Taxable Estates: The Do’s And Don’ts Of Designations On Life Policies

Taxable Estates: The Do’s And Don’ts Of Designations On Life Policies

Why is it that the most important item on an insurance application is allocated so little space?  Why is it that the second most important item gets equally parsimonious treatment?

All that other stuff is necessary from either a practical or a legal standpoint, but when the dust of policy issue and underwriting have settled and the contract is in force, all that really matters going forward is who owns the policy while the insured is alive and who will get the dough when he or she dies.

Now, having so simply acknowledged this truth – look at the room given on most applications to set down in writing the intentions of the applicant.

The dangerous psychology of the inadequately small boxes is that they seem to suggest that if more room is needed then a client, or an agent or advisor making recommendations, must be excessive at best and obsessive at worst.

The little boxes encourage short, compulsive answers that seem workable at the time, but that could result in disaster if not later re-addressed and cleaned up.

Real-life case in point:

The business owner/proposed insured needs coverage for anticipated estate tax liability (we’re talking several million in coverage).  Time is of the essence because the clock is running on a good underwriting offer.  Everyone is so busy (and hey, who isn’t?) that the advisors and clients can’t get together to talk through the proper structuring the policy.

Finally, the day before the offer will be withdrawn, word comes that for now the policy should be owned by the company (heck, why not, it will be paying the premiums), and the beneficiary will be the insured’s wife.  The first of only two items of good news is that, at least, there is coverage in force.  The other is that the designations commanded are so short that they fit nicely into the boxes on the application.

Other than that there are several potential problems:
  • An “unholy triangle” had been created.  The owner, insured and beneficiary are different parties.  Payment of the death benefit to the spouse could create an income taxable event.  Depending on the manner in which the company was taxed and some other factors this may not be a problem, but nobody took time to think it through.
  • The joint taxable estate of the insured and his wife stands to increase by the amount of the benefit at his death.  Policies purchased to help with estate taxes are held by third parties – usually irrevocable trust whose beneficiaries the same as the insured’s heirs.  This takes planning during the underwriting stages of case.
  • No instructions are given regarding who should be the beneficiary if the wife dies first (maybe it is just as well given that there was no more room in the beneficiary box on the application).  Depending on the contract language the default beneficiary could be either the owner, or the estate of the insured if they are the same.  So now the millions could go into probate court where they are subjected to the expense delay and publicity that attends that process.
Accept three good rules to live by:
  • Be prepared to submit ownership and beneficiary instructions on a separate sheet of paper that is referred to in and is a part of the application.
  • Always submit complete descriptions that include contingent owners and beneficiaries where the primary parties are natural persons.
  • Ask us for help – we will assist as you draft thorough instructions for designation of primary and contingent parties to a policy and will, when necessary, get the blessing of the claims department of the carrier involved.

It always works better when you think outside the box.