Blog & Articles

Get The Latest Updates Here

That means that she is going to have to use assets other than the insurance proceeds to pay the tax

That means that she is going to have to use assets other than the insurance proceeds to pay the tax

To make matters worse, the spouse did not actually receive the death benefit, even though she is deemed to have made a gift of it. It may be that the children, wishing to relieve their mother of that financial burden, would give her enough of the policy proceeds to pay the tax. Unfortunately, since that is considered a gift from the children back to their mother, it only compounds the problem.

What is the solution?

Obviously the easiest solution is not to have three different people as owner, insured and beneficiary. That is fairly easy to accomplish in the case of an insured whose estate will not be subject to estate taxation. The insured and the owner can be the same person or the beneficiaries themselves can own the policy.

If the estate is large enough to be subject to estate taxation and the insured is the owner of the policy, the policy proceeds will be subject to estate tax. In that case, it is not wise to have the insured own the policy. A possible solution is to have an entity such as an irrevocable life insurance trust (ILIT) own the policy.

In community property states, each spouse is considered to be the owner of 50% of all community property assets. This includes life insurance policies, even if just one spouse is listed as the owner on the application and the policy. If children in these states are the beneficiaries of a policy where one spouse is the insured and deemed to be the owner, the non-owner spouse will still have made a potentially taxable gift to the children when the insured spouse dies.

Let’s consider a community property example. Assume that the husband is the owner of a policy insuring his life for $1,000,000 and that his wife and three children are each listed as beneficiaries of 25% of the death benefit. At the husband’s death, the wife and each child will receive $250,000. If the premiums were paid from community property funds, the wife will be deemed to have made a gift of one-half the death benefit ($125,000) paid to each child.

In community property states where one spouse is the owner, applicant and insured and the children are listed as beneficiaries, premiums should be paid from the owner spouse’s separate assets in order to avoid the gift tax problem.

The Business “Unholy Trinity”

This mistake is similar to the previous one. However in this case, a business is the policy owner rather than an individual. The presence of a corporate owner alters the tax consequences of the transaction so that instead of gift tax there is income tax.

This form of the “unholy trinity” may occur when the insured, as an owner of a business, uses the business to own the policy and names a third party, such as a spouse, children, or another shareholder as the policy beneficiary. As mentioned previously, the beneficiary generally receives life insurance death benefits free of income tax under IRC § 101(a), but, if there is an “unholy trinity,” the proceeds will be subject to income tax at the death of the insured.

The exact nature of the taxation will depend upon the relationship of the parties involved. If the beneficiary is a shareholder, the proceeds may be taxable as a nondeductible dividend. If the insured is an employee, then the proceeds may be taxable as compensation. This is an area where it is important to seek the advice of knowledgeable advisors.