Most people, even those in the financial services world, don’t know what they don’t know about life insurance. Life insurance death benefits are one of the very few assets that pays out to the beneficiaries completely free of federal and state income taxes. Unless it gets screwed up.
In the part of the internal revenue code that applies to life insurance, the rules that are often ignored, misunderstood, or both, are the transfer for value rules.
If a life insurance policy is sold or transferred, the gain (amount of death benefit less what was paid for the policy) will be taxable to the new owner when the insured dies and the contract pays out. This makes sense, for example, when a policy is purchased as an investment in a life settlement or viatical situation. However, when purchased in a family or business circumstance where the policy is still providing for a family or business need, there are exceptions to the rule.
Exceptions apply when a policy is transferred or sold to:
The insured
A business partner of the insured
A partnership in which the insured is a partner, or
A corporation in which the insured is a shareholder or officer
A related issue to this is the Goodman Triangle. If one person owns a life insurance policy, a different person is the insured, and a third individual is the beneficiary, the death benefit becomes taxable. For example, if a company owns a policy on an executive and the beneficiary is their spouse, the payment of death benefit proceeds is an income taxable event. It’s like paying the spouse a bonus instead of a death benefit.
Although life insurance, when not tainted by a transfer for value, is not income taxable, it is subject to estate taxes unless it is held in a trust drafted appropriately to remove assets from the grantor’s estate. These trusts have a variety of names and could be Irrevocable life insurance trusts (ILITs), dynasty trusts (grantor or non-grantor), intentionally defective grantor trusts, etc. This relates to Connelly and transfer for value because the issue for the Connelly family was estate tax related, not an income tax problem. The insurance paid into the company was ultimately added to the value of the company and subject to estate tax at a high rate. This could have been fixed with the correct planning and, perhaps, transfers.
Why should we care about the Connelly ruling and transfers for value?
Based on the SCOTUS decision in Connelly, when businesses now realize they own insurance on their owners and / or executives they will need to examine how the coverage is owned and payable, how that fits with their current plan, then make changes where needed. They could unintentionally create a situation where changes of owner and beneficiary are made and they have then turned one of the few truly non-taxable assets into something taxable. This can be fixed easily, if it is discovered. The fix is to transfer the policy to someone who is an exception to the rule and make certain there are only two parties to the transaction (no Goodman triangle).
Typically, lawyers should not represent themselves, doctors shouldn’t operate on themselves and life insurance issues should be handled by advisors who truly understand life insurance.
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