Incidents of Ownership: What Pulls a Life Insurance Policy Back Into the Estate

What are incidents of ownership in a life insurance policy?

They are rights to the economic benefits of the policy. The regulation names the power to change the beneficiary, to surrender or cancel the policy, to assign it, to revoke an assignment, to pledge it for a loan, and to borrow from the insurer against its surrender value (Treas. Reg. § 20.2042-1(c)(2)). If the insured holds any one of them at death, alone or with another person, the proceeds are in the gross estate (IRC § 2042(2)).

The regulation says the term “is not limited in its meaning to ownership of the policy in the technical legal sense.” It refers, “generally speaking,” to “the right of the insured or his estate to the economic benefits of the policy.” The list of powers ends with “etc.,” so it is a set of examples and not a complete catalogue. The name on the policy is therefore not the whole test. An insured who has assigned the policy to someone else but kept the right to change the beneficiary still holds an incident of ownership.

The ILIT pillar page explains why this rule is the reason an irrevocable life insurance trust exists. This page covers what counts as an incident, including the versions that are held indirectly.

Two routes into the estate

Section 2042 has two paragraphs, and they work independently.

• Proceeds receivable by the executor. The gross estate includes insurance on the decedent’s life “to the extent of the amount receivable by the executor” (IRC § 2042(1)). This paragraph has no ownership condition.
• Proceeds receivable by other beneficiaries. These are included if the decedent “possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person” (§ 2042(2)).

The first route reaches further than a policy that names the estate. Under Treas. Reg. § 20.2042-1(b)(1), it “makes no difference whether or not the estate is specifically named as the beneficiary.” If another beneficiary receives the proceeds subject to a legally binding obligation to pay taxes, debts, or other charges enforceable against the estate, the amount required for those payments is included. Proceeds of a policy the decedent bought in favor of another person as collateral security for a loan are also treated as receivable for the benefit of the estate, with a deduction for the loan balance and accrued interest.

The phrase “alone or in conjunction with any other person” in the second route means a shared power counts. A right that the insured can use only with someone else’s consent is still an incident of ownership under the statute’s wording.

Powers the regulation lists

The table gathers every power or interest that § 2042(2) and the regulation identify as an incident of ownership. The sections below explain the last three rows.

The regulation also says what is outside the term. The possibility that the insured might receive a policy or its proceeds “by inheritance through the estate of another person, or as a surviving spouse under a statutory right of election or a similar right” is neither a reversionary interest nor an incident of ownership (§ 20.2042-1(c)(3)).

Reversionary interests and the 5 percent threshold

A reversionary interest is a possibility that the policy or its proceeds “may return to the decedent or his estate, or may be subject to a power of disposition by him” (§ 2042(2)). It can arise from the terms of the policy, from another instrument, or by operation of law.

The statute counts a reversionary interest as an incident of ownership “only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent.” The value is determined by the usual methods of valuation, including mortality tables and actuarial principles, without regard to the fact of the decedent’s death.

Rights held by other people are taken into account in that valuation. The regulation’s example: the decedent is not treated as having a reversionary interest worth more than 5 percent if the power to obtain the cash surrender value belonged to another person immediately before the death and was exercisable by that person “alone and in all events” (§ 20.2042-1(c)(3)).

Powers held as trustee

A policy held in a trust can still be reached. Under Treas. Reg. § 20.2042-1(c)(4), a decedent has an incident of ownership in a policy on his or her life held in trust if, under the terms of the policy, the decedent has the power “(as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment thereof, even though the decedent has no beneficial interest in the trust.” The power counts whether the decedent holds it alone or together with other people.

The same paragraph adds a second consequence where the decedent created the trust. Such a power may bring other property the decedent transferred to the trust into the gross estate under § 2036 or § 2038. The regulation’s example is a power to surrender the policy where the income that had been paying the premiums would then become payable to a trust beneficiary.

Read on its terms, paragraph (c)(4) is the reason an insured who serves as trustee of a trust that owns a policy on his or her own life is exposed to § 2042, even without any right to benefit from the trust.

Policies owned by a corporation the insured controls

A corporation’s incidents of ownership can be attributed to a shareholder. Treas. Reg. § 20.2042-1(c)(6) sets the rule for a decedent who is the “sole or controlling stockholder”:

• Proceeds payable to the corporation are not attributed to the decedent. Proceeds paid to a third party for a valid business purpose, such as satisfying a business debt of the corporation, are treated as payable to the corporation. The regulation points to a separate rule under which those proceeds are considered in valuing the decedent’s stock.
• Proceeds not payable to or for the benefit of the corporation are different. The corporation’s incidents of ownership over that part are attributed to the decedent through the stock.

The regulation gives two examples. If a controlling stockholder is insured under a policy the corporation owns and the proceeds are payable to the stockholder’s spouse, the proceeds are in the stockholder’s gross estate under § 2042. If the proceeds are payable 40 percent to the spouse and 60 percent to the corporation, only 40 percent is included.

Control has a fixed meaning here. A decedent is not a controlling stockholder unless, at death, he or she “owned stock possessing more than 50 percent of the total combined voting power of the corporation.” For that test only, the decedent is treated as owning stock whose legal title was held by:

• the decedent, or the decedent’s agent or nominee;
• the decedent and another person jointly, counting only the share attributable to the consideration the decedent furnished;
• the trustee of a voting trust, to the extent of the decedent’s beneficial interest; or
• any other trust of which the decedent was treated as the owner under the grantor-trust rules immediately before death.

Group-term life insurance has its own sentence. For group-term coverage as defined in the regulations under § 79, the power to surrender or cancel a policy held by a corporation “shall not be attributed to any decedent through his stock ownership.” Business-owned coverage is discussed further on who should own the policy.

State law and community property

The policy’s wording is not the last step. The regulation requires regard for “the effect of the State or other applicable law upon the terms of the policy” (§ 20.2042-1(c)(5)). Its example is a policy bought with community funds on which the insured kept the right to surrender. Because under local law the surrender proceeds would have gone to the marital community, the insured held that power over the spouse’s half as the spouse’s agent. The insured is deemed to possess an incident of ownership in only one-half of the policy.

A related rule applies to the first route. Where proceeds payable to the estate are community assets and half belongs to the surviving spouse, only half is treated as receivable by the estate (§ 20.2042-1(b)(2)).

Giving up incidents and the three-year lookback

Section 2042 looks at the moment of death. The regulation states the result when nothing is left: if the decedent owned a policy and, four years before death, irrevocably assigned the entire interest to a spouse and kept no reversionary interest, the proceeds are not included under § 2042 (§ 20.2042-1(c)(1)).

A separate section covers a release made close to death. If the decedent transferred an interest in property or relinquished a power during the three-year period ending on the date of death, and the property would have been included under § 2042 had the interest or power been kept, its value is included in the gross estate (IRC § 2035(a)). The rule does not apply to “any bona fide sale for an adequate and full consideration in money or money’s worth” (§ 2035(d)). The three-year rule page covers how that lookback applies to a policy moved into a trust.

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