Little Mistakes Can Roll Into Big Disasters

Assigning creditors as beneficiaries can damage estate value

A 14th century proverb says, “Great oaks from little acorns grow.” Everyone would agree that beautiful shade trees in the front yard are appealing and desirable, but perhaps the old adage offers an admonition as well. Mistakes that appear small at first can grow into problems later that are disproportionate when compared to a seemingly minor act of misfeasance.

We are in the business of selling the most tax-efficient product in the marketplace. Life insurance has no less than five potential income tax advantages. In addition, it can be structured to avoid the ravages of gift, estate and generation-skipping tax—both with regard to the policy itself and the eventual proceeds it will pay at death.

This favorable tax environment serves to greatly enhance an already effective tool for meeting several considerable financial needs of the parties to a contract, both during their lives and upon the death of the insured. But the protection and benefits a policy can provide—and the tax advantages that attend—can only be achieved and secured if all is done in good order. And it is the insurance advisor who must continually be on the prowl to protect against the seemingly small mistakes during sales and servicing situations that could result in unfulfilled planning goals the policy was purchased to secure.

For example, a common lifetime use of a life insurance contract is to post the policy as security on a loan or other obligation of the owner. This presents an attractive situation for all involved because the creditor is assured of repayment in the event of the premature demise of the borrower and the heirs pay off the loan with income tax-free dollars. Everyone is happy except, perhaps, the dead debtor. Too often, the simplest method of achieving this end is chosen rather than the most advisable. The creditor is made a policy beneficiary—and, with that stroke of the pen, more potential pitfalls are dodged than space permits for discussion. Therefore, here are five to consider:

1. How secure is the security?

The first person to object the “simple” arrangement should be the creditor. A beneficiary has no rights under the contract until the insured is dead. Designations can be changed without notice to the dismissed beneficiary. The designation could be made irrevocable, but even that awkward relationship leaves the door open to the problems that might follow.

2. Coming to terms.

The specifics concerning the conditions and details that apply to the establishment, the administration, the enforcement and the release of a properly constructed security agreement are significant and lengthy. Carriers are reluctant to accept undue administrative responsibility for long-winded instructions in a beneficiary designation and may prohibit the same.

3. Access to the excess.

Most times, property secures an obligation that decreases over time—e.g. the declining balance on a loan. What happens to any portion of the death benefit not needed to satisfy the claims of the beneficiary creditor? The policy owner can appoint a remainder beneficiary, but how is the remainder share designated? So as not to have any unallocated death benefit, most carriers require that rights of the beneficiaries be defined in percentages and that the shares total 100 percent. This would require that the dollar amount of the security interest be converted to a percentage and that the percentages be adjusted periodically to reflect any changes in the balance of the obligation. (What a mess!)

4. Tax-cess on the excess.

What if, under the worst circumstance, no remainder beneficiary is named? Or what if the percentages haven’t been reallocated recently and the creditor is paid more death benefit than is necessary? If the creditor proves a “ne’er do well” or an honest creditor has died and left the interest to some ne’er do well, jack-leg offspring, he or she might just keep the money. But, even if they turn over the extra cash, some questions remain: a) to whom do they pay the money, and b) what are the tax implications? At best, it could be deemed a potentially taxable gift—and, at worst, in a business situation it might be taxable, ordinary income.

5. A taxable transfer?

The Treasury regulations are clear that the pledging or assignment of a policy as collateral security is not a transfer for value. If a creditor beneficiary is named on an existing policy, however, then as an actual party to the contract, the creditor may be deemed neither a pledge nor an assignee, triggering a possible transfer-for-value and income taxation—at least on the proceeds paid to the creditor. Another lesser-known proverb serves our purposes here, too: “A separate written collateral assignment agreement covers a multitude of sins.” Institutional lenders or others in the trade will usually dictate the procedures to formally secure a debt or obligation. But, in less formal situations, the parties to an agreement should always execute a formal collateral assignment, making sure the form is satisfactory to the carrier. Insurance companies will provide their own form or a standard financial industry specimen they will accept—just make sure the collateral assignment is filed in an appropriate manner with the carrier and determine the procedures the carrier uses when settling a death claim involving a collateral assignee. This will reduce confusion among the parties if death does occur while the assignment is still in force. As an agent you should encourage the practice but not take a role in the drafting or execution of the document. Collateral assignments are often completed without the assistance of counsel. But if your client is unsure of the ramifications of what is being signed, he or she should consult a legal advisor. As a cautionary aside, always check to determine whether the policy being used as collateral is a modified endowment contract. If it is, then the transaction will be deemed a potentially taxable LIFO distribution from the contract in the amount of the pledge with the possibility of a 10 percent tax penalty. Be on guard to avoid involvement— as an insurance advisor—in a transaction that may add a new dimension to the definition of “collateral damage.”

By Thomas Virkler, JD, CLU for InsuranceNewsNet Magazine.  Thomas, is director of CPS Advanced Markets, where he assists brokers, as well as other professional advisors involved in work with clients, concerning matters of estate and business planning and issues of income and transfer taxation that attend the sale, implementation and administration of products and plans.

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