The Apportionment Rules: Who Pays the Estate Tax on Life Insurance Proceeds?

This is an extremely important issue that is often overlooked or that falls between the cracks of an otherwise good estate plan. As a general rule, to collect the federal estate tax, the IRS can follow life insurance proceeds as far as it can trace them. Any person who receives includable property is personally liable to the IRS for a deficiency in the estate tax. Each life insurance beneficiary is liable for that deficit, up to the full amount of the proceeds payable to him that were included in the insured’s gross estate, regardless of a direction in the will exonerating the beneficiary from payment of the tax or a direction that the tax be paid from the probate estate. The IRS can follow any person who received life insurance proceeds and collect its tax from other property even if the proceeds themselves have been spent. If the proceeds have been spent, the government’s lien extends to any property bought by or for the beneficiary with the proceeds.

Ordinarily, this tracking is not necessary because the executor, who is primarily liable, usually pays estate taxes out of probate funds. But what happens when significant nonprobate assets such as life insurance generate a tax but the proceeds are not payable to the executor to pay that tax?

Executor’s Right to Recover

The Internal Revenue Code specifically authorizes an executor to recover from named beneficiaries of life insurance proceeds on the decedent’s life a proportionate share of the taxes. The executor cannot claim reimbursement or contribution until after the executor pays the tax. Each beneficiary must (absent direction otherwise under the decedent’s will or local law) reimburse the executor for his proportionate share of the federal estate tax. The IRS technically can’t go against an insurance company for the tax regardless of how the proceeds are payable. But the executor may be able to reach the insurance proceeds held by the insurer to the extent the executor is entitled to contribution from the insurance beneficiary.

In the apportionment formula, total tax paid is multiplied by:

Example. Assume a client died and a $5,000,000 policy on his life was paid in equal shares to his two children. Assume further that the insurance was equal to about one half the client’s taxable estate (total taxable estate was $16,000,000) and that the total estate tax was $1,750,000. The insurance in this simplified example would have generated half of the $1,750,000 estate tax (assuming a $11 million estate tax exemption), $875,000. Each child received half of the $5,000,000 proceeds, so each would be liable for about $437,500, one-fourth of the estate tax.

Marital Share Exception

If life insurance proceeds were paid to the insured’s surviving spouse in a manner qualifying for the estate tax marital deduction, the rule is different. There, the executor can require reimbursement by the beneficiaries only for the tax attributable to the excess of proceeds over the aggregate amount of marital deductions. So, if the entire amount of proceeds payable to the surviving spouse qualified for the marital deduction, the spouse would have no duty to contribute toward the payment of the federal estate tax.

If only a portion of the proceeds paid to the surviving spouse qualified for the marital deduction, then the surviving spouse would be liable to reimburse the executor for the proportionate share of tax on the balance. For instance, if $200,000 of life insurance was payable to a spouse but only $120,000 qualified for the marital deduction, the executor would be entitled to reimbursement on the $80,000 taxable difference. If the total taxable estate were $250,000, then $80,000/$250,000 would be multiplied by the total tax payable to ascertain the spouse’s required contribution.

Apportionment Provisions by Client

Clients can engineer a different result through a combination of state law and careful will planning. For instance, if the will directs how the tax burden is to be apportioned, those directions will generally be followed by both state and federal authorities (to the extent tax collection is not jeopardized). For example, if the client’s will provides that “my son and daughter shall pay all death taxes,” they would end up paying even the estate tax on life insurance payable to other beneficiaries. This can obviously lead to unintended results and emphasizes the importance of co-ordination between the attorney drafting the client’s will and the client’s life insurance agent.

Use of Disclaimers

A disclaimer is an unqualified refusal to accept property (such as assets left under a will or trust or life insurance proceeds). Can a disclaimer avoid a potential tax disaster? For example, assume a client’s will provides that all estate taxes will be paid out of the residue (what’s left after specific gifts) of the probate estate. The client’s spouse was the beneficiary of the residue (which would qualify for an estate tax marital deduction.) The client’s son was the beneficiary of a $10,000,000 policy on the client’s life, and the client’s mother received another $10,000,000 from the client’s estate, which would obviously would generate a very sizable federal estate tax). The client died. The son received $10,000,000 of insurance proceeds and the mother received a notice from the estate’s executor that the tax on that money had to come out of her share of the estate (thus dramatically increasing the federal estate tax). To increase the size of the marital deduction and therefore decrease the amount of the estate tax, the client’s son disclaims his right to have his mother pay the federal estate tax on the insurance he received.

Will the son be successful? The answer is “Yes,” if the right steps are taken at the right time. A bequest is a direction to the executor to pay someone a part of the probate estate’s assets. A common form of bequest is the forgiveness of a debt owed the testator. If, under state law, the decedent’s allocation of estate taxes to the wife in the example above is from the son’s perspective a valuable property interest tantamount to forgiving a debt, it may be disclaimed.

No Exception for Charity

Suppose a client named a charity as beneficiary of a large life insurance policy. Assuming the charity was qualified, the payment of the insurance, no matter how large, would not generate any federal estate tax. Yet, absent specific provision in a state law apportionment statute or in the decedent’s will, the charity may have to bear (to the extent of the insurance it received) a portion or all of the federal estate tax on assets paid to other beneficiaries.

This doesn’t seem to mesh with the rules exonerating a surviving spouse from a reimbursement obligation; to the extent life insurance payable to a surviving spouse qualifies for a marital deduction, it is exempted from the reimbursement obligation under federal law. Yet federal law provides no comparable protection for proceeds payable to charities.

If the charity’s share of life insurance proceeds is reduced by the reimbursement requirement then the decedent’s charitable deduction will be decreased. This in turn increases the decedent’s estate tax burden, which increases the charity’s burden, which… results in complex calculations.

Planning in Advance

Estate tax apportionment of life insurance should be arranged deliberately and carefully while the client is alive and his wishes can be known. The place to do this planning is in the client’s will or revocable trust so that estate taxes and other expenses are shouldered by the parties the client wishes to carry them. It is important to be sure that in the attempt to lower the tax burden to its minimum legal level, the planning team does not lose sight as to what is necessary to uncover and effectuate the intended dispositive plan of the client.

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

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