Top Ten Tax Traps for Life Insurance
Life insurance is a unique asset that receives preferential treatment under U.S. tax law. These tax benefits can be jeopardized if clients and advisors do not comply with certain rules. Help your clients preserve the tax benefits of life insurance by discussing the top ten tax traps that clients often fall into when utilizing life insurance.
1. THE “GOODMAN TRIANGLE”
When the three components of an insurance policy structure – owner, insured, and beneficiary – are three different people, then the death benefit will be considered a gift from the policy owner to the beneficiary and might subject the policy owner to gift taxes. (This trap is sometimes called the “Unholy Trinity.”)
Example: Insured: husband; owner: wife; beneficiary: daughter. At husband’s death, the full death benefit will be considered a gift from wife to daughter.
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. THREE-PARTY BUSINESS INSURANCE
Similar to the Goodman Triangle scenario above, when a business is the owner of a policy insuring an employee, the structure might create an income tax for the employee or beneficiary.The income may be characterized as compensation, a dividend, or a distribution, depending on the type of business entity, relationship between the insured and the business, and other facts and circumstances.
Example: Insured: shareholder; owner: C corporation; beneficiary: daughter. At the shareholder’s death, the death benefit will likely be considered a dividend to the shareholder.
Solution: Use a split dollar arrangement to provide the death benefit to the shareholder’s chosen beneficiary or have the shareholder own the policy with the business funding the premiums through an executive bonus plan.
3. EMPLOYER-OWNED LIFE INSURANCE RULES
The default rule for employer-owned life insurance contracts issued after August 17, 2006 is that the death benefit is included in the employer’s taxable income.
Solution: The death benefit will remain income tax-free if both (1) the “Notice and Consent” requirements are met before the policy is issued, and (2) the structure meets an exception based on the insured’s or beneficiary’s status.1 Also, policies issued on or before August 17, 2006 are grandfathered from this rule, and policies received after this date via a 1035 exchange will remain grandfathered as long as no “material changes” are made to the policy.2 Top Ten Tax Traps for Life Insurance Life insurance is a unique asset that receives preferential treatment under U.S. tax law. These tax benefits can be jeopardized if clients and advisors do not comply with certain rules. Help your clients preserve the tax benefits of life insurance by discussing the top ten tax traps that clients often fall into when utilizing life insurance. 1 See IRC § 101(j) for exceptions. 2 See IRS Notice 2009-48 for details on what constitutes a “material change.”
4. CORPORATE-OWNED INSURANCE ISSUES
There are several other traps that might apply when a corporation owns an insurance policy:
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Premiums are not deductible to the corporation.
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The policy death benefit and cash value may trigger the alternative minimum tax and accumulated earnings tax applicable to C corporations.
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If the insured is a controlling shareholder, the policy death benefit will be included in the insured’s estate.
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The policy and death benefit may be subject to the claims of the corporation’s creditors.
Solution: Have the shareholders personally own the policies under a cross-purchase style buy/sell agreement or have the policies owned in an “Insurance LLC.”
5. TRANSFER FOR VALUE (TFV) RULE
Transfer of a policy in exchange for “valuable consideration” may cause a portion of the death benefit to be subject to income tax. Consideration is broadly defined, and includes obligations and promises in addition to cash and property. Thus any transfer that is not motivated by a “donative intent” (i.e., a gift) may be subject to the TFV rule, such as transferring a policy to a business or transferring a policy from a business to an employee or business owner.
Solution: Structure the sale as a transfer to one of the five exceptions to the rule. The last transfer controls the tax treatment, so you can fix a “bad” TFV with a “good” TFV. Exceptions to the TFV include transfers to:
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The insured (including a grantor trust where the insured is considered the grantor)
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A partner of the insured
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A partnership of which the insured is a partner
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A corporation of which the insured is an officer or shareholder (but not a director)
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An entity whereby the new owner’s basis in the policy is determined in whole or in part by the old owner’s basis in the policy (e.g., transfer to an acquiring company in a tax-free corporate merger)
6. THREE-YEAR LOOKBACK RULE
When the insured gives away a policy on his/her own life, the death benefit will be included in the insured’s gross estate if the insured dies within three years of the gift.
Solution: Sell the policy for “adequate and full consideration” rather than giving it away. (But be mindful of the TFV rule!)
7. “FAIR MARKET VALUE” (FMV) OF LIFE INSURANCE
Determining a life insurance policy’s FMV is important in many contexts, basically whenever the ownership of the policy is transferred from one person or entity to another.
For example: the gift tax consequences of transferring a policy from an insured to a trust and the income tax consequences of transferring a policy from a corporation to an employee will depend upon the policy’s FMV. Determining a policy’s FMV for federal tax purposes has become significantly more complicated with the development of new products, the life settlement market, and the lack of updated IRS guidance regarding appropriate valuation standards.
Solution: Don’t assume that the policy’s FMV is equal to its cash value, as this is almost never the answer. Instead request a valuation 3 from the insurance company and use this as the basis of the FMV, with adjustments for the insured’s particular facts and circumstances as necessary. Top Ten Tax Traps for Life Insurance 3 Policy valuations are reported on IRS Form 712, Life Insurance Statement. Be careful requesting a 712 unless you know the value in advance, because insurance companies are required by law to provide a copy to the IRS. Consider requesting an “informal” valuation before requesting the value on a Form 712. The reserve value for guaranteed UL policies often far exceeds the total premiums paid, even though the policy has little to no cash value. Advanced Sales TECHNICAL BULLETIN Page 3 of 3 For Insurance Professional Use Only. Not intended for use in solicitation of sales to the public. For use with non-registered products only. The annuity and insurance products described may be issued by various companies and may not be available in all states.
8. 1035 EXCHANGES AND POLICY LOANS – THE “BOOT” ISSUE
If a policy loan is forgiven during the process of a 1035 exchange, income tax could be triggered to the policy owner based on the amount of the loan that is forgiven (the “boot”) and the amount of gain in the former policy.
Solution: Carry the loan over to the new policy or pay off the loan on the old policy using outside funds (and not via a withdrawal from the former policy’s cash value).
9. PLEDGING A MODIFIED ENDOWMENT CONTRACT (MEC)
Pledging a MEC as collateral will trigger income tax to the policy owner based on the amount of gain in the policy, including collateral assignments under split dollar plans.
Solution: Avoid creating a MEC whenever possible, and if working with a MEC, carefully consider the consequences of transferring the policy or using it for anything other than providing a tax-free death benefit.
10. INVALID “CRUMMEY” GIFTS
The default rule is that gifts in trust do not qualify for the annual gift tax exclusion, because they are not gifts of a present interest in property. The Crummey case (among others) paved the way for annual exclusion gifts to trusts by giving the beneficiaries limited withdrawal rights on gifts to a trust. Where the 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 if not reported on a gift tax return.
Solution: Crummey gifts are deceptively simple; make sure the trust is properly administered and that all formalities are followed. Plan ahead for any Crummey gifts in the first year – consider how the trust will be funded before the policy is ready to be issued.