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.
Getman noted, however, that owners of LLCs, partnerships and S corporations cannot avoid tax when the business pays insurance premiums on a policy owned by the business. She observed, too, that the individuals involved, such as a majority owner, independent contractor or highly compensated employee, will determine how the arrangement is structured.
Adverse tax consequences await business owners who also fail to comply with Internal IRC Section 101(j), which requires that employers provide notice to, and secure the consent of, employees whose lives they insure through the purchase of employer-owned contracts. Unless the EOLI policy falls within certain exceptions based on the insured’s status (e.g., the employee was a highly compensated director at the time the policy was issued) or on who receives the death benefit (such as a family member or estate of the insured), then a portion of the death proceeds will be subject to income tax.
“Unfortunately, if you violate the notice and consent requirements of 101(j), the only way to correct the mistake is to start over,” said Getman. “There is no waiting three years. You can’t do a 1035 exchange. Once you’ve messed up, that’s it and you have to begin the process anew.”
A pitfall that high net worth individuals often overlook, said Getman, is the three-year estate tax inclusion rule, which stipulates that when an insured gifts a policy, the contract remains within his or her estate for three years from the date of transfer. Exceptions to the rule include transfers that qualify as a “bona fide sale for full and adequate consideration.” Getman observed, however, that questions remain as to what constitutes consideration. Some experts say it’s the cash value, while others peg the death benefit, replacement cost or some other value.
Yet another mistake that clients make is transferring a policy in exchange for value, which (unless one of 5 statutory exceptions is invoked) results in a portion of the death proceeds being subject to ordinary income tax. Individuals desiring to bypass this rule, said Getman, can structure the policy as a sale to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is an officer or shareholder. But Getman cautioned participants to be mindful of certain caveats with respect to partnerships and limited liability companies.
“Because a partnership or LLC is hybrid, the IRS sometimes views it as a separate entity and at other times sees it as a business with multiple owners working together; the latter can result in the policy being included in the insured’s estate,” Getman said. “A large number of cases, both IRS private letter ruling and tax court rulings, offer guidance on what can be done to mitigate this risk. The bottom line is that you need to work with highly qualified insurance and legal professionals to make certain you’re complying with IRS and case law requirements.”