Use Caution When It Comes To Backdating Policies
Life insurance policies are priced on the age of the insured — the lower that age, the lower the price. Consequently, the practice of backdating policies has developed as a way of keeping down the cost of coverage, and one year can make a significant difference in some cases.
Besides obtaining a lower price, another objective often associated with the acquisition of life insurance is to keep the death proceeds out of the insured’s gross estate for federal estate tax purposes. Key to accomplishing that goal is the avoidance of the three-year rule under IRC § 2035. That rule provides that life insurance death proceeds will be included in the estate of the decedent if within three years of death, the decedent possessed and later transferred incidents of ownership in the policy.
The courts have held, however, that insurance proceeds should not be included in a decedent insured’s estate if the policy was purchased and owned by a third party, was not made payable to the insured’s estate and the insured held no incidents of ownership in the policy at death. Consequently, to avoid estate inclusion, the practice has developed of having the policy applied for and owned by a third party such as an irrevocable life insurance trust, or ILIT.
Confusion arises, however, over the implications of backdating a policy prior to the effective date of the ILIT. Essentially, the question is whether dating the policy before the date of the trust gives the insured, rather than the trustee, incidents of ownership in the policy. Fortunately, the three-year rule should not apply since, in reality, the application for the coverage is not made until after the trust is formed. Prior to that time, there is no ownership interest in a life insurance policy for the insured to transfer in violation of the rule. This is significant because in Estate of Leder vs. Commissioner,1 the tax court stated that for the three-year rule to apply, the decedent must first possess incidents of ownership as outlined in IRC § 2042. In this regard, the fact that the issue date shown on the policy pre-dates the application date and the date the trust was created is merely the result of administrative convenience designed to save the policy owner some premium dollars. The controlling date should be the date the policy is actually applied for.
Caution dictates, however, that any customer involved in such a situation carefully document the circumstances that caused the policy date to precede the date of the ILIT’s creation. This will enable the decedent insured’s executor to provide a proper explanation to the IRS should death occur within three years of the policy’s purchase.
By Louis S. Shuntich, J.D., LL.M. for LifeHealthPro. Louis S. Shuntich, J.D., LL.M., is senior vice president, Advanced Planning, Lincoln Benefit Life Company, Lincoln, Neb
1. Estate of Leder v. Commissioner, 89 TC 235 (1987) aff’d 893 F.2d 237 (10th Cir. 1990)