Life insurance tax traps for the unwary


Life insurance death benefits are generally thought to be tax-free, but are not necessarily so (as the old song goes). First, death benefits on a policy owned by the insured are includable in the insureds taxable estate and can incur federal estate tax if the estate is large enough. This problem can be solved by third-party ownership, most commonly by an irrevocable life insurance trust (ILIT) or by the insureds children. Another blunder occasionally seen is having a policy that is used to fund a buy-sell agreement owned by the insured, resulting in both the death benefits and the business interest to be purchased being includable in the insureds estate.

Second, certain traps for the unwary can subject life insurance death benefits to income taxation. This avoidable result generally occurs because of a violation of the transfer-for-value rule, which provides that, if a policy has been transferred for consideration, the death benefits in excess of the consideration paid plus subsequent premiums paid is taxed to the beneficiary as ordinary income. An obvious example is a policy that has been sold by the original owner to another individual or an entity. However, consideration is very broadly construed to mean anything of value, including a promise to do (or refrain from doing) something (e.g., a promise to use the proceeds to purchase the insureds business interest under a buy-sell agreement). A transfer-for-value can even be triggered by a gift of a policy with a policy loan balance in excess of tax basis, because the donees assumption of the policy loan is effectively treated as a purchase for consideration.

To avoid a transfer-for-value, the transfer must fall within one of several exceptions: (i) a transfer to the insured (which the IRS has ruled includes the insureds grantor trust), (ii) a transfer to a partnership or LLC in which the insured is a partner or member, (iii) a transfer to a corporation in which the insured is a shareholder or officer, or (iv) a transfer to a partner or fellow member (in an LLC) of the insured (but, oddly, not to a fellow shareholder in a corporation).

Finally, death benefits can be subject to gift tax if the policy ownership and beneficiary designation are arranged improperly. For example, if A owns a policy on the life of B, with C as the beneficiary, A (as the policyowner) is deemed to make a gift of the death benefits to C upon Bs death. In this example, the policy should instead be owned by B (the insured) or, if the estate is large enough, by C or by an irrevocable life insurance trust (ILIT) created by B for the benefit of C.

Life insurance death benefits can be fully tax-free, but care must be taken to avoid the above traps that can cause estate, gift, and/or income taxation.