“Incidents of ownership” are three powerful words in estate planning where life insurance is concerned. The phrase is a key component of Internal Revenue Code Section 2042, which provides for the inclusion in a taxpayer’s gross estate, for estate tax purposes, of the proceeds of insurance policies on the taxpayer’s life under two circumstances. First, if the proceeds are actually received by the estate, they are included. Second, proceeds are included in an estate for tax purposes when the money is received by named beneficiaries other than the estate if the taxpayer died possessing “incidents of ownership” in the policy.
Section 2042 is the reason an estate planning advisor typically strives to ensure that a client does not own life insurance policies on the client’s own life. This is frequently accomplished by creating an irrevocable life insurance trust. As an alternative, many clients give life insurance policies to charitable organizations, not only for the estate tax benefits, but also for potential income tax benefits during the client’s lifetime.
Before you assist your client with a gift of life insurance to a charity, here are five pointers.
- Check state law first. Most–but not all–states allow transfers of life insurance policies to a charity.
- Request change of ownership and change of beneficiary forms from the insurance company, and make sure you have the right forms. The paperwork is not always user-friendly. There are instances where a taxpayer completed the wrong set of forms and thus failed to accomplish the intended transfer. The charity will need to be the policy owner and, unless the charity intends to surrender the policy, also be the named beneficiary.
- Carefully calculate the charitable income tax deduction for the gift of the life insurance policy to the charity. The taxpayer is eligible for a deduction equal to the lesser of the policy’s value or the taxpayer’s basis (usually the total amount of premiums paid). The “value” of the policy is computed using the replacement cost or the “interpolated terminal reserve” plus unearned premiums.
- Be sure to check for loans against the policy to avoid an income tax event for the taxpayer.
- Finally, do not run afoul of the “insurable interest” rules, which can come into play where the charitable entity pays the premium on a life insurance policy transferred to or secured by the charity on your client’s life.