The Problem With Three Corner Life Insurance Policies
What happens if the Owner of a life insurance policy is not the insured and not the only Beneficiary? …A huge, unexpected gift tax bill.
In theory, making someone else the owner, other than the insured, could help prevent the policy from being included in the insured’s gross estate.(1) However, when the owner of the policy is not the insured and not the only beneficiary, it is very likely that gift taxes will apply. This is commonly seen when one spouse owns a policy on the other spouse and then names the children as beneficiaries. Or, when an adult child takes a policy out on a parent(s) and names himself and his siblings as beneficiaries. In both of these situations, the thought is that since the insured never owned the policy, the proceeds will not be included in the gross estate. Although this is true, this is not the complete story. Within a transaction, one must not only examine the estate tax implications, but also the impact of gift taxes.
The Internal Revenue Service has ruled a number of times that when one party has owned a policy on the life of a second party and named a third party as the beneficiary, on the death of the insured the policy owner makes a completed gift to the beneficiary (third party) of the death benefit proceeds.(2) In such cases, the amount of the gift is not the premiums paid or the account value, but the total of the insurance proceeds, less the value of any interest retained by the donor/policy owner. The justification for such a result is based upon the razor thin difference between completed and incomplete gifts. If the owner reserves the right to change the beneficiary, which is a right of the owner unless otherwise indicated within the beneficiary agreement, he/she has not made a completed gift under § 2503.(3)
“A gift is incomplete in every instance in which a donor reserves the power to revest the beneficial title to the property in himself. A gift is also incomplete if and to the extent that a reserved power gives the donor the power to name new beneficiaries or to change the interests of the beneficiaries as between themselves unless the power is a fiduciary power limited by a fixed or ascertainable standard.”
The gift will only be deemed completed when the owner can no longer make such an election.(4) In such a situation, the moment when a donor can no longer make such an election is when the insured passes away. At this moment, the gift becomes completed and the value of such a gift shall be determined based upon the value of the policy proceeds. For the unsuspecting owner, who thought he was helping the situation, has made a gift to his siblings for which he is responsible for paying any taxes created by the transaction.
But what if the owner, who is not the only beneficiary to the contract, wishes to make the beneficiary election irrevocable to create a completed gift? “If a donor transfers … and retains no beneficial interest in the trust property and no power over it except fiduciary powers… to change the beneficiaries of the transferred property, the donor has made a completed gift and the entire value of the transferred property is subject to the gift tax.”(5) Therefore, when the policy has accumulated a substantial internal value, greater than the annual present limit of §2503(b), then the transfer could be considered a taxable gift.(6) Even so, this is a much better option than waiting for the death benefits to be paid and using the value of the proceeds at the calculation for gift taxes.