Frequently Asked Questions about
Estate Planning, Wills, Trusts, and Probate

• Can I avoid estate tax on life insurance proceeds?

In addition to favorable estate-tax treatment for property left in an exemption trust, the Internal Revenue Code also provides favorable estate-tax treatment for life insurance in certain limited circumstances. This favorable treatment often can be a boon to people with taxable estates.

The reason is that only property of the deceased person is subject to tax. If the deceased person did not own the policy or retain any rights that the tax code deems equivalent to ownership, then it would be unfair to charge an estate tax. And Congress has drawn a line: life insurance proceeds are included in a deceased person’s estate if that person had “incidents of ownership” over the policy during the last three years of his life. Otherwise, they’re not taxed. (Why three years? To discourage last-minute purchases or gifts of insurance policies just to avoid estate or gift taxes.)

One solution is simple – have someone else buy your life insurance policy and pay the premiums. Thus, Mrs. Lee could buy a life insurance policy on Mr. Lee’s life, and Mr. Lee could buy a policy on Mrs. Lee’s life, and each would pay the premiums out of their own separate checking accounts (very important!).

If, however, the beneficiaries are going to be the insureds’ children, a problem arises. It is unlikely that the children will independently go out and buy life insurance policies on their parents, and often they lack adequate funds to pay for such policies. In that case, an irrevocable life insurance trust (“ILIT”) may be used. The settlor or settlors of such a trust names a friend, relative, or attorney as trustee, and gives the trustee enough money to buy the policies and pay the first year’s insurance premiums. Then, each year, the settlor makes gifts to the ILIT adequate to fund that year’s insurance premiums.

These approaches should be used with care – estate planning to avoid taxes on life insurance is made more complex by the IRS rules used to decide whether a deceased person had “incidents of ownership” over a policy. To obtain maximum estate tax-avoiding benefits from life insurance, it is advisable to have your Virginia attorney and your life insurance agent work together. The important point to remember is that ILITs are not back-handed schemes to get you to buy life insurance – they have real benefits. They are a little bit complicated, but not bewilderingly complicated. And the alternative is to pay estate taxes out of your estate's or trust's assets, which can be far more expensive.

“Two men working as a team will produce more than three men working as individuals.”  –Charles P. McCormick