A great deal of attention is usually paid by estate planners to identifying the best choice as owner of a life insurance policy and, when the ownership is changed, the beneficiary of the policy. However, even when the insured will own the policy, care must be taken in deciding who should be the beneficiary. 50
Specifically, five options will be considered:
1. Payment to a named individual beneficiary in a lump sum
2. Payment to a named individual beneficiary under a settlement option
3. Payment to the insured's estate
4. Payment to a trust under the insured's will
5. Payment to an inter vivos revocable trust
Naming an individual as beneficiary of a life insurance policy, to receive the proceeds in a single lump sum, is by far the most common beneficiary designation option. Certainly, it has several distinct advantages. First, it is simple, with no legal or accounting fees or other out-of-pocket costs. For insureds with relatively small estates, this may be the ultimate issue.
Second, the insured will usually understand the designation of an individual. This factor should not be undervalued, as an insured who does not understand how the proceeds will be paid is likely to misinform his or her family about what it should expect, and the family members will attribute the disparity between the actual distributions and their expectations to an error on the part of the insurance agent or attorney.
Third, the use of an outright distribution to a named beneficiary results in the proceeds being made available to the beneficiary very quickly after the insured's death and without any significant expense in collecting them. If the beneficiary is a surviving spouse or child who will need these funds for living expenses, this may be an important consideration.
The use of a lump-sum designation is not entirely without its problems. First, the beneficiary designation may become inadequate or incorrect because of changed circumstances. Probably the most common changed fact involves the death of the beneficiary before the insured. In this case, the proceeds go to a contingent beneficiary. If no contingent beneficiary is named under the policy, the proceeds usually go to the insured's estate. If the beneficiary is the insured's spouse, however, divorce or permanent estrangement will not necessarily terminate the rights of the spouse in the policy. 51
This problem can be reduced through the “rule of two.” The beneficiary designation should always include at least two alternate beneficiaries. It is also appropriate to consider naming a charity as a final backup beneficiary. 52
Second, if a beneficiary is a minor or for any other reason is legally incompetent, a guardian must be appointed to receive the proceeds. A beneficiary designation may require the use of a Uniform Transfers to Minors' Act custodianship or Uniform Custodial Trust Act trust, but this must be specifically indicated in the beneficiary designation, and such indications are rare. Furthermore, in many cases the beneficiary is legally competent, but insufficiently mature or experienced to be able and willing to manage or invest and conserve the proceeds.
Third, the beneficiary may not be willing to use any part of the proceeds to help pay the insured-client's estate taxes or settlement costs. If the life insurance is intended to provide estate liquidity, there is no assurance that the beneficiary will cooperate. Even if the beneficiary wishes to cooperate, furthermore, he or she may be involved in a divorce or have substantial creditors who will preclude the use of these proceeds to solve estate liquidity problems.
Fourth, the insured loses the ability to influence or direct the ultimate disposition of the proceeds at the beneficiary's death. Once the beneficiary receives an outright distribution of the proceeds, the insured's wishes are (legally, at least) irrelevant.
Fifth, proceeds remaining at the beneficiary's death are includable in his or her estate.
In Luxton v. State Farm Life Insurance, Inc., 52.1 a U.S. District Court held that the Service was entitled to the proceeds of life insurance to which the decedent's children, the named beneficiaries of the insurance, claimed they were the proper recipients, because the insured policyowner had assigned the coverage to the Service as collateral for unpaid taxes. Beverly Luxton, the insured, had named her children as beneficiaries of several life insurance policies. Unfortunately, Luxton also owed the Service for back income taxes.
In 1995, Luxton collaterally assigned the right to policy proceeds to the Service as security for those unpaid income taxes. After Luxton's death, both the Service and Luxton's children claimed the proceeds. The insurer held the proceeds until the proper recipient could be determined.
Luxton's children alleged that the insurer breached the insurance contracts by failing to pay the proceeds of the policies to them as required by the contracts' terms. The district court denied their request for a temporary restraining order preventing the insurer from disbursing the life insurance policy proceeds to the Service. The court stated that the facts remained in dispute, precluding a temporary restraining order. The only clear fact, the court found, was that the terms of the life insurance policies, when read together with Luxton's assignments, were ambiguous, because “they simultaneously purport to assign the right to the proceeds to the IRS and yet appear to maintain the provisions that grant the same right to the beneficiaries.” Furthermore, the court noted, Luxton retained the right to change the beneficiaries, but she never named the Service a beneficiary.
The Service proved that the terms of the policies did not prohibit their assignment, the assignments were valid, and were effective to transfer ownership of the policies to the Service, “subject to the terms of the polic[ies] and as modified by the assignment[s].” Each policy specifically stated that a valid assignment may limit the interest of any beneficiary. This was enough for the court to find that the assignments limited the interest of the beneficiaries to the amount of the proceeds remaining after payment of Luxton's existing liabilities to the Service.
The court also held that the life insurance
proceeds were not protected by state law (
On a motion to amend, the children then asserted that the IRS claim against the policy should be limited to the cash surrender value of the policies, but the District Court disagreed, finding no authority for the limitation.
The children also alleged that the IRS had not met an appropriate burden of proof regarding its claim to the proceeds. The District Court agreed that “[a]nyone attacking the right of a named beneficiary to receive the proceeds of an insurance policy has the burden of proving that the beneficiary is not entitled thereto.” 52.2 Unfortunately for the children, the District Court also concluded that the IRS clearly satisfied this burden in establishing its right to the proceeds of the life insurance policies.
The U.S. Court of Appeals for the Eighth Circuit affirmed, noting that the collateral assignments granted the IRS an interest in the proceeds that was superior to the rights of the named beneficiaries. The court noted that state law permits collateral assignment of a life insurance policy without the consent of the beneficiary, if the policy contains an express reservation of that right. The Luxton policies contained such an express clause, and state law may exempt a debtor's life insurance policies from an ordinary creditor's claim, but it does not preclude the IRS from claiming against the policy as an assignee.
As with outright distributions to an individual, there are several factors that favor the use of a settlement option together with the designation of one or more individuals as the beneficiaries of a life insurance policy. First, the election of a settlement option for a beneficiary is quite simple, with no legal or accounting costs or other out-of-pocket costs. Thus, the settlement option approach may be the perfect “poor person's trust” in cases in which policy proceeds will be relatively modest.
Second, the principal is retained by the insurer for investment, with a higher degree of safety than might be available if the beneficiary retains the funds. Of course, the degree of safety will depend in part on the stability and solvency of the insurer, but a careful examination of the ratings of the various rating companies will help assure that one deals with strong insurers.
Third, the use of a settlement option relieves the beneficiary of the responsibility for managing and investing the proceeds. For elderly or very young beneficiaries, this may be an especially important consideration.
There are several problems with designating a named beneficiary as the recipient of a life insurance death benefit, even if the benefit is held under a settlement option that defers receipt of the entire sum. First, the election of a settlement option is usually irrevocable. Once it is made, it cannot be altered, even if the beneficiary's physical condition, marital status, family situation, or financial needs change. A trust, however, can be drafted to change the distributions as conditions are changed.
Second, because monthly payments under most settlement options are fixed, inflation can reduce the purchasing power produced by the proceeds. This is particularly important when the beneficiary is relatively young and can be expected to receive payments over many years.
Third, the guaranteed return under most settlement options is relatively low. Many companies have overcome this with highly competitive interest rates for Universal Life and other similar products, and these rates are usually similar to mutual funds with similar investments.
Fourth, if a settlement option is selected, the life insurance proceeds may not be available to help pay estate taxes and other costs at insured's death.
Fifth, payments not consumed or given away by the beneficiary by the date of his or her death are includable in the beneficiary's gross estate for federal estate tax purposes and in his or her probate estate for probate purposes.
While payment of life insurance proceeds to the insured's estate is a fairly common approach to the distribution of death benefits, particularly when the designated beneficiary has predeceased the insured, it is rarely the best approach.
There are several distinct advantages to naming the insured's personal representative (executor or administrator) as beneficiary. The first, of course, is simplicity. The designation of one's estate is a simple act that is likely to be understood by every client, and that will bring with it few, if any, out-of-pocket costs.
Unfortunately, the disadvantages of designating one's estate as the beneficiary on one's life insurance policies usually far outweigh the advantages. First, the proceeds will be subject to federal estate tax under Section 2042(1) , regardless of who owned the policy.
Second, the proceeds will also be subject to state death taxes, even if life insurance proceeds payable to a named beneficiary are otherwise exempt from such taxes. While the federal estate tax is certainly imposed at a higher rate than state death taxes, state taxes often have low exemptions and should be considered carefully in planning an estate.
Third, proceeds payable to a decedent's personal representative will be included in the insured's estate for probate purposes. This may result in higher estate administration expenses, as filing fees and certain other costs may be based on the size of the probate estate. Furthermore, however, it may subject these proceeds to the claims of the insured's creditors, which claims may not be enforceable against assets passing outside of the probate estate.
Fourth, the insured's spouse can, in most states, renounce the provisions made in his or her behalf under the decedent's will and claim a statutory “elective” or “forced” share of the estate. In many states, however, the elective or forced share relates only to probate assets, and in these states designating the estate as the beneficiary on the policy is inadvisable.
There are several key advantages to designating a trust as the beneficiary of an insurance policy. First, it is relatively easy to name as beneficiary a trust created under the insured's will.
Second, a trust can provide for a number of contingencies such as the death of the primary beneficiary before the insured's death or the incompetency of any beneficiary, and the use of professional management and investment expertise is available.
Third, the dispositive provisions of a trust can be drafted with enough flexibility to meet changing financial family situations.
Fourth, a testamentary trust is funded and its operations begun immediately on the receipt of the life insurance proceeds. Completion of probate proceedings is not necessary to begin administering and benefitting from the proceeds.
Fifth, the life insurance proceeds can pass to the trust free from the claims of the beneficiary's creditors.
Sixth, the life insurance proceeds can be integrated with insured's other assets and other policies.
While there are several disadvantages to
designating one's testamentary trust as the beneficiary of a life insurance
policy, they are not always of immense significance. First, in some states,
naming a testamentary trust as the beneficiary of insurance proceeds will
subject the proceeds to state inheritance taxes. In other states, such as
Second, if the insured dies intestate or the will is held to be invalid because of incompetency, duress, fraud, or improper execution, there would be no trust to receive the insurance proceeds, and the proceeds would pass by state laws of descent and distribution.
Third, some states have no laws specifically authorizing the naming of a testamentary trustee as beneficiary of a life insurance policy. In such states, such a designation may be invalid, since the trust does not exist on the date of the designation.
Fourth, the addition of a trust to the insured's will adds to its cost and complexity.
Fifth, compared to the simplicity of naming an individual as beneficiary, this choice is relatively complex. The proceeds must be managed by the trustee and distributed pursuant to the terms of a formal trust, created under either a separate instrument or the insured's will.
Sixth, the insured and the beneficiaries may not understand why a trust is needed or how its terms operate. This necessitates that time and effort be spent on educating the insured and beneficiaries, and often results in added expenses.
Where the size of the policy justifies the complexity, payment to an inter vivos (“living”) trust may be the best alternative. Generally, the use of such a trust should be considered in every case where the insured policyholder would like to postpone ownership and limit control by the beneficiary.
The first of the advantages of using an inter vivos trust as the beneficiary of a life insurance policy is that the life insurance proceeds will pass free of the time and expense of state law probate. Of course, this same advantage is available where an individual is named beneficiary.
Second, proceeds payable to an inter vivos trust may pass free from the claims of the creditors of the insured's estate.
Third, in many states, no state inheritance taxes will be imposed when life insurance is payable to an inter vivos trust.
Fourth, the insured can select the state law that will control the interpretation of the trust terms. This may be important when the insured lives in a state that precludes out-of-state individuals or banks from serving as trustees of testamentary trusts or executors under a will.
There are several disadvantages associated with naming an inter vivos trust as the beneficiary of a life insurance policy. First, naming the trustee of an inter vivos trust as beneficiary is more complicated than naming an individual or one's estate, and there are potentially significant legal costs associated with preparing the trust. If the trust is irrevocable, there may also be legal and accounting costs associated with its continued operation.
Second, some states do not consider the mere naming of the trustee of an inter vivos trust as a life insurance policy beneficiary as a sufficient transfer of property to create the trust, and other assets will have to be included in the trust.
A number of states have recently passed laws affecting the beneficiary designations in life insurance and annuity contracts (as well as pensions, profit-sharing plans, and certain other contractual arrangements) when the insured or participant becomes divorced. 53 Under these laws, divorce immediately and automatically voids any designation in favor of the former spouse, unless there is a written contract or court order, or the wording of the beneficiary designation itself is clear that the parties intended for the beneficiary designation to survive the divorce. Insurance companies that make payments to someone other than the named spouse after a divorce are protected from liability to the spouse.
These laws are particularly important because insureds may move between states in which divorce will and will not automatically terminate a spouse's beneficial interest in an insurance policy. Therefore, in the event of a divorce or separation, an insured should carefully examine each beneficiary designation and state whether the former spouse is to remain the beneficiary of these policies.
See Knight, “Practical ACTEC: A Case Study in Reformation of an Insurance Policy Beneficiary Designation Form,” 25 ACTEC Notes 29 (Summer 1999); and Leimberg & Langdon, “Insurance Planning: Who Should Be the Beneficiary and Owner?” 10 Prob. & Prop. 19 (July/Aug. 1996).
See, however, Va. Code § 20-111.1 (1993 Acts of Virginia, ch. 417) , automatically revoking insurance beneficiary designation in case of divorce.
When meeting with a client for whom the life insurance policies are a significant asset, it is useful to ask the insurer to confirm in writing the identity of the beneficiaries. The insured's recollection may, and often is, faulty in this regard.
Luxton v. State Farm Life Ins. Co., 89 AFTR2d 2002-866, __ F. Supp. 2d __, motion to amend denied, 89 AFTR2d 2002-2417 (D. Minn. 2002) , aff'd, 340 F3d 659, 2003 WL 21991809 (8th Cir. 2003) .
American Cas. Co. v. Rose, 340 F2d 469, 471 (10th Cir. 1964) ; Zolintakis v. Orfano, 119 F2d 571, 575 (10th Cir. 1941) (one denying the right of a named beneficiary to receive the proceeds of a policy has the burden of showing that the beneficiary is not entitled to the fund); Follenfant v. Rogers, 359 F2d 30, 31 (5th Cir. 1966) (one claiming the policy proceeds as against the beneficiary named in the certificate has the burden to show a valid change of beneficiary); McCollum v. Sieben, 211 F2d 708, 712 (8th Cir. 1954) (placing burden of proof on plaintiff to establish that insured executed change of beneficiary in his lifetime); Munn v. Robison, 203 F2d 778 (8th Cir. 1952) (placing burden on claimant to support his claim of an equitable assignment by substantial evidence).
See, e.g., Pa. Acts of 1992, Act 152, amending Pa. Estates and Fiduciaries Code §§ 5601–5608; and Va. Acts of 1993, ch. 417, adding Va. Code § 20-111.1.
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