary trustee for the benefit of a named beneficiary other than the insured’s estate will be treated as if received by the named beneficiaries rather than by the estate and will therefore be estate tax free (unless the insured held an incident of ownership in the policy).
But does the term “executor” mean anyone who happens to be an executor of the estate or does it mean only the person receiving the proceeds specifically as the estate’s representative? If the proceeds are received in the new owner’s individual capacity as beneficiary and not as the representative of the estate, proceeds are not deemed payable to or for the benefit of the estate. The test is whether or not the recipient is bound to the legal duty of then distributing the money according to the terms of the insured’s will or state intestacy laws. If the recipient is so bound, then inclusion is mandated.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM