You only need to look at your last paystub to be reminded that, as long as taxes are around, what you “get” is not usually what you “get”. But the nice thing about the death benefit on a life insurance policy is that the amount you see on the contract is what you get . . . maybe.
The most powerful and the most sellable tax advantage of life insurance is the opportunity to offer a tax-free death benefit. But it is only an opportunity and it can be lost if the policy is mishandled and structured improperly.
If too many cooks can spoil the broth, consider the affect that too many parties to a contract can have on taxation at death.
Every policy needs an insured, an owner and a beneficiary. So long as the three spots are filled by just two parties you are probably in good shape – at least as far as the issue at hand. But if the three roles are filled by three separate parties, tax implications come into play.
Such an arrangement is often referred to as the terrible triad, or the unholy trinity by those more theologically inclined. Consider the possible unintended and unsavory circumstances that could result.
Family planning situation #1: Assume that Dad is the insured, Mom is the owner, and Mom names Daughter as the beneficiary. When Dad passes away Mom is deemed to have made a gift of the death benefit to Daughter. If the death benefit exceeds $14,000 this year (which it probably will unless you bought the policy from a machine at an airport) then Mom has made a potentially taxable gift. Potentially because Mom can use a portion of her lifetime exemption to avoid tax on the amount of the death benefit over $14,000. This may not be a problem because Mom didn’t intend to use all of her $5,430,000 exemption amount anyway. The inconvenience is that Mom must file a gift tax return in order to use part of her exemption to avoid the tax.
Family planning situation #2: Dad has a $10,000,000 policy to benefit his four children that he doesn’t want included in his or his wife’s taxable estate. He doesn’t want to go through the fuss of creating an irrevocable trust to hold the policy (call him penny-wise and pound-foolish) so he makes his most responsible child the owner trusting her to treat her siblings fairly. She does, naming all four kids equal beneficiaries. Dad dies and the IRS informs Daughter-owner that she has made three $2,500,000 gifts whose total is well in excess of her lifetime exemption. Other than that Mrs. Lincoln . . .
Business planning situations: A Company buys a policy on a non-owner executive to serve double duty as both key person insurance and to provide a death benefit to her spouse. The executive dies and half the death benefit is paid to the surviving husband. The IRS will treat the amount received by the husband as compensation to the executive, reportable on her final income tax return. The good news for the company is it can take a business expense deduction for the amount allowing room for an additional bonus to help relieve the tax burden, if it is so inclined.
Fortunately the red flag in terrible triad scenarios is easy to spot: three different parties as the insured, owner and beneficiary. If you are assisting in the structure of a policy and have questions, give a me call at 706-354-0401 or wire firstname.lastname@example.org.