SilverStone Group is often asked by other advisors to provide guidance on complex life insurance questions. While it is relatively difficult to lose tax-favored treatment, it is possible. To help you avoid unfavorable life insurance taxation, we’ve provided four scenarios that outline what not to do when structuring your policy.
Don’t “Triangulate” a Policy
- Scenario: The owner of a closely held business insured his top salesman, Joe, for $1 million. The company owned the policy, paid the premiums and named itself as the beneficiary of $750,000 while naming Joe’s spouse, Jane, as the beneficiary of $250,000. Upon Joe’s death, Jane would have to report the $250,000 as ordinary income.
- Suggestion: For life insurance taxation purposes, do not have three separate parties be owner, insured and beneficiary. The company should purchase two separate policies on Joe’s life. It should be the owner and beneficiary of a $750,000 policy. Joe should be the owner of a $250,000 policy that names Jane as the beneficiary with the annual premiums reported as income each year.
Don’t Gift a Policy That Has a Loan
- Scenario: Tim owned a $1 million policy on his life. He had paid a total of $200,000 in premiums. The cash value was $350,000. Tim wanted to gift the policy to a trust for the benefit of his children. However, he took a policy loan of $300,000 before transferring the policy to the trust. The IRS would treat Tim as having received $100,000 of taxable income.
- Suggestion: Tim should repay the loan prior to gifting the policy to the trust and / or the trust should be a “grantor” trust.
Don’t Transfer a Policy for Value
- Scenario: Alan, Barb and Carl own equal shares of NewCo Inc. stock. They purchase $1 million of life insurance on each other’s lives to fund the stock buyout upon a shareholder’s death. Barb retires and sells the policy she owns on Carl to Alan. Subsequently, Carl dies. Alan collects the $1 million of insurance proceeds from the policy on Carl’s life. Upon filing his tax return, Alan must report the $1 million death benefit as ordinary income.
- Suggestion: Alan, Barb and Carl should have formed a partnership before Carl’s death, or Barb should have sold the policy she owned on Carl’s life to Carl to fall within a “transfer-for-value” exception.
Don’t Forget to Follow the Rules for Key Person Life Insurance
- Scenario: Alan, Barb and Carl are owners in NewCo Inc. NewCo purchases life insurance on all three to redeem their shares at the time of their deaths. NewCo must provide written notice to Alan, Barb and Carl of its intent to purchase life insurance on them. The notification must state the amount of the insurance. It must also declare that NewCo will be the owner and beneficiary of the policy and that it may continue the policy even after a shareholder’s employment ends. Alan, Barb and Carl must provide their own written consent to the arrangement. If NewCo fails to comply with these Notice and Consent rules, the full amount of the policy proceeds must be treated as ordinary income by NewCo.
- Suggestion: If NewCo purchases Key Person Life Insurance on its employees, it must abide by the Notice and Consent rules, and it must file an informational return with the IRS each year.
DO Talk to a Professional
Life insurance can have valuable tax attributes. However, improper changes in ownership and beneficiary designations can have unintended consequences that result in unfavorable life insurance taxation. We suggest that you work with an insurance professional when structuring your coverage portfolio. The experts at SilverStone Group can help you make the most out of your life insurance policy.
This article originally appeared in the 2018 | ISSUE THREE of the SilverLink magazine, under the title “ Life Insurance Taxation: Dos & Don’ts.” To receive a complimentary subscription to the SilverLink magazine, sign up here.