Estate Tax Considerations of Second-to-Die Policies

Estate Tax Considerations of Second-to-Die Policies
American Bar Association

In recent years, lawyers have seen an increased marketing and sale of second-to-die, or "survivor-ship," life insurance policies, which typically insure the joint lives of a husband and wife and are payable on the death of the surviving spouse. This type of coverage is often recommended in the situation where the life insurance proceeds are intended to provide liquidity to pay estate taxes at the death of the surviving spouse. The survivorship life insurance policy is also attractive because it generally can be obtained at less cost than a single insured life policy on either spouse.

Despite the popularity of these policies, unresolved questions remain as to the application of Sections 2042 and 2035 to survivorship policies. Section 2042 provides that the decedent's gross estate shall include "amounts receivable" by the decedent's executor or beneficiaries" under policies on the life of the decedent with respect to which the decedent possessed at this death any incidents of ownership." If both insurers have incidents of ownership in the survivorship policy, might Section 2042 apply at both deaths? Clearly, on the death of the second of the joint insurers (assuming he or she possessed incidents of owner-ship), the policy proceeds would be included in his or her estate.

Although Treas. Reg. Section 20.2042-1 consistently uses the term "proceeds," inclusion in the decedent's estate is not obviously premised on payment of the "amount receivable" as a direct result of the decedent's death. A strict and literal reading of the statute could, therefore, include policy proceeds in the estate of the first to die of the insurers, even though no proceeds can be paid until the second insured's death. This incredible and incongruous result is not precluded under existing law, although it would create significant estate-tax reporting problems (since the amount of inclusion could not be determined until the second death) and would fly in the face of policy considerations in favor of facilitating the final resolution of tax obligations. Nor would the effect of double taxation be ameliorated by the application of the credit for tax on prior transfers (Section 2013) in the surviving insured's estate, since there would be no transfer of the "amount receivable" from the first deceased insured to the surviving insured. (The credit is only allowed if federal estate tax was previously paid with respect to the transfer of property to the decedent.) One can only hope that the Treasury will maintain a position that the "amount receivable" means the amount receivable as the direct result of the death of the decedent. A thoughtful revision of Section 2042 which fully takes into account the modern life insurance market-place is the best solution.

The more logical approach would be to include the interest of the first deceased insured in his or her estate as if the decedent had died owning a life insurance policy on another's life. If, under the contract, the decedent insured's interest in the policy automatically passed to the surviving insured as joint owner, then Section 2040 (joint interests) should be applied. If the decedent insured's interest in the policy automatically passed by inheritance to the surviving insured or any other individual, Section 2033 (property in which the decedent had an interest) should be applied. Section 2042 could then apply only at the second insured's death and only if the second insured had incidents of ownership.

Even with this approach, a problem exists concerning the valuation of the decedent's interest. Insurance companies have written survivorship policies in one of two ways. Most newer policies insure on the basis of the joint life expectancy of the insurers. Older policies were written to insure both lives separately under a single contract. With the older-type policy, when the first insured dies, the "proceeds" of the coverage on that insured are added to increase the continuing coverage for the surviving insured.

Treas. Reg. Section 20.2031-8(a) provides that if the decedent owns a life insurance policy on another's life, the value of that policy for federal estate-tax purposes is the interpolated terminal reserve value of the policy plus the prepaid premium. This regulation (although presently specifically inapplicable to insurance on the decedent's life) logically could be applied to value a "joint life" survivorship policy in the first deceased insured's estate. The regulation is not conceptually applicable, however, to the valuation of those contracts which insure both lives separately. With the "separate lives" coverage, the appropriate value to be included in the estate of the first deceased insured may be the value of the "proceeds" added to the continuing coverage on the surviving insured. Thus, the value of essentially similar (from the insured's perspective) coverage at the first insured's death might be markedly different depending on the manner in which the policy was written. For consistency, it may then be best if the "separate lives" coverage could be valued at the first death as if it had been written as a "joint life" policy. These valuation problems will certainly arise and will have to be addressed.

Consider the situation where only one of the insurers possesses incidents of ownership. Section 2042 would then apply only to augment the gross estate of that owner/insured (since "incidents of ownership" are a prerequisite to the applicability of Section 2042). If the owner/insured is the second to die, Section 2042 would obviously apply to include the proceeds in the owner/insured's estate. Suppose instead that the owner/insured dies first. Again, problems exist concerning the meaning of the "amount receivable" language of Section 2042, and again it is suggested that the decedent's interest is more appropriately measured and included in the decedent's gross estate under Section 2033 rather than Section 2042.

Given the less-than-clear application of Section 2042 to these policies, to what extent might the proceeds be includable in an insured's estate under Section 2035? Section 2035 provides that property which is transferred by the decedent within three years of the decedent's death, and which (absent the transfer) would have been included in the decedent's estate under Section 2042, will be included in the decedent's gross estate. When might Section 2035 apply when the owner/insured has relinquished incidents of ownership in a survivorship policy? Consider the following alternative situations which demonstrate the practical absurdity of any expansive definition of Section 2042's "amount receivable" language when considering the applicability of Section 2035:

Situation 1: Harry and Grace purchased a survivorship policy on their joint lives. In 1990 they both assign ownership (including all "incidents of ownership") to their son Charles. After the assignment:

Fact Pattern A: Harry dies in 1992 and Grace dies in 2001.

Fact Pattern B: Grace dies in 1991 and Harry dies in 1992.

Situation 2: Harry purchased a survivorship policy on the lives of himself and Grace. Grace never has any incidents of ownership in this policy. In 1990 Harry assigns ownership (including all incidents of ownership) to their son Charles. After the assignment:

Fact Pattern A: Harry dies in 1992 and Grace dies in 2001.

Fact Pattern B: Grace dies in 1992 and Harry dies in 2001.

Fact Pattern C: Harry dies in 1991 and Grace dies in 1992.

Fact Pattern D: Grace dies in 1991 and Harry dies in 1992.

An expansive reading of Section 2042 would cause Section 2035 to apply in Situation 1.A and would result in inclusion of the insurance (however and whether it could be valued) in Harry's estate; Situation 1.B would result in inclusion in both Harry's and Grace's estates. Under this approach, in both Situations 1.A and 1.B there would have been a transfer of an interest in property within three years of death that would otherwise have been includable in the particular decedent's estate under Section 2042. A similar rationale would cause includability under Section 2035 in Situations 2.A. 2.C and 2.D

Under the better approach, where Section 2042 could not apply until the second insured's death, Section 2035 would only cause includability in Situations 1.B and 2.D (and only in Harry's estate), since those are the only situations where proceeds are receivable as a direct result of a transferor's death within the three-year Section 2035 period. This approach still leads to the anomalous result of non-inclusion in Situation 2.C, even though there has been a transfer of incidents of ownership by Harry less than three years before the maturing of the policy. Again, some legislative revision is indicated.

Under present law, from an estate-planning perspective, it is preferable to have the survivorship policy owned by one rather than by both insureds, since the potential for inclusion will only exist for the owner/insured's estate (assuming the other insured never has any incidents of ownership). Under ideal circumstances, the owner/insured will die first, so that the amount of inclusion (assuming Section 2033 rather than Section 2042 is applicable should be less. Life expectancies should, therefore, be considered in deciding which insured should own the policy.

The best estate planning that can be undertaken with these policies, which should avoid all the Section 2035 and Section 2042 problems discussed above, would be to have the survivorship policy applied for, acquired and always owned by someone or some entity other than the insureds. If the insureds never had incidents of ownership in the policy, there is no risk of having the policy or its proceeds included in an insured's estate. An irrevocable insurance trust will usually be the recommended vehicle (rather than having a child or other person own the policy), since it affords greater flexibility and is most apt to effect the grantor/insureds' intent concerning the disposition of the policy proceeds. Taxpayers have successfully argued that the insured/grantor has no incidents of ownership in an insurance policy applied for by a related third party. Estate of Leder, 90-1 U.S.T.C. Section 60,001 (10th Cir. 1989); Estate of Litman, 90-1 U.S.T.C. Section 60,023 (W.D. Pa. 1990); Estate of Ard, T.C. Memo 1990-294 (1990). This rationale has been extended to irrevocable trusts created by the insured. Estate of Headrick, 90-2 U.S.T.C. Section 60,049 (6th Cir. 1990), Estate of Richins, T.C. Memo 1991-23 (1991).

The unsettled state of estate-tax law with respect to these policies is an especially compelling reason to have these policies applied for and acquired by irrevocable trusts. This technique can also effectively transfer significant amounts of insurance proceeds to the next generation without estate-tax consequences. See Hakala, Survivorship Life Insurance: Providing the Liquidity to Preserve Family Wealth, J. Tax'n. Tr. & Est., 47 (Winter 1990). It is recommended that neither of the insureds be a trustee or beneficiary of this trust; a whole separate set of questions arise concerning the estate-tax consequences of granting such powers and rights to an insured, even if the insured did not previously have incidents of ownership in the policy.

Finally, the Treasury Department and/or Congress should consider the extent to which interests in survivorship policies should be subject to estate tax and resolve the above-described ambiguities with new legislation, rulings or regulations.