To: Mr. Keith’s Estate

Facts:
1. Mr. Keith and Mr. Lars were business partners for 30 years.
2. Each partner had a life insurance policy on the other partner so that the insurance proceeds could be used to purchase the deceased partner’s interest in partnership from his estate.
a. Each partner was allowed veto power over any beneficiary that was chosen or changed on the life insurance policy that was on his own life.
3. Mr. Keith died recently and Mr. Lars received the $500,000 life insurance proceeds.
a. Mr. Lars did use the proceeds to purchase Mr. Keith’s interest in their partnership from Mr. Keith’s estate.
Issues and Analysis:
Did Mr. Keith’s veto right over the beneficiary designation give him “incidents of ownership”?
Reg. §20.2042-1 (c)(4) Proceeds of life insurance (being capable of changing the beneficial ownership in the policy gives Mr. Keith “incidents of ownership” based on this Reg. and IRC 2042)
Would this require Mr. Keith’s estate to include the insurance proceeds of $500,000 in his gross estate?
§2042 Proceeds of life insurance. (If Mr. Keith has incidents of ownership the proceeds will be included in his gross estate)
Is there a problem with the life insurance proceeds being used to purchase the deceased individuals interest in the partnership from the deceased’s estate?
§2042 Proceeds of life insurance (this would cause the life insurance proceeds to be included in gross estate if life insurance proceeds, even if owned by another individual, are used to benefit the deceased’s estate, either directly or indirectly).
How could Mr. Keith and Mr. Lars keep the insurance proceeds out of their perspective gross estates?
§2042 Proceeds of life insurance (not have incidents of ownership in the policy on your own life nor use proceeds to directly or indirectly benefit the deceased’s estate)
Is the insurance proceeds taxable to Mr. Lars?
§101 (a)(1) Certain death benefits (not taxable)
Conclusion and Reasoning:
Based on my tax research, Mr. Keith’s estate will have to include the $500,000 insurance proceeds in the gross estate because Mr. Keith did have incidents of ownership as defined by the IRC section 2042. Furthermore, Mr. Lars used the insurance proceeds to purchase Mr. Keith’s interest in the partnership from Mr. Keith’s estate. This had a direct benefit to Mr. Keith’s estate therefore based on IRC section 2042 this would also cause the insurance proceeds to be included in Mr. Keith’s gross estate.
The reason Mr. Keith retained incidents of ownership, even though he was not the owner of the policy, was because he was able to veto any change to the beneficial owner of the policy. Thus he kept some control over said policy. This element of control effectively terminates the excludability of the life insurance policy from his gross estate. (Reg. §20.2042-1 (c)(4)) Proceeds of life insurance and §2042 Proceeds of life insurance).
On the other hand, the insurance proceeds end up having a direct benefit to Mr. Keith’s estate because they were specifically purchased to use the proceeds to purchase the other partner’s interest in the partnership from his estate. This will be a huge influx of money to the estate, thus the estate has a direct benefit from insurance proceeds. In IRC section 2042, it states that life insurance proceeds, even if owned by another individual, cannot be used to benefit the deceased’s estate, either directly or indirectly.
If Mr. Keith would have received our advice before creating this agreement then we could have saved his estate from possibly paying tax on the life insurance proceeds (of course the tax owed depends upon his estate tax being prepared). Mr. Keith would have had to sever all control over the policy then the insurance proceeds would not have been included in his gross estate. Furthermore, it should not have been stated that the insurance proceeds must pay for the partner’s interest of the partnership from his estate. Since both Mr. Keith and Mr. Lars put this in their partnership agreement then it would seem that they both have control over how the money is to be spent (i.e. a stated benefit to his estate). I do believe from my understanding of section 2042, that as long as it was not stated that the proceeds were to be used in such a manner then the proceeds would not have been taxable.
On the other hand, we can let Mr. Lars know that he will not have to pay taxes on the life insurance proceeds that he received. Actually, it would not have mattered whether or not the insurance proceeds were included in Mr. Keith’s gross estate or not. (§101 (a)(1) Certain death benefits)