Life professionals often struggle with sophisticated questions of policy ownership or finding a source for premiums when they work on their cases. Often, basic issues related to beneficiary designations are overlooked.
The Designation is Wrong
Here’s a typical example of how an agent might come up with a flat-out wrong beneficiary designation.
Say that Bob and Ted are the two shareholders of a corporation. Bob and Ted agree that in the event of a death they want the business to buy the shares of the business from the deceased owner’s spouse.
Their insurance agent decides that getting a lawyer to do a buy-sell agreement will frustrate the process. So, after discussion with the owners, they decide that the business will be the owner of the policies, and that the insured owner’s spouse will be the beneficiary of each policy. The parties believe that this method will get the money into the hands of the deceased owner’s spouse at the right time.
Unfortunately, that shortcut is the wrong way to handle the situation.
While in the event of Bob’s death, Bob’s widow would get the insurance proceeds, Bob’s shares of the company would also stay with Bob’s widow—because there’s no document creating a legal obligation for her to sell to the company. Further, the company would have no extra money to buy from her, because she was named beneficiary of the insurance policy—not the company.
Under the hypothetical situation described, Ted would almost certainly make an E & O claim against the agent.
The correct method would have been to have the company be the beneficiary of the policy, and to have an agreement in place where it would buy shares from Bob’s widow at an agreed price.
The Designation is Not Coordinated with the Estate Plan
For clients who are married with children, many life agents routinely name spouse as the first beneficiary, and children as the contingent beneficiaries.
What’s wrong with that? That approach may be inconsistent with the married clients’ overall planning. For example:
o If the clients are in a second marriage situation, the first beneficiary might need to be some type of marital trust created under one client’s will;
o If one or more of the children are too young to handle money responsibly, the beneficiary might need to be a testamentary trust for their benefit, instead of naming a child as a direct beneficiary;
o If a named beneficiary has qualified—or might in the future qualify—for needs-based government benefits, naming that person as a beneficiary might endanger those benefits.
Asking to see a client’s estate planning documents, or having an open discussion with their estate planning lawyer, can go a long way toward ensuring a coordinated plan.
The Designation Creates Tax Trouble
If a life insurance policy is owned by someone other than the insured, naming a beneficiary other than the policyowner would create adverse tax consequences.
For example, say that the wife owns a policy on the life of husband. Let’s also assume that she names their children as beneficiaries of the policy. At the husband’s death, the death proceeds payable to the kids are considered to be a taxable gift from the wife to them. See Goodman v. Comm., 156 F.2d 218 (2d Cir. 1946).
Similarly, third party ownership with a different beneficiary leads to bad tax results in business situations. Take the earlier example, where the business is the policyowner and the insured’s spouse is the beneficiary. At the death of the insured, the business would be making a taxable dividend equal to the death proceeds to the surviving spouse. See Golden v. Comm., 113 F.2d 590 (3rd Cir. 1940) and Revenue Ruling 61-134.
Keep alert for the nuances of beneficiary designations and help make sure all the life proceeds are used in the way that they are intended.
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