Many believe life insurance is inherently tax-free, unaware that ownership, use, or payment structures can trigger taxes. Knowing these pitfalls allows you to avoid them. This article outlines common life insurance tax traps and offers guidance to navigate them.
Corporate Owned
The Connelly brothers co-owned a company with a buy/sell agreement: upon one’s death, the survivor would buy the deceased’s share, funded by company-owned life insurance. After one brother’s death, the company collected the proceeds, paid the deceased’s family, and transferred ownership. All advisors assumed the tax-free death benefit wouldn’t increase the company’s value due to the buyout obligation. In Connelly v. United States, the IRS and Supreme Court disagreed. The proceeds nearly doubled the company’s value, taxing it in the deceased’s estate and triggering additional taxes on distribution to the family, all due to corporate ownership and payment structure.
Insured Owned
When the insured owns a life insurance policy, the death benefit is included in their taxable estate, even if ownership is indirect, like through a company. “Incidents of ownership”—such as changing beneficiaries or borrowing from the policy—cause inclusion. This was an unwelcome surprise for the Connelly brothers, despite being a basic principle for estate planners.
Spouse Owned
Couples often name the surviving spouse as beneficiary, assuming the funds will be used without tax issues. However, the death benefit increases the spouse’s taxable estate, amplified by using proceeds to pay debts or invest. Dr. Doctor’s case illustrates further risks: his wife owned his policy to avoid his taxable estate and professional claims, funded by documented “gifts.” When she learned of the policy’s cash value, she cited marital unhappiness and divorced him, leveraging the policy’s value. Spousal ownership carries both tax and personal risks.
SLAT Owned
A Spousal Lifetime Access Trust (SLAT) can provide spousal benefits without estate tax inclusion, but errors in control, funding, or use can negate this. SLATs also carry risks akin to spouse-owned policies, as seen with Dr. Doctor. While better than direct spousal ownership, SLATs aren’t always optimal.
Transfer for Value
Life insurance death benefits are typically income tax-free, but transferring a policy for value (e.g., selling it) can make them taxable. The transaction’s nature, not its label, determines taxability. Exceptions include partner exchanges, gifts to certain trusts or family, or sales to “intentionally defective grantor trusts.” Consult advisors when changing ownership to avoid tax triggers.
ILIT Owned
An Irrevocable Life Insurance Trust (ILIT) prevents estate tax inclusion, but requires careful setup: neither the insured nor their spouse can be trustee or beneficiary, and premiums are funded by gifts. Most ILITs distribute proceeds and dissolve post-death, missing broader benefits. An ILIT would have helped the Connelly brothers and Dr. Doctor, but not all ILITs maximize advantages.
“Dynasty” ILIT Owned
Standard ILITs are single-use, discarding potential for multi-generational benefits like business succession, heirloom asset management, tax advantages, and asset protection. A “Dynasty” ILIT, designed for longevity, preserves these. When an ILIT is suitable, a Dynasty ILIT is the superior choice, with nuances to be explored in future articles.
Why It Matters
Life insurance’s tax-free nature makes it a powerful estate planning tool, but missteps can erase this advantage. The Connelly brothers’ attorneys reached the Supreme Court but couldn’t avoid the initial tax trap. Skilled advisors ensure tax-free structuring, preventing costly errors.
Life Insurance Tax Traps © 2025 by Rick Durfee is licensed under CC BY 4.0 
Life Insurance Tax Traps