Avoiding the trifecta of tax trouble

tax trouble
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It’s a fact that the vast majority of LBM business owners own life insurance. How they own their life insurance could mean tax trouble, sometimes in the millions of dollars depending on the size of the policies. Many LBM business owners are under the impression that life insurance payouts are always tax free…not so fast.

Our previous LBM Journal articles and educational seminars we’ve presented to many LBM organizations have focused on business succession and estate planning, and we’ve also discussed the many potential problems surrounding life insurance.

Life insurance is supposed to be one of the last true tax-free assets available. And that statement would be both right AND wrong. Yes, contractually the growth of life insurance cash values and death benefits are tax free. However, if the policy ownership structure is incorrect, the death benefit—the largest piece of the life insurance pie— will absolutely be taxable.

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Here are three common, yet avoidable, traps that often lead LBM business owners into tax trouble.

1. Pension Protection Act of 2006: If an entity (corporation, LLC, partnership, etc) takes out an insurance policy on any employee, including the owner(s) of the company, an “Acknowledgement and Consent” form must be signed by the proposed insured prior to the policy being issued in order to avoid the entire death benefit being subjected to income taxes. Yes, that’s right the entire death benefit in this situation will be income taxable.

If the policy has a death benefit of $5 million, as an example, more than $1 million will be lost to taxes simply because a basic form wasn’t signed. As a point of reference, many insurance companies do not include the Acknowledgement and Consent form with their standard application packages, so do not assume that one may have been signed. In addition, IRS Form 8925 is to be filed with the company’s tax returns each year that the policy is in existence.

The bad news is that there is no “do over” if an Acknowledgement and Consent form wasn’t signed prior to policy issue. The IRS will not accept a signed form at a later date. The only choices at that point are to keep the policy and have a taxable death benefit or scrap the policies and start new.

2. Three Party Contracts: A three party contract comes into play when a business owns a policy on an employee, many times the owner of the company, and the owner’s spouse is named the policy beneficiary.

This constitutes a three party contract: party one is the company as owner of the policy, party two is the employee/owner as the insured, and party three is spouse as the named beneficiary. Depending on the size of the policy, hundreds of thousands and possibly millions of dollars will be paid in income taxes that could have easily been legally avoided. There are solutions to guard against this but it’s critically important to work with specialists that understand both life insurance and tax law.

3. Estate Inclusion: Life insurance often plays a very significant role in estate planning matters, specifically providing the needed liquid funds to satisfy taxes and other liquid Estate taxes come due nine months after the date of death and there are various ways to pay the tax bill in addition to life insurance. Other examples include using cash from the estate, borrowing the money or selling illiquid assets.

As an example, if a business owner owes $10 million in estate taxes, the out-of-pocket cost to pay can be quite different. Of course, using cash will be dollar for dollar; however, if the $10 million needs to be borrowed, the cost will be $10 million as well as interest payments until the loan is satisfied. If illiquid assets are sold in a fire sale situation, it’s very unlikely to receive true value for the asset, which means the actual value of assets sold will be more than $10 million in order to net $10 million.

This brings us back to life insurance, the premiums paid to create a $10 million death benefit are typically significantly less than the other options available. The life insurance strategy effectively “discounts” the $10 million that is owed.

Great caution must be taken, however, to assure that the death benefit remains both income and estate tax free. If a policy is personally owned or the business owns the life insurance on a majority owner of the company, the entire death benefit will be added to the business owner’s estate at death and be fully includable in the estate, thus becoming estate taxable. At the current 40% federal estate tax rate, after exemption, this will cause $4 million in tax trouble owed in estate taxes that could have easily been avoided.

In summary, proceed carefully prior to implementation of life insurance in order to avoid the trifecta of tax trouble. It is never good when a supposedly tax-free asset becomes a heavy tax burden.

Lee Resnick is a partner in Resnick Associates, a nationally recognized business succession, estate planning and life insurance advisory and implementation firm with offices in Kansas City and Harrisburg, Penn. Lee works with many LBM-related co-ops and their individual business owner members across the U.S. Contact Lee at lee@resnickassoc.com or 913.681.5454.

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