87 / What are the incidents of ownership of employer-paid death benefits that would cause life insurance proceeds to be includable in the insured’s estate?

An employee insured’s right to designate the beneficiary of an employer-paid death benefit is not treated as an incident of ownership in the insurance funding the benefit if the employer is sole owner of the policy and sole beneficiary for its exclusive use.¹ (However, see Q 3638 through Q 3640 for potential income tax implications.) The IRS has taken the position that if the insured under a corporation-owned policy has an agreement with the corporation giving the insured the first right to purchase the policy for its cash surrender value if the corporation decides to discontinue the coverage, the purchase option is an incident of ownership.² The Tax Court has held, however, that the insured’s contingent purchase option as described in Revenue Ruling 79-46 is not an incident of ownership within the meaning of IRC Section 2042(2).³

The IRS also has ruled that where, under an insured stock redemption agreement, a stockholder had the right to purchase the policies the corporation owned on the insured’s life if the insured ceased being a stockholder, such contingent purchase option was not an incident of ownership in the insurance.⁴ An insured who held the right to purchase a policy upon termination of a buy-sell agreement did not possess incidents of ownership so long as the contingency had not occurred, but would possess incidents once the agreement was terminated.⁵

Also, a shareholder was not treated as holding incidents of ownership in a life insurance policy where the shareholder could purchase a corporate-owned policy upon disability, or upon a cross-purchase of the shareholder’s stock if the shareholder dissented to sale of the corporation to a third party or a public offering.⁶ However, an insured was treated as holding incidents of ownership in a policy held in a trusteed buy-sell arrangement where the insured was considered to have transferred the policy to the trust and retained the right to purchase the policy for its cash surrender value.⁷

The right to receive dividends has been held not to be an incident of ownership in the policy.⁸ It has been held that if the insured has the power to terminate the interest of the primary beneficiary with only the consent of the secondary beneficiary, the insured has an incident of ownership.⁹ However, a sole shareholder would not be treated as holding incidents of ownership in a life insurance policy on the shareholder’s own life where a collateral consequence of a termination of an employee’s employment would be a termination of the employee’s option agreement to purchase the shareholder’s stock with a corresponding change in beneficiary of the insurance proceeds held in an irrevocable life insurance trust created by the employee.¹⁰

The assignment of a life insurance policy by a third-party owner as an accommodation to the insured to cover the insured’s debts does not in itself create in the insured an incident of ownership.¹¹ But if a policy owner collaterally assigns a policy as security for a loan and then makes a gift of the policy subject to the assignment, the donor will be deemed to have retained an incident of ownership.¹²

Where an insurance funded buy-sell agreement prohibited each partner from borrowing against, surrendering, or changing the beneficiary on the policy each owned on the life of the other partner without the insured’s consent, the Tax Court held that the decedent-insured did not possess an incident of ownership in the policy insuring the decedent-insured’s life.¹³ However, it has been reported that the IRS, citing an internal ruling dated January 7, 1971, has declined to follow the decision.¹⁴

An insured was treated as holding incidents of ownership in a policy held in a trusteed buy-sell arrangement where the trust could only act as directed by the shareholders through the buy-sell agreement and the insured could thus withhold consent to the exercise of policy rights.¹⁵

Where an insured absolutely assigned a policy that required the insured’s consent before the policy could be assigned, or the beneficiary changed, to someone who had no insurable interest in the insured’s life, the IRS ruled that the insured had retained an incident of ownership.¹⁶

Similarly, the Tax Court has held that an employee’s right to consent to a change of beneficiary on a split dollar policy owned by the employee’s employer on the employee’s life is an incident of ownership.¹⁷ The Tax Court also has held that where the insured assigned policies, retaining the right to consent to the assignee’s designating as beneficiary, or assigning the policies to, anyone who did not have an insurable interest in the insured’s life, the assignee’s act of designating an irrevocable beneficiary did not eliminate the insured’s retained incidents of ownership. The Third Circuit reversed the Tax Court in this case, however, taking the position that because under the facts presented the insured could not have enjoyed any economic benefit from exercising the insured’s veto power over the designation of beneficiaries or assignees, the insured’s retained power did not amount to an incident of ownership.¹⁸ The insured’s right to purchase the policy from an assignee was treated as equivalent to the right to revoke an assignment, which is an incident of ownership.¹⁹