Common mistakes in life insurance arrangements.

• Author: Smucker, David K.

EXECUTIVE SUMMARY

* Ownership and beneficiary designations of a life insurance policy should be carefully considered to ensure that arrangements that seem practical do not have unintended income, gift, or estate tax consequences.

* In a Goodman triangle three parties are involved: the insured, the policy owner, and a beneficiary of the insurance policy who is not the policy owner. In the event of the insured's death, the death benefit is considered a taxable gift from the policy owner to the beneficiary.

* The Sec. 2035 three-year lookback rule requires the proceeds of a life insurance policy gifted to a trust within three years of a decedent's death to be included in the decedent's estate.

* Policy premiums paid by the insured directly to the insurer may not be present interest gifts to the policy owners or to the beneficiaries of a trust that owns the policy.

* An exchange between co-owners of a business of insurance policies that are the basis of a cross-purchase buy/sell agreement will be a barter transaction on which gain may be recognized.

PREVIEW

* Life insurance is an essential tool in business succession planning and personal financial planning that tax practitioners should understand how to use.

* Choosing the wrong beneficiary or other errors can result in unintended income, gift, or estate taxes that could easily be avoided.

* Situations that practitioners might encounter when their clients consult them are illustrated, and suggested solutions to the planning problems are provided.

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. (1)

Case 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 others 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.

The Issues

There are two issues. The first is what is called a Goodman triangle (2)--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...