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Real Property, Probate & Trust Law

Insurance Planning: Who Should Be the Beneficiary and Owner?

Stephan R. Leimberg and Thomas P. Langdon

What are the pros and cons of various beneficiary and ownership arrangements for life insurance? Estate planners must consider individual as well as trust ownership and beneficiary designations, including the use of an irrevocable life insurance trust as the repository for insurance in moderate and large estates. The planner must analyze income, gift, and estate tax consequences.

As with any estate planning tool or technique, when life insurance ownership and beneficiary designations are considered, the forms must match the facts and objectives of the parties. Planners should always utilize the solution that provides the most benefit for the client’s family, at the least cost, and with the most certainty of accomplishing its objective. Whether the solution can be implemented quickly and effectively in a cost-effective manner is a critical consideration.

Lump Sum Payment to an Individual. Naming an individual as beneficiary of a life insurance policy is simple. There is no cost involved, and the beneficiary designation is easily understood by the client. On the insured’s death, typically the proceeds are paid without delay, and the beneficiary does not incur any expenses collecting the proceeds.

Problems can arise with this simple beneficiary designation if the named beneficiary predeceases the insured. If no contingent beneficiary is named, the proceeds typically are paid to the estate of the insured. If a contingent beneficiary is named, the proceeds will go directly to that person or party, escaping both probate and potential state death tax inclusion, although some states, such as Pennsylvania, do not impose a death tax on life insurance proceeds even if paid to the estate. Another concern when naming an individual as the lump sum beneficiary of a policy is the minority or legal incompetency of the beneficiary. If a minor is the beneficiary of a life insurance policy, a guardian must be appointed to receive and manage the proceeds. Likewise, if for any reason a named beneficiary becomes legally incompetent, a guardian must be appointed, which can be both troublesome and costly. Expenses rise as other professionals are retained to manage the life insurance proceeds for the beneficiary.

Control is a third consideration the planner must address. By naming an individual as a beneficiary, the insured gives up a degree of control over the proceeds. For example, if the life insurance policy was bought to provide estate tax liquidity for the insured’s estate and the beneficiary is unwilling, after receiving the death benefit, to apply it to that purpose, the insured-decedent’s estate plan and testamentary scheme may be severely affected. By naming an individual as the beneficiary, the insured client loses the ability to influence or direct the ultimate disposition of the proceeds at the beneficiary’s death, because once the beneficiary receives the proceeds, the insured’s wishes are, legally at least, irrelevant. Any life insurance proceeds remaining at the death of the beneficiary are included in the beneficiary’s estate.

To avoid the shortfalls of this simple but effective technique, keep in mind "The Rule of 2": always have at least two backup beneficiaries. A charity may be considered as a final backup beneficiary. The estate planner should ask the insurer to confirm, in writing, the identity of the beneficiaries at least once every three years. To the great surprise of many clients, an ex-spouse or deceased individual may still be named as the present beneficiary. While all of the parties are still alive, the lawyer should check also for transfer for value problems. While the insured is alive, it may be possible to avoid this potentially disastrous tax trap by making a policy transfer to a "safe harbor" party.

Payment to an Individual: Settlement Options. Settlement options are contractual provisions in a life insurance policy allowing either the policy owner or the beneficiary to select one or more annuities or other forms of payment. Settlement options can provide several advantages for the beneficiary and the insured. The election of a settlement option is simple, and no out-of-pocket costs are incurred by either the insured or the beneficiary. Safety of principal (the death benefit) is assured, and the beneficiary does not bear management and investment responsibilities. A settlement option is a good way to provide a steady and consistent income when relatively small amounts of money are involved, or when a trust is inappropriate for any reason.

Before electing a settlement option, however, the planner must carefully consider the alternatives and the disadvantages. Typically, once the settlement option is selected, it cannot be altered even if the beneficiary’s physical condition, marital status, family situation, or financial needs change. If monthly payments under a settlement option are fixed, inflation reduces the purchasing power provided by the proceeds. The guaranteed return on the principal may be lower than with some alternatives, although many insurers have addressed this problem by providing a highly competitive interest rate and, in some cases, a rate of return higher than alternative investments. From an estate-planning perspective, only a limited amount of the proceeds will be available to help pay estate taxes and other costs at the insured’s death, and payments not consumed or given away by the date of the beneficiary’s death generally are includable in the beneficiary’s estate.

Payment to the Insured’s Estate. Designating the executor of the insured’s estate as the beneficiary of the policy is simple. Insurance proceeds become immediately available to pay creditors and provide cash for current bills, thereby assuring liquidity for the estate.

However, ensuring liquidity in this manner can be costly. The life insurance proceeds payable to the executor will be subject to federal estate taxes in the insured’s estate, regardless of whether the insured owned the policy or had any incidents of ownership at death. The proceeds will also be subject to state death taxes in most states, although a few states, such as Pennsylvania, exempt insurance proceeds from the state inheritance taxes even if the proceeds are payable to the insured’s estate. Because the proceeds are payable to the estate, they will be included in the probate estate, increasing estate administration costs. They will be subject to the claims of the insured’s creditors and subject to public scrutiny.

In many states, the insured-decedent’s spouse is entitled to an "elective" or "forced" share of the estate, regardless of what the decedent’s will provides. If insurance proceeds are large enough to encourage the spouse to elect against the estate, the decedent’s estate and testamentary plan may be compromised. Finally, the insured-decedent’s plans depend on the effectiveness of his or her will in disposing of estate assets (including the proceeds of the life insurance contract). A will can be attacked and broken, or elected against. Absent a valid will, the proceeds may be exposed to a much more expensive estate administration.

Payment of life insurance proceeds to the estate of the insured, or to the executor of the insured’s estate, is seldom appropriate and can lead to malpractice suits or disgruntled heirs because of the likelihood of needless expenses and taxes. The practitioner should request written confirmations from the insurer of "backup" or contingent beneficiaries to eliminate the possibility of the estate receiving the proceeds if the named beneficiary predeceases the insured. Although there are legitimate reasons for naming an estate as the beneficiary of a modest amount of life insurance (e.g., an amount sufficient to pay debts that the estate must pay in any event), as a general rule, direct payment to a named individual, trust, LLC, or FLP is the more cost-effective solution.

There is no perfect solution to the question of who should be the beneficiary or owner of a life insurance policy. Each alternative has its costs as well as its benefits. The key considerations are the client’s desires and the beneficiaries’ circumstances, as well as the federal and state tax implications and advantages.

Stephan R. Leimberg is a professor of taxation and estate planning at The American College in Bryn Mawr, Pennsylvania, and is adjunct professor in the Masters of Taxation Program of Temple University School of Law. Thomas P. Langdon is an assistant professor of taxation at The American College.

This article is an abridged and edited version of one that originally appeared in Probate & Property 4 , (July/Aug. 1996).

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