Sometimes divorce requires Life Insurance, but there can be an Estate Tax Impact.
The estate tax inclusion for life insurance policies holds that the divorcing spouse is to own or maintain, and for an estate tax deduction if the insurance is includible the gross estate. An exposure to estate tax inclusion is from the decedent possessing incident of ownership in the policy pursuant to Code §2042(2). However, even if the deceased spouse is the owner, lack of actual control or economic benefits from the policy may result in in incidents of ownership.
An estate tax inclusion could result under Code §2036 by retained rights by the decedent – for example, when the policy is held in a trust and the decedent may benefit from it.
Another source of inclusion is a transfer of ownership of the policy within three (3) years of death under Code §2035.
Deductibility can be available under Code §2053(a)(3) as a claim against the decedent’s estate. However, when the obligation is to obtain the policy and name the other spouse as beneficiary (as contrasted with an obligation to pay a fixed amount at death to the surviving spouse), there is no claim remaining after death so this provision may not allow a deduction.
Deductibility may also arise under Code §2053(a)(4) as a debt against property (the insurance proceeds).
Requirement that obligation be contracted in a bona fide manner and supported by adequate and full consideration can be an obstacle to deductibility. For example, relinquishment of marital rights in decedent’s property is not adequate consideration under Code §2043(b)(1) – however, meeting the requirement of Code §2516 will allow for a finding of adequate and full consideration.
There are numerous other factors that impact estates during a divorce, too numerous to mention. However, here is just a sample of some common issues:
Limits Under Trusts. Many non-marital trusts (particularly in second marriages) are
drafted to provide that the remarriage of a former spouse will reduce or eliminate trust
benefits and/or remove the spouse from acting as a Trustee.
Portability. If a widow or widower remarries, they run the risk of losing any remaining
transfer tax “portable” exemption of a deceased former spouse. Under the “last
deceased spouse rule” if the new spouse dies before the widow or widower has used
the former spouse’s transfer tax exemption, the widow or widower will be limited to
the exemptions of the second deceased spouse. However, as long as the new spouse is not deceased, the widow or widower can use the former spouse’s unused exemptions, including if the widow or widower predeceases the new spouse.
Charitable Remainder Trusts. If a couple created CRTs that have a lifetime payouts for the lives of the two spouses. The IRS has approved such divisions of the CRT. In lieu of a division of an existing CRT, you may consider one party renouncing one of CRTs as a part of the negotiated divorce terms. This renunciation might create a charitable deduction to the disclaiming party because the present value of what the charity will receive may have increased. If they file a joint return in the year of the renunciation (e.g., they remain married until the following year), the nondisclaiming spouse could receive a tax benefit from the renunciation. Retirement Plans. In managing the divorce negotiations, advisors and clients should understand the differences in the tax treatment of various retirement plans. For example, if distributions are made pursuant to a qualified domestic relations order (QDRO) from a qualified retirement plan to an alternative payee before the plan participant reaches age 59½, then the funds can be withdrawn without having to pay an early withdrawal penalty of 10%. A similar exception does not apply to IRAs.
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