Life Insurance Proceeds: 706 Form Inclusions Explained

Life insurance proceeds are generally included on Form 706, the federal estate tax return, and must be reported by an estate administrator. This is the case even if the proceeds are not subject to estate tax. The inclusion of life insurance proceeds in the gross estate depends on various factors, such as ownership of the policy, incidents of ownership, and the beneficiary. If the proceeds are receivable by the estate or for its benefit, they are typically included. However, if the decedent did not possess any incidents of ownership at the time of death and did not transfer them in contemplation of death, the proceeds may not be included in the gross estate. Understanding the role of Form 712 Life Insurance Statement is crucial when dealing with life insurance proceeds and estate tax returns.

Proceeds of life insurance

The full amount of the proceeds of insurance on the decedent's life must be included in the gross estate if it is receivable by the estate or can be used for the benefit of the estate. This is the case even if there is a legally enforceable obligation on the beneficiary to pay taxes, debts, or other charges of the estate. It also does not matter who owns the policy, who the beneficiary is, or who paid the premiums.

If the decedent did not possess any incidents of ownership at the time of death or transfer them in contemplation of death, no part of the proceeds would be included in the gross estate. For example, if the decedent irrevocably assigned their entire interest in the policy to another person and retained no reversionary interest, the proceeds would not be included.

The proceeds of life insurance can be excluded from the gross estate by transferring ownership of the policy outside of the taxable estate. This can be done by gifting the policy to a trust. This must be an actual change of ownership of the existing insurance contract; simply gifting the premiums does not count. The transfer of ownership must be reported to the IRS on a Form 709 Gift Tax Return, and a Form 712 Life Insurance Statement must be included for each policy transferred.

Incidents of ownership

The term "incidents of ownership" is often used in the context of life insurance or property disputes. It refers to the rights of a person or trustee to change the beneficiaries on a life insurance policy, borrow from the cash component, or alter the policy in some way. Incidents of ownership can have important implications for tax liability, particularly in the context of estate planning and gift taxes.

In the case of life insurance, incidents of ownership refer to the rights of the policy owner to change the named beneficiaries, pledge the policy for a loan, assign it to a new owner, or surrender the policy to receive any cash value. If the insured person has incidents of ownership, the death benefit from the policy may be included in their taxable estate, even though the benefit is only realised after their death. This can result in an unexpected estate tax liability.

To avoid such incidents of ownership, the insured person cannot own the policy themselves. Instead, they may transfer ownership to a trust specifically designed to hold life insurance, such as an Irrevocable Dynasty Trust or an Irrevocable Life Insurance Trust (ILIT). By doing so, they give up all legal rights to the policy and must not pay any premiums, thereby avoiding tax responsibility for the proceeds.

The Internal Revenue Service (IRS) may investigate incidents of ownership when a life insurance policy is gifted to another person or entity. If the insured or transferor dies within three years of the date of the policy transfer, the life insurance proceeds will be included in the gross value of the original owner's estate, according to the three-year rule.

Estate tax issues

When a life insurance policy is gifted to a trust, the ownership of the policy is shifted outside of the taxable estate, and the proceeds may be passed to the beneficiaries without incurring income or estate tax consequences. It is important to note that a simple transfer of premiums does not count as a change of ownership. When the insured makes the gift, it must be reported to the IRS using a Form 709 U.S. Gift Tax Return.

After the death of the insured, estates that need to file an estate tax return will need to request a Form 712 "Life Insurance Statement" from each insurance company for every policy covering the decedent. This form is critical for determining the value of the policy and must be included with the Form 706 Estate Tax Return. Form 712 should also be included with any Form 709 Gift Tax Return related to policy transfers during the insured's lifetime.

The value of all policies on the decedent's life must be reported on the estate tax return, regardless of whether they are included in the gross estate for tax purposes. The IRS Form 712 contains critical information about who owned the policy, its value, and the basis of the policy. Additionally, it discloses whether the decedent had any incidents of ownership or transferred the policies within three years of their passing, which could result in the death benefit being included in the estate and subject to estate taxes.

Tax-free proceeds to the beneficiary

Life insurance proceeds are generally tax-free for the beneficiary. This is one of the major benefits of life insurance. However, this only applies if the life insurance is properly administered. If the life insurance is owned inside the estate at the time of the insured person's death, it may trigger estate tax issues.

Federal law currently exempts estates valued at less than $12,060,000 from estate tax, so it may be acceptable for a life insurance policy to remain inside an estate that doesn't exceed this threshold when including the death benefit proceeds. However, once an estate starts to approach this exemption limit, taxpayers should consult their advisors to determine if it makes sense to transfer ownership of the life insurance policy outside of the estate. This can be done by making a gift to a trust.

When a life insurance policy is gifted to a trust, the ownership of the policy is shifted outside of the taxable estate, and the proceeds can pass to the beneficiaries without income or estate tax consequences. It's important to note that there must be an actual change of ownership of the existing life insurance contract to get this benefit; simply gifting the premiums doesn't count. The transfer of ownership must be reported to the IRS using the appropriate forms, such as Form 709 and Form 712.

Form 712, or the "Life Insurance Statement," is critical in determining the tax implications of life insurance proceeds. It should be requested from the insurance company and included with any Form 709 Gift Tax Return related to policy transfers during the insured's lifetime. It is also necessary to include Form 712 with the Form 706 Estate Tax Return after the insured's death for all policies insuring the decedent's life. This form provides valuable information about the ownership of the policy, its value, and any incidents of ownership that may impact the tax treatment of the proceeds.

Form 712 and the estate tax return

Form 712, also known as the "Life Insurance Statement", is filed by executors with Form 706 for insurance policy or premium amounts. This form plays a critical role for individuals planning to bequeath a significant estate and who own life insurance outside their taxable estate, or when changing the ownership of an existing life insurance policy outside of their taxable estate.

Form 712 should be included with Form 706, the Estate Tax Return, after the death of the insured for all policies insuring the life of the decedent. This is because the value of all policies on the decedent's life must be reported on the estate tax return, regardless of whether they were owned inside or outside the estate. The form contains key information, including who owned the policy at death, the policy's value, and its basis.

For estates that need to file an estate tax return, a request must be made to the insurance company to provide a Form 712 for each policy insuring the decedent. This is not automatically sent out for every policy since most estates fall within the exemption amount and are not required to file a Form 706. Form 712 reports the value of a policy, which is necessary for preparing the estate tax forms.

Additionally, Form 712 discloses critical information about non-owned policies, including whether the decedent had any incidents of ownership or transferred policies within three years of their passing. In both cases, the death benefit would be includible in the estate and potentially subject to estate taxes. Therefore, it is crucial to address the planning early and not delay in early-gifting the life insurance policy if it aligns with your planning objectives.

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