There are, it seems, countless ways that individuals and businesses can get hit with a painful income or estate tax hit if they’re not mindful of IRS rules and case law governing life insurance transactions. Terri Getman, a vice president of advanced marketing at Prudential Financial, Newark, N.J., shed light on many common errors committed by clients during a session at the Society of Financial Services’ 2008 Forum, held here recently.
A typical scenario: The client wants to avoid including policy proceeds within his or her estate while also sidestepping the complexity and cost of using an irrevocable life insurance trust to remove those proceeds from the estate. As an alternative to making the trust (or children) the policy owner, many insured individuals elect to name the spouse. And they thereby commit the first of Getman’s mistakes: creating an “unholy trinity” of 3 on the policy–the (typically) husband as insured, the wife as policy owner and the children as beneficiaries. That’s a problem because it creates a gift tax issue at the death of the insured.
“What they fail to realize is that upon their death, they will be deemed to have made a gift of the death benefit to the children,” said Getman. “That of course is not cool because you’re limited to a $1 million exemption. So this unholy trinity can trigger significant gift taxes. This happens quite frequently.”
The solution to the problem, added Getman, is to name the third-party owner (in this case, the spouse) as policy beneficiary. If the third-party owner is an individual, then the insured should take care to avoid a second mistake: not naming a successor owner. If the owner should predecease the insured, the policy becomes accessible to the owner’s creditors; and, should ownership pass back to the insured, policy proceeds may be included in his or her estate.
The insured errs yet again, said Getman, by not naming a successor (or contingent) beneficiary. In the event the beneficiary predeceases the insured, the proceeds will be paid to the insured’s estate, subjecting the policy once more to creditor claims, probate and potentially more taxes.
The “unholy trinity” problem finds its analog, Getman added, in business situations. To avoid being taxed on premiums paid on a policy purchased for the benefit of the business owner’s family, the business owner errs when again naming “three on a policy:” the business owner as insured, the corporation as policy owner and the spouse or other family member as beneficiary. Result: Policy proceeds will be classified as dividends or compensation upon the business owner’s death, and therefore will be considered a gift subject to income tax.
To avoid this outcome, said Getman, the business owner can name the spouse both owner and beneficiary; make the insured an owner while leaving the spouse as beneficiary; or, alternatively, incorporate the life insurance policy into an executive bonus or split-dollar arrangement.