Life Insurance Planning And Estate Taxes

Who should be the owner and beneficiary of your life insurance policy? The answer depends on tax and property considerations and on what it actually means to be the owner of the policy.
A life insurance policy is issued to an “applicant” who may be the insured, a spouse, the estate of the insured, a trustee of a trust, or another person having an insurable interest. The applicant designates the “owner” of the policy and the “beneficiary”. The owner is the person who has the right to change the beneficiary, borrow from the cash value, cancel the policy, and exercise other rights of ownership. The beneficiary is the person who receives the death benefit upon the death of the insured.
To begin with some good news: unless the owner of the policy is a C Corp, or unless the owner of the policy actually received the policy for consideration from a previous owner, there is generally no income tax on the death proceeds paid under a life insurance policy. Additionally, at the time of death, at least in Pennsylvania, the state Inheritance Tax does not apply to life insurance proceeds.
As a result, tax planning for insurance policies should be of interest only to taxpayers who have an estate that is subject to the federal Estate Tax. At the moment the high federal estate tax thresholds make this a non-issue for most households; the current thresholds are $11,400,000 per decedent and $22,800,000 per married couple. However, beginning in 2026 these amounts will revert to $5,490,000 and $10,980,000 (subject to inflation), unless there is further legislation. Alternatively, if there is further legislation the thresholds could be lower depending on the election results in 2020. For example, both Bernie Sanders and Elizabeth Warren have proposed that the estate tax apply to estates of $3,500,000 or more.
For those affected by the Estate Tax, a major factor to be considered in deciding who should be the owner or beneficiary of a life policy is the potential impact of the federal estate tax. If the owner of the policy is the insured, upon death of the insured the proceeds will be included in his or her estate for federal estate tax purposes. Also, if the beneficiary of the policy is the insured or the estate of the insured, the proceeds would be subject to federal estate tax.
To prevent insurance proceeds from being subject to federal estate tax upon death of the insured, the applicant generally designates the insured’s spouse, children, or the trustees of an irrevocable trust as the owner of the policy. If the owner is an individual, a contingent owner should be named who will become the owner if the original owner dies before the insured dies. If the owner is a trustee of a trust having a term longer than the life of the insured, there is no need to designate a contingent owner.
Once ownership is determined, the owner designates the beneficiary. If the beneficiary is an individual, a contingent beneficiary should be named in the event the primary beneficiary dies before the insured. No contingent beneficiary is needed if the beneficiary is a trust which will still be in existence after death of the insured.
What if the insurance policy is owned by a pension, profit sharing or other qualified plan? In all instances, the owner is the trustee of the plan. The beneficiary is sometimes the trustee of the plan and sometimes an individual designated by the participant, such as the participant’s spouse.
Life insurance is often used to fund the purchase of a business interest (corporation or partnership) under a Buy/Sell Agreement. Where the Buy/Sell Agreement provides for a corporation or partnership to purchase the interest of the deceased owner, the owner and beneficiary of the life policy is the corporation or partnership. Alternatively, if the arrangement provides for the surviving shareholders or partner to purchase the interest, those persons are the owners and beneficiaries of the policy.
Property and other non-tax factors can sometimes outweigh tax considerations. For example, the insured may want the death benefit to be paid to the insured’s estate to pay a specific debt or mortgage so that a particular property will pass debt-free under the insured’s will. In such an instance, it may be that the estate is the proper beneficiary and estate tax considerations are secondary.
Although ownership of a policy can be changed (i.e., transferred from one owner to another), it is preferable to establish the correct owner at the initial purchase of the policy. A transfer during life may have gift tax consequences, and a transfer of ownership by the insured during the last three years of the insured’s life will generally result in the proceeds of the policy ending up in the insured’s estate.
In summary, be cautious where the insured is the policy owner, or where the insured or the insured’s estate is the beneficiary. There is no general rule as to who the owner and beneficiary of a life policy in a buy/sell arrangement should be although for corporate income tax reasons there is typically a strong disincentive to have a C Corp be an owner of a policy. Other property and tax factors need to be analyzed on a case by case basis.
— Rod Fluck