AA—Life Insurance as Property

Life insurance differs from most other kinds of contracts because life insurance can potentially place specific rights in three types of persons: theinsured, theowner, and thebeneficiary. These characteristics make life insurance unique when compared to other types of property. In fact, their arrangement will determine whether or not the death benefit will be subject to estate or even gift taxes.

A. Death proceedswillbe included in the gross estateif the insured possesses any incidents of ownership in the contract at the time of his or her death, or within three years of his death, no matter who might be the beneficiary.

B. Likewise, when the insured’s estate is named beneficiary, the death proceeds will be included in the gross estate, even though the insured may have possessed no incidents of ownership.

C.Death proceedswill notbe included in the gross estateof the insured if the insured possesses no incidents of ownership in the policy at death or within three years before death and proceeds are not payable to, or for the benefit of, the insured's estate. However, there may be gift tax problems where the insured, the owner, and the beneficiary are all different persons. This arises, for example, where one spouse is the insured, the other spouse the owner (with a right to change beneficiaries), and a child the beneficiary. When the insured dies, the surviving spouse will be considered as having made a gift of the death proceeds to the child. For purposes of the gift tax, property owned by one person (the surviving spouse) is transferred upon the insured’s death to another (the child). This deemed transfer from owner to beneficiary is a gift and could result in the surviving spouse having to pay agift tax, or in having to use up some or all of the available unified credit.

D. Where estate and gift tax issues are a concern, all incidents of ownership should be held by the beneficiary from the issuance of the policy. For example, one individual would be the insured and the policy would be owned by and payable to either his spouse, a child, or an irrevocable life insurance trust. This arrangement will assure that the proceeds from the life insurance contract are received untouched, untaxed, and on time: untouched in that they would be payable directly to the heirs; untaxed in that they would be free of income and estate taxes; and on time in that they would be paid when needed at death, whether death occurs immediately or at some indefinite time in the future.

E. Review of beneficiary designations is especially important when planning for couples who are divorced and illustrates the critical importance of policy reviews. Several court cases have addressed what happens when an ex-spouse continues to be named as beneficiary of life insurance proceeds on an ex-spouse’s life even without any mention of life insurance in the divorce decree. In Sveen v. Melin (138 S. Ct. 1815, June 11, 2018), the Supreme Court ruled against Kaye Melin, the ex-wife of decedent Mark Sveen and ruled that Mark Sveen’s kids get the life insurance proceeds instead of his ex-wife. The court followed state law, in this case, Minnesota.

Mark Sveen and Kaye Melin married in 1997. When Sveen purchased a life insurance policy in 1998, he designated Melin as the primary beneficiary and his two children from a prior marriage as contingent beneficiaries. The couple divorced in 2007. The life insurance policy was not mentioned in the divorce decree, and the same beneficiaries were in place when he died in 2011. Under Minnesota law, a spouse’s designation as a beneficiary for life insurance or a retirement plan is revoked upon divorce. However, Sveen’s children and Melin made competing claims for the insurance proceeds and the case came before the Supreme Court.

Minnesota passed a law in 2002 trying to help people ensure their life insurance proceeds went as intended. The law made the assumption that when people divorce, they don’t intend to leave their ex-spouses as life insurance beneficiaries. So the law will automatically revoke your ex-spouse designation when you get divorced. If you want to leave the ex-spouse listed, you’ll have to take affirmative action to work around the law.

Like Minnesota, almost all states revoke a spouse’s status as a beneficiary when couples divorce, but the rules are more varied when it comes to life insurance policies and retirement plans. The federal statute governing pension plans (ERISA) and the laws in 24 states leave pre-divorce designations in place after divorce. Laws in the other 26 states, however, revoke such designations when a couple divorces.