Not often does the United States Supreme Court, our nation’s highest court, rule on estate planning matters. Last month, however, the Supreme Court ruled on a case, Connelly v. United States, involving the proper calculation of the estate tax liability when life insurance is paid to a business. In a unanimous decision befitting the recent July 4th national holiday, the Supreme Court ruled that the company’s receipt of life insurance increased the value of the company ownership interest, and therefore increased the estate tax liability. God Bless America.
By reason of the U.S. Supreme Court’s treatment of the estate tax issue, in this month’s update I offer a reminder of the importance of coordinating the ownership and beneficiary designations on life insurance as part of a comprehensive estate plan. While life insurance should always be coordinated with estate planning documents, this coordination is particularly important in the following three situations:
- Blended Family Situations
In blended family situations, life insurance can be an excellent tool to provide a financial inheritance to either the client’s children, or client’s spouse, or both. A life insurance policy death benefit is distributed at death to the individuals or entities designated by beneficiary designation, not necessarily by the terms of a trust or Will. For that reason, a step-mother or step-father who is likely named as beneficiary of most of the deceased’s assets does not necessarily need to be involved in the life insurance payouts. It is critical in these situations that the designation be coordinated with the rest of a comprehensive estate plan, including the terms of the Will or Trust.
- Estate Tax Planning
For families with a potential estate tax liability, the ownership and beneficiary designations on life insurance should be structured in a tax-efficient manner. The death benefit on life insurance is generally not subject to income taxes. However, if the insured as any attributes that are considered “incidents of ownership” in the policy, the death benefit paid would add to an estate tax liability.1 Therefore, for clients who potentially face an estate tax liability at death, the ownership of a life insurance policy might be gifted to children or to trust(s) for a spouse or children, including a spousal lifetime access trust. If the ownership and beneficiary designations on the life insurance are coordinated with the rest of the estate plan, the death benefit could pass free of both income taxes and estate taxes.
- Business Succession Planning
For business owners using life insurance to achieve business succession goals, the ownership and beneficiary designations should be carefully coordinated with the business succession legal documents. Life insurance can either be owned by the business itself (called “company-owned life insurance”) or by the other business owners (considered “cross-purchase life insurance”). The logistical benefit of company-owned life insurance is that the company itself, not the individual owners, are responsible for the ongoing premium payments. A cross-purchase plan requires the business owners to keep up on premium payments. While more logistically difficult, a cross-purchase plan would have avoided the estate tax liability that resulted in the Connelly case. Therefore, in light of the Connelly decision, business owners using life insurance should review and possibly amend their business succession plan and coordinate the life insurance accordingly.