The Life Insurance Tax Trap – And How to Avoid It

A major advantage of life insurance is a (typically) tax-free death benefit. In structuring life insurance, the owner of the policy generally assumes that the beneficiary will receive the death benefit without any tax being due. However, this assumption can prove incorrect in special cases. The 1946 court case, Goodman vs. Commissioner of the Internal Revenue Service, examined whether the death of an insured party created a taxable gift from the owner of the policy to the beneficiary. Commonly called the Goodman Triangle, the case can inform solutions to assure benefits remain tax free and help you avoid the life insurance tax trap. As an example, assume the following:

1. The policy is owned by son
2. The policy insures the life of the father
3. The beneficiaries of the policy are son and daughter

Ultimately, following the case, it was decided that in this instance the death of the father would constitute a completed (taxable) gift from son to daughter, valued at 1/2 of the death benefit, largely for two reasons:

1. The death of the insured terminated the owner’s right to change the beneficiary
2. The death of the insured matured the policy

A Goodman Triangle tax trap occurs when three distinct individuals inhabit the three points (owner, insured, beneficiary) of the triangle. The person who owns the policy, not the beneficiary, is on the hook for potential gift taxes in this case.

The solution for this is simple – ensure that at least two of the aforementioned three parties are the same. Typical structures might include:

1. The insured being the sole owner and insured of the policy.
2. The insured setting up an Irrevocable Life Insurance Trust (ILIT) serving as both the owner and beneficiary of an insurance policy. The benefits of setting up the ILIT are:
   • The ILIT helps keep the death benefit of the policy out of the insured’s taxable estate.
   • The ILIT helps provide creditor protection and controls how to distribute the death benefit amongst the insured’s heirs.

There are many other financial considerations that may come into play when purchasing and maintaining a life insurance policy, which should be evaluated in the broader context of a comprehensive financial and estate plan. Review the terms of your existent or prospective policy with a qualified advisor to ensure you are mindful of this ruling to avoid tax penalties.

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