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Common Life Insurance Mistakes – Kasmann Insurance Agency, IncKasmann Insurance Agency, Inc

eleanor roosevelt once said: “learn from the mistakes of others. you can’t live long enough to make them all yourself.” the point is that a wise person learns from the mistakes of those who came before while striving to avoid them himself. When life insurance mistakes are made, the consequences for our clients can be financially significant. some would say that’s why the bugs & There is omission insurance. but as far as possible, I’m sure we can all agree that it’s a policy you never want to make a claim on. the rules that affect life insurance are not always easy to use; and some rules are traps for the unwary. There is a chance of making a serious and costly mistake, but with education, you can improve your chances of avoiding it.

the personal “unholy trinity”

The so-called “unholy trinity” exists when three different parties are designated as the owner, insured, and beneficiary of a life insurance policy. If the insured dies under those circumstances, the policy proceeds are considered a gift from the policyholder to the beneficiary. The beneficiary of a properly structured insurance policy should generally receive the death benefit free of income, gift, and estate taxes. let’s look at an example to see how things can go wrong.

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Suppose a wife owns a life insurance policy on her husband’s life and names their two children as beneficiaries. that seems innocuous enough and is all too common. one could reasonably conclude that there is no problem here and that on the death of the husband, the children would receive the benefits of the policy in the usual tax-free manner. unfortunately, that may not be the case.

In 1946, a federal court ruled that in a case where the “unholy trinity” existed at the time of the insured’s death, the policyholder gifted the proceeds to the beneficiaries. in this example, that would mean that on the death of the husband, the wife would be deemed to have made a gift of the earnings to her children. The justification is somewhat technical, but simply stated, it is as follows: as long as the insured is alive, the policyholder can change the beneficiaries, so there is no complete donation.

but the death of the insured does two things: first, it ends the owner’s ability to change the beneficiary. that termination is considered a full gift, subject to gift taxes. Second, the insured’s death expires the policy, making the gift amount the full death benefit.

Assuming the death benefit in the example was $2,000,000, we can see the impact of making this mistake. Upon the death of her husband, the wife shall be deemed to have received the $2,000,000 and gave each of her children a gift of $1,000,000. that gift is subject to gift tax.

Tax laws may provide some relief, but they won’t necessarily eliminate all of the tax. In 2007, a person can donate up to $12,000 to as many other people as they wish, gift tax-free. Since the wife can give each of her children a gift of $12,000 tax-free, the amount of the taxable gift (assuming no other gifts to the children during the year) is $988,000 for each child. .

In addition to this annual per-person exclusion, each individual has a lifetime gift tax exemption of $1,000,000. this means that the first million dollars of the donation, after applying the annual exclusion, will also be tax-free. that helps, but it doesn’t eliminate the tax. in the example, the wife’s donation, after applying the annual exclusion, was twice $988,000 or $1,976,000. after subtracting the $1,000,000 exemption, $976,000 will be unnecessarily subject to gift tax.

To make matters worse, the spouse did not actually receive the death benefit, even though it is considered gifted. that means he’s going to have to use assets other than insurance proceeds to pay the tax. it may be that the children, wanting to relieve their mother of that financial burden, give her enough of the policy proceeds to pay the tax. Unfortunately, since this is considered a gift from the children 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’s fairly easy to accomplish in the case of an insured whose estate will not be subject to estate taxes. the insured and the owner may be the same person or the beneficiaries themselves may be policy holders.

If the estate is large enough to be subject to estate tax and the insured owns the policy, the policy proceeds will be subject to estate tax. in that case, it is not prudent for the insured to own the policy. One possible solution is to have an entity such as an irrevocable life insurance (ilit) trust own the policy.

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

Let’s consider an example of community property. Assume the husband owns a $1,000,000 policy insuring her life and his wife and his three children are each listed as beneficiaries of 25% of the death benefit. Upon the death of the husband, the wife and each child will receive $250,000. if premiums were paid from community property funds, the wife will be deemed to have donated half of the death benefit ($125,000) paid to each child.

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In community property states where one spouse is the owner, applicant and insured, and children are listed as beneficiaries, premiums must be paid from the separate property of the owning spouse to avoid the gift tax problem.

the “unholy trinity” business

This error is similar to the previous one. however, in this case, a company is the policy owner rather than an individual. the presence of a corporate owner alters the tax consequences of the transaction, so instead of the gift tax there is an income tax.

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

The exact nature of the taxes will depend on the relationship of the parties involved. If the beneficiary is a shareholder, the proceeds may be taxed as a non-deductible dividend. If the insured is an employee, then the earnings may be taxed as compensation. this is an area where it is important to seek the advice of expert advisors.

lack of appointment of a successor owner

When we think of the assets we own, we generally think of stocks, bonds, real estate, and personal property. Too often we don’t think of an insurance policy as an asset. not doing so is a potential error.

If a person owns the traditional assets mentioned above, those assets would be subject to succession at the time of the owner’s death. a life insurance policy is no different. If the owner and the insured are two different persons and the owner dies first, ownership of the policy must pass to a successor owner until the death of the insured results in payment of proceeds to a beneficiary. Succession, which is the process by which property passes to the next owner, can cause unnecessary costs, frozen assets, and wasted time. it can also nullify many of the benefits that insurance enjoys.

On the death of one owner, the policy passes as a succession asset to the next owner, either by will or intestate succession, if no successor owner is named. this could cause ownership of the policy to pass to an unwanted owner or be divided among multiple owners.

If the policy is inherited by the insured upon his or her subsequent death, the benefits of the policy may be subject to inheritance or estate taxes. Also, in some states, once the policy is part of the estate, it becomes accessible to the decedent’s/owner’s creditors.

The solution is quite simple. When the insured and the owner are different people, name at least one successor owner or have an entity, such as a trust, own the policy.

naming the estate as beneficiary

The general rule is never to name an estate as the beneficiary of an insurance policy. this can be an unnecessary and costly mistake. If the insured’s estate is the beneficiary, policy proceeds may be unnecessarily subject to estates, creditor claims, and estate or estate taxes (possibly both) at the state and federal levels.

Life insurance protection from creditor claims takes many forms and varies from state to state, so it is important to obtain advice from legal counsel regarding your specific situation. Insurance death benefits actually paid to a designated beneficiary are generally exempt from garnishment by creditors of the deceased insured. however, if those policy proceeds are paid into the insured’s estate, they are no longer considered life insurance. instead, they are considered cash in the estate and are subject to the rights of creditors.

Any assets that become part of the decedent’s estate, including insurance policies and their death benefits, are also potentially subject to probate time and costs. if the estate is named as beneficiary, the proceeds will pass to the deceased’s heirs either by will or by intestate succession. that could result in proceeds being passed on to unintended beneficiaries, including minors.

This error can easily occur unintentionally. if only one beneficiary is named, but he or she predeceases the insured, then by default the insured’s estate becomes the beneficiary.

The solution is to name primary and secondary (contingent) beneficiaries. if there are;

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(1) no estate or estate tax issues, (2) no concerns about a creditor reaching the policy proceeds, and (3) no concerns that the proceeds will be subject to probate,

then it might be appropriate to name the estate as beneficiary. otherwise, it is generally more advantageous to name specific beneficiaries other than an estate.

the three-year inclusion rule

If, at death, the insured owns or has “property incidents” on a life insurance policy, the entire death benefit may be included in the taxable estate for estate tax purposes. if the total value of the insured’s estate, including life insurance proceeds, is less than the estate tax exclusion amount ($2 million in 2008 and $3.5 million in 2009) or passes to a surviving spouse under the Unlimited marital deduction, there should be no federal estate tax. In this situation, it may be desirable for an insured to own their policy.

However, if an insured’s estate is large enough to be subject to estate taxes, their policy property will generate unnecessary estate taxes. What does the owner/insured do when he discovers that the ownership of the policy creates a tax problem? the most obvious solution is to give ownership of the policy to someone else or to a trust. that sounds like a quick and easy fix, but it could have unintended consequences.

The Internal Revenue Code contains a “three-year inclusion rule” with respect to life insurance that states: If an insured who owns a policy on his or her life gives the policy to another person, trust, or entity and then dies within three years of the transfer, the proceeds from the policy will be included in the insured’s estate and will be subject to the inclusion of estate tax.

This inclusion rule captures transfers that involve more than just direct ownership of the policy. another provision of the code states that if the decedent/owner owned any “property incident” on the policy at the time of his death, the death benefit is subject to estate tax. Property incidents include the right to:

(1) change the beneficiary, (2) surrender or cancel the policy, (3) assign the policy, (4) revoke an assignment, (5) pledge the policy for a loan, or (6) obtain a policy loan.

Because of the interaction of these two code sections, when the insured transfers the policy, they must waive these rights, and the transferring owner must live more than three years after the waiver or transfer for the proceeds of the transfer to patrimony escape policy. inclusion of taxes.

The “three-year listing rule” does not apply to a bona fide sale for adequate and valuable consideration. however, if the transaction is structured as a sale, it can be caught in another trap, known as the transfer-for-value rule. this rule may apply unless the transfer is structured to fit within one of the permitted “transfer for value” exceptions. (a topic for an article in a later brokerage report)

How can a policy transfer that is not a gift and all incidents of ownership be a solution to the three-year inclusion rule? The three-year rule often comes into play when an owner/insured surrenders an existing policy to an irrevocable life insurance trust (ILIT). Since the three-year inclusion rule affects only gifts, the transfer can be structured to be a sale to the trust as long as the trust is wholly owned by the owner/insured of the policy. many legal experts feel that this transaction will avoid both the “three-year listing rule” and the “transfer for value” rule because the trust and the policy owner are considered the same person; therefore, the owner is, in effect, selling it to himself.

Another solution is to purchase term insurance to cover the three-year period during which the transferred policy would be subject to estate taxes. the term death benefit would pay estate tax due to the income that was returned to the estate.

be sure with the people you trust

The choices and rules involved in buying and understanding life insurance can be difficult. we have already learned from the costly mistakes of others and are happy to pass that knowledge on to you. contact kasmann insurance and let our life insurance experts help you navigate through the myriad of concerns, companies, and questions you may have.

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These materials are not intended to be used to avoid tax penalties and were prepared to support the promotion or marketing of the matter discussed herein. the taxpayer should seek the advice of an independent tax advisor.

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