Tax Traps Involving Life Insurance
Improper beneficiary and ownership designations can sometimes have disastrous tax consequences for clients. This article reveals a few of the more common “tax traps.” How many are you familiar with?
February 21, 2008
Sponsored by NFP Insurance Services, Inc.
by Keith Buck, JD, LLM, CLU, Vice President – Strategy R&D, NFP Insurance Services, Inc.
Improper beneficiary and ownership designations can have adverse, and sometimes disastrous, income, estate, and/or gift tax consequences to clients. During the 17-plus years I’ve spent working in the financial services industry with producers and advisors, I’ve seen numerous recurring “tax traps” involving beneficiary and ownership designations.
This is the first article in a four-part series that will discuss eight of the more common tax traps. How many of these are you familiar with? As a tax, legal and/or insurance professional you have a duty to be knowledgeable about these tax traps so that you can properly advise your clients when assisting them with their financial and estate planning. To help identify circumstances where tax traps may exist, I’ve used common fact situations to illustrate each one and also discussed potential solutions.1
Tax Trap #1 — Goodman Triangle
Parent (unmarried) wants to purchase $1 million of death benefit for the benefit of both her adult children (C1 and C2). She would like to avoid adverse estate tax consequences by having the policy owned outside her estate. Therefore, she would like C1 (the more responsible child) to own the policy insuring her, with both C1 and C2 as the named beneficiaries. She plans to pay the $22,000 annual premium directly to the insurance company.
There are actually two problems with this fact situation. The more obvious one has to do with the gift tax consequences of her payment of the insurance premium. Her premium payment is an indirect gift to C1. Since C1 is the sole owner of the policy, only one annual exclusion ($11,000) is available, meaning that one-half of the premium payment will be a taxable gift. If structured properly, for example if an ILIT with Crummey withdrawal provisions were used, then the annual exclusions for both C1 and C2 could have been used to avoid any of the premium being a taxable gift.
The second problem is the tax trap that is frequently overlooked. This fact situation violates the so-called Goodman Triangle because three different people are owner (C1), insured (Parent) and beneficiary (C1 & C2) of the policy. In the case of Goodman v. Commissioner, 156 F.2d 218 (1946) it was held that in such a situation the owner of the policy is deemed to make a gift to the non-owner beneficiary upon the death of the insured. Thus, upon the death of the Parent, C1 will be deemed to have made a gift of one-half the death benefit ($500,000) to C2.
There are several possible solutions with respect to avoiding the consequences of the Goodman Triangle:
Make C1 sole beneficiary of the policy. Of course, that leads to C2 being treated unfairly, and may not be the best solution.
Make both C1 and C2 owners of the policy (thus the owners and beneficiaries are the same, and the Goodman Triangle doesn’t exist). However, since the Parent is concerned about making C2 an owner due to responsibility issues, this also may not be the best solution.
Probably the most feasible solution would be to have an ILIT own the policy.
Tax Trap #2 — Premium Gifts to Joint Owners
Same fact pattern as #1, except that now the Parent has indicated that she is comfortable with C1 and C2 both being owners and beneficiaries of the policy.
The Goodman Triangle is not an issue this time. The problem has to do with the fact that the Parent is paying the premium directly to the insurance company. This will be an indirect gift to the owners of the policy (C1 & C2). However, since the policy is co-owned (the insurance company will generally presume it to be owned jointly with rights of survivorship) and neither C1 nor C2 can access the policy cash values without the consent of the other, this is a future interest gift. Because a prerequisite for the annual exclusion is that it must be a present interest gift, no annual exclusions are available and the entire $22,000 annual premium constitutes a taxable gift.
Have Parent create an ILIT for the benefit of C1 and C2 that has Crummey withdrawal provisions.
Have Parent gift one-half of the premium directly to both C1 and C2, who in turn pay their share of the premium. The direct gifts to C1 and C2 are present interest gifts and will qualify for the annual exclusion.
Make C1 and C2 tenants in common. This may be easier said than done. Insurance companies’ administrative systems are generally set up to administer co-owned policies as owned jointly with rights of survivorship. However, if a tenants-in-common agreement were drafted and submitted, an insurance company may be willing to accept it and administer the policy pursuant to the terms of the agreement. If C1 and C2 are tenants in common, they each have an undivided one-half interest in the cash value and do not need the consent of the other owner to access their interest, thus making the direct payment of premiums by Parent a present interest gift.
Life insurance professionals should request that any clients desiring to make an unusual ownership or beneficiary designation consult their tax advisor before doing so. Tax advisors have a responsibility to thoroughly research the income, gift, and estate tax consequences of unusual ownership or beneficiary designations to ensure that their clients do not suffer any unexpected tax consequences.
For more information, contact NFP Insurance Services, Inc.
1 This is a concept summary only. This material is for informational purposes only and is not to be construed as tax or legal advice. Individual situations will vary and clients should consult with their own tax, legal and accounting advisors before implementing any plan. The hypothetical case study results should not be deemed a representation of past or future results. This example does not represent any specific product, nor does it reflect sales charges or other expenses that may be required for some investments. No representation is made as to the accurateness of the analysis.
Keith Buck, J.D., LLM, CLU, FLMI is Vice President, Strategy Research & Development, for NFP Insurance Services, Inc. Keith is a graduate of the University of Iowa, Iowa City. He obtained his law degree from Drake Law School, Des Moines, Iowa and his Masters of Law Degree (LLM in Tax) from Boston University Law School. He holds the Chartered Life Underwriter designation from The American College and the Fellow, Life Management Institute designation. He has several published articles in various industry publications and has spoken at a number of conferences, including the MDRT Top of the Table Conference, on a variety of estate and business planning topics.