Practicing CPAs need to have a basic familiarity with the uses of life insurance in business succession planning and personal financial planning. Almost all clients have life insurance; they understand the need for it and have the cash flow to commit to premiums. They need guidance in how to use life insurance to their best advantage.
Familiarity with life insurance will elevate a practitioner's service from being compliance-oriented to being consultative. Clients sometimes do not think things through; careful analysis can help fix or prevent their inadvertent mistakes. Questions about life insurance should be a common part of meetings with clients; they should be on every practitioner's checklist, right along with the questions about births, deaths, divorces, etc.
Life insurance ownership and beneficiary designations require caution and study; what seems logical and sensible can create unnecessary income, estate, and/or gift tax. The same unnecessary taxes can result when circumstances have changed. Case studies and examples can often illustrate and drive home points better than a straight conceptual explanation, so this article presents several case studies to highlight the issues and suggest possible solutions.1Case Study 1
T and R own a business; they have a cross-purchase buy/sell agreement. As is appropriate in cross-purchase agreements, T and R are cross-insured; T owns a policy on R's life, and vice versa. Both agree if either of them dies, their widows will ultimately get the death benefit. Therefore, to save time, each names the other's wife the beneficiary of the policy. On the policy that T owns on R's life, R's wife is the beneficiary, and on the policy that R owns on T's life, T's wife is the beneficiary. The business is worth $12 million, so the death benefits are $6 million each.
There are two issues. The first is what is called a Goodman triangle2—three parties are involved; one person owns a life insurance policy on the life of a second person, and the beneficiary of the policy is a third person. In this situation, the owner of the policy is treated as making a gift to the beneficiary of the death benefits paid to the beneficiary. The result is that if T dies, R will be considered to have given a taxable gift of $6 million to T's widow.3
The second issue relates to ownership of the stock, which will be in T's estate. How is R going to get ownership of the stock to which he is clearly entitled? That will have to be left to the attorneys, the parties involved, and possibly the IRS.
The solution is simple—observe the formalities of the arrangement. R should be the beneficiary of the policy on T's life, and vice versa.4 That way, if T dies, R will get the policy benefit and will be able to buy T's stock from his estate.Case Study 2
K wants to purchase a $5 million life insurance policy on her life, with annual premiums of $50,000. She is establishing an irrevocable life insurance trust (ILIT) next month and wants to give the policy to the trust after she has done so.
The issue is the Sec. 2035 three-year lookback rule. If property to which Sec. 2042 applies (i.e., a life insurance policy) is transferred out of an estate within three years of the date of death, for estate tax purposes it will be brought back into the estate. The problem is not the $50,000 annual premium; it is the $5 million death benefit. If K should die within the three years following her gift of the policy to the ILIT, the premiums will not be brought back into her estate, but the $5 million death benefit will, possibly creating an additional $2 million of federal estate tax (depending on how much of her exemption has been used).
Solution 1: The simplest solution will be for K to delay a formal application for, and therefore issuance of, the life insurance until after she creates the ILIT, which would include appointment of the trustee. The trustee will then apply as the original owner, and K will avoid the three-year rule.
Solution 2: The second solution is selling the policy to the ILIT for fair market value (FMV), which is an exception to the three-year rule found in Sec. 2035(d). That may not be as easy as it sounds because there is no clear guidance on determining FMV in a sale. There is guidance for estate and gift tax purposes and for transfers under Sec. 79 (group term life insurance purchased for employees), Sec. 83 (property transferred in connection with performance of services), and Sec. 402 (taxability of beneficiaries of an employees' trust), but not for an outright sale, which would be covered by Sec. 1001 (determination of amount of and recognition of gain and loss).5 Rev. Ruls. 2009-13 and 2009-14 refer to sales to parties that would suffer no economic loss in the event of the insured's death (e.g., life settlement house or third-party investor); however, there is no guidance on how the selling prices were determined.
Solution 3: Should K go ahead as planned, she might protect herself with what generically is known as an estate protection rider. Insurers offer these riders to temporarily provide additional coverage to fund the additional estate tax should the insured die during the three-year lookback period.Case Study 3
To be sure the cost of their grandchild's college education is covered, the grandparents want to insure the life of the parent who earns the family income. The grandparents want their grandchild, who is currently a minor, to be the beneficiary, and they want to own the policy.
There are three issues in this case.
Issue 1 is that the beneficiary is a minor; if the insured parent dies, a court will have to appoint a guardian for the child to oversee management of the policy benefit, which will entail extra cost and time. In addition, the child will get custody of the money upon reaching the age of majority. In this case, the grandparents are concerned that when the beneficiary receives the money, he or she will not be responsible enough to prudently manage it.
Issue 2 is, again, the Goodman triangle, so the policy benefit will be a taxable gift to the grandchild. Issue 3, compounding Issue 2, is that the gift will be a generation-skipping transfer subject to the generation-skipping transfer (GST) tax. However, given the $5,450,000 lifetime gift and estate tax exclusion for 2016, and the $5,450,000 GST tax exemption (both adjusted for inflation), Issues 2 and 3 may pale in comparison to Issue 1.
In light of the above-mentioned exclusions from tax, Issues 2 and 3 may simply be acceptable risks. Issue 1 could be resolved by having a conversation with the future surviving spouse, explaining that the policy benefit is to be used for the grandchild's education, followed by changing the beneficiary to the potential surviving spouse. A possibly more certain solution would be to create a simple revocable trust, with an independent trustee, for the grandchild's benefit, naming the trust the beneficiary of the policy. If need be, the "simple revocable trust" could be turned into an ILIT.6Case Study 4
A mother wants to provide a $1 million gift to each of three children: A, B, and C; and she wants to buy $3 million of life insurance to fund the gifts. She wants the death benefit to be outside of her estate, so she does not want to own the policy. A, the responsible child, is to own the entire policy outright. A, B, and C are to be equal beneficiaries. The mother wants to pay the $35,000 premium directly to the insurance company.
Issue 1 is the Goodman triangle, again. Specifically, the $1 million going to B and C, each, will be a taxable gift from A, consuming $2 million of his lifetime gift and estate tax exclusion.
Issue 2 is that only some of the $35,0007 premium may qualify for the annual exclusion, and the balance will consume some of the mother's lifetime gifting exclusion amount.
Solution 1 would be to make A, B, and C joint equal owners and beneficiaries of the policy. That would avoid the gifts from A to B and C, but the $35,000 may not qualify for the annual exclusion because the policy value cannot be accessed unless all three joint owners consent.8 Ownership of the policy as tenants in common might qualify the premium for the annual exclusion, but an insurance company might find tenants-in-common ownership administratively unacceptable. The mother's reference to A as the "responsible child" makes both variations unlikely solutions.
Solution 2 would be to create an ILIT with A as the trustee and the three siblings as joint equal beneficiaries. If the trust called for immediate distributions, it would mirror the mother's original intentions.
A variation would be to create an ILIT with an independent trustee, not telling A, B, or C of the arrangement, which the mother might prefer for personal reasons. A's $1 million gifts to B and C would be avoided, and the $35,000 premium would then definitely not qualify for the annual exclusion.Case Study 5
P, who is 48, owns a single premium universal life policy on himself. The premium was $100,000, and the cash value is $200,000. P wants to borrow some money from the bank and pledge the policy as collateral.
A single-premium life insurance contract is, by definition, a modified endowment contract (MEC). MECs are taxed like annuities. Specifically, pledging an MEC as collateral for a loan is treated as a taxable distribution under Sec. 72(e)(4)(A)(ii). The following year, P will receive a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., from the insurer reporting the entire $100,000 gain as a taxable distribution. Further, since P is under age 59½, the $100,000 will be subject to the 10% additional tax on premature distributions from MECs.9
The solution is simple—find something else to pledge as collateral.Case Study 6
B and A own a business and have an insured cross-purchase buy/sell agreement. B and A are the same age and health, so their policies are identical.
Premiums paid on each policy were $300,000; over the years $75,000 of mortality costs10 were charged to each policy, and the current cash value of each policy is $500,000.
B and A have sold the business to S and are retiring. B and A want to keep the policies on their lives, but want to trade policies, so each will own the policy on her own life.
This is a barter transaction. B is selling the policy that she owns on A to A, for $500,000, and vice versa. In accordance with Situation 2 in Rev. Rul. 2009-13, expired cost-of-insurance charges (COIs) have to be taken into account. The transactions are shown in the exhibit below.
A further consideration is that these trades will be transfers for value—the policies are actually being sold to the insureds—so there is a potential transfer-for-value issue, which could make the death benefit in excess of premiums paid subject to income tax. However, because the exception to the transfer-for-value rule for transfers to the insured applies, the death benefit will be income tax-free.11
If A and B do not want the death benefit coverage on themselves, they have some alternatives:
- They could sell the policies to a life settlement house, or
- They could exchange the policies for annuities, under Sec. 1035, making themselves the annuitants.
Case Study 7
R has a universal life policy for which he paid $100,000 in premiums. The surrender charges have expired, and the policy has a gross cash surrender value of $250,000. He has borrowed $50,000 from it, and it has a remaining net cash value of $200,000. He wants to make a tax-deferred exchange of the policy, under Sec. 1035, into a new policy with better mortality costs. The loan will be extinguished as part of the exchange.
The $50,000 will be considered "boot" and will be subject to ordinary income tax.12
R should repay the loan from personal funds then do the exchange.
Case Study 8
This case study does not need a fact pattern. Practitioners should remind clients to update life insurance beneficiary designations after divorces or deaths; that simple step is often overlooked.
Practical: As stated in footnote 4, the general rule is that whoever will need the policy benefit at the insured's death should be the owner and beneficiary of the life insurance. If that would create problems—e.g., minor child, irresponsible beneficiary, potential estate taxation—then it may be necessary to create a trust or make other arrangements.
Motivational: Clients need life insurance; most clients have life insurance. It must be dealt with. Their trusted adviser needs to maintain a working knowledge of life insurance and of ownership and beneficiary designations. Having that knowledge will add value to your services and luster to your professional stature.
1Because large numbers of closely held businesses are taxed as S corporations, this article is written in the context of corporations, stockholders, and stock unless otherwise noted.
2Named for Goodman, 156 F.2d 218 (2d Cir. 1946). The case itself does not use the term triangle, but it is cited as the source of the term "Goodman triangle" and support for the proposition that having more than two parties when a life insurance policy is involved can result in a taxable gift. Sometimes the Goodman triangle is referred to as the "Devil's triangle."
3It must be remembered that the gift and estate tax exclusions are cumulative. In this instance, R's entire lifetime gift and estate tax exclusion will have been consumed, so that at his death he will have only whatever inflation adjustments to the exclusion amounts occurred subsequent to this $6 million gift.
4Unattributed advice on ownership and beneficiary designations is that the owner and beneficiary should be the party that will need the benefit if the insured dies. In some circumstances that may require creation of a trust.
5Van Brunt and Griffin, BNA Tax Management U.S. Income Portfolios 529, Income Taxation of Life Insurance and Annuity Contracts, Detailed Analysis VII (2012).
6A revocable trust becomes irrevocable at the death of the grantor. However, in this context, a trust can be made irrevocable by changing the trust document to make it irrevocable. The term "irrevocable life insurance trust" is simply industry terminology for an irrevocable trust that owns life insurance.
7Because A owns the policy, he may have immediate access to the policy values; if so, some of the premium may qualify for the annual exclusion, since it will qualify as a gift of a present interest under Sec. 2053(b). Because B and C are not policy owners, as to them, none of the rest of the premium would qualify for the annual exclusion.
8To qualify for the annual exclusion, it must be a gift of a present interest. To be a gift of a present interest, the donee must have ready access to it. Given the requirement for three signatures, the children may not have ready access, so the premium may not be a present interest gift.
9Sec. 72(v)(1). A loan is considered a distribution as well (Sec. 72(e)(4)(A)).
10The mortality cost is a reduction based on the likelihood the insured will die. Mortality cost is an annual cost, charged to each policy. Essentially, it is the insured's share of the death benefits that are paid out to beneficiaries on account of the deaths of other insureds.
12Secs. 1035 and 1031(b).
David Smucker is Advanced Consulting Group director with Nationwide Insurance in Columbus, Ohio. To comment on this article, contact firstname.lastname@example.org.