Estate Tax Effects on Cross-Owned Life Insurance

August 24, 2010

Today, Professor Beyer’s blog links to an article regarding the current status of the federal estate tax.  Unfortunately, many are left in a holding pattern while Congress decides whether or not to reinstate the tax before 2011.  If the tax is reinstated, it is unknown  if a decedent’s first $1 million, $3.5 million, $5 million, or another amount will be exempt.

While many would smirk at even the $1 million exemption thinking that they will never attain this amount of wealth, be aware that if you are not careful, your life insurance policy proceeds could eventually end up in your estate and possibly be taxed.

Spouses or domestic partners who own life insurance on the lives of their partners may be especially affected.  Ordinarily, the main benefit of this strategy is to keep the policy proceeds out of the first estate and thereby defer taxes, if any, until after the second death.

However, under the Internal Revenue Code, proceeds of a life insurance policy are included in the deceased’s estate if they are paid to the estate, the deceased had any “incidents of ownership” (i.e. the ability to make changes to any of the provisions) in the policy or if the deceased had given away the policy within three years of his/her death.

For illustration, let’s say A owns policy #1 on B’s life and B owns policy #2 on A’s life.  If A dies first, B gets the proceeds to policy #2.  These proceeds will not be subject to any taxes or probate because B was always the owner of policy #2, so the proceeds would not be included in A’s estate.  But if A had, say, left everything to B, then B would become the owner of policy #1.  If this was unchanged at B’s death, the policy #1 proceeds would also be taxable, effectively adding two policy payouts to B’s estate.

In other words, if Congress decides on a lower exemption amount, the previously effective cross-ownership strategy could instead create a significant estate tax bill for many survivors’ beneficiaries.

One option to avoid this situation would be to create an Irrevocable Life Insurance Trust (hereinafter “ILIT”).  The ILIT acts as a separate entity that owns your insurance and is also its beneficiary.  If the ILIT is drafted properly, the estates avoid any incidents of ownership in the policy.  However, aside from the greater expense in setting this up, difficulties could arise if, for instance, you do not meet certain requirements in every year the ILIT exists as set forth by the IRS.

Another option is to have your wills drafted or revised to make sure that the policy on the survivor’s life is not included in the survivor’s estate.  For instance, if A’s will leaves ownership of policy #1 to an adult relative instead of B, then at B’s death, the relative would receive the policy proceeds.  However, while a less expensive option, this could also have income and gift tax implications if not set up properly.

Finally, you could simply hope that Congress will create a higher exemption or even eliminate the estate tax.

Be certain to contact a qualified attorney and any additional professionals to help implement the best strategy for you.

 Estate Tax Effects on Cross Owned Life Insurance


Scott R. Zucker, Esq. is the owner of The Zucker Law Firm PLLC, located just outside the Capital Beltway in Annandale, within five miles of the City of Fairfax, the county seat of beautiful Fairfax County, Virginia. The firm focuses mainly on estate planning services for Virginia, Maryland and Pennsylvania clientele, and seeks to do so in an affordable and approachable way. People interested in learning more can contact Scott by phone or email.

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