Two recent Tax Court decisions illustrate the danger (and cost) of not paying attention to the details when it comes to life insurance policies and taxes. In each case the taxpayer failed to dot their i’s and cross their t’s, which created adverse estate tax consequences in one case and adverse income tax consequences in the other.
In the first case, Estate of Dwight T. Fujishima et al v. Commissioner, TC Memo 2012-6, the decedent was the record owner of three life insurance policies. The decedent was severely injured after which his mother cared for him in her home. The decedent’s mother fed him, clothed him, and paid his bills with her own funds. The Tax Court noted she did this gratuitously, without expectation of payment.
Following the decedent’s death on January 23, 2005 the decedent’s estate filed a Form 706 (United States Estate and Generation Skipping Transfer Tax Return). On the return the estate listed two of the three policies as owned by the decedent (and therefore includible in the decedent’s estate for federal estate tax purposes), but listed a third policy issued by West Coast Life Insurance Co., with a death benefit of $1,037,973, as “disputed ownership” and did not include it in the value of the decedent’s estate.
At trial the decedent’s mother claimed that because she paid the premiums the policy was really owned by her. The Tax Court flatly rejected this contention noting that the estate listed two other policies as owned by the decedent despite the fact that the decedent’s mother paid the premiums on those policies as well. The Tax Court went on to state, “record ownership of the West Coast policy is the most persuasive evidence [of ownership of the policy]”.
Had Mr. Fujishima and his mother simply transferred ownership of the policy to Ms. Fujishima or to an Irrevocable Life Insurance Trust (“ILIT”), the value of the policy, $1,037,973, would NOT have been included in Mr. Fujishima’s estate for federal estate tax purposes.
In the second case, Yulia Feder v. Commissioner, TC Memo 2012-10, the petitioner purchased a Northwestern Mutual life insurance policy with a death benefit of $50,000.00 in 1982. The policy required quarterly premiums of $73.00. Petitioner paid the premiums as they became due until November 1987. Shortly afterwards, Ms. Feder sent Northwestern Mutual a letter requesting cancellation of the policy and asked that all future communications be sent to her new address.
Apparently Northwestern Mutual never received the letter. Instead of cancelling the policy as requested, when Ms. Feder stopped making premium payments the automatic loan provision of the policy went into effect and Northwestern began advancing the premiums from cash value of the policy until the cash value was exhausted. In 2007, when the cash value was exhausted, the policy lapsed for non-payment of premiums. Northwestern used the policy’s cash value of $12,654 to pay off the premium loans of the same amount and issued Ms. Feder a 1099-R showing income of $5,625 (Cash value of $12,654 – premiums paid of $7,029 = taxable distribution of $5,625).
At trial the Tax Court noted that Ms. Feder failed to introduce a copy of the policy at issue. Had she done so the court may have found that she complied with the notice provisions of the policy and given effect to the cancellation that Northwestern said it never received.
When it comes to life insurance and taxes, pay attention to the details. Life insurance is afforded generous income and estate tax treatment when handled in the right manner. Further, a number of states protect the cash value and death benefits of life insurance policies from the claims of various creditors –if structured properly. In each case had those involved simply dotted their i’s and crossed their t’s, these issues would have never arisen.