ELITE ADVISOR BEST PRACTICES

Taxation of Life Insurance

Four common tax traps for advisors and their clients to avoid

By Guy Baker

Key Takeaways:

  • A faulty ownership arrangement or inaccurate beneficiary designation for a new life insurance policy could result in expensive income, estate or gift tax consequence to your client.
  • Many advisors do not find insurance policy ownership and beneficiary designation exciting. But we are paid to do this right, and having this knowledge protects our status as a client’s most trusted advisor.
  • High-performing advisors stay current on tax triangles, premium gifts to owners, credit shelter trusts and corporate-owned policies paid to personal beneficiaries.


The worst thing any insurance agent can do is fall inadvertently into a “tax trap.” To set up an insurance arrangement that ends up being taxable is an unforgivable sin, especially when it could have been easily avoided. A faulty ownership arrangement or inaccurate beneficiary designation for a new life insurance policy could result in expensive income, estate or gift tax consequence to your client. Here are four examples of expensive mistakes and possible ways to avert them:

Tax Trap No. 1 — The Tax Triangle. Let’s say Bob owns a policy on Steve, but names Charles as the beneficiary of the policy. At Steve’s death, Bob has in effect made a taxable gift of the death benefit to Charles. Converting tax-free death proceeds into a taxable gift is not good planning. How should this transaction have been handled? Either Steve needed to own the policy, in which case it would be included in Steve’s taxable estate. Why? Because under current law, if Steve’s estate was less than $5.34 million, it might not have been large enough to incur a federal estate tax. The other option would have been for Charles to own the policy. Why would Bob own the policy unless he was going to pay the premiums? If that was the issue, Bob could have arranged a private split-dollar plan and loaned Charles the premium collateralized by the death benefit.

Tax Trap No. 2 — Premium Gifts to Joint Owners. In this case, the agent writes insurance to fund a cross-purchase buy-sell agreement. Bob and Charles are co-owners of a policy on Steve’s life, with Steve being a minority shareholder. Steve pays the premiums as part of the cross-purchase arrangement, to equalize compensation and to give him control of the policy. Unfortunately, Steve’s premium payments constitute a gift to both Bob and Charles. The arrangement allows neither Bob nor Charles to access the policy cash values without the consent of the other. These premiums are taxable because they are not completed gifts and thus do not qualify for the annual exclusion. Possible solutions are:

  1. Set up the ownership of the policy in an irrevocable life insurance trust (ILIT).
  2. Have Steve gift Bob and Charles each with one-half of the premium.
  3. Arrange for Bob and Charles to own the policy as tenants in common, not jointly.

Tax Trap No. 3 — Putting Life Insurance into the Credit Shelter Trust. Jackie, the surviving spouse, is the trustee of her credit shelter trust. She authorizes the trust to purchase life insurance on her own life. As trustee, Jackie has “incident of ownership” and a limited power of appointment. This results in the death benefit being included in her estate. If she resigns as the trustee prior to purchasing the policy, then there is no problem. An alternative, if the trust has this provision, is to appoint a special trustee for the purpose of owning the policy.

Tax Trap No. 4 — Having a Corporate-Owned Policy Payable to a Personal Beneficiary. In this case, a corporation purchases a policy and is the owner of it. Let’s assume the policy is on Steve and Steve directs the company to make his wife, Diane, the beneficiary. The death proceeds will be taxed either as a dividend or as ordinary income. There are several solutions:

  1. Make the company the beneficiary and set up a DBO (death benefit only) plan. This does not solve the income tax problem, but it does reduce the chance of an audit. This may be undesirable if Steve wants Diane to be the beneficiary.
  2. Another solution is to set up a 162 plan and have the corporation pay the premium as a bonus to Steve. In this case, there is no taxable risk on the death benefit.
  3. The third solution is to set up a split-dollar plan and to loan Steve the premium, which would be paid back from either the death benefit or policy loan.
Conclusion

Among the least exciting subjects are the proper ownership and beneficiary designations. But we are paid to do this right. It pays to know how so that our professional status is not jeopardized by someone who knows this area of the law.


About the Author

Guy Baker, MBA, MSFS, CFP® is a financial advisor to business owners. He works to help owners find ways to reorganize their planning to achieve tax-efficient solutions to their succession, retirement and estate planning problems. Guy is a 34-year member of Top of the Table and recognized by Worth magazine as one of the top 250 financial advisors. For more information, you can contact him at guy@bmiconsulting.com or through www.bmiconsulting.com.