Life Insurance Tax Traps

Unknown to most insureds is the fact that the beneficiary and/or ownership designations of a life insurance policy may have adverse income, estate and even gift tax consequences.  The following discussion will help identify and clear up these very costly mistakes.

Trap #1 – Gifts to Joint Owners

Scenario:  An unmarried parent would like to purchase a $2,000,000 life insurance policy for the benefit of his adult children.  In order to avoid adverse estate taxes, he would like to have the policy owned by somebody other than himself.  He is comfortable with both of his children being the owners and beneficiaries on the policy.

Challenge:  The glitch is the parent paying the premium directly to the insurance company.  This could be treated as an indirect gift to the two children acting as owners.  Since the policy is co-owned, the insurance company will presume it to be owned jointly with rights of survivorship.  Consequently neither child can access the policy values without the consent of the other, thereby creating a future interest gift, which negates the use of the annual $12,000 exclusion.  A prerequisite for the annual exclusion gift, currently $12,000 per person per year, is that it must be a present interest gift in order to avoid any taxation or utilization of the lifetime exclusion.

Resolution:

  1. Parent can create an Irrevocable Life Insurance Trust (ILIT) with Crummey Withdrawal provisions for the benefit of both children; or
  2. Parent may gift half of the premium directly to each of the children, who in turn will then pay their share of the premium.  The direct gifts will represent a present interest, and thus will qualify for the annual exclusion; or
  3. The children can become Tenants in Common.  However, this may be more challenging than at first blush.  Most insurance companies are generally set up to administer co-owned policies with rights of survivorship.  It is possible to draft a Tenants in Common agreement and submit it to an insurance company in the hopes they will accept it and administer the policy pursuant to the terms of the agreement.  If the children are Tenants in Common, they will then have an undivided one half interest in the cash value; therefore; they do not need the consent of the other owner to access their interest. This, in turn, will allow the parent to make a direct payment of the premiums and treat them as a present interest gift.  The second issue regarding this technique arises when there is a death or divorce of either of the co-owners, thereby placing the deceased or divorced owner’s interest in the hands of a third party.  This may be nothing more than an inconvenience, but at worst, it could present a very difficult legal situation.

Trap #2 – Goodman Violation

Scenario:  The same fact pattern as Trap #1 except the parent would like to name the responsible child as the owner, but at the same time name both children as beneficiaries.  Premiums are paid directly to the insurer.

Challenge #1:  Again, the premium payment is an indirect gift to the responsible child.  Since the responsible child is only entitled to one-half of the annual exclusion, the second half of the premium representing the other half of the annual exclusion will be a taxable gift in the year it is made.

Resolution: The use of an ILIT with Crummey Withdrawal provisions allowing for annual exclusions for both of the children will avoid any of the premium becoming taxable.

Challenge #2:  The second issue, which is often overlooked, violates the court case of Goodman v. Commissioner.  Where there are three different parties involved, the policy owner, the insured, and the beneficiaries, the courts have held that the owner of the policy is deemed to be making a gift to the non-owner beneficiary upon the insured’s death, i.e. upon the death of the parent, a gift of one half of the death benefit will be deemed to have been made to the non-responsible child beneficiary.

Resolution:

  1. Make the responsible child not only the owner, but also the sole beneficiary.  This naturally could lead to the non-responsible child being treated unfairly, and in most cases does not meet the objectives of the client; or
  2. Make both children the owners and beneficiaries, thereby negating the Goodman Violation.  This, in and of itself, presents a problem to the parent who is concerned about the capability of the non-responsible child acting as owner; or
  3. Have an ILIT apply for and own the policy and name itself as beneficiary.  This is by far the cleanest resolution and resolves all of the parent’s concerns.

Trap #3 –Life Insurance Owned by a Credit Shelter

Scenario:  A credit shelter trust already exists, and the trustee would like to purchase a single premium policy insuring the life of the surviving spouse, who is acting as trustee.  This spouse is also the beneficiary of the credit shelter trust, and in addition has a limited power of appointment over the trust.  Even though the surviving spouse does not need the trust funds currently, this may change in the future, and it may be necessary to take distributions from the cash values of the policy if the surviving spouse’s needs should change.

Challenge:  The first complication with this scenario is the possibility the death benefits will be included in the spouse’s taxable estate.  Under code section 2042, life insurance proceeds are included in the insured’s estate if the insured possesses any incidents of ownership in the policy on the insured’s life.  This fact pattern indicates the insured’s spouse may have an incident of ownership via the trusteeship of the trust, as well as the limited power of appointment at the time of the spouse’s death.

The second issue is the use of a single premium policy.  In most cases, this type of policy will create a modified endowment contract (MEC).  A MEC could cause the lifetime distributions from the policy to the spouse/insured to be taxable to the extent of any gain in the policy, as well as possibly being subject to a 10% penalty tax.  Most advisors believe the 10% penalty tax would not be applicable due to the potential age of the spouse/insured being over 59 ½ , or possibly having a disability or receiving substantially equal payments over the life expectancy of the insured.  However, this exception is not granted since those exceptions focus on the taxpayer (code section 72(v)).  In this situation, the owner/taxpayer is a trust, not a natural person, which cannot have an age, become disabled, or have a life expectancy. Thereby, no exceptions to the 10% penalty appear to apply.

It is possible that if the distributions from the trust are made in the same tax year, then the ultimate taxpayer, the trust beneficiary, should be used for purposes of applying the exceptions.  It is conceivable the IRS would consider the trust to be the taxpayer, but unfortunately the IRS has not yet addressed this situation.

Resolution:

  1. Have the spouse resign as trustee prior to the purchase of the policy by the trust.  The spouse’s limited power of appointment should also be eliminated, but this may not be as easily done depending on the terms of the trust and state law.
  2. By purchasing the policy as a non-MEC from the outset, the 10% penalty, if distributions must be taken from the policy, can be avoided.  This is generally accomplished by paying the premiums over a period of three to four years rather than all in the first year.

Trap #4 – Transferring Policies for Buy Sell Purposes

Scenario:  D and C are co-shareholders in XYZ, Inc.  They have executed a Cross Purchase Buy Sell arrangement.  D and C each own individual life insurance policies on their own lives.  D is currently uninsurable, thus new insurance cannot be purchased to fund the Buy Sell agreement.  Therefore, D and C intend to transfer their respective polices to each other in order to fund the buy out agreement.  Once the policies are transferred, they will then each pay the annual premium on the policy they own insuring the other shareholder’s life.

Challenge:  Upon the death of either D or C, the death benefit received will not be income tax-free under code section 101(a)(2).  The reason is the Transfer for Value rule, wherein if a policy is transferred for valuable consideration, the death benefit is tax-free only to the extent of consideration paid and premiums paid thereafter.  Consideration regarding the application of the Transfer for Value rule is the exchange of policies for business purposes.

Resolution:

  1. Purchase new policies to fund the Buy Sell agreement.  However, the sticky part here is D is uninsurable.
  2. Qualify for an exception to the Transfer for Value rule so the policies can be transferred without causing the loss of the income tax-free death benefit.  One of the exceptions to the Transfer for Value rule is the transfer to a partner.  This could be done by creating a partnership if D and C are not already partners.  Another way is to invest in the same publicly traded partnership.

Trap #5 – Corporate Owned Insurance Payable to a Personal Beneficiary

Scenario:  XYZ, Inc. plans on purchasing an insurance policy insuring the life of its shareholder.  The wife of the shareholder will be named the beneficiary.

Challenge:  The death benefit from the policy may be treated as a taxable dividend, or the payment may be treated as compensation and thus taxed.  Since the corporation is the owner, in reality it is entitled to the death proceeds, not the spouse.  From the IRS’s point of view, the proceeds are being paid to the corporation and then they are constructively transferred to the shareholder’s surviving spouse.

Resolution:

  1. Make XYZ, Inc. the beneficiary of the policy.  Unfortunately, this may not meet the objective of providing a death benefit to the spouse; or
  2. Have either the shareholder or the spouse own the policy and the corporation pay the premiums as a bonus; or
  3. Utilize an endorsement Split Dollar arrangement, thereby taxing the shareholder only on the economic benefit of the death benefit endorsed by the company to the owner.  This will result in a smaller taxable income to the insured employee.

Trap #6 – Collateral Assignment of a MEC Policy

Scenario:  An ILIT is created in order to acquire a life insurance policy on the life of the insured.  The insured loans $100,000 to the ILIT instead of making a gift to the ILIT to pay the premiums.  The trustee then utilizes the loan to then purchase a single premium policy.  The trustee, in turn, provides the insured a collateral interest in the policy in order to secure the loan.

Challenge:  Since this arrangement falls under the loan regime of the final Split Dollar regulations, one of the potential concerns is the policy may be included in the insured’s estate depending on the terms of the collateral assignment.  This would occur if the assignment provides the insured any form of incidents of ownership, such as the right to access policy cash values.

Another problem occurs due to the fact that a single premium policy will almost always be a MEC.  Under code section 72(e)(10) and (e)(4)(A), when a MEC is assigned, it is treated as a distribution, and thus taxable to the extent of any gain.  However, there is some controversy regarding this.  Some believe that as long as there isn’t any gain at the time of assignment, there should not be any tax consequences. Others believe that as long as the assignment exists at the time gains begin to accrue, then those gains become taxable at that time.  The unfortunate part of all of this is the IRS has not addressed this issue.

Resolutions:

  1. A restrictive collateral assignment could be used to avoid any estate inclusion resulting from the assignment.  The insured’s only rights would be to receive his collateral interest in the event of death or termination of the loan arrangement.  No other incidents of ownership would exist.
  2. In order to avoid the tax consequences of assigning a MEC, it would be best to avoid creating one.  This can be done by paying the premiums over a period of three to four years rather than all in one year.
  3. The use of other property as collateral for the loan would be another answer.  Naturally, this assumes the ILIT has other property, which in most cases it does not.

Trap #7 – 1035 Exchange With a Policy Loan

Scenario:  The insured has a $500,000 policy taken out some time ago.  His goal is to exchange the policy for a new policy under a tax-free 1035 exchange.  His current policy has a value of $200,000 and a loan of $100,000, leaving net cash value of $100,000.  The total premiums, or basis, paid to date is $125,000, so the policy has a $75,000 gain.  The insured wishes to transfer only the net cash value by not carrying over the policy loan.

Challenge:  If this exchange occurs, the insured will incur $75,000 of taxable income, i.e. the loan.  Since the loan is extinguished, it is considered “boot” as part of the exchange and is taxable to the lesser of the gain or the boot.  In this case, the gain is lower.  The effect of this is the insured is exchanging a policy with a gross cash value of $200,000 for a policy with a gross cash value of $100,000.  The insured is not going to receive the $100,000 of cash as part of the exchange, which is identified as “boot,” because the insured instead is being relieved of his obligation to repay the $100,000 policy loan.

Resolutions:

  1. Pay off the loan prior to the exchange.  This can be done in one of two ways:
    1. The policy owner could use his or her own out-of-pocket funds.
    2. The policy owner could take a withdrawal to basis from the policy in order to repay the loan.  However, if this is done close to the time of exchange, the IRS may consider this to be a Step Transaction and attempt to assert there is still taxable “boot.”
  2. The loan could be transferred as part of the exchange.  There are several private letter rulings (PLR 8806058, 8604033, and 8816015) in which the IRS has indicated that an exchange of a policy with a current loan for another policy subject to the same indebtedness will constitute a valid 1035 exchange.  After a reasonable amount of time, i.e. one year, the policy owner could then eliminate the loan on the new policy by taking a withdrawal to basis and then using it to repay the loan.

As you can see, it is extremely important to review, and research any income, gift and/or estate tax consequences, especially with unusual ownership and beneficiary designations.  By doing this, it will ensure that the insured/owner does not suffer any unexpected tax consequences.