An outright gift of a life insurance policy is a time-tested technique for accomplishing a number of estate planning objectives including, but not limited to, saving federal and state death taxes and protecting proceeds from the claims of the original policyowner’s creditors. The primary advantage of an outright gift of a life insurance policy is incredible leverage; the gift tax value of the lifetime transfer is considerably less than the death proceeds removed from the client’s estate. If the future value of the gift tax (if any) actually payable currently is exceeded by the future value of the estate tax saved, the gift is advantageous.
Example. Assume a client is in a 40 percent federal estate tax bracket. Assume further that the client owns a $1,000,000 life insurance policy on his own life with a gift tax value of $200,000. If the client does nothing, $400,000 (40 percent of $1,000,000) will be lost in federal estate taxes. But if the client makes a gift of the policy and survives the gift by more than three years, none of the proceeds will be in the client’s estate.
Of course, if the lifetime value of the policy is large enough, there will be (assuming the transfer does not qualify for the gift tax annual exclusion or the client has used up the allowable gift tax exemption) federal gift tax payable currently on the transfer. In the example above, the gift tax is 50 percent of the $200,000 value of the policy at the time it was transferred. Assuming a long-term growth rate of 8 percent or less over a twenty-year life expectancy, the tradeoff of paying a small tax today to save a much larger tax in the future makes sense. If any current gift tax is payable, the future value of this gift tax must be calculated and compared against the potential estate tax savings to measure the true advantage of a gift of the policy.
When is a gift of a life insurance policy a completed gift? In other words, at what point does the taxable gift occur? The IRS has held that the relinquishment of every right that would normally cause a life insurance policy to be included in the insured or in the policyowner’s estate would mark the completion of a gift of the contract. So as long as the insured held any incident of ownership that would cause the policy proceeds to be included in his estate or as long as a client owned a policy on the life of another, no gift is yet made. A completed gift occurs at the moment every interest the insured and/or policyowner held is surrendered or otherwise assigned. So the insured must give up the right to the policy’s cash value, to borrow on the contract, pledge it as collateral, name, change or veto a change of beneficiary, and every other right of any significant value. Until then, no completed gift occurs.
What is the effect of a reversionary interest on whether or not a completed gift of a policy has been made? Will the possibility of a reversion back to the donor of a life insurance policy render the gift incomplete? For example, the insured makes an absolute assignment of life insurance on his life to his wife. Assume the wife then names the insured’s estate as a beneficiary in the event the insured dies before the new policyowner (the wife) dies. There is a possibility that the proceeds would revert back to the insured. But that possibility is not enough to prevent the gift from being considered complete and therefore taxable. However, a possibility of reverter may allow a reduction in the value of the taxable gift assuming recognized actuarial standards can be applied to measure the value of the reversion.
When a gift of a life insurance policy is made or an individual is named as beneficiary, the new owner’s (or beneficiary’s) right to receive the policy’s proceeds is conditioned on surviving the insured. This does not, however, affect the completeness of the gift. It merely affects the valuation.
Of course, if the trust to which a life insurance policy is transferred is revocable, so is the gift and therefore no completed gift has been made.
But what if the policy is given to an irrevocable trust? Is there a gift (and, if so, will it qualify for and be sheltered by the annual exclusion)? Both the transfer of a policy to such a trust and the payment of premiums subsequent to the transfer will be considered completed gifts subject to the gift tax. Absent special provisions, no annual exclusion would be allowable in either case because the typical irrevocable trust, by design, limits the time or manner in which the beneficiaries of the trust enjoy the property (including any life insurance policy transferred to the trust).
Assume, for example, a father transferred life insurance on his own life to a trust he created for his daughter’s benefit. The trust provides that upon the father’s death, policy proceeds are to be invested and the income paid to the daughter for the rest of her life. The daughter does not have the immediate, unfettered, and ascertainable right to use, possess, and enjoy that income or any other right inherent in the life insurance policy until after the death of her father. Since the donee daughter’s interest does not take effect until sometime in the future (i.e., at her father’s death), the donor father will not be allowed an annual exclusion for either his gift of the policy or for future premiums he pays to keep it in force.
Do the results differ if the policy in question is group-term insurance? Will a gift of a group term policy be considered a gift of a present interest? The answer depends again upon the terms and conditions of the irrevocable trust rather than upon the type of insurance involved. The gift of a life insurance policy will not be considered a future interest or will fail to qualify for the annual exclusion merely because it is a term insurance policy.
A gift tax annual exclusion would be allowed, for example, if the rights to a $50,000 group term contract together with cash were contributed to the trust. The annual exclusion could be obtained through a trust provision that allows the beneficiary the noncumulative right to withdraw a specified amount each year and provides that any asset in the trust, including life insurance coverage, could be used to satisfy that demand right. Furthermore, since the coverage itself should qualify for the annual exclusion as a present interest, so should subsequent premium payments on the group coverage.
Assume that the terms of a trust provide that immediately upon the death of the insured covered under a group term contract, the trust’s only beneficiary is to receive the entire policy proceeds as soon as they are received by the trust. As soon as the proceeds are transferred and the deemed gift occurs, the beneficiary has the immediate, unfettered, and ascertainable right to use, possess, and enjoy the money. So an annual exclusion should be allowed for the value of the coverage at the moment of transfer. Gifts deemed to be made by the employee insured each time the employer made an actual premium payment on the group term should be considered gifts of a present interest and qualify for the annual exclusion.
Would the result have been the same had the terms of the trust required the trustee to hold and invest policy proceeds and pay only the income to the trust’s beneficiary? The answer is that such a gift (each actual payment by the employer and deemed payment by the insured employee) would be considered a gift of a future interest and would therefore not qualify for the annual exclusion.
Particular care must be used when a life insurance policy is contributed to a Section 2503(c) trust, an irrevocable trust for a minor beneficiary. Gifts of a life insurance policy to a Section 2503(c) trust for a minor will typically qualify for the annual exclusion if:
- policy values can be used for the minor’s benefit; and
- the policy will pass to the minor at age twenty-one (or, if the minor dies prior to that date, the policy will pass to the beneficiary named in his will or to the person(s) appointed by the minor during lifetime or by will). Premiums paid on the policy by the trust’s grantor should also qualify for the annual exclusion.
Planners should also note the following points about life insurance and the gift tax:
- Gifts to minors can qualify for the annual exclusion even if the child has no legal right to exercise ownership privileges under the policy and even if no guardian has been appointed.
- Generally, gifts of life insurance to minors in states that have adopted the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act UTMA (UTMA) will qualify for the gift tax annual exclusion. (There may be some question of qualification, however, if the state statute departs from one of these two Uniform Acts and allows custodianship to extend beyond the donee’s twenty-first birthday.)
- Clients making gifts of large policies should consider splitting the contract into two or more smaller policies (assuming the life insurance carrier so permits) and transferring one policy in one year and the other(s) in other years so that all gifts fall within annual exclusion limits. (This technique may slightly increase the total premium cost and administrative burden.) Alternatively, a loan could be taken against the policy to reduce the gift tax value (but not in excess of the policy basis, as the “transferee’s basis is determined by reference to the transferor’s basis” exception to the transfer for value rule would not apply to this part gift/part sale). The loan could then be repaid gradually over the next few years using the gift tax annual exclusion.
- An outright gift of a life insurance policy from one spouse to another will qualify for the gift tax marital deduction and eliminate any gift tax on intraspousal transfers.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM