Help Clients Avoid These Common Life Insurance Planning Mistakes

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.”