Many people are aware of the estate tax — the tax that is levied on the assets owned by someone when they die. And many people are aware that the estate tax is levied on all sorts of assets, including the proceeds of any life insurance policies that the decedent owned at the time of death. Since nearly three-quarters of American adults have life insurance, the taxation of life insurance proceeds at the time of death potentially affects many people. (Fortunately, the federal estate tax generally affects only the very well-to-do and state estate tax rates, which affect many more people, are much lower than the federal rate.)
An easy way to avoid this taxation is through life insurance trusts. If your life insurance is owned by a trust, it is not taxed when you die (because the tax only affects assets that you own).
But creating a life insurance trust requires some expenditure of money and time and attention to detail. It can be a pain. For this reason, some people consider cross-ownership of life insurance as an alternative to a life insurance trust.
Cross-ownership means that two people each own life insurance policies on the life of the other. If A dies, the policy that B has on A’s life will be paid out to B, ensuring B’s fiscal health. LIkewise, if B dies, the policy that A has on B’s life will be paid out to A, ensuring A’s fiscal health. Because it is B, not A, who owns the life insurance policy, the proceeds of the policy are not included in the value of A’s estate.
But unfortunately cross-ownership is not a perfect solution. There are multiple issues to consider when comparing cross ownership to a life insurance trust.
1. First, many people incorrectly believe that a cross-owned insurance policy has no tax consequence to the owning spouse. That is not entirely true. Internal Revenue Code Reg. Sec. 20.2031-8 provides that a term life policy will be valued the interpolated terminal reserve value plus the value of paid but unused premiums. However, that tends to be a relatively low amount for a term life policy. Therefore, if the life insurance policy at issue is a term life policy, it will nto generally be a significant concern because it causes only modest tax consequences when the owning spouse dies. By comparison, though, the life insurance trust avoids death taxes entirely upon the death of either partner. Thus, the ILIT prevails in this round, albeit by modest measure.
2. Consideration of the taxation of an estate when someone dies is important, but it is not usually the most important consideration. Because the estate tax can be avoided to the extent that you leave your estate to your lawfully-married spouse, estate taxes can be avoided when the first spouse dies, and so the bigger concern is the estate tax when the second spouse dies. The concern is exacerbated by the fact that the second spouse oftentimes owns both his or her own assets as well the deceased spouses’s assets, increasing the likelihood and amount of taxation. In this regard, the primary benefit of the life insurance trust for most people is not to avoid estate taxes upon the death of the first to die, but to avoid estate taxes on those sums upon the death of the surviving spouse. Because the beneficiary of an trust-owned life insurance policy is often the surviving spouse, so long as the surviving spouse avoids what we call “incidents of ownership” over those assets, the proceeds will not be taxed in surviving spouse’s estate. This is a huge benefit, and in this regard the cross-ownership has no value whatsoever.
3. Next, with a life insurance trust, which has a designated (perhaps professional) trustee and a written trust instrument, there is some assurance about how the policy will be controlled during the lifetime of the insured (for example, it will not be sold, cashed out, exchanged, or attached by creditors, it will not lapse so long as paid, etc.). On the other hand, if the beneficiary or a third party cross-owns the policy, the insured may have a sense that these issues are under control but, as they say, “there is many a slip twixt the cup and the lip”, and of course the insured cannot exert any control over the policy. The life insurance trust, again, comes out on top.
4. In the same vein, with a life insurance trust you can control the use of the assets after your death by tailoring the terms of your life insurance trust agreement. You cannot do so with cross-ownership. So if you have any desire to control the use of policy proceeds, such as benefiting minors or not benefiting a spouse after divorce or who inherits any money leftover after your surviving spouse dies, then the written trust instrument is plainly required. Bear in mind that this extends far beyond the idea of simply controling the use of the money in any conventional sense. It includes inhibiting proceeds from flowing to the creditors of the beneficiary and inhibiting statutory claims by new spouses arising from subsequent remarriages. It also includes funding death taxes. Once again, the life insurance trust is the better option.
5. In addition, we general operate from the presumption that if A owns a policy on B’s life, then the policy will not be taxed to B’s estate when he dies. However, you should bear in mind that having a cross-owned policy does NOT guarantee that the insurance proceeds will be excluded from the taxable estate of the insured. Careless funding of the policy premiums, or exerting other control over the policy (directly or indirectly by the insured, for example) during the lifetime of the insured could be characterized as an “incident of ownership” and cause the policy proceeds to be included in the taxable estate of the insured.
6. Adding insult to injury, the policy proceeds could be taxable in the estate of the insured but the policy proceeds paid to the beneficiary, with the result that the estate does not have the assets to pay the taxes! While there are state and federal statutes which allow the estate to demand that the beneficiary pay a pro rata share of the estate tax burden, if you do not have a cooperative beneficiary, that presents a problem, to say the least.
7. Finally, an important factor is always cost. Given that cross-ownership involves no actual cost to the policy holders, but life insurance trusts clearly involve creation and maintenance costs, this round soundly favors cross-ownership.
Cross-ownership of life insurance trusts offers some benefits. But as compared to a trust-owned insurance policy, cross-ownership is a partial solution that promises more than it can deliver.