Q. We are working on some estate planning issues and have a question about life insurance. We plan to buy a “second to die” policy and have our three daughters named as beneficiaries. Our youngest daughter lives 40 miles away and the other children are out of state. We think the youngest is also the most capable of managing affairs and getting things done so we have named her as executrix. The attorney has suggested we buy the policy and have it owned by an irrevocable life insurance trust which will ensure that the policy proceeds will not be subject to estate tax. Right now we don’t have an estate tax problem but we are concerned Congress will reduce the exemption in the future since the country is in so much debt. One thought we had was to own the policy ourselves and if the exemption is reduced we would change ownership to our daughter. The attorney said that this may cause a problem if we were to die within three years of making the change. We don’t like the idea of the trust and think it would be much simpler to have our youngest daughter own the policy and name all three children as beneficiaries. We’d make the premium payments. Do you see any problem with this approach?
A. First of all, I must make my usual disclaimer that I do not practice law. I don’t think an irrevocable life insurance trust costs that much to set up and shouldn’t be that difficult to administer. I suggest you ask your attorney to review the costs and the logistics of an irrevocable life insurance trust before you decide against having the trust purchase the policy. There is indeed a three year look back period. The IRS will bring the proceeds back into your estate if you die within three years of transferring ownership of the policy.
From speaking with Jean Gordon Carter, a partner at the law firm McGuireWoods, I learned that gift tax will be an issue if one person owns a life insurance policy and other beneficiaries are named. I also ran your question by Jason Torske, my contact at life insurance company Ameritas Direct. He checked with their advanced planning department and they cited the “Goodman Rule.” This rule came from insurance owned by a business with employees named as beneficiaries but it impacts non-business owners of life insurance as well. In the case Goodman v. Commissioner (1946) it was decided that when the owner, insured and beneficiary of a policy are all different, the owner is deemed to have made a taxable gift to the beneficiary upon the insured’s death.
So, if your youngest daughter is the owner and all three children are named beneficiaries, upon the second death, the proceeds will avoid estate tax but your daughter who owns the policy will be deemed to have made a taxable gift of the 2/3 of the death benefit to her siblings. This may not be a major problem if the exemption remains as high as it is ($5.4 million for 2016) and your youngest daughter’s estate including the amount gifted is below that upon her death. She would need to file a gift tax return for any amount gifted over the gift tax exemption ($14,000 for 2016).
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If you don’t want an irrevocable life insurance trust, have all three of the children own the policy and have all three named as beneficiaries. For the proceeds not to be subject to estate tax you must have no incidents of ownership of the policy. These include: owned by you upon death, retaining any power to cancel, surrender or convert the policy, being able to use it as collateral, being able to change a named beneficiary or select a method of payment. If you make the premium payments the IRS may take this as evidence that you are the true owner. It would be best if the children paid the premium. You can gift up to $14,000 a year to each child (and to their spouse if married) and hopefully they will use some of that money to pay the premium.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624