Navigating the Pitfalls of the Three-Year Rule in Life Insurance Estate Planning

Mar 30
17:15

2024

Julius Giarmarco

Julius Giarmarco

  • Share this article on Facebook
  • Share this article on Twitter
  • Share this article on Linkedin

Life insurance is a critical component of estate planning, offering a way to provide for loved ones after one's passing. However, the intersection of life insurance and estate taxes can be complex, particularly when it comes to the Internal Revenue Code (IRC) Section 2035. This section stipulates that life insurance policies transferred within three years of the policyholder's death are included in the estate for tax purposes. Understanding and circumventing this rule is essential for estate planners and policyholders aiming to maximize the financial benefits for their beneficiaries.

Understanding IRC Section 2035

IRC Section 2035 is designed to prevent individuals from reducing their taxable estate by gifting away assets,Navigating the Pitfalls of the Three-Year Rule in Life Insurance Estate Planning Articles including life insurance policies, shortly before death. If a life insurance policy is transferred to a third party, such as an irrevocable life insurance trust (ILIT), within three years of the insured's death, the proceeds from that policy are considered part of the insured's gross estate and are subject to estate taxes.

The most straightforward strategy to avoid this outcome is to establish the ILIT as the original policy owner and beneficiary from the beginning. This means that even if the insured provides the funds for the ILIT to purchase the policy, they should never directly own the policy themselves within the three-year window preceding their death.

Strategies for New Policies

When setting up a new policy, there are a few options to consider if the ILIT has not yet been established:

  1. Oral Trusts: Some states recognize oral trusts, which can be formalized later. In these jurisdictions, an oral trust could initially own and be the beneficiary of the policy. However, this method carries the risk that the trust may not be considered irrevocable while it remains oral.

  2. Third-Party Purchase: A relative, such as a child or spouse, could purchase the policy and later transfer it to the ILIT. This approach has several drawbacks, including potential gift tax implications and the risk of the policy being included in the purchaser's estate under IRC Section 2036. Additionally, the IRS may disregard this arrangement under the step transaction doctrine if it appears to be a prearranged plan to circumvent tax laws.

  3. Withdraw and Replace Application: Another method involves applying for insurance in the insured's name and then withdrawing that application to submit a new one with the ILIT as the owner. This is only effective if the initial application did not involve any binding consideration.

Handling Existing Policies

For existing life insurance policies, avoiding the three-year rule requires different tactics:

  • Bona Fide Sale: The insured can sell the policy to the ILIT for full and adequate consideration, which is not considered a gratuitous transfer and thus not subject to the three-year rule.

  • Transfer-for-Value Rule: A sale of a policy could trigger the transfer-for-value rule, resulting in taxable income upon the insured's death. However, according to Rev. Rul. 2007-13, a sale to a grantor trust, where the insured is the owner for tax purposes, is exempt from this rule.

  • Promissory Note Purchase: The ILIT can purchase the policy with a promissory note, which avoids the appearance of a prearranged plan to gift funds for the purchase. The ILIT would then make interest payments on the note, funded by annual gifts from the insured.

When employing these strategies, it's crucial to accurately value the policy. For an insured in good health, the value is typically the interpolated terminal reserve plus any unearned premiums. For those in poor health, the life settlement market may provide a more accurate valuation.

Key Takeaways

  • The three-year rule in IRC Section 2035 can significantly impact the taxation of life insurance proceeds.
  • Establishing an ILIT as the original policy owner is the safest way to avoid estate inclusion.
  • For new policies, consider oral trusts, third-party purchases, or application replacement strategies.
  • For existing policies, bona fide sales to an ILIT, particularly through a promissory note, can circumvent the three-year rule.
  • Accurate policy valuation is essential, especially when the insured's health is a factor.

It's important to note that this article is for informational purposes and should not be used as a sole source for tax planning or penalty protection. Consulting with a tax professional or estate planning attorney is recommended for personalized advice and strategies.

IRS Rev. Rul. 2007-13 provides further guidance on the sale of life insurance policies to grantor trusts. For more information on estate taxes and life insurance, the IRS website offers a wealth of resources.

Also From This Author

Navigating Estate Planning: Understanding Portability and Disclaimer Trusts

Navigating Estate Planning: Understanding Portability and Disclaimer Trusts

In the realm of estate planning, the Tax Relief Act of 2010 introduced significant changes, including a $5 million exemption from federal estate and gift taxes per individual, adjusted for inflation since 2012, and a top tax rate of 35%. A key feature of this act is the concept of "portability," which allows the unused estate tax exemption of a deceased spouse to be transferred to the surviving spouse. This article delves into the intricacies of portability and disclaimer trusts, providing a comprehensive guide for couples seeking to optimize their estate planning strategies.
Strategic Use of Trusts for Heir Protection

Strategic Use of Trusts for Heir Protection

Trusts are a powerful tool in estate planning, offering a unique combination of control, tax benefits, and protection against creditors and divorce for beneficiaries. Unlike outright ownership, trusts can provide heirs with a safeguarded inheritance that addresses potential vulnerabilities and ensures long-term financial stability.
Harnessing Life Insurance for Strategic Business Succession

Harnessing Life Insurance for Strategic Business Succession

Life insurance isn't just a safety net for families; it's a strategic tool in business succession planning. It offers a range of benefits, from providing estate liquidity to ensuring fair inheritance distribution among heirs. This article delves into the multifaceted role of life insurance in securing the future of family businesses, highlighting its advantages and applications in various succession strategies.