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Owning life insurance can make estate planning complicated

A life insurance policy can be an important part of an estate plan. The tax benefits are twofold: The policy can provide a source of wealth for your family income-tax-free, and it can supply funds to pay estate taxes and other expenses. However, if you own your policy, rather than having, for example, an irrevocable life insurance trust (ILIT) own it, you will have to take extra steps to keep the policy’s proceeds out of your taxable estate.

3-year rule explained

If you already own an insurance policy on your own life, you can remove it from your taxable estate by transferring it to a family member or to an ILIT. However, there is a caveat.

If you transfer a life insurance policy and do not survive for at least three years, the tax code requires the proceeds to be pulled back into your estate. Thus, they may be subject to estate taxes.

Fortunately, there is an exception to the three-year rule for life insurance (or other property) you transfer as part of a “bona fide sale for adequate consideration.” For example, let’s say you wanted to transfer your policy to your son. You could do so without triggering the three-year rule as long as your son paid adequate consideration for the policy.

Determining adequate consideration is not an exact science. One definition is fair market value, which is essentially the price on which a willing seller and a willing buyer would agree.

Triggering the transfer-for-value rule

The problem with the bona fide sale exception is that, when life insurance is involved, it may trigger another, equally devastating, rule: the transfer-for-value rule. Under this rule, a transferee who gives valuable consideration for a life insurance policy is subject to ordinary income taxes when the proceeds are received on the amount by which the proceeds exceed the consideration and premiums the transferee paid.

So, in the previous example, even if your son purchased the policy for the appropriate amount to avoid the three-year rule, he could be subject to some income tax when he receives the proceeds.

Selling to a trust

It may be possible to avoid the three-year rule — without running afoul of the transfer-for-value rule — by selling an existing life insurance policy for adequate consideration to an irrevocable grantor trust. A grantor trust is a trust structured so that you, the grantor, are the owner for income tax purposes but not for estate tax purposes.

You are also treated as the owner of any life insurance policy held by the trust. So the transfer-for-value rule will not apply because you are essentially transferring the policy to yourself.

Options available

An insurance policy can be a primary building block of an estate plan. But if you own the policy, consider implementing strategies to remove its proceeds from your estate and minimize the risk that they will be pulled back if you do not live for the three years after the transfer. Discuss your options with your estate planning advisor.

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