Incidents of Ownership
Why are “Incidents of Ownership” Important?
This is a question that frequently arises in estate planning, particularly regarding life insurance. The reason this question is important is this:
If the insured (the person on whose life the insurance policy is based) has “incidents of ownership” in the policy, then the death benefit is included in the taxable estate of the insured.
Intuitively, this does not seem fair or right. The insured has to die for the benefit to be realized, but the benefit is going to be taxed as if the insured owned it. That’s right. That’s an estate tax “gotcha”. This is not an issue so long as the total value of the insured’s estate, including life insurance death benefits, are below the estate tax threshold. When the non-insurance assets are below the estate tax threshold, it seems like there will be no estate tax. However, life insurance owned by the insured can push the value over the estate tax threshold, resulting in an estate tax.
In such a scenario, the insured is paying premiums on life insurance for the benefit of the IRS.
How Can We Tell If We Have Incidents of Ownership
The insured (or anyone else) has an incident of ownership in a life insurance policy, if they have the right to:
- Change the beneficiary of the policy
- Transfer the ownership of the policy
- Borrow from the policy
- Use the policy as collateral for a loan
- Modify the policy
- Terminate the policy
When someone has an incident of ownership in life insurance, the proceeds from the policy can be counted as part of the estate. Some people transfer ownership of their life insurance policies to an Irrevocable Life Insurance Trust to avoid estate taxes.
How Do We Avoid Incidents of Ownership
It seems simple, but to have no incidents of ownership in a life insurance policy, the insured can’t own the policy. Then who should own it?
A Trust specifically designed to hold life insurance like an Irrevocable Dynasty Trust. You can learn more about such Trusts here.
If you own a life insurance policy on yourself, you may be paying premiums for the benefit of the IRS. If your children own the life insurance, you are making it vulnerable to their life issues including divorce, car accidents, premature disability or death, financial crisis, litigation, substance abuse, and so forth. If you have your business entity own the life insurance, you may be triggering other unwanted tax consequences.
Own life insurance right, or don’t have it at all.
This is why people who buy life insurance, and the insurance advisors who sell it to them, should consult with a knowledgeable attorney before making the purchase. Including an estate planning attorney in the life insurance acquisition process is what separates life insurance sales people from life insurance professionals.
Durfee Law Group can help.