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

Understanding IRC Section 2035

IRC Section 2035 is designed to prevent individuals from reducing their taxable estate by gifting away assets, 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.