Avoiding Life Insurance Tax Traps

Last time we looked at some of the base tenets surrounding life insurance and the austere outlook of the IRS when it comes to premiums, loans, and withdrawals.

More specifically, there are some significant traps that can snare you when utilizing life insurance. Here we’ll look at three and their potential solutions.

1. The “Goodman Triangle” conundrum was named after the Goodman v. Commissioner of Internal Revenue case that came before the Second Circuit Court of Appeals in 1946. The court ruled that if the three components of a policy structure – owner, insured, and beneficiary – are all different people, the death benefit will be considered a gift from the policy owner to the beneficiary and might subject the owner to gift taxes. For example, a wife might own a policy on her husband with their daughter as beneficiary. Upon the husband’s death, the full death benefit may be considered a gift from wife to daughter. Obviously, this was not the intent.
   SOLUTION: Have the insured or beneficiary own the policy, or use a trust to own the policy with the trust as the owner and beneficiary.
2. Employer-Owned Life Insurance
   Since August of 2006, nearly all employer-owned life insurance death benefits are includable in the employer’s taxable income. This can wreak havoc upon the death of a key employee.
   SOLUTION: If both specialized “Notice and Consent” requirements are met before the policy is issued and the structure meets an exception based on the insured’s or beneficiary’s status¹. Notably, policies issued on or before August 17, 2006 are grandfathered from this rule, and policies received after this date via a 1035 (“like kind”) exchange will remain grandfathered as long as no “material changes” are made to the policy.

¹See IRC § 101(j) for exceptions. See IRS Notice 2009-48 for details on what constitutes a “material change.”

3. Invalid “Crummey” Gifts
   The default rule regarding paying premiums into a trust on behalf of heirs is that such gifts do not qualify for the annual gift tax exclusion (currently $14,000 per person per year). This is because they are not really gifts of a present interest in property, but rather a future benefit (the death benefit of the policy).  The Crummey case (among others) paved the way for annual exclusion gifts to be used for life insurance in trusts by crafting a procedure that provides the beneficiaries limited withdrawal rights on gifts to a trust.
   SOLUTION: These rights are typically outlined in a letter from the trustee to the beneficiary, and the beneficiary then acknowledges a forfeiture of his/her right to access the gift.  However, if these withdrawal provisions are not properly executed, gifts to trust will likely not qualify for the annual exclusion and could have severe gift and estate tax consequences, including full inclusion of the death benefits in the estate of the trust creator.

As always, these issues require careful planning and consideration. Consult with your tax and financial planner for further assistance.

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