Using Life Insurance to Satisfy Support Obligations in a Divorce

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By Louis A. Mezzullo

McKenna Long & Aldridge LLP, Rancho Santo Fe, CA

A recent case, Estate of David A. Kahanic, et al. v.
, T.C. Memo 2012-81, and a recent Chief Counsel
Advice (CCA) 201328030, highlight several issues that should be
considered when using life insurance to satisfy an obligation of
one spouse to the other spouse pursuant to a marital settlement
agreement. Of course the objective of the insured spouse is
generally not to have the proceeds included in his or her estate
for federal and state estate tax purposes or to have the payment of
the proceeds treated as satisfying a debt that is deductible under
§2053(a)(4).  With careful planning, either of these results
should be possible. 

In Kahanic, the two issues relevant to this discussion
concerned the federal estate tax inclusion of life insurance
proceeds payable to a former wife and, if includible, whether the
insurance proceeds were nonetheless deductible under
§2053(a)(4).  Under §2042(b)(2), when the proceeds of life
insurance are not receivable by the executor of the insured, they
will be included in the insured's estate if the insured retained
any incidents of ownership in the policy, exercisable either alone
or in conjunction with others.  For this purpose, an incident
of ownership includes a reversionary interest if the value of the
reversionary interest exceeds five percent of the value of the
policy immediately before the death of the insured.  In this
case, the court found that the insured did possess such a
reversionary interest, and therefore the proceeds were included in
the insured's gross estate. The court then considered whether an
estate tax deduction was allowable with respect to the proceeds
under §2053(a)(4). 

Generally, §2053(a)(4) allows a deduction from the gross estate
for indebtedness in respect of property the value of which is
included in the gross estate undiminished by the indebtedness.
Section 2053(c)(1)(A) permits the deduction for a debt founded on a
promise or an agreement only if the debt was contracted for an
adequate and full consideration in money or money's worth. This
normally would not be the case with regard to a debt owed to a
former spouse pursuant to a divorce settlement. However,
§2043(b)(2) considers a transfer of property that satisfies the
requirements of §2516, which relates to certain property
settlements, to be made for an adequate and full consideration in
money or money's worth. Section 2516 treats transfers of property
pursuant to a written settlement agreement as made for an adequate
and full consideration in money or money's worth if a divorce
occurs within a three-year period beginning one year before the
settlement agreement is entered into. The court determined that
under Illinois State law the modification of an earlier settlement
agreement that required the insured to name his former wife as the
beneficiary of a $2,500,000 life insurance policy on his life
satisfied §2053.

Note that in this case, there was also a $3 million policy held
in an irrevocable trust designed to satisfy the insured's support
obligations to his children. The proceeds were not included in the
insured's estate. Apparently the insured died more than three years
after he transferred the policy to the trust or the trust was the
initial owner of the policy. While it is unlikely that an insured
who owns a policy on his or life will not have any incidents of
ownership in the policy, in the CCA discussed below, the insured
apparently owned the policy and the CCA concluded that the insured
did not have any incidents of ownership in the policy. 
However, holding an insurance policy in a qualifying irrevocable
trust such as an irrevocable life insurance trust is another way to
insure that the insurance proceeds will not be included in the
insured's estate and may be the safest approach.

In CCA 201328030, the issue was whether the right to receive the
dividends with respect to an insurance policy was an incident of
ownership. The insured owned the insurance policy that named his
former spouse as the beneficiary. Under the couple's settlement
agreement, the insured was restricted from changing the beneficiary
and borrowing against or pledging the policy. Dividends from the
policy belonged to the insured. Apparently, under the settlement
agreement, but not stated in the CCA, the insured could not
exercise any other incident of ownership with respect to the
policy. Citing Estate of Bowers v. Commissioner, 23 T.C.
911 (1955), and Jordahl v. Commissioner, 65 T.C. 92
(1975), the CCA concluded that the right to receive dividends is
nothing more than a reduction in the amount of premiums paid rather
than a right to the income of the policy and therefore is not an
incident of ownership.  The CCA does not state facts
concerning when the settlement agreement was signed, so it is not
possible to determine whether the proceeds would have been
deductible under §2053(a)(4), as the proceeds were in the
Kahanic case.

In conclusion, there are at least three ways to avoid inclusion
of the proceeds of a life insurance policy payable to a former
spouse in the insured's estate. Perhaps the safest approach is to
have the policy held in a qualifying irrevocable trust. Second, the
proceeds could be payable pursuant to a property settlement
agreement that satisfies the requirements of §2516. Third, and
perhaps the least advisable, is to restrict the insured from owning
any incidents of ownership pursuant to a settlement agreement. The
concern with regard to the last approach is that the restrictions
imposed on the insured may not cover all possible incidents of

This commentary also will appear in the November 2013 issue
of the
 Estates, Gifts and Trusts Journal. For more
information in the Tax Management Portfolios, see Wofford, 515
, Divorce and Separation, Danforth, 823 T.M.,
Taxation of Jointly Owned Property, and Budin, 826 T.M.,
Life Insurance, and in Tax Practice Series, see ¶6190, The
Gross Estate - Section 2033, and ¶6260, Expenses, Debts, Taxes
& Losses (Estate Tax Deductions).