FLORIDA TAX REVIEW

Tax Consequences of Assigning Life
Insurance-Time For Another Look
Douglas A. Kahn* and Lawrence W. Waggoner"

I. INTRODUCTION ................................ 382
HI. THE ECONOMIC COMPONENTS OF LIFE INSURANCE ....... 384
M. THE GENERAL FRAMEWORK FOR TAXING LIFE

INSURANCE ................................... 388
A. Inconme Taxation of Life Insurance ............. 388

1. Exclusion of Proceeds from Gross Income .. 388
2. Appreciation in Reserve ............... 389

B. Gift Taxation of Life Insurance ................ 390
C. Estate Taxation of Life Insurance .............. 392

1. In General ........................ 392
2. Transfers Within Three Years of Death ..... 393

IV. ASSIGNMENT MORE THAN THREE YEARS BEFORE
DEATH ...................................... 395
A. Payment of Premiums by the Insured ............ 396
B. Premium Payments as a Constructive Transfer of a

Portion of a Policy ........................ 396
V. ASSIGNMENT IN SUBSTANCE WITHIN THREE YEARS OF

DEATH ...................................... 398
A. The Proper Boundary of the Constructive

Transfer Principle ......................... 400
B. The Ill-advised Abrogation of the Constructive

Transfer Principle ......................... 402
VI. OUTRIGHT ASSIGNMENT WITHIN THREE YEARS OF

DEATH ...................................... 405
VIII. CONCLUSION .................................. 416

VOLUME 4 NUMBER 5

* Paul G. Kauper Professor of Law, University of Michigan.

** Lewis M. Simes Professor of Law, University of Michigan.
Copyright © 1999 by Douglas A. Kahn and Lawrence W. Waggoner.



Florida Tax Review

I. INTRODUCTION

The Taxpayer Relief Act of 1997 furnishes the courts and the Internal
Revenue Service an opportunity to close certain loopholes in the federal tax
consequences of assigning life insurance. About twenty years ago, we
published an article arguing that the tax consequences of assigning life
insurance affords taxpayers unwarranted opportunities for tax avoidance.'
Since then, developments in the case law and Internal Revenue Service
rulings have broadened the loopholes. In this update of our article, we show
how the new tax law supports our original position.

The most litigated estate tax issue concerning life insurance' is
whether the proceeds are includible in the insured's gross estate. This
question is usually governed by section 2042 of the Internal Revenue Code
of 1986 (Code), the estate tax provision specifically dealing with life
insurance. To be included under section 2042, the insured must "possess at
his death any of the incidents of ownership [in the policy], exercisable either
alone or in conjunction with any other person," or the proceeds must be
"receivable by the [insured's] executor.",3

Usually at minimal gift tax cost, an insured can avoid section 2042
by giving the policy to the beneficiary or placing it in an irrevocable trust.4

I. Douglas A. Kahn & Lawrence W. Waggoner, Federal Taxation of the Assignment
of Life Insurance, 1977 Duke L.J. 941.

2. Under the terminology used in connection with life insurance, the insurer is the
company that issues the policy, the insured is the person whose life is insured by the policy,
the beneficiary is the person to whom the proceeds of the insurance are payable, and the
policyholder is the owner of the policy. As owner, the policyholder possesses the economic
rights in and power over the policy, including the right to surrender the policy for cash, borrow
against the policy, and name the beneficiary. The policyholder need not be the insured.

3. IRC § 2042. Some of the previously unresolved questions concerning the
interpretation of § 2042 have apparently been settled. Compare Estate of Skifter v.
Commissioner, 468 F.2d 699 (2d Cir. 1972) (broad fiduciary powers conveyed to, and not
retained by, an insured did not constitute an "incident of ownership"), and Estate of Connelly
v. United States, 551 F.2d 545 (3d Cir. 1977) (power to elect settlement option, and thus to
affect proceeds' payment schedule, the exercise of which required consent of employer and
insurer, did not constitute an "incident of ownership" under IRC § 2042), with Terriberry v.
United States, 517 F.2d 286 (5th Cir. 1975) (power, as a trustee, to elect a settlement option
constituted an "incident of ownership" even though insured's wife could terminate his power
at will), and Rose v. United States, 511 F.2d 259 (5th Cir. 1975) (power, as a trustee, to alter
time and manner of enjoyment of policy held in trust constituted an "incident of ownership").
Skifter is the most significant case in that list. Although the Commissioner initially rejected
the Skifter decision in Rev. Rul. 76-261, 1976-2 C.B. 276, the Commissioner later revoked that
ruling and adopted the Skifter position. See Rev. Rul. 84-179, 1984-2 C.B. 195.

4. For gift tax purposes, a life insurance policy is valued on the date of the gift
without regard to the insured's actual life expectancy or medical condition. See infra text
accompanying notes 26-28.

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Tax Consequences of Assigning Life Insurance

If the insured dies within three years after making the gift, however, and if
the policy was not terminated, the full value of the proceeds may be included
under another section of the Code, section 2035. As amended by the
Taxpayer Relief Act of 1997, section 2035 provides that if the decedent,
within three years of death, transferred an interest in or relinquished a power
over property, the value of which would otherwise have been included in the
decedent's gross estate under certain specified sections including section
2042, then "the value of the gross estate shall include the value of any
property (or interest therein) which would have been so included" had the
transfer or relinquishment not taken place.'

Under the case law that predated the 1997 Act, it was well
established that a gift of life insurance within three years of death caused the
full value of the proceeds to be included in the insured's gross estate if no
post-assignment premiums became due.6 If, however, the insured outlived the
period covered by the last pre-assignment premium, post-assignment
premiums had to be paid in order to keep the policy in force. If the insured
paid the post-assignments premiums, the case law predating the 1997 Act
included the full value of the proceeds in the insured's gross estate. If the
assignee paid the post-assignment premiums, the pre-1997 Act case law
reduced the amount includible.

The leading case on the latter issue is Estate of Silverman v.
Commissioner,8 a case decided by the Tax Court in 1973. The Tax Court
struck a ratio of premiums paid by the insured and by the assignee to the

5. IRC § 2035(a), as amended by the Taxpayer Relief Act of 1997, P.L 105-34 §
1310. Section 2035 does not apply if an insurance policy is transferred pursuant to a bona fide
sale for adequate and full consideration in money or money's worth. See IRC § 2035(d).

6. See, e.g., Berman v. United States, 487 F.2d 70 (5th Cir. 1973); Bel v. United
States, 452 F.2d 683 (5th Cir. 1971); Rev. Rul. 71-497 (situation 2), 1971-2 C.B. 329. See also
Regs. § 20.2042-1(a)(2).

7. See, e.g., Estate of Compton v. Commissioner, 532 F.2d 1086 (6th Cir. 1976);
Vanderlip v. Commissioner, 155 F.2d 152 (2d Cir. 1946). See also Estate of Silverman v.
Commissioner, 521 F.2d 574, 576 (2d Cir. 1975). In Compton, the premiums on a group-term
life insurance policy, which became due after the insured had assigned the policy, were
presumably paid by the insured's employer. If so, the insured would be deemed to be the
transferor of the premiums. See Estate of Porter v. Commissioner, 442 F.2d 915, 919-20 (1st
Cir. 1971); Rev. Rul. 76-490, 1976-2 C.B. 300.

8. 61 T.C. 338 (1973), aff'd on the limited grounds raised on appeal, 521 F.2d 574
(2d Cir. 1975). When Silverman arose, one of the requirements for including the proceeds of
an assigned life insurance policy in the insured's gross estate was that the assignment have
been made in contemplation of the insured's death as well as having been made within three
years of that death. In Silverman, the Tax Court found that the insurance policy, which had
been assigned to the insured's son six months prior to the insured's death, had been assigned
by the insured in "contemplation of his death." The "contemplation of death" requisite was
eliminated when the Code was amended in 1976.

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total premiums paid on the policy. 9 The court, then, applied that ratio to the
proceeds of the policy to determine the amount includible in the insured's
gross estate. In Silverman, the insured had paid 88.71% of the premiums and
the assignee had paid 11.29% of the premiums. The Tax Court held,
therefore, that 88.71% of the proceeds of the policy were includible in the
insured's gross estate and 11.29% were excludible.

Our position is that the Silverman analysis gives taxpayers a windfall
and provides life insurance an unfair advantage over other investment
vehicles. We argue that Silverman was inconsistent with the law existing
when the case was decided and, more importantly, is inconsistent with section
2035 as reformulated by the 1997 Act. To set the stage for our argument, we
begin with brief discussions of the operation of life insurance, the different
types of life insurance, and the economic elements that comprise life
insurance. We next survey the relevant provisions of the tax laws, as they
now exist, that apply to life insurance policies and proceeds. Finally, we
examine several different types of circumstances in which an insured has
assigned life insurance to a third party and consider whether the current tax
treatment of such assignments "has it right," in light of the amendments to
section 2035 made by the 1981 Act and especially the 1997 Act. Special
emphasis will be given to the Silverman-type situation in which the insured
assigns a policy within three years of death and the assignee pays the post-
assignment premiums.

II. THE ECONOMIC COMPONENTS OF LIFE INSURANCE

Life insurance covers the risk that the insured will die while the
policy is in force. Once purchased, a policy remains in force as long as the
premiums are paid. Unless a policy is a single-premium policy, premiums
become due at specified intervals.10 If the insured dies while the policy is
in force, the life insurance company pays a specified amount of money to the
beneficiaries of the policy.

The cost of the risk coverage (the pure insurance cost of the policy)
is determined roughly in the manner indicated by the following example.

9. Although the Tax Court spoke of the ratio of premiums paid by the insured and
by the assignee to the total premiums paid on the policy, it seems clear that the Tax Court
meant to refer to the ratio of premiums paid by the insured before or after the assignment and
the premiums paid by the assignee (or someone else) after the assignment. The difference
between the two formulations made no difference in the Silverman case itself, because the
insured paid all of the premiums that became due before the assignment and the assignee paid
all of the premiums that became due after the assignment.

10. Because there is no legal obligation to pay the premiums on a life insurance
policy, the policy can be terminated at any time.

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Tax Consequences of Assigning Life Insurance

Suppose that a person of x age and in good health wishes to acquire $1,000
of life insurance for a one-year period. The insurance company's actuarial
tables indicate that 1% of persons of x age will die during that year. Thus, a
premium charge of approximately 1% ($10) will cover the risk of death for
that year. But the company will pass on management and selling expenses,
and will charge a somewhat higher premium. If the insurer is a profit-making
stock company, the premium may also include an allowance for the
company's profit. If the insurer is a mutual company," the company will
charge a larger premium than it reasonably expects to need and at the end of
each year will return the excess amount over its actual needs to the policy-
holders as a so-called "dividend."' 2 Policies that pay such "dividends" are
called "participating insurance." While participating insurance is commonly
offered by mutual companies, it is also offered by some stock companies.

Pure insurance coverage for a stated term is called "term insurance."
In the case of the insured of x age, the annual premium of a $1,000 one-year
term policy was $10 plus. If the insured should wish to continue that
coverage for an additional year, the premium cost will be higher, since the
percentage of persons x + 1 years of age who are projected to die during the
year is greater than the percentage of persons only x years of age. Thus, each
year the premium cost of the term insurance will increase. Term insurance
typically is issued for a specific term such as five years, with an automatic
renewal for an additional five years at the end of each term." The premium
cost of the insurance, however, will increase as the insured ages. If the
insured attains an advanced age, the premiums will become quite costly.

If the insured wishes to have insurance for more than one year but
seeks to avoid this steady increase in the annual premium, the insured can
purchase life insurance for a term consisting of a substantial number of years
and pay the same amount of premium each year for a decreasing amount of
insurance. The annual premium payments will remain constant, but every few
years the amount of insurance coverage will be reduced. This variation of
term insurance is called "declining term life insurance."

A second type of life insurance is ordinary life, frequently called
"straight life" or "whole life." Ordinary life insurance combines the purchase
of pure risk coverage with an investment. Part of the premium is charged to
the pure insurance coverage of the policy (including the company's expenses)
and part of the premium is treated as an investment by the policyholder with
the insurer. The investment portion is referred to as the policyholder's

11. A mutual company has no stockholders and passes its earnings on to its
policyholders and to certain beneficiaries of matured policies.

12. See infra notes 21-22.
13. Because the policyholder can terminate a policy at any time. the policyholder

need not accept the renewal.

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Florida Tax Review

"reserve," or "terminal reserve," or "equity reserve" in the policy. The reserve
is an equity interest that typically appreciates in value each year at a fixed
rate established in the insurance contract. 14

In the first few years of an ordinary life policy, the policyholder
obtains little or no reserve in the policy because most of the early premiums
are used to pay the company's expenses, including selling commissions. After
this initial period, the reserve increases each year, both because of
appreciation in the established reserve and because of the policyholder's
payment of additional premiums. Since the amount payable at death is
typically a fixed dollar figure (or a minimum amount), the amount of
insurance risk coverage purchased by the policyholder is the difference
between the amount payable at death and the policyholder's reserve. Since the
reserve, representing the policyholder's equity, increases each year, the
policyholder actually purchases less insurance each year, resulting in
premiums that remain at a constant level. In effect, the policyholder has
combined an investment program providing a secure (but often relatively low)
rate of return with declining term life insurance coverage.

A policyholder has the right to borrow against the reserve or to
surrender the policy for its cash surrender value. Because of administrative
costs, the cash surrender value is slightly less than the policyholder's reserve.
The cash surrender value of a nonvariable ordinary life insurance policy can
typically be determined from tables included in the policy. After
approximately five years from the date a policy is taken out, the cash
surrender value will usually be only slightly less than the policyholder's
reserve and can be used as an approximation of the reserve for planning
purposes. Upon request, the insurer will provide the policyholder with a
statement of the current value of the reserve. In the case of variable life
insurance, the insurer's statement will be the only means of obtaining a
valuation.

On the death of the insured, the proceeds of the policy are payable
according to the method of settlement elected by the owner of the policy or
by the beneficiary. The various methods available for settling the proceeds of
a matured life insurance policy are referred to as "settlement options." These
settlement options, typically elected by the beneficiary after the insured's
death, permit an election either to have the insurance proceeds paid in one

14. A variation of ordinary life is "variable life insurance." It is similar to ordinary
life insurance, except that it may not guarantee a specified return. The policyholder's reserve
and the death benefit may vary from year to year according to the relative success or failure
of the insurer's investment program. A guaranteed minimum death benefit is, however,
typically provided.

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Tax Consequences of Assigning Life Insurance

lump sum or to have the insurance company retain the proceeds and pay them
out under one of a variety of plans.' 5

Three economic components of life insurance emerge from the above
description of life insurance: (1) the term insurance coverage component
(coverage against the risk of the insured's death within the period covered by
the last premium paid); (2) the right of continuation component (the right to
continue having insurance coverage at a fixed price, regardless of the
insured's health, beyond the period covered by the last premium); and (3) the

15. Some of the most common options are:
(a) Interest only or deposit option-interest is paid currently to the beneficiary, who
is empowered to change to some other settlement option (including a lump sum
payment). Some policies require the beneficiary to make a change of election within
some stated period of time after the insured's death, but most policies permit the
change of election to be made at any time. The purpose of the deposit option is to
provide interest on proceeds left with the insurer while the beneficiary decides which
settlement to elect.
(b) Fixed period option-the proceeds are paid out in installments of no less than
a specified amount over a fixed period of time. If the policy earns more than a
minimum guaranteed interest for any installment period, the amount of installment
payment made to the beneficiary for that period will be increased accordingly.
(c) Fixed amount option-the proceeds are payable in a specified minimum number
of installments of a fixed amount. If the policy earns more than the guaranteed
minimum income, the number of payments is increased but the amount of each
installment payment remains constant.
(d) Straight life annuity-a periodic payment of a fixed dollar amount to be made
during the life of the beneficiary. Recently, some life insurance companies have
offered a variation of the straight life annuity called the "variable life annuity,"
under which the periodic payments will vary in amount according to the success of
the company's investments.
(e) Self and survivor annuity-an annuity of a specified amount paid periodically for
the life of the primary beneficiary and on his or her death, survived by a named
secondary beneficiary, an annuity of a specified amount (which may be smaller than
the primary beneficiary's annuity) will be paid to the secondary beneficiary for life.
(f) Joint and survivor annuit)---an annuity for the joint lives of two beneficiaries and
for the life of the survivor. (The term "joint and survivor annuity" is sometimes used
to describe a self and survivor annuity option.)
(g) Annuity with a refimd or guaranteed payment-a refund feature of an annuity
provides that if less than a specified amount has been paid to the beneficiary or
beneficiaries at the time of the death of the last annuitant, the difference is payable
in one lump sum to some named person or persons. Another variation of this is an
annuity option with a guaranteed payment feature which provides that payments aill
be made for no less than a specified period of time, regardless of when the
beneficiaries die.

Although settlement options are not as flexible a vehicle as a trust, they are not entirely
inflexible. For example, a fixed period option may provide for installment payments for part
of the option period larger than other payments, although the size of the payments typically
must be fixed at the time that the election is made.

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equity or terminal reserve component. Of course, not all life insurance
policies contain all three components. Term insurance, for example, provides
no equity for the policyholder. Nevertheless, it is important to keep these
components in mind for they will be crucial to our analysis of the proper tax
treatment that should be accorded to assignments of life insurance policies.
To set the stage for this analysis, Part II describes the general framework of
the current system of taxing life insurance.

M. THE GENERAL FRAMEWORK FOR TAXING LIFE INSURANCE

A. Income Taxation of Life Insurance

1. Exclusion of Proceeds from Gross Income.-In general, section
101 of the Internal Revenue Code excludes life insurance proceeds from the
beneficiary's gross income.1 6 The exclusion is straightforward when the
proceeds are payable in one lump sum.

The exclusion becomes somewhat complicated when the pay-out is
governed by one of the settlement options providing for the retention of the
proceeds by the insurer. Interest paid to a beneficiary on proceeds held by the
insurer is included in the beneficiary's gross income.17 In the case of
installment payments,'" the interest portion of the payment is included in the
beneficiary's gross income, but the portion of the installment payment that
is characterized as principal is excluded. 9 Typically, the "principal" portion
of an installment payment is a percentage of the face amount of the
insurance. The same proportion of each installment payment is excluded at
least until the aggregate of the excluded amounts exceeds the face amount of

16. One important exception to the exclusion is the "transferee for value" rule. If
the person owning a life insurance policy on the death of the insured had acquired it for
valuable consideration from someone other than the insurer, the amount of proceeds excluded
from gross income is limited to the consideration, premiums, and certain other amounts paid
by such person. See IRC § 101(a)(2). For policies issued after June 8, 1997, the reference to
"other amounts" includes interest paid or accrued by the transferee on a debt incurred with
respect to the insurance if such interest is not deductible because of IRC § 264(a)(4). This rule
does not apply to a person who initially purchased the policy from the insurer, nor to a
transferee of a policy who received it without consideration, provided that the transferor was
not a transferee for value (or a transferee of a transferee for value). See Regs. §§ 1.101-
l(b)(3)(iii), 1.101-1(b)(5) ex. (4). Even if a transferee acquired the policy for valuable
consideration, the transferee for value rule is not applicable if the transferee was the insured,
a partner of the insured, a partnership in which the insured is a partner or a corporation in
which the insured is a shareholder or officer. See IRC § 101(a)(2)(B).

17. See IRC § 101(c).
18. Typically, such payments are made under an annuity, fixed amount, or fixed

period option. See supra note 15. Special rules apply to certain life insurance policies that were
issued before 1985 (or before 1983 in certain cases). See IRC § 101(f).

19. See IRC § 101(d)(1).

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Tax Consequences of Assigning Life Insurance

the policy, which occurs when a beneficiary of an annuity option outlives his
or her life expectancy.2

2. Appreciation in Reserve.-A policyholder's reserve or equity
interest in an ordinary life insurance policy appreciates each year. Although
the appreciation constitutes "earnings" from the policyholder's investment to
the extent that the appreciation is not due to the payment of additional
premiums, those "earnings" are not taxed to the policyholder.21 The rationale
is that the income has not been "realized," or even "constructively received,"

20. If the transferee for value rule applies, however, the principal portion is not
excluded from gross income. See supra note 16.

It is currently unclear whether the principal portion continues to be excluded for

payments received in excess of the face amount of the policy. Before the adoption of the Tax
Reform Act of 1986, the principal portion continued to be excluded, even though the face
amount of the policy had already been received by the beneficiary. The regulations still so
provide. See Regs. § 1.101-4(c). Before 1986, the same rule of exclusion applied to annuity
payments taxable under § 72. However, in the Tax Reform Act of 1986. Congress amended
§ 72 to limit the exclusion to the investment in the annuity contract. See IRC § 72(b)(2).
While no explicit amendment was made to § 101, the question remains whether the
amendment to § 72 implicitly amended § 101 as well.

21. If a policyholder owns a participating life insurance policy, the so-called
"dividend" paid by the insurer to the policyholder each year is in fact a return of part of the

premiums previously paid by the policyholder, and so such "dividends" are not included in the
policyholder's gross income. See I J. Mertens, The Law of Federal Income Taxation § 7.08
(rev. ed. 1974) (citing Regs. § 1.72-11(b) (1960)); cf. Rev. Rul. 64-258, 1964-2 C.B. 134,
obsoleted by Rev. Rul. 82-148, 1982-2 C.B. 401 (holding that such payments do not constitute
an inurement of net earnings to the policyholders so that a tax exempt organization's
distribution to its members of the "dividends" it received on policies insuring the life of its
members did not disqualify the organization of its tax exempt status under IRC § 501(c)( 10)).
Even "dividends" remitted on paid-up policies-policies for which no further premium
payments are due-are excluded from gross income because such dividends are in essence a
reduction of premiums paid in prior years. See I J. Mertens, supra, § 7.08, at 18 n.35. If,
however, the policyholder does not withdraw the dividends from the insurance company, but
instead leaves them on deposit with the insurer to earn interest, the interest credited to the
accumulated dividends is included in the policyholder's gross income; such interest is no
different from interest credited to a savings account deposit. Id.

If a policyholder sells an insurance policy to a third party, the policyholder will
recognize a gain on the sale only if the amount realized thereon exceeds the policyholder's
basis in the policy. Since all of the premiums previously paid by the policyholder (less
"dividends" received) are included in the policyholder's basis, the amount realized often will
not exceed the seller's basis. The reason that the amount realized on a surrender of the policy

often will be less than the policyholder's basis is that the policyholder is permitted to include
in basis the portion of the premiums that was attributable to the purchase of the insurance
coverage for a specified period. The policyholder's basis is not limited to the portion of the

premium that constituted the policyholder's addition to the reserve. Under a special provision
in IRC § 101(g), sales by an insured who is chronically or terminally ill of any part of a death
benefit to a "viatical settlement provider" will not be taxed.

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in the tax sense.22 Moreover, even though the face amount of the proceeds
payable to the beneficiary upon the death of the insured includes this
appreciation in the policyholder's equity, such proceeds are typically excluded
from the gross income of the beneficiary by section 101.23

B. Gift Taxation of Life Insurance

There is no statutory gift tax provision expressly dealing with the
transfer of a life insurance policy or the payment of its premiums. Such
transfers are dealt with under the general gift tax provisions applicable to all
types of transfers. 4 The regulations do provide that if the insured
irrevocably assigns an insurance policy to another, "[t]he insured has made
a gift of the value of the policy" to the extent that the assignment exceeds the
value of any consideration received by the insured.25

The gift tax value of a life insurance policy is its replacement
cost-the amount necessary to purchase a comparable policy from a company
regularly engaged in selling insurance.26 Although the value of a policy can
be influenced by unusual provisions in the policy itself,27 the value is not
affected by any external facts such as the health of the insured at the time of
the gift. If the insured's health were taken into account, it would be necessary
to determine the health of the insured in the case of every assignment and to
estimate the effect of the insured's health on the valuation question by
resorting to medical evidence and actuarial expertise. Such inquiries would
impose a great administrative burden on both the government and on
taxpayers. Presumably believing the burden to be too costly, the Service has
not taken the insured's health into account in valuing policies for gift tax
purposes.'

In some cases, such as the case of a policy that has been in effect for
some time and upon which further premiums must be paid, the value of an
insurance policy may not be readily ascertainable. In such cases, if the
insurance is an ordinary life, nonvariable policy, the value of the gift is
obtained by combining the amount of the terminal reserve of the policy at the
date of the gift and the proportionate part of the last premium paid before the

22. See Cohen v. Commissioner, 39 T.C. 1055, 1062-64 (1963).
23. It should be recalled, however, that IRC § 101(a)(2)-the "transferee for value"

provision discussed supra note 16-is an exception to this rule.
24. See IRC §§ 2511-2512.
25. Regs. § 25.2511-1(h)(8). Although the regulation only refers to a gift by the

insured, a gift tax will be imposed on any donor of a life insurance policy, unless a section
of the Code expressly provides otherwise.

26. See Regs. § 25.2512-6(a).
27. See id. See also Rev. Rul. 77-181, 1977-1 C.B. 272.
28. Nor has the Service taken the insured's health into account for estate tax

purposes when a decedent dies owning a policy on the life of another.

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Tax Consequences of Assigning Life Insurance

date of the gift covering the period extending beyond that date.Z9 If the
insurance is a variable policy, the value can be obtained from the insurer. If
the donor continues to pay premiums after assigning the policy, each
premium payment is an additional gift.3"

All or a portion of a gift of a life insurance policy may be excluded
from gift tax. Section 2503(b) provides that a donor is entitled to an annual
exclusion (currently in the amount of $10,000) for gifts, other than gifts of
"future interests,"'" given to each donee. An outright gift of an insurance
policy (as contrasted to a gift in trust) is treated as a gift of a present interest,
even though the proceeds will not be collected until a future date.32 The

29. The Regulations give the following example:
Example (4). A gift is made four months after the last premium due date of an ordinary life
insurance policy issued nine years and four months prior to the gift thereof by the insured,
who was 35 years of age at date of issue. The gross annual premium is S2,811.
The computation follows:

Terminal reserve at end of tenth year S14,601.00
Terminal reserve at end of ninth year 12.965.00
Increase S 1,636.00
One-third of such increase (the gift having been
made four months following the last preceding
premium due date), is S 545.33
Terminal reserve at end of ninth year 12,965.00
Interpolated terminal reserve at date of gift 13,510.33
Two-thirds of gross premium ($2,811) 1.874.00
Value of the gift S15,384.33

Regs. § 25.2512-6(a) ex. 4.
30. See Regs. § 25.2511-1(h)(8).
31. The term "future interest" has its own definition under the gift tax provisions

and does not have the same meaning as it does under general property law. Any gift under
which the donee's possession, use or enjoyment is postponed is a gift of a future interest. See
Regs. § 25.2503-3(a). Note that beginning in 1999, the $10,000 exclusion figure will be
increased annually to reflect inflation. IRC § 2503(b)(2).

If the donor is married and the donor's spouse consents to split the donor's gifts
between them under IRC § 2513, the S10,000 available annual exclusion for the donor's gifts
to a third party (someone other than the donor's spouse) may be doubled to $20,000. If a gift
is made to the donor's spouse, only $10,000 can be excluded, but the balance of the gift may
qualify for a marital deduction.

32. In Rev. Rul. 55-408, 1955-1 C.B. 113, the Commissioner repudiated a
suggestion made by the Tax Court in Nashville Trust Co. v. Commissioner, 2 T.C. Memo
(CCH) 99 (1943), that a gift of a policy before it had built up any cash surrender value was
a gift of a future interest. See also Regs. § 25.2503-3(a). It should be noted, however, that if
the gift is subject to a limitation which restricts the donee's right to reassign the policy, obtain
its cash surrender value or borrow against its terminal reserve, then the donated property
constitutes a future interest, and no annual exclusion can be claimed. See Ryerson v. United
States, 312 U.S. 405, 408-09 (1941); Skouras v. Commissioner, 188 F.2d 831 (2d Cir. 1951);
Smyth v. Commissioner, 2 T.C. Memo (CCH) 4 (1943).

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annual exclusion can also apply to premium payments subsequently made by
the donor.33 If a life insurance policy is assigned to a trustee, however, the
gift of the policy and any subsequent premiums paid by the donor likely will
not qualify for the annual exclusion.' A gift of a life insurance policy or the
payment of premiums on a policy owned by another may also be exempt
from gift taxation if the gift qualifies for the gift tax charitable or marital
deduction.35

C. Estate Taxation of Life Insurance

1. In General.-Upon the insured's death, the proceeds paid to the
beneficiaries are composed of two elements: the policyholder's equity interest
in the policy and a death benefit payment (an amount representing the
proceeds of the risk coverage element of the policy).36

If the proceeds are payable to the insured's executor, section 2042(1)
requires the proceeds to be included in the insured's gross estate, even if the
policy was owned by another at the insured's death. Application of this
provision, while not free of ambiguity, has not been especially troublesome.
In general, the reference to the insured's "executor" means payable to or on
behalf of the insured's estate.37

If the proceeds are payable to someone other than the insured's
executor, section 2042(2) requires the proceeds to be included in the insured's
gross estate if the insured possessed, at death, any "incidents of ownership"
in the policy. Although the Code makes no attempt to define "incidents of
ownership," the regulations provide that the term is not limited to actual
dominion over the policy, but also includes a lesser economic interest or
benefit, such as the right to surrender or cancel the policy, change the named
beneficiary, or pledge the policy for a loan.38

33. See Rev. Rul. 76-490, 1976-2 C.B. 300; Rev. Rul. 55-408, 1955-1 C.B. 113.
34. See Kahn & Waggoner, supra note 1, at 954. But see Rev. Rul. 76-490, 1976-2

C.B. 300.
35. See IRC §§ 2522, 2523.
36. See, e.g., United States v. Bess, 357 U.S. 51, 59 (1958); Old Kent Bank and

Trust Co. v. United States, 430 F.2d 392, 395-96 (6th Cir. 1970). This view of insurance
conforms with the actuarial justification for the size of premiums charged for a policy, which
is that the premiums are sufficient only to purchase risk coverage for the difference between
the face amount of the policy and the policyholder's equity. See supra text accompanying
notes 10-11.

37. See Regs. § 20.2042-1(b).
38. See Regs. § 20.2042-1(c)(2). The term also includes "a reversionary interest in

the policy or its proceeds, whether arising by the express terms of the policy or other
instrument or by operation of law, but only if the value of the reversionary interest
... exceeded 5 percent of the value of the policy." Regs. § 20.2042-1(c)(3).

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Tax Consequences of Assigning Life Insurance

2. Transfers Within Three Years of Death.-Section 2035 operates
in conjunction with section 2042 to impose an estate tax on life insurance
proceeds when an insured assigns a policy to another within three years of
death.

Before 1976, the estate and the gift tax statutes operated
independently. 39 Each tax had its own structure, tax rates, exemptions, and
other rules. Testamentary transfers were taxed separately from and more
heavily than inter vivos gifts. The major reform implemented by the Tax
Reform Act of 1976 was the integration of estate and gift taxation. The 1976
Act adopted a single transfer tax base, subjected that base to a comprehensive
rate schedule, and reduced the tax produced by that schedule by a "unified
credit."' 4

Under section 2035 as it existed before the 1976 Act, all gifts made
within three years of death (and in contemplation of death) were included in
the donor's gross estate at their death-time value.4 Although the 1976 Act
continued section 2035's application to all gifts within three years of death,
a byproduct of integrating the estate and gift taxes was to remove much of
the purpose for subjecting all such gifts to the estate tax, especially since the
1976 Act also introduced a gross-up rule under which any gift tax paid on a
gift within three years of death was brought into the donor's gross estate.4"
Under the integrated system, the only tax saving that would be produced by
a gift of property that otherwise would have been included in the donor's
gross estate under section 2033 would be to exempt the post-gift appreciation
on the property from transfer taxation.

The integration of estate and gift taxes did not, however, eliminate
all potential for using death bed transfers to reduce transfer taxes. A potential
for abuse continued to exist for a gift of an item whose retention would have

39. See Douglas A. Kahn et al., Federal Taxation of Gifts, Trusts and Estates 1-8,
387-91 (3d ed. 1997).

40. See id.
41. More precisely, such gifts were included at their estate tax value. Ordinarily, the

decedent's gross estate is valued at its death-time value, but it might be valued at a date up
to six months after the decedent's death if the executor elects the alternate valuation method
under IRC § 2032. In this article, we refer to the death-time value because the estate tax value
of a life insurance policy equals the value of its proceeds, which is its death-time value even
if the alternate valuation method is elected.

42. More precisely, this provision requires inclusion of the gift tax paid by the
decedent (or by the decedent's estate) on any gift made by the decedent or by the decedent's
spouse within three years of the decedent's death. See IRC § 2035(b). This provision was
originally set forth in § 2035(c) prior to the amendment made by the Taxpayer Relief Act of
1997. The purpose of adding this provision was to eliminate the incentive for making deathbed
taxable gifts in order to exclude the resulting gift tax payments from the donor's transfer tax
base. See H.R. Rep. No. 1380, 94th Cong., 2d Sess. 14 (1976).

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caused a much larger amount than would result from ordinary post-gift
appreciation to be included in the donor's gross estate than the item's current
value, most notably a gift of a life insurance policy.

The 1976 Act could therefore have limited the scope of section 2035
by making it applicable only to transfers having the potential for abuse. But
it did not. Instead, the 1976 Act expanded the scope of section 2035. Before
1976, section 2035 required the inclusion in a decedent's gross estate of the
value of all property, including life insurance, given away by the decedent
within three years of death, but only if the transfer was made in
contemplation of death. The 1976 Act eliminated the contemplation of death
requirement. As revised in 1976, section 2035 required the inclusion of all
gifts made within three years of death, regardless of motive.

The Economic Recovery Tax Act of 1981 made section 2035 no
longer applicable to all gifts within three years of death.43 The 1981 Act
confined section 2035 to what we call "tainted gifts"-gifts of an interest in
or power over property that would have been included in the decedent's gross
estate under sections 2036 through 2038 or section 2042 had the transfer not
taken place.' The 1981 Act also retained the provision pertaining to the

43. See IRC § 2035(a). This narrowing of the scope of § 2035 was originally set
forth in § 2035(d)(1) prior to the amendment made by the Taxpayer Relief Act of 1997. For
an article urging Congress to return § 2035 to the form it took under the 1976 Act, under
which all gifts within three years of death were included in the donor's gross estate, see
Jeffrey G. Sherman, Hairsplitting Under IRC Section 2035(d): The Cause and the Cure, 16 Va.
Tax Rev. 111 (1996).

44. See IRC § 2035(a)(2). This provision was originally set forth in § 2035(d)(2)
prior to the amendment made by the Taxpayer Relief Act of 1997. In general terms, IRC
§ 2036 includes in the gross estate transfers with a retained life estate, § 2037 includes
transfers with a retained reversionary interest, and § 2038 includes transfers with a power to
alter, amend, revoke, or terminate. The inclusion of § 2038 in § 2035's list of tainted gifts was
probably unnecessary, since § 2038 itself already provided that a relinquishment of the power
to alter, amend, revoke, or terminate within three years of death causes the full value of the
property to be included in the decedent's gross estate. See IRC § 2038(a)(1).

Congress should reconsider its decision to classify a gift of a retained life estate or
a relinquishment of a power to revoke within 3 years of death as a tainted gift to which § 2035
applies. Under IRC § 2702, added to the Code in 1990, a transfer to a family member with
a retained life estate subjects the full value of the property to gift taxation, not the value of
the remainder interest. The original transfer, whether within or more than 3 years before death,
is in effect treated as an outright gift with no strings attached. Under Regs. § 25.2511-2, a
relinquishment of a power to revoke, whether within or more than three years before death,
subjects the full value of the property to gift taxation.

Because the question of whether Congress should amend § 2035 to remove these
types of gifts from the tainted gift category is beyond the scope of this article, we do not
discuss the question further. For a more complete discussion of this question, see Sherman,
supra note 43, at 148-51.

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inclusion of the gift tax on all gifts within three years of death. 5

Congress restyled and reorganized section 2035 in the Taxpayer
Relief Act of 1997. Although Congress largely retained the substance of the
1981 revisions, it shifted the wording in a subtle but significant way. As
reformulated in 1997, section 2035 straightforwardly includes the amount that
would have been included had the tainted gift not been made.' The
preceding version was less clear regarding how the amount to be included
was to be calculated.47

In sum, although section 2035 has undergone significant change over
the years, the need for section 2035 to prevent evasion of section 2042 has
remained constant.

IV. ASSIGNMENT MORE THAN THREE YEARS BEFORE DEATH

If, more than three years before death, an insured assigns to another
all incidents of ownership in a life insurance policy (whether the assignment
is made outright or in trust), the proceeds of the policy will not be included
in the insured's gross estate, provided that the insured does not retain or
subsequently acquire (directly or indirectly) any incident of ownership in the
policy. Section 2035 does not apply since, on its terms, that provision only
covers transfers made within three years of death. The assignment is, of
course, subject to the gift tax, except to the extent that the assignment
qualifies for the gift tax annual exclusion or the marital or charitable

45. See supra note 42.
46. As revised in 1997, IRC § 2035 provides that "if (1) the decedent made a

transfer (by trust or otherwise) of an interest in any property, or relinquished a power with
respect to any property, during the 3-year period ending on the date of the decedent's death.
and (2) the value of such property (or an interest therein) would have been included in the
decedent's gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or
relinquished power had been retained by the decedent on the date of his death, [thenl the value
of the gross estate shall include the value of any property (or interest therein) which would
have been so included." (Emphasis added.)

The Taxpayer Relief Act of 1997 is applicable to estates of decedents dying after
August 5, 1997. In this article, we sometimes refer to the law existing before the effective date
of the 1997 Act as "pre-1998" law, though the 1997 Act does apply to part of 1997.

47. The language of the preceding version was generally read to include an amount
calculated by determining the death-time value of the donated property. As revised in 1981,
§ 2035 provided in effect that if the decedent transferred "an interest in property which is
included in the value of the gross estate under section 2036, 2037, 2038, or 2042 or would
have been included under any of such sections if such interest had been retained by the
decedent," then "the value of the gross estate shall include the value of all [such] property to
the extent of any interest therein of which the decedent has at any time made a transfer, by
trust or otherwise, during the 3-year period ending on the date of the decedent's death."
(Emphasis added.)

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deduction. Except to the extent excludible or deductible, the value of the gift
is also included in the insured's estate tax base as an "adjusted taxable
gift."

48

A. Payment of Premiums by the Insured

If, after assigning a policy to another more than three years before
death, the insured continues to pay the premiums, those payments are subject
to the gift tax, except to the extent that they are excluded by the annual
exclusion or deductible under the marital or charitable deduction. Any such
premium payments that are not excludible or deductible are also included in
the insured's estate tax base as "adjusted taxable gifts."49

The question of the amount includable under section 2035 because
of premium payments made by the insured within three years of death, once
a controversial issue, has been settled for some years now. The nature of this
controversy and its ultimate resolution bear on the question of the merits of
the Silverman approach, which is the focus of this article. We now turn to
that issue.

B. Premium Payments as a Constructive Transfer of a Portion of a Policy

In 1967, in Revenue Ruling 67-463,5o the Commissioner ruled that
the insured's gross estate included that proportion of the insurance proceeds
equal to the ratio that the amount of premiums paid by the insured within
three years of death bore to the aggregate amount of premiums paid on the
policy. The theory was that an insured's payment of a premium on a life
insurance policy owned by another-in this case, the person to whom the
insured had previously transferred the policy-constituted a transfer to the
policyholder of a proportionate interest in the underlying policy.5

Revenue Ruling 67-463 relied on the 1929 decision of the Supreme
Court in Chase National Bank v. United States.51 In Chase, the insured had

48. See IRC § 2001(b). If the assignment was made to someone other than the
insured's spouse, and the insured and his or her spouse elected to split the gift under IRC
§ 2513, then only the insured's one-half share (less the annual exclusion, if any) is included
in the insured's adjusted taxable gifts. The other half (less any annual exclusion allowed to the
nondonor spouse) will be included in the estate tax base of the nondonor spouse on that
spouse's death.

49. If split gift treatment under IRC § 2513 was elected for such payments (see
supra note 48), the portion of the payments attributable to the insured's spouse is excluded
from the insured's adjusted taxable gifts. See IRC § 2001(b).

50. 1967-2 C.B. 327 (revoked by Rev. Rul. 71-497, 1971-2 C.B. 329).
51. Id. The position adopted by the Commissioner in 1967 applied only to premium

payments made in contemplation of death. As noted in the text, the 1976 Act eliminated the
contemplation of death requirement.

52. 278 U.S. 327 (1929).

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Tax Consequences of Assigning Life Insurance

purchased life insurance in which he named his wife as beneficiary and
retained incidents of ownership until his death. The insured, who died within
two years of purchasing the insurance, had paid all premiums due on the
policies. The insured's estate challenged the constitutionality of the statute
(the antecedent of section 2042(2)) that subjected the insurance proceeds to
estate taxation. The estate contended that the tax was one on property itself,
and therefore an unconstitutional unapportioned direct tax, rather than a tax
on a "transfer" of property. This was so, the estate argued, because the
insured had never transferred the proceeds to the beneficiary. Rather, the
beneficiary had acquired the proceeds directly from the insurer.53

In upholding the validity of the tax, the Supreme Court held that in
substance the insurance proceeds had been transferred by the insured to the
beneficiary, since his instruction to the insurer to pay the proceeds to his wife
constituted a procurement of the proceeds by him for delivery to his wife.
The Court determined that a person who purchases property from another to
be delivered to a third party is to be treated as having transferred that
property to the third party, and indicated that this principle would apply in
interpreting the word "transfer" in the Code as well as in deciding the
constitutionality of a particular provision.'

The courts, however, uniformly rejected the Commissioner's attempt
to apply the Chase holding to premiums paid within three years of death on
a policy that the insured had irrevocably transferred to another more than
three years before death.55 The courts did not repudiate the Supreme Court's
construction of the word "transfer," but held it inapplicable to the payment
of premiums on a policy owned by another. The clearest statement of the
rationale for rejecting the Commissioner's position' was given by the Fifth
Circuit in First National Bank v. United States:57

53. Id. at 334.
54. Id. at 337-38.
55. See First Nat'l Bank v. United States, 423 F.2d 1286, 1288 (5th Cit. 1970);

Gorman v. United States, 288 F. Supp. 225, 228-31 (E.D. Mich. 1968); Estate of Coleman, 52
T.C. 921, 923-24 (1969). See also Estate of Chapin, 29 T.C. Memo (CCH) 11, 15-16 (1970);
Lowndes & Stephens, Identification of Property Subject to the Federal Estate Tax, 65 Mich.
L. Rev. 105, 124-25 (1966); Note, Section 2035 as a Basis for Including Life Insurance
Proceeds in the Gross Estate of an Insured Who Paid Premiums on a Policy Owned By
Another Person, 67 Mich. L. Rev. 812 (1969).

56. Even if the Commissioner had prevailed in arguing that there was a constructive
transfer of a portion of the insurance proceeds, the portion includible should not have been
figured on the basis of the Commissioner's formula. The Commissioner's formula undoubtedly
was derived from the old payment of premiums test that Congress eliminated from IRC § 2042
in 1954. The failings of the premium payment test are discussed in Kahn & Waggoner, supra
note 1, at 970-75.

57. 423 F.2d 1286 (5th Cir. 1970).

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Florida Tax Review

The actual essence of the Government's position is that it
wishes to place a decedent who pays the premiums on a
policy owned by another on the same footing with one who
physically transfers the policy itself. It is said that the
... [policyholders] received insurance benefits and not cash
and that the payment of each and every premium helped to
produce the proceeds. The answer to this, however .... [is]
that the rights maintained belonged to the owners, not to the
decedent, and were thus neither transferred nor transferrable
by the decedent.58

After losing every litigated case on this issue, the Commissioner
reconsidered his original position and issued Revenue Ruling 71-497, which
revoked the 1967 ruling and conceded that only the dollar amount of
premiums paid by the insured within three years of death would be included
in the insured's gross estate. 59 This latter portion of Revenue Ruling 71-497
was made obsolete by the 1981 amendments of section 2035. 60 For
decedents dying after 1981, premium payments made by an insured within
three years of death are subject to the gift tax but are no longer includible in
the insured's gross estate, though any gift tax paid on such premium
payments is includible.1

V. ASSIGNMENT IN SUBSTANCE WITHIN THREE YEARS OF DEATH

Revenue Ruling 71-49762 dealt with another issue-the purchase of
an insurance policy for another within three years of death. Under the facts
considered in this portion of the ruling, the insured, nine months before he
died from accidental causes, purchased a one-year term accidental death
policy insuring his life. The insured's children were designated as the owners
as well as beneficiaries of the policy. Although the insured never actually
possessed an incident of ownership in the policy, the Commissioner ruled that
under section 2035, the entire proceeds were includable in the insured's gross

58. 423 F.2d at 1288, accord Bintliff v. United States, 462 F.2d 403, 406 (5th Cir.
1972).

59. 1971-2 C.B. 329, revoking Rev. Rul. 67-463, 1967-2 C.B. 327. In Rev. Rul.
71-497, the premiums were paid on both an ordinary life insurance policy and on a term life
insurance policy.

60. None of the exceptions discussed supra in the text accompanying notes 43
through 45 apply.

61. See IRC § 2035(b). Also, any premium payments that constituted a gift will be
included in the donor's adjusted taxable gifts to the extent not covered by the annual exclusion
or the marital or charitable deduction. See IRC § 2001(b).

62. 1971-2 C.B. 330.

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Tax Consequences of Assigning Life Insurance

estate. The Commissioner's theory was that the insured had transferred
ownership of the policy to his children and had not merely paid a premium
on a policy that they owned. The Commissioner again relied on the Chase
National Bank case, and this time, until section 2035 was amended in 1981,
the Commissioner's position was sustained by the courts, initially in a
decision of the Fifth Circuit, Bel v. United States.6

In Bel, the insured had used community funds each year to purchase
a one-year term accidental death policy in the name of his three children. 4

The insured died within ten months of acquiring the last policy.' Referring
to the Chase National Bank opinion and relying on section 2035 rather than
section 2042, the Fifth Circuit treated the insured as having assigned the
policy itself to his children within three years of death and accordingly
included half of the proceeds (the insured's community share) in his gross
estate.66 While explicitly recognizing that the insured never possessed any
incident of ownership, the court concluded:

[S]ection 2042 and the incidents-of-ownership test are totally
irrelevant to a proper application of section 2035. We think
our focus should be on the control beam of the word
"transfer." The decedent, and the decedent alone, beamed the
accidental death policy at his children, for by paying the
premium he designated ownership of the policy and created
in his children all of the contractual rights to the insurance
benefits. These were acts of transfer. The policy was not
procured and ownership designated and designed by some
goblin or hovering spirit. Without [the decedent's]
conception, guidance, and payment, the proceeds of the
policy in the context of this case would not have been the
children's. His actions were not ethereally, spiritually, or
occultly actuated. Rather, they constituted worldly acts which
by any other name come out as a "transfer." Had the
decedent, within three years of death, procured the policy in
his own name and immediately thereafter assigned all
ownership rights to his children, there is no question but that
the policy proceeds would have been included in his estate.
In our opinion the decedent's mode of execution is
functionally indistinguishable. Therefore, we hold that the
action of the decedent constituted a "transfer" of the

63. 452 F.2d 683 (5th Cir. 1971).
64. See id. at 686.
65. See id.
66. See id. at 691-92.

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Florida Tax Review

accidental death policy within the meaning of section 2035,
and that the district court erred in failing to include [the
decedent's] community share of the proceed value of the
policy in his gross estate.67

The position adopted in Bel is sometimes referred to as the
"constructive transfer principle" or as the "beamed transfer principle." As a
consequence of the 1981 amendment to section 2035, the courts subsequently
repudiated the constructive transfer principle. The Commissioner also
accepted that it is no longer valid. 68 Although we later discuss (and decry)
the rejection of the constructive transfer principle to original purchases of
policies in the name of another, we first defend the inapplicability of that
principle to payments of insurance premiums on policies owned by another.

A. The Proper Boundary of the Constructive Transfer Principle

As previously noted in Part IV, even before the repudiation of the
constructive transfer principle, the courts had rejected its application to
payments of insurance premiums on policies owned by another, but accepted
its application to original purchases of policies in the name of another. In
each case, the donor purchased something of his or her choosing from the
insurance company for the donee. From this standpoint, both cases are quite
different from a situation clearly outside the proper boundary of the
constructive transfer principle, for example, where the donor gives cash to a
donee to do with it as the donee sees fit. It should be equally clear that, prior
to its repudiation, the constructive transfer principle was fully warranted in
the case of an original purchase of a policy for a donee. Indeed, it would be
difficult to think of a case that would fall more clearly within the proper
boundary of that principle.69

Why then, while the constructive transfer principle was still valid, did
the situation where an insured paid premiums within three years of death on
a policy owned by another not also fall within the proper boundary of that

67. Id. at 691-92.
68. See infra text accompanying notes 77-78.
69. Prior to 1981, other situations were held to fall within the constructive transfer

principle. For example, when a decedent "had" his wife apply for term insurance on the
decedent's life and subsequently paid the policy premiums, the decedent was deemed to have
transferred the policy to his wife. See First Nat'l Bank v. United States, 488 F.2d 575 (9th Cir.
1973). Similarly, when a decedent created an irrevocable trust, directed the trustee to acquire
$100,000 of insurance on the decedent's life out of cash transferred to the trust, and died
within six months thereafter, the decedent was deemed to have transferred the $100,000 policy
to the trustee. See Detroit Bank & Trust Co. v. United States, 467 F.2d 964 (6th Cir. 1972).
See also Estate of Kurihara v. Commissioner, 82 T.C. 51 (1984) (reviewed by the Court).

[VoL 4:5



Tax Consequences of Assigning Life Insurance

principle? Simply put, the reason is that the item of property that the donor
acquired for the donee when purchasing an insurance policy for the donee,
a situation where the constructive transfer principle previously applied, is an
item of property that the donor could have acquired and then given to the
donee. But when an insured pays the premiums on a policy already owned
by the donee, the donor's premium payment does not purchase items of
property that the donor could have acquired and then transferred to the donee.
Only the donee, the policyholder, owns the right to keep the policy in force,
and thus is the only person in whose name the term insurance coverage7"
can be continued and who can benefit from the increase in the equity reserve
in the policy resulting from the premium payment made by the donor. In the
words of the Fifth Circuit in First National Bank, these property interests
were not "transferable by the decedent. ' 71

Holding that the insured's payment of premiums on a policy owned
by another is outside the boundary of the constructive transfer principle
conforms to the policy underlying section 2035. That section was aimed at
capturing in a decedent's gross estate property that would have been included
had the decedent not made a transfer shortly before death. If the insured
possessed no incidents of ownership in a policy within three years of death,
the proceeds would not be included in the decedent's gross estate regardless
of whether the premiums were paid or not.' The gift of the premium
payments therefore do not remove an item (the proceeds) from the decedent's
gross estate since the item would not be part of the decedent's gross estate
in any event.

Since the premium payments do remove the dollar amount of those
payments from the decedent's gross estate, the pre-1982 version of
section 2035 captured all or part of those premium payments in the
decedent's gross estate. As a result of the 1981 amendment of section 2035,
the premium payments are no longer captured by that provision. The
integration of estate and gift taxes made it irrelevant that the dollar amount
of the premium payments themselves were removed from the decedent's
holdings during life rather than transferred at death.

The 1997 amendment of section 2035 makes it even more obvious
that the insured's payment of premiums does not cause an inclusion of the

70. In this article, the phrase "insurance coverage" refers to the difference between
the proceeds payable on the death of the insured and the policyholder's equity reserve in the
policy.

71. See First Nat'l Bank v. United States, 423 F.2d 1286. 1288 (5th Cir. 1970).
72. However, if the proceeds were payable to the decedent's executor (i.e.. payable

on behalf of decedent's estate), the proceeds would be included in decedent's gross estate
under IRC § 2042(1). In this article, we have not discussed that provision because it has no
relevance to the issues at hand.

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Florida Tax Review

insurance proceeds. The current version of section 2035 applies to a transfer
of life insurance within three years of death only when the insurance proceeds
would have been included in the decedent's gross estate under section 2042
if the transfer had not taken place. Manifestly, if the insured possessed no
incidents of ownership within three years of death, section 2042 would not
operate regardless of whether the insured paid premiums during that period.

In sum, the now defunct constructive transfer principle was properly
limited, at least insofar as section 2035 is concerned, to purchases in the
name of the donee of property interests that the donor could have acquired.

B. The Ill-advised Abrogation of the Constructive Transfer Principle

Changes made by Congress to section 2035 in 1981 led three United
States Courts of Appeals, one of which affirmed a unanimous decision by
eighteen Tax Court judges, to abrogate the constructive transfer principle (as
it had been applied in Bel). In Estate of Perry v. Commissioner,3 the
decedent, within three years of death, applied for two insurance policies by
signing application forms as the person to be insured. The decedent's three
sons signed the applications as the proposed policy owners. The decedent
paid the only premium that fell due on one of the policies by a check drawn
on his personal checking account. The decedent paid all of the premiums on
the other policy, consisting of an initial premium paid by check drawn on his
personal checking account and subsequent monthly premiums by pre-
authorized withdrawals from his personal checking account.

In Estate of Headrick v. Commissioner,74 the decedent, a tax
attorney, within three years of death, drafted an irrevocable trust agreement
that authorized, but did not require, the trustee to invest in life insurance
policies on his life and to hold such policies as trust principal. The decedent
selected a bank to act as trustee of the irrevocable trust. The bank president
testified that based on a discussion with the decedent he believed that the
decedent intended the trust to function as an "insurance trust for his family,"
although the decedent did not condition the establishment of the trust on the
bank's commitment to acquire life insurance with the funds contributed to the
corpus. After the trust was established, the bank, as trustee, completed an
application for an insurance policy on the decedent's life. The application
stated that the policy owner and the beneficiary would be the bank as trustee
of the decedent's trust. The decedent signed the application as the insured.

73. 927 F.2d 209, 210-11 (5th Cir. 1991).
74. 918 F.2d 1263, 1264 (6th Cir. 1990), affg 93 T.C. 171 (1989) (unanimous,

reviewed opinion).

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Tax Consequences of Assigning Life Insurance

The bank paid the premiums on the policy from funds that the decedent
contributed to the trust.

In Estate of Leder v. Connissioner,75 the decedent, within three
years of death, signed an insurance application form as the insured and his
wife signed the application as the owner. The premiums were paid by
preauthorized withdrawals from the account of the decedent's wholly owned
corporation. The corporation treated the premium payments as loans to the
decedent.

The courts in all three cases reasoned that the 1981 amendment of
section 2035 makes that section apply to life insurance proceeds only when
section 2042(2) would have applied if the insured had retained an incident of
ownership in the policy instead of transferring it. The courts concluded that
section 2035 does not apply unless the insured once possessed an incident of
ownership and transferred that incident within three years of death. If the
original ownership of the policy was placed in someone other than the
insured, the courts held that the fact that the insured had initiated the
purchase of the policy and directly or indirectly paid the premiums is not
enough to trigger the post-1981 version of section 2035.76

In light of the unanimity of these decisions, the Commissioner con-
ceded the issue in an Action on Decision.' In that AOD, the Commissioner
asserted disagreement with the results in these cases, but decided not to
litigate the issue any further. In several subsequent rulings, the Commissioner
acknowledged that the constructive transfer principle is no longer valid.78

Complete abrogation of the constructive transfer principle was ill-
advised. The constructive transfer principle, which is merely an application
of the widely-utilized substance-over-form doctrine, and is analogous to the
indirect transfer doctrine recognized in the gift tax regulations, 9 should

75. 893 F.2d 237, 238 (10th Cir. 1989), aff g 89 T.C. 235 (1987).
76. See Perry, 927 F.2d at 211-13; Headrick, 918 F.2d at 1265-68: Leder, 893 F.2d

at 240-42.
77. See A.O.D. 1991-012 (Jan. 18, 1991) ("Although we continue to believe that

substance should prevail over form and that such indirect transfers should be included in a
decedent's gross estate, in light of the three adverse appellate opinions .... we will no longer
litigate this issue.").

78. See Tech. Adv. Mem. 93-23-002 (Feb. 24, 1993); Tech. Adv. Mem. 91-41-007
(Jun. 19, 1991).

79. See Regs. § 25.2511-1(a). The regulation provides: "The gift tax applies to a
transfer by way of gift whether the transfer is in trust or otherwise, whether the gift is direct
or indirect, and whether the property is real or personal, tangible or intangible." Id. (Emphasis
added.) Regs. § 25.2511-1(c)(1) explains: "The gift tax also applies to gifts indirectly made.
Thus, any transaction in which an interest in property is gratuitously passed or conferred upon
another, regardless of the means or device employed, constitutes a gift subject to tax." Id.
(Emphasis added.)

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Florida Tax Review

continue to apply to cases in which, in substance, the insured acquired the
policy and then assigned it, even though nominally the assignee initially
acquired the policy. The insured's payment of premiums should not be a
decisive element. Rather, the insured's premium payments should be just one
datum of evidence suggesting that the insured was the actual acquirer of the
policy. Other factors, such as whether the insured initiated the acquisition of
the policy, should also be taken into account. This more restricted view of the
constructive transfer principle had been adopted by the Tax Court before the
doctrine was abrogated entirely.8"

By elevating the formal facts over the substance of what took place,
the courts have opened a loophole in the system. It should not matter that the
donee nominally acquired the newly issued policy from the insurer if the
substance of the arrangement is that the insured instigated the acquisition and
is the true purchaser behind the scenes. It also should not matter whether the
insured was in good health when acquiring the policy because the initial
purchase of a policy in the name of another is a hedge against increased
estate tax liability if the insured dies prematurely, which should only be
allowed to succeed if the insured outlives the initial purchase by more than
three years.8 ' The abrogation of the constructive transfer principle allows

80. See, e.g., Estate of Clay v. Commissioner, 86 T.C. 1266, 1272-73 (1986); cf.
Schnack v. Commissioner, 848 F.2d 933, 939-40 (9th Cir. 1988) (following Clay).

81. For a contrary argument, see Harrison S. Lauer, Estate Taxation of Life
Insurance Transfers: The Impact of the Tax Reform Act of 1976 Still Ignored Twelve Years
Later, 41 Tax Law. 683, 696, 730 (1988). Lauer's argument is that an insured must be in good
health in order to acquire a policy and, consequently, only about half of the insureds who
acquire a policy will die prematurely, the other half outliving their life expectancy. See id. at
716. Thus, he argues, this is not the type of situation to which § 2035 is properly addressed.
He assumes that the only reason that the assignment of an existing policy within three years
of death is brought back into the insured's gross estate under § 2035 is because at the time of
assignment the insured's health might have deteriorated, even if assignment occurred one day
after purchasing the policy, so that at death the insurance element of the policy will have
appreciated substantially beyond its gift tax value at the time of assignment. See id. at 720-21.

Lauer's argument rests on several false assumptions. First, it is not always true that
an insured must take a physical examination and be found to be in good health in order to
acquire a life insurance policy. Employer-paid group term life insurance is usually provided
to new employees without a physical. Secondly, there will be a time gap between taking a
physical examination and the actual purchase of the policy, so that the insured's health might
have deteriorated before purchasing the policy. Finally, and most importantly, application of
§ 2035 does not depend on a finding that the insured was in poor health at the time of
assignment. Section 2035 is not based exclusively on a policy of preventing tax benefits from
accruing to transfers made in anticipation of imminent death. Even the original "contemplation
of death" rule referred to death motives for making the transfer, such as a potential reduction
of estate tax liability, rather than to an anticipation of imminent death. A transfer of a policy
by a healthy individual is a hedge against the possibility of premature death. The purpose of
having another person own the policy is a further hedge designed to reduce the insured's estate

[Vol 4:5



Tax Consequences of Assigning Life Insurance

anyone contemplating the purchase and gift of a life insurance policy to
structure the form, but not the substance, of the transaction to eliminate the
risk of incurring estate tax on the full proceeds if death occurs within three
years. Nothing in the legislative history suggests that Congress intended to
open up such a loophole when it amended section 2035 in 1981. The issue
likely is moot now, but the Commissioner might wish to reconsider the
decision to concede the position taken by the Tax Court and the three courts
of appeal.8 2

VI. OUTRIGHT ASSIGNMENT WITHIN THREE YEARS OF DEATH

We now turn to a gift of a life insurance policy within three years of
death by an insured who, before making the assignment, unquestionably
owned incidents of ownership in the policy. Under section 2035 as
reformulated by the Taxpayer Relief Act of 1997, the amount included in the
decedent's gross estate is the amount that would have been included under
section 2042 had the gift not been made.8 3 Oe sometimes call this the
what-would-have-been-included method of calculating the amount includible.)
Because section 2042 requires the full value of the proceeds to be included
in the insured's gross estate if the insured possessed at death any of the
incidents of ownership in the policy, the starting point is that a gift by the
insured within three years of death of any incident of ownership requires
inclusion of the full value of the proceeds under section 2035.

In 1981, Congress confined section 2035 to tainted gifts.84 (A
"tainted gift" is a gift within three years of death of an interest in or power
over property that would have been included tunder sections 2036 through
2038 or section 2042 had the gift not been made.) Before 1981, most of the
litigation and rulings under section 2035 concerned nontainted gifts-gifts of
property that would have been included in the donor's gross estate under
section 2033 had the gift not been made. The practice under the case law and
rulings, supported by the language of the statute,' was to revalue the
donated property as of the date of death and include that amount in the

tax liability in the case of premature death, which should be allowed to succeed only if the
insured lives for more than three years.

82. See also Sherman, supra note 43, at 131-37.
83. See IRC § 2035(b); see also supra note 46. Any gift tax paid on the gift is also

included. See IRC § 2035(b).
84. See supra text accompanying notes 43-44.
85. IRC § 2035 then provided that the decedent's gross estate includes "the value

of all property to the extent of any interest therein of which the decedent has at any time made
a transfer... in contemplation of his death."

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donor's gross estate.86 (We sometimes call this the death-time-value-of-the-
gift method of calculating the amount includible.)

We argue that even before the 1997 Act expressly adopted the what-
would-have-been-included method, the use of that method for gifts of a life
insurance policy would have avoided many difficulties and would have led
to a more sound result.87 We want to emphasize that using that method is
not essential for a gift of a life insurance policy.8 The old death-time-value-
of-the-gift method, properly applied, would reach the correct result in the
case of a gift of a life insurance policy within three years of death. The
advantage of the new what-would-have-been-included method is that the
correct result is much easier to recognize. In fact, even under the death-time-
value-of-the-gift method, the courts and the Service did reach the correct

86. This practice sometimes proved troublesome. See, e.g., Commissioner v. Estate
of Gidwitz, 196 F.2d 813 (7th Cir. 1952) (income generated by property transferred within
three years of death not includible in donor's gross estate); Rev. Rul. 80-336, 80-2 C.B. 271
(death-time value of gift of stock within three years of death includes the value of post-gift
stock dividends paid before death); Rev. Rul. 72-282, 72-1 C.B. 306 (value of gift included
in donor's gross estate at its death-time value even though the donee had sold the donated
property before the donor's death).

87. Even before Congress confined § 2035 to tainted gifts, the courts had at least
indirectly recognized that the proper amount includible in the case of one type of tainted gift,
a gift of a retained life estate within three years of death, was the amount that would have
been included had the gift not been made-the full value of the property, not the death-time
value of the then-expired life estate. See, e.g., United States v. Allen, 293 F.2d 916, 917-18
(10th Cir. 1961) (although the decedent sold her retained life income interest within three years
of death for more than its value, the court held that the consideration received was not
adequate for estate tax purposes because it was less than would have been included in her
gross estate if the "sale" had not taken place); Estate of D'Ambrosio v. Commissioner, 101
F.3d 309, 312 (3d Cir. 1996) (citing Allen with approval). Also, well before Congress confined
§ 2035 to tainted gifts, Congress itself had expressly recognized that the proper amount
includible in the case of another type of tainted gift, a relinquishment of a retained power to
revoke within three years of death, is the amount that would have been included had the gift
not been made-the full value of the property, not the death-time value of the then-expired
power to revoke. Section 2038 of the Code has long expressly so provided. See IRC
§ 2038(a)(1) (applicable to transfers after June 22, 1936); IRC § 2038(a)(2) (applicable to
transfers on or before June 22, 1936). The Tax Reform Act of 1976 substituted "during the
3-year period ending on the date of the decedent's death" for "in contemplation of ... death."
See Tax Reform Act of 1976, Pub. L. No. 94-455, § 2001(c)(1)(K), 90 Stat. 1520, 1852-53
(1976). These express provisions in IRC § 2038 made the reference in § 2035 to § 2038
duplicative and unnecessary.

88. In contrast, use of the what-would-have-been-included method is essential for
a gift of a retained life estate or relinquishment of a retained power to revoke because the
death time value of the gift-the retained life estate or power to revoke-would be zero. See
supra note 87. Note, however, the need for Congress to reassess its decision to classify a gift
of a retained life estate or a relinquishment of a power to revoke within three years of death
as a tainted gift to which § 2035 applies. See supra note 44.

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Tax Consequences of Assigning Life Insurance

result in cases in which no post-assignment premiums became due. The pre-
1998 case law and rulings held that the full value of the proceeds was
includible,89 which is the same amount that would be includible under the
new what-would-have-been-included standard.

It was principally when the assignee paid some or all of the post-
assignment premiums that the case law faltered and reached an incorrect
result. As noted earlier,9 the leading case on the issue is Estate of Silverman
v. Cormnissioner,91 a case decided by the Tax Court in 1973, before section
2035 was confined to tainted gifts,9- and long before the 1997 reformulation
expressly adopted the what-would-have-been-included standard.

In Silvennan, the insured, within six months of death, assigned a
$10,000 life insurance policy to his son. Before the assignment, the insured
had paid the monthly premiums as they became due, but after the assignment,
the insured's son paid the premiums. In total, $3,261.20 in premiums were
paid on the policy. Of these, the insured paid $2,893 and the son paid
$368.20.

The Tax Court attempted to determine the death-time value of the
insured's gift by using the ratio of premiums paid by the insured to the total
premiums paid on the policy. Because the insured paid 88.71% of the
premiums, the insured, in the Tax Court's view, only transferred 88.71% of
the policy within three years of death. In consequence, the Tax Court held
that only 88.71% of the proceeds should be included in the insured's gross
estate:

[Because] the petitioner [the assignee of the policy] paid all
the insurance premiums after the assignment ... [,] we feel
that the petitioner contributed to the value of the policy, and
it would be inappropriate to include in the gross estate that
portion of the value which petitioner contributed.

89. See supra text accompanying note 6.
90. See supra note 8.
91. 61 T.C. 338 (1973), affd on the limited grounds raised on appeal, 521 F.2d 574

(2d Cir. 1975). When Silverman arose, one of the requirements for including the proceeds of
an assigned life insurance policy in the insured's gross estate was that the assignment have
been made in contemplation of death as well as having been made within three years of death.
In Silverman, the Tax Court found that the insurance policy, which had been assigned to the
insured's son six months before the insured's death, had been assigned in contemplation of
death. Congress eliminated the "contemplation of death" requirement when it amended the
Code in 1976.

92. As explained earlier, a "tainted" gift is a gift within three years of death of an

interest in or power over property that would have been included in the decedent's gross estate
under §§ 2036 through 2038 or § 2042 had the transfer not taken place. See supra text
accompanying note 44.

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Florida Tax Review

Throughout its existence, including the time of
transfer, the policy had a face value of $10,000. At the time
of the decedent's death, however, a certain number of
premiums were required to keep the face value intact. It is
apparent, therefore, that at the time the decedent transferred
the policy, only a portion of the premiums necessary to
maintain the face value payment on death had in fact been
paid. The petitioner's continued premium payments were thus
a vital part of the consideration necessary to secure full pay-
ment on the insurance policy on decedent's death. To hold
otherwise would tax the estate on an asset greater than that
which the decedent transferred. .. . We are further bolstered
in our decision by sec. § 20.2035-1(e), Estate Tax Regs.,
which states: "However, if the transferee has made improve-
ments or additions to the property, any resulting enhancement
in the value of the property is not considered in ascertaining
the value of the gross estate." We therefore hold that the
decedent's estate must include that portion of the face value
of the life insurance policy which the decedent's premium
payments bore to all premium payments.93

The taxpayer appealed to the Second Circuit, contending that only the
cash surrender value of the policy at the time of assignment ($1,120) or the
amount of premiums paid by the insured within three years of death ($1,525)
should have been included.94 In response, the Commissioner merely urged
the court to affirm the Tax Court's decision, but did not argue that the Tax
Court's analysis was more favorable to the taxpayer than warranted. In
dismissing the taxpayer's contention, the Second Circuit "freely admit[ted]
some uneasiness"95 about the Tax Court's use of the ratio of premium
payments to calculate the amount includible. The circuit court noted that
another possible approach would have been to include the full dollar value
of the proceeds, reduced only by the dollar amount of the post-assignment
premiums paid by the son.96 Since the Commissioner had not challenged the
Tax Court's analysis, however, the Second Circuit affirmed without
developing the analytical argument for the position it seemed to favor.97

93. 61 T.C. at 342-43. (Emphasis added.) We noted earlier that the Tax Court meant
to refer to the ratio of premiums paid by the insured before or after the assignment and the
premiums paid by the assignee (or someone else) after the assignment. See supra note 9.

94. 521 F.2d 574 (2d Cir. 1975).
95. Id. at 577.
96. See id. at 577-78.
97. See id. at 578.

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Tax Consequences of Assigning Life Insurance

Unfortunately, the Commissioner acquiesced in Silverman and applied the
Tax Court's analysis in subsequent rulings and internal memoranda. 91 As a
result, the issue has not been litigated since.99

Although Silvennan applied the old death-time-value-of-the-gift
standard, not the new what-would-have-been-included standard, the Tax
Court's view that each premium payment purchases a fractional share of the
policy" cannot be completely dismissed as irrelevant. The Tax Court used
the ratio of premiums paid by the insured to the total premiums paid on the
policy to hold that the insured had only transferred 88.71% of the policy. The
Tax Court bolstered its position by suggesting that the assignee's premium
payments were in the nature of expenditures for improvements or additions
to the property transferred. If the Tax Court's analysis were correct, then only
88.71% of the policy ought to be included even under the new what-would-
have-been-included standard.' 0'

The fallacy of Silvennan, however, is the idea that the decedent only
transferred a fractional interest in the policy. At the time of the transfer,
which is when the property transferred should be determined, the decedent
was the sole owner of the policy. The decedent was not a part owner. There
was no co-owner. The decedent owned and transferred the entire policy."c

98. The Commissioner acquiesced in the Tax Court's decision, see 1978-1 C.B. 2,
and applied the Silverman analysis in A.O.D. 1978-113 (1978); A.O.D. 1978-114 (1978); Gen.
Couns. Mem. 38,110 (Sept. 25, 1979); Tech. Adv. Mem. 79-07-011 (Oct. 27, 1978): Priv. Ltr.
Rul. 87-24-014 (Mar. 11, 1987).

99. In Estate of Friedberg v. Commissioner, 63 T.C. Memo (CCH) 3080 (1992), the
Service unsuccessfully sought to distinguish Sil'ennan, not to overturn it. The insured had
transferred his life insurance policy to his daughter within three years of death. The daughter
paid the post-assignment premiums and was the beneficiary of the policy. Because the
daughter served as the executor of the insured's estate, the Service argued that the full value
of the proceeds was included under § 2042(l). The Tax Court held that the proceeds were
payable to the insured's daughter in her individual capacity, not in her capacity as the
insured's executor. Therefore, the Tax Court applied the Silerman proration approach to
determine the amount includible in the insured's gross estate under § 2035.

100. "To hold otherwise," the Tax Court said, "would tax the estate on an asset
greater than that which the decedent transferred." 61 T.C. at 343.

101. If a decedent-insured only owns a fractional interest in a policy at death, only
that fractional interest of the proceeds is includible under IRC § 2042. See Regs. § 20.2042-
1(c)(5), -1(c)(6).

102. The Tax Court's position in Silernan is reminiscent of the premium payment
test that was once employed by the estate tax laws as part of the antecedents to § 2042(2).
Under the premium payment test, which Congress repudiated in 1954. the estate of a deceased
insured was required to include in the gross estate a percentage of the life insurance proceeds
equal to the percentage of premiums that were paid by the insured. This test was properly
eliminated by Congress when it adopted the 1954 Code. See Kahn & Waggoner, supra note
1, at 970-75.

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Florida Tax Review

As noted above, the Tax Court attempted to bolster its position by
suggesting that the assignee's premium payments were in the nature of
expenditures for improvements or additions to the property transferred. Were
this a correct characterization, the death-time value of the improvement or
addition would not be included in the decedent's gross estate because the
decedent did not transfer the improvement or addition. After all, if the sole
owner of a parcel of vacant land gave the land to a grantee who built a
building on it, the death-time value of the gift would ignore the value of the
building.

In actuality, however, only a small part of the assignee's premium
payments can properly be characterized as expenditures for improvements or
additions to the transferred policy. The other part of the payments are more
in the nature of maintenance expenses.

To develop this point, we return to the economic components of a life
insurance policy. An insurance policy has three components: the equity or
terminal reserve component, the term insurance coverage component, and the
right of continuation component. 3 To determine the death-time value of
the gift accurately when the assignee pays the post-assignment premiums, the
Tax Court should have identified and examined these components separately,
since they are what the decedent's assignment transferred.

The equity reserve component. If the policy had an equity reserve
component at the time of the transfer, the decedent clearly transferred it. The
equity reserve may increase between the time of the transfer and the time of
death. The increase is partly attributable to the appreciation of the equity
reserve that the decedent transferred. That portion of the proceeds attributable
to the transferred equity reserve component and the appreciation thereon is
clearly includible in the transferor's gross estate.

A portion of the post-assignment premiums paid by the assignee is
added to the equity reserve component. That portion, including the
appreciation thereon, is in the nature of an improvement or addition to the
property by the assignee, and should be excluded under section 2035.'l4

103. See supra text accompanying notes 15-16.
104. It is arguable that when Congress amended § 2035 in 1981, it should have

excluded the entire equity reserve component of a life insurance policy transferred within three
years of death. The 1981 amendments restricted § 2035 to items of property in which the value
of the gift is likely to be much less than the amount that would have been included in the
transferor's gross estate if the transfer had not taken place. With respect to a transferred life
insurance policy, the component that dramatically increases in value is the term insurance
coverage component, not the equity reserve component. Because the equity reserve component
does not dramatically increase in value at the insured's death, it is more like the types of
property to which § 2035 no longer applies-property such as land or stocks and bonds. It
would better suit tax policy then for Congress to have expressly excluded all of the equity
reserve element of a life insurance policy from the insured's gross estate-i.e., the equity

[Vol 4:5



Tax Consequences of Assigning Life Insurance

That portion of the equity reserve was not transferred by the decedent and,
since the insured did not pay those premiums, would not have been included
in the insured's gross estate had the transfer not occurred.

The tenn insurance coverage and the right of continuation
components.105 An assignment of a life insurance policy also constitutes a
gift of the term insurance coverage component. The value of the term
insurance component at the time of death is the full value of the proceeds of
the policy, less any equity reserve. In one respect, however, it could be
argued that the term insurance coverage component that the insured
transferred has expired by the time of death and was replaced by the term
insurance coverage bought by the assignee's last premium payment. The
question is, should the assignee's last premium payment be treated as a de
novo purchase of term insurance coverage or should all of the assignee's
premium payments combined be treated merely as a maintenance expense of
the term insurance coverage that the insured transferred? The only reason that
the assignee had the right to maintain the insurance coverage in force is

reserve at the time of the gift, the incremental additions thereto, the equity reserve added by
the assignee's premium payments, and the incremental additions thereto.

As drafted, however, § 2035 clearly includes the equity reserve component in the
transferor's gross estate. Perhaps Congress considered the several components of life insurance
to be so blended into the proceeds payable at death as to make it inappropriate or
administratively inconvenient to separate the proceeds into its several component elements. In
fact, however, the amount of the equity reserve can be determined easily and presents no
administrative or other difficulties.

More likely, Congress simply did not think about the idea of separating the elements
that make up the proceeds payable at death. It would be worthwhile for Congress to consider
amending § 2035 to exclude that portion of insurance proceeds attributable to the equity
reserve component.

105. At the time of assigmnent, the value of these components is at least equal to
the portion of the premium previously paid by the insured that is attributable to the remainder
of the period for which that premium was paid. Thus, if the insured paid a premium of S 1,200
on March 1 for term insurance coverage for one year, and the insured assigned the policy to
his wife three months later (on June 1), he would have made a gift having a value of at least
$900 (three-fourths of $1,200). If the insured is in good health, this allocation of the premium
will accurately reflect the value of both components. The amount of each premium will equal
the value of the risk coverage involved; the premium will have been set according to an
actuarial determination of the risk assumed by the insurer, including the granting to the
policyholder of an option to continue that insurance coverage in future years at a cost designed
for healthy persons. Stating it differently, if the assignee has an insurable interest in the
insured, the assignee could purchase the same amount of insurance coverage, including a right
of continuation component, at the same price. However, if the insured is in poor health at the
time of the assignment, the premium payable for the term insurance coverage will be less than
the actual value of such insurance coverage; consequently, the value of the insurance granted
to the assignee (both the coverage for the remainder of the period and the option to continue
the coverage at a bargain price) will exceed the premium allocation described above.

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Florida Tax Review

because the assignment of the policy carried with it the right of continuation
component.1'6

Rather than treating each premium payment as the purchase of an
independent asset (risk coverage for a stated term), it is more accurate to
characterize such payments as a maintenance expense of the term insurance
coverage component. The insurance coverage element of a policy should
therefore be treated as a continuum and not as a collection of a number of
individual contractual arrangements-one for each term of a premium
payment.107

Treating insurance coverage as a continuum or single asset is not only
a realistic view of the asset itself, it is necessary in order to accommodate the
legislative purpose of section 2035 and to avoid great administrative burdens.
If the assignee's last premium payment were treated as an independent
purchase of risk coverage for the stated term, it might then be necessary to
exclude the entire risk coverage element of the proceeds (that is, the
difference between the amount of the proceeds and the reserve), since that
value would then be deemed to have been added by the assignee.

Excluding this amount would frustrate the purpose of section 2035,
which is to prevent the use of lifetime transfers in anticipation of imminent
death as a means of minimizing transfer tax costs. Particularly when the
insured was in poor health when assigning the policy, this method would
overstate the amount added to the policy's value by the assignee. There is a
way of preventing that frustration and overstatement, but doing so would
necessitate valuing the risk coverage element of the policy at the time of

106. If the assignee had an insurable interest in the insured, the assignee could have
bought a new policy on the insured, but not the existing policy that the insured transferred. If
the insured was in poor health at the time of the assignment, the cost of a new policy would
be much higher than the premiums on the existing policy. In fact, the insured's health might
be so poor that he or she was then uninsurable.

107. In two earlier and now obsolete revenue rulings, the Service recognized that
life insurance coverage is properly characterized as a continuum. Under pre-1982 law, when
an insured assigned a straight life or a term policy more than three years before death but paid
premiums within three years of death, the Service only included the amount of premiums paid
by the insured within three years of death. See Rev. Rul. 71-497, 1971-2 C.B. 329; text
accompanying supra note 56. This position treats a premium paid on term or straight life
insurance as merely maintaining continuous insurance coverage, not as a de novo purchase of
new insurance coverage. See also Rev. Rul. 82-13, 1982-1 C.B. 132, where the Service ruled
that § 2035 did not apply to a case in which the insured, more than 3 years before death,
assigned a group term, employer-paid policy to another. Although the insurance was for a
term, it was subject to an automatic right of renewal by payment of the premiums for the next
term. After the assignment, the employer continued to pay the premiums, which were therefore
deemed to have been paid by the insured. Some of the premiums were paid within 3 years of
the insured's death. Since the policy was renewable, the Service treated the premium payments
as a continuation of a single policy, not as a de novo purchase of a new policy.

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Tax Consequences of Assigning Life Insurance

assignment and then deducting that value from the risk coverage element at
death to determine the amount of the proceeds that actually are attributable
to the assignee's premium payment. This method would provide a more
accurate reflection of the assig-nee's addition to the value of the policy.

Valuing the risk coverage element at the time of assignment is
objectionable, however, because it would require making an appraisal of the
health of the insured at the time of assignment and making an actuarial and
medical evaluation of the insured's life expectancy at that time. The
difficulties in making that determination and the burden of exploring those
issues led the government to value unmatured insurance policies for gift tax
purposes without regard to the actual health of the insured." s The same
difficulties point to rejecting the idea of valuing the risk coverage element of
the policy at the time of assignment and then deducting that value from the
risk coverage element at death to determine the amount of the proceeds that
actually are attributable to the assignee's premium payment. Indeed, the
factual problems raised by requiring such a valuation are reminiscent of the
problems that arose in determining whether a transfer was made in
contemplation of death. Congress replaced the "contemplation of death" test
in 1976 with an automatic rule of inclusion just so that it could eliminate
both the administrative burden of making inquiries of this type and the
frequent factual errors made in resolving such issues. While it is true that the
contemplation of death rule involved questions of subjective intent that would
not be raised in examining the insured's state of health, it would still be
necessary to look into the past and determine some aspect of an individual's
personal state possibly without having any access to information from the
individual.

Even if the health evaluation method were correct in theory, it would
operate equitably only when the past health of the insured could be accurately
determined. The great likelihood that substantial errors would be made in
resolving such factual issues renders this approach undesirable. While treating
the assignee's payments as maintenance of the right of continuation
component is somewhat draconic, it has the advantage of being doctrinally
supportable, not only for the reasons discussed above, but also because such
treatment is consistent with the usual perceptions of the insured and assignee.

As previously noted, the portion of the assignee's premium payments
that are added to the equity reserve should be deducted from the amount of
death proceeds that otherwise would be included in the insured's gross estate.
Viewing the assignee's contribution as a maintenance cost, the question is
whether the proceeds should also be reduced by the rest of the assignee's
post-assignment premium payments. Since the insured's gross estate would

108. See Rev. Rul. 77-181, 1977-1 C.B. 272; supra text accompanying notes 27-28.

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Florida Tax Review

have been reduced by such payments if the insured had retained the policy
and made the premium payments (that is, the cash used to pay the insurance
cost would no longer be part of the insured's assets), the assignee's payment
should be treated as a contribution to the extent that the payment is allocated
to the cost of purchasing insurance coverage (which cost includes the
insurer's expenses that are passed on to its policyholders). Therefore, the
amount of the portion of each premium payment that is not applied to the
policy's reserve should also be deducted from the proceeds that are includible
in the insured's gross estate.' °9

Consequently, the proper method of calculating the amount includible
under the old death-time-value-of-the-gift method was to include the full
value of the proceeds less the dollar amount of the post-assignment premiums
paid by the assignee, not by using the ratio of premiums paid by the insured
to the total premiums paid on the policy, as the Tax Court did in Silverman.
The Second Circuit, it turns out, had it right."'

The new what-would-have-been-included standard makes it
unnecessary to identify and separately revalue the components of the policy
that the insured transferred. The starting point is that a gift by the insured
within three years of death of any incident of ownership requires inclusion
of the full value of the proceeds. The question under this standard is whether
there should be any reduction in the amount includible because of the
assignee's premium payments, and if so how that reduction should be
calculated.

We believe that that amount should be reduced by the dollar amount
of the post-assignment premiums paid by the assignee. As noted above, if the
insured had in fact retained the policy, the insured would have paid the
premiums in order to maintain the policy. Because those premium payments
would have reduced the amount includible in the insured's gross estate under
section 2033, the assignee's premium payments should be deducted from the
full value of the proceeds in order to determine the amount ultimately
includible under section 2035 in its current form. We make this argument
purely as a matter of tax policy. Section 2035 makes no provision for such
a reduction. It requires inclusion of the amount that would have been

109. Cf. Estate of Peters v. Commissioner, 386 F.2d 404 (4th Cir. 1967) (the value
of a surviving joint tenant's capital improvements were deducted from the value of jointly
owned property that was included in the decedent's gross estate under § 2040). The joint
tenants were the decedent and her son.

110. Recall that the Second Circuit expressed uneasiness about the Tax Court's use
of the ratio of premium payments to calculate the amount includible, and noted that another
possible approach would be to include the full dollar value of the proceeds, reduced only by
the dollar amount of the post-assignment premiums paid by the son. See supra text
accompanying note 95.

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Tax Consequences of Assigning Life Insurance

included under section 2042 had the gift not been made, not the amount that
would have been included overall. Our position is that it is consistent with
tax policy to graft this reduction onto section 2035, either by administrative
or judicial construction.

The final question is, what if the insured, not the assignee, paid the
post-assignment premiums? Under the case law and rulings that predated the
1997 Act, the full value of the proceeds was included without any reduction
for the amount of the post-assignment premiums."' One could argue that
in substance the insured's post-assignment premium payments should be
attributed to the assignee." 2 The rationale would be that the assignee, as
owner of the policy, is the only one entitled to pay the premiums on the
policy.' Consequently, if without objection from the assignee the insured
pays the post-assignment premiums directly, the transaction could be treated
as a gift from the insured to the assignee of the cash amount of the
premiums, coupled with a constructive payment of the premiums by the
assignee. 114

Assuming that post-assignment premiums paid by the insured are
properly treated as constructively made by the assignee, the question still
remains whether the amount of the constructive payments should reduce the
amount of the proceeds that are included in the insured's gross estate under
the what-would-have-been-included standard of the 1997 Act. Our argument
for such a reduction when the assignee actually pays the post-assignment
premiums rests on the theory that the insured would have paid the premiums
if the policy had not been assigned, thus removing the amount of those
payments from the insured's gross estate. It is another matter, however, to
grant such a reduction when the assignee pays the premiums from funds
obtained from the insured.

Whether there should be such a reduction turns on the extent to
which the assignee's payments constitute an act that is independent from the
insured's gifts to the assignee. When the insured pays the premiums directly,
the gifts to the assignee are in effect conditioned on being used to pay the
premiums, making the gifts so connected to the premium payments that the
rationale for reducing the includible insurance proceeds by the amount of the

111. See cases and rulings cited supra note 7.
112. See Lauer, supra note 81, at 725-27.
113. See id. at 686, 726.
114. In other contexts, the tax law has so treated the payment of another's debt. See,

e.g., Rev. Rul. 57-481, 1957-2 C.B. 48, in which the Service ruled that a third party's payment
(as a gift or loan to the taxpayer) of interest owed by the taxpayer on a loan is a payment by
the taxpayer, making it deductible by the taxpayer under the provisions then existing that
allowed an income tax deduction for interest payments. This line of authority is analogous to
the insured's payment of premiums on a policy owned by the assignee, despite the fact that
the assignee has no legal obligation to pay those premiums.

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Florida Tax Review

assignee's premium payments is negated. In that case, the payments do not
reflect amounts that substitute for what otherwise would have been payments
that reduce the insured's gross estate. Since the premium payments were
derived from the insured, the gifts already reduced the insured's gross estate.
No additional reduction by deducting the payments from the insurance
proceeds is justified.

VIII. CONCLUSION

We end where we began. The Taxpayer Relief Act of 1997 furnishes
the courts and the Internal Revenue Service an opportunity to rectify the
erroneous conclusion reached by the Tax court in Silverman, which affords
taxpayers unwarranted opportunities for tax avoidance.

The Silverman analysis gives taxpayers a windfall and provides life
insurance an unfair advantage over other investment vehicles. Silverman
misapplied the death-time-value-of-the-gift standard and, more importantly,
is inconsistent with the what-would-have-been-included standard expressly
adopted by section 2035 as reformulated by the 1997 Act. If the insured dies
within three years after making the gift, the full value of the proceeds less the
dollar amount of the premiums paid by the assignee should be included under
section 2035 as reformulated by the Taxpayer Relief Act of 1997.

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