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Eleanor Roosevelt once said, “Learn from the mistakes of others.  You can’t live long enough to make them all yourself.”  The point is a wise person learns from the mistakes of those who came before while endeavoring to avoid them himself.  When mistakes are made with life insurance, the consequences to our clients can be financially significant.  Some would say this is why Errors & Omissions insurance exists.  But to the extent possible, I am sure we all agree that it is one policy on which you never want to file a claim. 
The rules that impact life insurance are not always user friendly; and some rules are traps for the unwary.  The potential is there to make a serious and costly mistake, but with education, you can improve your chances of avoiding them.

The Personal “Unholy Trinity”

Buying Life Insurance The so-called “unholy trinity” exists when three different parties are designated as the owner, the insured, and the beneficiary of a life insurance policy.  Should the insured person die under those circumstances, the policy proceeds are considered to be a gift from the owner of the policy to the beneficiary.  The beneficiary of a properly structured insurance policy should generally receive the death benefit income, gift and estate tax free.  Let’s look at an example to see how things can go awry.

Suppose that a wife owns a life insurance policy on her husband’s life and names their two children as the beneficiaries.  That seems innocuous enough and is all too common.  One could reasonably conclude that there is no problem here and that at the death of the husband, the children would receive the policy benefits in the usual tax-free manner.  Unfortunately, that may not be the case.

Back in 1946, a federal court ruled that in a case where the “unholy trinity” existed at the time of the death of the insured, the policy owner made a gift of the proceeds to the beneficiaries.  In this example, that would mean that at the death of the husband, the wife would be deemed to have made a gift of the proceeds to her children.  The rationale is somewhat technical, but simply stated, is this:  as long as the insured is alive, the owner of the policy can change the beneficiaries, so there is no completed gift.

But the insured’s death does two things:  First, it terminates the owner’s ability to change the beneficiary.  That termination is considered a completed gift, subject to gift taxation.  Second, the insured’s death matures the policy, making the amount of the gift the full death benefit.

Assuming that the death benefit in the example was $2,000,000, we can see the impact of making this mistake.  At the death of her husband, the wife will be deemed to have received the $2,000,000 and given each of her children a gift of $1,000,000.  That gift is subject to gift taxation.

The tax laws may provide some relief but will not necessarily eliminate all of the tax.  In 2007, an individual can give as much as $12,000 to as many other individuals as he or she wants, free of gift tax.  Since the wife can give each of her children $12,000 gift tax free, the amount of the gift subject to taxation (assuming no other gifts to the children during the year) is $988,000 to each child.

In addition to this annual per person exclusion, every individual has a lifetime gift tax exemption of $1,000,000.  This means that the first million dollars of the gift, after applying the annual exclusion, will also be tax-free.  That helps, but it does not eliminate the tax. In the example, the gift that the wife made, after applying the annual exclusion, was two times $988,000 or $1,976,000.  After subtracting the $1,000,000 exemption, $976,000 will needlessly be subject to gift tax.

To make matters worse, the spouse did not actually receive the death benefit, even though she is deemed to have made a gift of it.  That means that she is going to have to use assets other than the insurance proceeds to pay the tax.  It may be that the children, wishing to relieve their mother of that financial burden, would give her enough of the policy proceeds to pay the tax.  Unfortunately, since that is considered a gift from the children back to their mother, it only compounds the problem.

What is the solution?

Obviously the easiest solution is not to have three different people as owner, insured and beneficiary.  That is fairly easy to accomplish in the case of an insured whose estate will not be subject to estate taxation.  The insured and the owner can be the same person or the beneficiaries themselves can own the policy.

If the estate is large enough to be subject to estate taxation and the insured is the owner of the policy, the policy proceeds will be subject to estate tax.  In that case, it is not wise to have the insured own the policy.  A possible solution is to have an entity such as an irrevocable life insurance trust (ILIT) own the policy.

In community property states, each spouse is considered to be the owner of 50% of all community property assets.  This includes life insurance policies, even if just one spouse is listed as the owner on the application and the policy.  If children in these states are the beneficiaries of a policy where one spouse is the insured and deemed to be the owner, the non-owner spouse will still have made a potentially taxable gift to the children when the insured spouse dies.

Let’s consider a community property example.  Assume that the husband is the owner of a policy insuring his life for $1,000,000 and that his wife and three children are each listed as beneficiaries of 25% of the death benefit.  At the husband’s death, the wife and each child will receive $250,000.  If the premiums were paid from community property funds, the wife will be deemed to have made a gift of one-half the death benefit ($125,000) paid to each child.

In community property states where one spouse is the owner, applicant and insured and the children are listed as beneficiaries, premiums should be paid from the owner spouse’s separate assets in order to avoid the gift tax problem.

The Business “Unholy Trinity”

This mistake is similar to the previous one.  However in this case, a business is the policy owner rather than an individual.  The presence of a corporate owner alters the tax consequences of the transaction so that instead of gift tax there is income tax.

This form of the “unholy trinity” may occur when the insured, as an owner of a business, uses the business to own the policy and names a third party, such as a spouse, children, or another shareholder as the policy beneficiary.  As mentioned previously, the beneficiary generally receives life insurance death benefits free of income tax under IRC § 101(a), but, if there is an “unholy trinity,” the proceeds will be subject to income tax at the death of the insured.

The exact nature of the taxation will depend upon the relationship of the parties involved.  If the beneficiary is a shareholder, the proceeds may be taxable as a nondeductible dividend.  If the insured is an employee, then the proceeds may be taxable as compensation.  This is an area where it is important to seek the advice of knowledgeable advisors.

Failure to Name a Successor Owner

When we think of the assets that we own, we generally think of stocks, bonds, real estate, and personal property.  All too often we fail to think of an insurance policy as an asset.  Failure to do so is a potential mistake.

If an individual owns the traditional assets mentioned above, those assets would be subject to probate at the time of the owner’s death.  A life insurance policy is no different.  If the owner and the insured are two different people and the owner dies first, the policy ownership has to pass to a successor owner until the death of the insured results in the proceeds being paid to a beneficiary.  Probate, which is the procedure by which the ownership passes to that next owner, can cause unneeded costs, frozen assets, and the loss of time.  It can also negate many of the advantages that insurance enjoys.

At the death of an owner, the policy passes as a probate estate asset to the next owner either by will or by intestate succession, if no successor owner is named.  This could cause ownership of the policy to pass to an unintended owner or to be divided among multiple owners.

If the insured inherits the policy at his or her subsequent death, the policy proceeds may be subject to inheritance or estate taxation.  Additionally, in some states, once the policy is part of the probate estate, it becomes accessible to the creditors of the decedent/owner.

The solution is quite simple.  Where the insured and owner are different individuals, either name at least one successor owner or have an entity such as a trust own the policy.

Naming the Estate as Beneficiary

The general rule is to never name an estate as the beneficiary of an insurance policy.  This can be a needless and costly mistake.  If the insured’s estate is the beneficiary, the policy proceeds may needlessly be subject to probate, creditor’s claims, and estate or inheritance taxes (possibly both) at the state and federal levels.

The protection of life insurance from the claims of creditors takes many forms and varies from state to state, so it is important to obtain advice from legal counsel concerning your specific situation.  Generally, insurance death benefits actually paid to a named beneficiary are exempt from attachment by the creditors of the deceased insured.  If those policy proceeds are paid to the insured’s estate, however, they are no longer considered life insurance.  Instead, they are considered cash in the estate and subject to the rights of creditors.

Any assets that become part of the decedent’s estate, including insurance policies and their death benefits, are also potentially subject to the time and costs of probate.  If the estate is named as beneficiary, the proceeds will pass to the decedent’s heirs either by will or by intestate succession.  That could result in the proceeds passing to unintended beneficiaries, including minors.

This mistake can easily occur unintentionally.  If only one beneficiary is named, but he or she predeceases the insured, then by default the insured’s estate becomes the beneficiary.

The solution is to name both primary and secondary (contingent) beneficiaries.  If there are;

(1)     No estate or inheritance tax issues,
(2)     No concerns about a creditor reaching the policy proceeds, and
(3)     No concerns that the proceeds will be subject to probate,

then naming the estate as beneficiary might be appropriate.  Otherwise, it is generally more advantageous to name specific beneficiaries other than an estate.

The Three-Year Inclusion Rule

If at death the insured is the owner of or has any “incidents of ownership” in a life insurance policy, the entire death benefit is includable in the taxable estate for estate tax purposes.  If the insured’s total estate value including the life insurance proceeds is less than the estate tax exclusion amount ($2 million in 2008 and $3.5 million in 2009) or is passing to a surviving spouse under the unlimited marital deduction, there should not be a federal estate tax.  In this situation, it may be desirable for an insured to own his or her policy.

However, if an insured’s estate is large enough to be subject to estate taxation, ownership of his or her policy will trigger unnecessary estate taxation.  What does the owner/insured do when he/she discovers that ownership of the policy creates a tax problem?  The most obvious solution is to give the ownership of the policy to another person or to a trust.  That sounds like a quick and easy solution, but it could have unintended consequences.

The Internal Revenue Code contains a “three-year inclusion rule” with regard to life insurance that states as follows: If an insured who owns a policy on his/her life gives the policy to another person, trust or entity and then dies within three years of the transfer, the policy proceeds will be included in the estate of the insured and will be subject to estate tax inclusion.

This inclusion rule captures transfers involving more that just direct policy ownership.  Another provision of the Code provides that if the decedent/owner possessed any “incidents of ownership” in the policy at the time of his or her death, the death benefit is subject to estate tax.  Incidents of ownership include the right to:

(1)     Change the beneficiary,
(2)     Surrender or cancel the policy,
(3)     Assign the policy,
(4)     Revoke an assignment,
(5)     Pledge the policy for a loan, or
(6)     Obtain a policy loan.

Because of the interaction of these two Code sections, when the insured transfers the policy, these rights must be relinquished, and the transferring owner must live more than three years after the relinquishment or transfer in order for the policy proceeds to escape estate tax inclusion.

The “three-year inclusion rule” does not apply to a bona fide sale for adequate and valuable consideration.  However, if the transaction is structured as a sale, it may become ensnared by another trap may, known as the transfer-for-value rule.  This rule may apply unless the transfer is structured to fit within one of the allowable “transfer for value” exceptions. (A topic for an article in a later Brokerage Briefs)

How can a non-gift transfer of the policy and all incidents of ownership be a solution to the three-year inclusion rule?  The three-year rule often comes into play when an owner/insured gives an existing policy to an irrevocable life insurance trust (ILIT).  Since the three-year inclusion rule impacts only gifts, the transfer can be structured to be a sale to the trust as long as the trust is wholly owned by the policy owner/insured.  Many legal experts feel that this transaction will avoid both the “three-year inclusion rule” and the “transfer-for-value” rule because the trust and the policy owner are viewed as the same person; hence, the owner is, in effect, selling it to himself.

Another solution is to purchase term insurance to cover the three-year period during which the transferred policy would be subject to estate taxation.  The term death benefit would pay the estate tax due to the proceeds that were brought back into the estate.

Insure With The People You Trust

The options and rules involved in purchasing and understanding life insurance can be tough. We have already learned from the costly mistakes of others and are happy to pass that knowledge on to you.  Contact Kasmann Insurance and let our trained life insurance experts help you navigate through the myriad of concerns, companies, and questions you may have.

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These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matter addressed in this document.  The taxpayer should seek advice from an independent tax advisor.