There’s a funny sounding phrase in the life insurance world that relates to a lethal tax trap called the “Goodman Triangle”. Sounds deadly doesn’t it?
Well, it actually refers to a court case Goodman v. Commissioner that dates back to 1946 believe it or not. And it is the “unholy trinity” of life insurance planning.
Why does the Goodman Triangle still matter in 2012 and how is it relevant to me?
It actually comes up more often that you’d realize with clients and unfortunately it seems that most agents are unaware of the adverse unintended consequences that improper ownership and beneficiary designations can have in regards to a life insurance policy. There are without question, numerous tax traps that exist within the realm of life insurance planning but none is more pervasive and has the potential to cause significant estate tax, gift tax, and income tax issues as the Goodman triangle.
What’s more is that it’s not as complicated an issue as some other estate planning situations that an agent might face.
The best way to explain the trap is to use an example that I’ve run into on more than one occasion.
Mary would like purchase say $1million life insurance policy to benefit her three adult children—Bill, Sally and Johnny. The annual premium for the policy is $26,000. She’s accumulated enough wealth that owning this policy will cause a significant estate tax issue for her heirs when she dies. Additionally she’s concerned about Johnny, he’s approaching 40, still lives in her basement and has never had much financial success. In other words, she doesn’t feel she can trust him.
So her crafty life insurance agent suggests an easy work-around…she should have the most responsible child, Bill, own the policy that’s insuring her, with Johnny, Sally and Bill all named as the beneficiaries.
That was easy, the agent pats himself on the back for a job well done.
Not so fast.
There are a couple of problems here.
- Most obviously is that her paying the life insurance premium is considered an indirect gift to Bill and since he is the sole owner of the policy there’s only one annual gift tax exclusion available ($13,000) which means half of her $26,000 premium is taxable.
- This problem is overlooked most frequently. This scenario is in direct violation of the “Goodman Triangle” because three different people are the insured(Mary), owner(Bill), and beneficiary(s)(Sally, Johnny &Bill) of Mary’s policy. In the Goodman v. Commissioner court case it was decided that in a scenario like this the policy owner is deemed to be making a gift to the non-owner beneficiaries at the death of the insured. Thereby meaning that when Mary dies Bill will be deemed to have given one half of the death benefit to Sally and Johnny.
How’s that you say?
Well, the rationale is this: the gift is not completed until the insured (Mary) dies since the policy owner (Bill) maintains the right to change or revoke any beneficiary. But, the insured’s death has a simultaneous effect: It instantly terminates the owner’s right to change the beneficiaries, thereby completing the gift, and it matures the policy.
This situation is commonly overlooked.
So, how can you achieve what Mary wants without the adverse consequences?
- We can make Bill the only beneficiary but that leads to Sally and Johnny not getting their share of the insurance proceeds.
- We could make all three children owners of the policy, that way there’s no Goodman Triangle at all because the beneficiaries and owners are the same. But not a great solution because Mary is concerned about Johnny’s financial woes and doesn’t necessarily think it’s a great idea to have him as an owner of the policy where he could access the cash value.
- In this case, probably the best solution would be to have an ILIT(irrevocable life insurance trust) own the policy. This would address all of Mary’s concerns and have the most favorable outcome in the end.
Now, we’re not always big advocates for ILIT’s and we think in general they’re overused by life insurance agents(because it makes them feel important) and attorneys(because it generates a handsome fee) as a cure-all, however, there are times when an ILIT just makes sense.
In this case, it would.
Obligatory Disclaimer: Clearly, we’re not in the business of dispensing tax or legal advice so any client should consult with their tax and legal advisors to carefully review their situation, their initial selection of policy ownership, and beneficiary designations in addition to any changes that are made after the fact. This includes any planning regards to the Goodman Triangle.