By: Randall A. Denha, J.D., LL.M.
One of the first things a life insurance agent will tell you when you are looking into purchasing insurance coverage is that life insurance proceeds are paid out tax-free to beneficiaries. Every client remembers this fact. However, while life insurance proceeds are tax-free in the majority of situations, it is important to realize that there are certain scenarios where this is not true. However, tax traps can frequently arise in structuring a policy and in common planning contexts. Effective planning should identify, avoid, or remediate planning mistakes and oversights – and preserve the unique tax benefits afforded to policy owners and beneficiaries. In addition, there are some cases when gift or estate tax may be owed. If you are dealing with a complicated estate planning or business situation, it is important to work with qualified advisors, to create an insurance strategy that works for you.
Income Tax on Life Insurance Proceeds
Most income tax traps occur when a business is involved. When it comes to avoiding income tax on your insurance proceeds, steer clear of situations like these:
- The Unholy Trinity, or Tax Triangle.You are part-owner of a C corporation with two other shareholders and have a buy-sell agreement drafted. The corporation purchases three insurance policies, naming the remaining two shareholders as beneficiaries for each insured’s policy. This formation is known as the “unholy trinity” and invokes the rule in Goodman v. Commissioner, 156 F.2d 218 (1946). That case held that when the owner, insured and beneficiary of a policy are all different, the owner is deemed to have made a taxable gift to the beneficiary upon the insured’s death. In a business situation, the business is deemed to have received the death proceeds and then paid them to the employee, who would owe income taxes on the death benefit as a distribution from the business. Solution: Ensure that the owner and beneficiary of each policy is the same. If you want the corporation to own the insurance policies, make sure it is the corporation, not the shareholders themselves that are the beneficiaries of the proceeds. This same result can occur with a life insurance contract with multiple different parties as further described below.
- Key Employee Insurance on Not-So-Key Employees.You own a business, which purchases life insurance policies on a non-owner “key” employee and names itself as beneficiary. The employee retires, yet the business retains the policy. Five years later, the employee dies. According to IRC 101(j), the life insurance proceeds will be income taxable to the business to the extent the proceeds exceed premiums paid for the policy, if the employee was not working there in the last year and was not a director or highly compensated individual. Solution: Give the proper notice and consent to the employee as mandated by statute, and allow the employee to take over the insurance policy at retirement (although you should discuss transfer for value” rules with your advisors). You can also pay the proceeds to the insured’s family after death (they get an exemption from paying income tax).
- Policy loans. These can create unintended tax consequences upon surrender, lapse, or transfer. If a policy with substantial borrowing is surrendered or lapses, the outstanding loan is treated as a distribution. The policy owner will recognize income to the extent the loan, plus remaining cash value, exceeds basis. Policies with outstanding loans that are kept in force until the insured’s death do not create an income tax problem, and the proceeds will remain income tax free. However, the loan is repaid by reducing the death benefit by the amount of the outstanding loan.
Policy loans can also trigger tax if the policy is transferred (including gifts). A policy loan taken prior to a transfer reduces the policy value for federal gift tax purposes. However, the transferor will recognize income to the extent the loan exceeds the policy’s adjusted basis, triggering income tax on the greater of the loan or policy gain. To avoid income tax on a transfer of a policy with a loan, the transferor could consider repaying at least a portion of the loan so it does not exceed basis at the time of the transfer. Transfer of a policy with an existing loan could also trigger the “transfer for value” rule (causing the death proceeds to be subject to income tax) since the transferor’s discharge of the liability is treated as consideration received – unless an exception applies (see below for exceptions).
It’s important to investigate a policy’s status to avoid inadvertent consequences associated with loans. It is of value to review a policy portfolio regularly with an insurance advisor to check for these issues, be alert to emerging problems, and examine options to avoid unanticipated tax.
- The dreaded “Transfer for Value” rule. If a life insurance policy is transferred from one person or entity to another, in return for something of value, then the death benefit (in excess of premiums paid) is subject to income tax – unless an exception is met. “Exempt transferees” are limited to the insured, a partner or partnership of the insured, or a corporation in which the insured is a shareholder or officer. An exception also exists for a transfer where tax law requires the transferee to take the transferor’s basis in the policy (e.g., gift).
What’s tricky is not all transfers for value are obvious. Neither a formal transfer of the policy nor tangible consideration is required. In some circumstances, a transfer for value can occur by naming a beneficiary or giving rights to all or part of the proceeds through a separate agreement. The consequence of triggering the transfer for value rule (without meeting one of the exceptions) is the beneficiary will be subject to income tax on the portion of the death benefit that exceeds the consideration paid for the policy, plus any subsequent premium payments and other amounts paid to maintain the policy.
Both personal and business planning contexts often involve transfers of existing policies to other parties. An understanding the transfer for value rule and its potential tax impact is critical when considering policy transfers. Therefore, before a life insurance policy is transferred, the circumstances should be carefully evaluated in light of the transfer for value rule and its exceptions.
Estate and Gift Tax on Life Insurance Proceeds
Even if a death benefit is free of income tax, it will not necessarily always be free from estate taxes. Many people develop complicated estate plans involving insurance to avoid estate taxes, only to find out too late that they have done it incorrectly. Here are some common scenarios to watch out for:
- Living Trust as Beneficiary.Your current estate is worth over $5.49 million (the current 2017 estate tax exemption for an individual). You do not want your life insurance proceeds to be subject to estate tax, and you heard that a trust can protect from this. You name your revocable living trust as the beneficiary of your insurance policy. While this is a relatively simple issue, many people overlook the fact that any incident of ownership will cause the life insurance policy to be included in your taxable estate. Since you have full control over your revocable trust, you will not avoid estate tax in this manner. Solution: Draft an irrevocable life insurance trust (ILIT) and name it as the owner and beneficiary of your policy. Since the trust is irrevocable, you will have no incidents of ownership and the proceeds will be excluded from your estate.
- Children as Beneficiaries.Your responsible adult child owns your insurance policy, as you heard this will avoid estate tax, but you name all three children as beneficiaries. This situation is another violation of the Goodman Rule, and the owner child would be deemed to have made a taxable gift of the 2/3 of the death benefit to the other two children. This Tax Triangle in life insurance planning is a common trap. The triangle occurs where there are three different parties to a life insurance contract – one party as the insured, a second party as the policy owner, and a third party as the policy beneficiary. Solution: Make sure the owner and the beneficiary of your life insurance policies are exactly the same, whether it be your spouse, adult children, or a life insurance trust.
- New Trust, Old Policy.You want your life insurance to be owned by your new ILIT, but your current policy lists you as the owner. Usually changing the policy owner to your new trust won’t be an issue, but be careful of the three-year look-back rule, which states that any life insurance policy owned by you in the last three years before death will be included in your taxable estate. Solution: If it’s a term policy, consider re-applying for coverage and naming the trust as the owner of the new policy. A cash-value policy can also be 1035 exchanged to a new policy with no income tax ramifications. If a new policy is not cost effective, you may have to take a chance on outliving the three-year time period.
- Incidents Of Ownership. Most life insurance acquired by high net worth individuals is held outside the taxable estate. Many of these estates are concentrated in illiquid assets, and these individuals want to be sure that the policies intended to provide liquidity for the estate do not increase the estate tax exposure. Personal ownership of the policy may not be a desirable strategy, as this would include the death proceeds in the insured’s estate. Consequently, third party ownership of the policy is often considered, such as by an irrevocable life insurance trust (ILIT). If the objective is to exclude the death proceeds from the taxable estate, the insured must also be careful not to retain any “incidents of ownership” in the policy – broadly defined as the right to name or change a beneficiary, surrender or assign the policy or revoke an assignment, receive policy loans, or pledge the policy as collateral for a loan. There are circumstances where an insured retains or acquires incidents of ownership (often unintentionally or inadvertently), or encounters other situations that can trigger estate inclusion. Incidents of ownership are not always obvious, and indirect incidents of ownership can arise in many planning situations and contexts, including ILIT planning. Incidents of ownership has no “de minimus” exception – and a single incident of ownership (no matter how minor) can cause estate inclusion of entire death benefit.
Tax mistakes can and do happen. While individuals purchase life insurance with the understanding that the policy and its proceeds will be taxed favorably, if a careful eye is not applied then “bad things can happen to good people.” Working with the right advisors and through proper planning, an individual can be better assured that favorable tax treatment can be achieved with life insurance so that more are left to who they want, when they want and how they want.