The Unholy Trinity Life Insurance Gift Tax Trap
People take out life insurance with the understanding that the death benefit is paid to their beneficiaries tax-free. What is often left out of the conversation regarding the tax treatment of the death benefit is how the policy is structured in terms of who is the insured, owner, and beneficiary. A simple oversight can create the unholy triangle or the Goodman rule trap.
The Goodman Rule is a 1946 US court case, Goodman v. Commissioner of Internal Revenue. Mrs. Goodman transferred several life insurance policies she owned on her husband to a Revocable Trust in 1930. The trust became irrevocable after Mr. Goodman passed away in 1946. Mrs. Goodman as the owner then donor failed to give up control of the trust and was responsible for making a “taxable gift.” The policy had been structured with Mr. Goodman as the insured, Mrs. Goodman as the owner and donor to the trust, and the beneficiaries were her three children and sister-in-law. Because Mrs. Goodman retained some control of the trust the death benefit was considered an “incomplete gift”. The gift tax would have been avoided had Mrs. Goodman relinquished control of the trust.
You can avoid the Unholy Trinity by being cognizant of the three title structure points of a life insurance policy. The insured, owner, and beneficiary. Two of these structure points should be the same person or entity. When all three are different you likely have the Unholy Trinity. In the Goodman Case, Mr. Goodman was the insured, Mrs. Goodman the owner and donor, and her children and sister in-law the beneficiaries.
Businesses taking out life insurance on owners and employees is a scenario where the policy falls victim to the Unholy Trinity. The business owns and pays for the policy on an employee who is the insured and the employee names their spouse as the beneficiary. The problem is that there are three different people or entities on each different structure point. An employer wanting to offer a benefit to an employee unknowingly creates a tax problem in the future. Executive bonuses or split-dollar arrangements can prevent that from happening.
When we talk about policy reviews, we always think about the policy performance, but a review should always include a review of the three title structure points to make sure there is no hidden gift tax issue lurking, because of the Unholy Trinity. The death of a loved one is stressful enough and being blindsided by additional taxes like Mrs. Goodman makes a tough time worse and it is avoidable.
Disclosures:
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through WCG Wealth Advisors, a registered investment advisor. WCG Wealth Advisors and The Wealth Consulting Group are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing in stock includes numerous specific risks including the fluctuation of dividend, loss of principal, and potential illiquidity of the investment in a falling market. Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. Investing involves risk including loss of principal.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
