Avoiding The Goodman Triangle

For all the benefits that can be accomplished with life insurance, great ideas can be undone by sloppy execution. A recurring error is improper designation of the three parties of interest for every life insurance transaction. When these relationships are incorrectly designated, intended benefits can be needlessly diminished, or undone.

Every life insurance policy has three crucial players. The policy owner is the person or entity that pays the premiums and has the authority to make changes to the policy. The insured is the person whose life is covered by the policy. The beneficiary is the person or the entity designated to receive the insurance benefit when the insured dies.

Standard insurance practice says two of the three parties of interest should be the same person or entity. Some examples: In a family insurance scenario, the owner and insured will typically be the same; the insured owns the policy on his/her life, and names the spouse as beneficiary. If a business wants to insure a key employee, the business will usually be both owner and beneficiary. However, if three different persons or entities play the roles of policy owner, insured, and beneficiary, adverse tax consequences may be incurred. This condition is often referred to as a “Goodman Triangle,” in reference to a 1946 court case, Goodman vs. Commissioner of the Internal Revenue Service. The main thrust of the Goodman case was that the owner of the policy was making gifts to non-owner beneficiaries upon the death of the insured. The tax logic behind this determination is convoluted, but some examples are instructive.

Example 1: A father owns a life insurance policy on his adult son (the insured), and the son’s wife is the named beneficiary. If the son dies, his wife will receive the insurance proceeds tax free. But the way the IRS sees it, the wife has received a gift from her husband’s father, the owner of the policy. This triggers a gift tax assessment against the father.

Example 2: Three shareholders in a C-corporation have a buy-sell agreement drafted. The corporation, as owner, purchases three insurance policies, naming the other two shareholders as beneficiaries for each insured’s policy. Since the three parties are different, the owner (the corporation) is deemed to have made a taxable gift to the beneficiaries (the surviving shareholders) upon an insured’s death. Instead of assessing a gift tax against the corporation, the IRS considers the insurance proceeds as a distribution from the business to shareholders, on which the recipients now owe income tax.

Example 3: Even a partially incorrect designation can result in a Goodman Triangle. A man obtains a policy on his life, naming his spouse as beneficiary. As his faculties begin to diminish, a decision is made to make the spouse the owner, giving her authority to make changes. So far, so good. But to assist in managing her affairs, the spouse adds the insured’s eldest son as a co-owner. With the addition of the son as co-owner, the owner (spouse and son) is now different than the beneficiary (spouse only).

There may be occasions when the rule of thumb that two of the three parties in a life insurance transaction should be the same doesn’t appear workable. These instances call for professional input, and sometimes, the establishment of a new entity, like a trust, to serve as either owner and/or beneficiary to satisfy the Goodman Triangle rules. Referencing Example 3, problems can arise also when the passage of time results in ownership or beneficiary changes. A Goodman Triangle assessment should be part of every life insurance review. Great ideas fail because of faulty execution. Make sure you, and your financial professionals, tend to the details.

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