By Sharon L. Klein, Family Wealth Strategist, Trusts & Estates Attorney
The Role of Life Insurance in Divorce Proceedings
In many divorce proceedings, life insurance plays an integral role as part of the ultimate resolution/settlement, whether it is an asset to be allocated between the parties or is required to be maintained for some period to secure settlement obligations.
Now more than ever – with the coronavirus pandemic wreaking havoc in this country, unprecedented jobless claims, and highly volatile markets – parties are well-advised to ensure settlement obligations are appropriately secured and to consider existing life insurance as a potential marital asset.
Periodic Life Insurance Policy Reviews Can be Critical
It is important to review life insurance policies periodically to ensure they are performing as intended at the best cost, and that the premiums are being paid by the responsible party.
A policy review may uncover some or all of the following factors:
Irrevocable Life Insurance Trusts (ILITs)
- The interest rate environment could have affected the policy performance, particularly if initial illustrations were run in a different interest rate environment
- Market returns may have underachieved expectations
- Policies issued prior to 2009 are based on 1980 mortality tables. Life expectancies have increased over time which may generate lower premium rates in newer policies
- Newer policies have guaranteed and/or extended Death Benefit Guarantees that may not have been available with the original policy
- There may have been a change in market conditions, the health of the insured or the original intention in purchasing the insurance (for example, to fund education), which may make other insurance options more attractive to consider.
Utilizing an Irrevocable Life Insurance Trust (ILIT) can be an advantageous way to purchase and maintain life insurance in divorce and other contexts. An ILIT is an irrevocable trust designed to hold ownership of an insurance policy. To create an ILIT, an individual establishes a trust and transfers funds to the trust. The trustee then purchases a life insurance policy payable to the trust upon the insured’s death. The primary benefit of using an ILIT is that, upon the death of the insured, policy proceeds pass to heirs free of estate taxes. An ILIT can also hold existing policies transferred to it by an insured. Provided the insured lives for three years following the transfer of the policy, the policy proceeds can avoid taxation in the insured’s estate.
5 Key Questions Family Law Practitioners Should Consider When Dealing with Life Insurance
Crucial questions a family lawyer or other family law practitioner should consider when dealing with life insurance in a divorce proceeding include:
1. Are premium notices being sent to the correct address and are premiums being paid on time?
It is critical to ensure that premiums are being paid in a timely fashion. Failure to maintain a policy can leave the obligor’s estate liable to pay the entire amount of the insurance proceeds – but full recovery might not be possible if the estate has insufficient assets.
In Woytas v. Greenwood Tree Experts, Inc.,(1) a Marital Settlement Agreement (MSA) required an ex-husband to maintain life insurance policies to secure his child support and alimony obligations. The MSA provided that, if either party failed to maintain the life insurance policy requirements, that party’s estate would be liable for any outstanding obligations owed under the agreement. The policy included a “suicide exclusion” barring recovery of benefits if the insured were to commit suicide within two years of purchase, which he did. The New Jersey Supreme Court affirmed that the ex-husband failed to “maintain” life insurance, and therefore breached the MSA, entitling the beneficiaries to payment from the ex-husband’s estate for the amount of the unrecoverable proceeds. Since the estate was less than the value of the claim, the court ordered that the entire balance of the estate be paid to the ex-wife.
Similarly, if no one is confirming that the premium notices are being sent to the right address, the result can be disastrous.
In Orchin v. Great-West Life & Annuity Insurance Company,(2) the insured’s friend and fellow dentist Orchin served as trustee of a trust holding a life insurance policy. He did not miss a single premium payment from 1993 (when the policy was assigned to the trust) through January 2009. In April 2009, Orchin moved his residence. Though he claimed to have told the post office his forwarding address, the insurance company was never notified of this change. It continued to send payment notifications to Orchin’s old address, and as a result, Orchin never received them – nor the notices that the policy was in default, nor the notice that the policy eventually lapsed.
On January 15, 2010, the insured died suddenly. At this point, Orchin realized he failed to pay the previous premium payments. Omitting to mention that the insured had died, Orchin convinced a supervisor to exercise her authority to make a one-time exception and reinstate the policy.
When Great-West discovered that the insured had died before the insurance was reinstated, they denied the claim. The insured’s wife and Orchin brought suit against Great-West for improper termination of the policy and breach of contract, and the insured’s wife also brought suit against Orchin for breach of fiduciary duty.
The court held that Great-West’s decision to reinstate the coverage was unenforceable. Although “a close question,” the court denied Orchin’s summary judgment motion because issues of fact remained. Specifically, there were questions regarding whether it was reasonable for Orchin to expect the insurance notices to reach his new address and whether he exercised ordinary diligence.
As noted, if an insurance policy required pursuant to a settlement agreement or court order lapses for failure to pay the premium, there may be a claim against the insured (or his or her estate, if deceased). However, there may not be sufficient assets to satisfy the value of the claim. Accordingly, practitioners might recommend that duplicate premium notices and/or confirmations of payment are sent to the other spouse or another party, or that some other arrangements are made to check that the policy is maintained.
As well as emphasizing the importance of having a reliable policy review mechanism in place to prevent a policy lapse, the Orchin case also highlights the issue that, when friends or family members are appointed as trustees, oftentimes they are simply unaware of the myriad of duties to which they are subject. One important step a trustee can take to minimize fiduciary risk is to hire trusted professional advisors who are cognizant of the responsibilities imposed on fiduciaries, and have expertise in fulfilling those responsibilities.
2. Is the policy properly titled from an ownership perspective?
As noted, if insurance is held in a properly designed insurance trust, the proceeds should pass free of estate taxes to heirs. If, however, a policy is owned by the insured, the proceeds will be includible in his estate, and will be potentially subject to estate tax (in 2020 the top federal estate tax rate is 40% and top state estate tax rates are 16%).
Attorneys may be subject to a malpractice action if insurance is not appropriately titled, and attorneys have been sued for failing to correctly advise clients as to how insurance should be owned. Whether a third-party beneficiary can maintain a malpractice action against an estate planning attorney depends on state law, and most states permit those actions to be brought under the appropriate circumstances. Very few states follow the concept of strict privity, which provides that only the client who suffered the malpractice can maintain an action against the attorney.
A Sampling of How Different States Approach the Issue of Privity
In Biakanja v. Irving,(3) the California Supreme Court rejected the strict privity test for professional liability. That court held that the determination whether in a specific case the defendant will be held liable to a third person not in privity is a matter of policy and involves the balancing of various factors, among which are:
- the extent to which transaction was intended to affect the plaintiff,
- the foreseeability of harm to him,
- the degree of certainty that the plaintiff suffered injury,
- the closeness of the connection between the defendant’s conduct and the injury suffered,
- the moral blame attached to the defendant’s conduct, and 6. the policy of preventing future harm.
In Florida, generally, a legal malpractice claim may be brought only by one who is in privity with the attorney. However, an exception exists that permits an intended third-party beneficiary of the legal services to bring suit where “testamentary intent as expressed in the will … [was] frustrated by the attorney’s negligence and as a direct result of such negligence the beneficiaries’ legacy [was] lost or diminished.”(4)
In Hawaii, a beneficiary may sue a testator’s attorney for failing to draft an instrument that carries out the testator’s intentions.(5)
In Michigan, a beneficiary may sue a testator’s attorney for failing to draft an instrument that carries out the testator’s intentions. However, Michigan courts have declined to allow plaintiffs to introduce extrinsic evidence to prove the testator’s intent when the trust terms are clear and unambiguous.
Until recently in New York, absent fraud, strict privity was required to maintain a legal malpractice claim against an estate planning attorney. Since negligence in the estate planning context is usually not discovered until after a client’s death, the strict privity requirement often resulted in the cause of action dying with the client.
In Estate of Saul Schneider v. Finmann,(7) the decedent’s estate commenced a malpractice action against the decedent’s estate planning attorney, alleging that the attorney negligently advised the decedent to transfer, or failed to advise decedent not to transfer, an insurance policy into his own name. The result was that the insurance proceeds were includable in the decedent’s estate and subject to estate tax. With proper planning, the policy should not have been in the decedent’s name, and the proceeds should have passed to heirs free of estate tax.
The New York Court of Appeals held that sufficient privity existed between the personal representative of the estate and the estate planning attorney for the personal representative to maintain a malpractice claim against the attorney on the estate’s behalf. According to the court, the strict privity rule leaves the estate with no recourse against an attorney who planned the estate negligently, and the estate essentially “stands in the shoes of a decedent,” giving the estate capacity to maintain the malpractice action.
In West Virginia, a direct, intended, and specifically identifiable beneficiary may sue a testator’s attorney who prepared the will where the testator’s intent expressed in the will has been frustrated by negligence on the part of the attorney so that the beneficiaries’ interest(s) under the will is either lost or diminished.(8)
Perhaps the most important lesson is not to rely on a privity doctrine to avoid liability, but for family law attorneys to be cognizant of adverse tax consequences and to carefully consider ownership of insurance policies with estate planning professionals.
3. Does the Policy Have the Correct Beneficiary Designation?
Divorced individuals and those in the process of getting divorced should update all their important planning documents, account titles and beneficiary designations to be certain chosen heirs are still appropriate. Of course, during the pendency of a divorce, parties may be prohibited from transacting financial affairs except in the usual course of business for customary and usual household expenses. This prohibition is designed to maintain the status quo and preserve marital property until final determination. Accordingly, clients should change the documents they are entitled to change immediately (in most jurisdictions a Will can and should be changed as soon as possible, subject to state rights and prior agreement), and be poised to change the balance as soon as they are permitted.
What if estate planning documents are not updated following divorce, and an ex-spouse remains the beneficiary at death? About half the states in the U.S.(9) have so-called revocation on divorce statutes. These statutes can revoke bequests to ex-spouses in wills or other estate planning documents if those documents have not been updated to reflect the divorce at the time of an individual’s death. However, half the states in the U.S. do not have these statutes, and even among those that do, not all revoke life insurance designations. Moreover, even if a revocation on divorce statute does apply, the statute will be inapplicable during the pendency of the divorce, until the final divorce decree is entered.
In Sveen v. Melin,(10) decided by the Supreme Court on June 11, 2018, the court determined that the retroactive application of a Minnesota statute does not vio late the Contracts Clause of the U.S. Constitution.
The statute under consideration provides that “the dissolution or annulment of a marriage revokes any revocable… beneficiary designation… made by an individual to the individual’s former spouse.” Under the statute, if one spouse has made the other the beneficiary of a life insurance policy or similar asset, their divorce automatically revokes that designation so that the insurance proceeds will instead pass to the contingent beneficiary or the policyholder’s estate upon death. The decedent’s children argued that under Minnesota’s revocation-on-divorce law, their father’s divorce canceled his ex-spouse’s beneficiary designation, leaving them as the rightful beneficiaries. The ex-spouse claimed that, because the law did not exist when the policy was purchased and she was named as the primary beneficiary, applying the later-enacted law to the policy violated the Constitution’s Con tracts Clause.
The court found that the law does not substantially impair pre-existing contractual arrangements. First, the law is designed to reflect a policyholder’s intent – and so to support, rather than impair, the contractual scheme. It applies a prevalent legislative presumption that a divorcee would not want his former partner to benefit from his life insurance policy and other will substitutes. Second, the law is unlikely to disturb any policyholder’s expectations at the time of contracting, because an insured cannot reasonably rely on a beneficiary designation staying in place after a divorce. Lastly, the law supplies a mere default rule, which the policyholder can undo in a moment. If the law’s presumption about what an insured wants after divorcing is wrong, the insured may overthrow it simply by sending a change-of beneficiary form to his in surer.
However, the most poignant lesson to be learned from cases like this is not to rely on state default law at all and to update all estate planning documents and beneficiary designations as soon as possible.
4. Are Taxes Apportioned as Intended?
A case decided in Georgia underscores the importance of having both the correct beneficiary designation and the tax apportionment result that was intended. In Smoot v. Smoot,(11) decedent’s ex-wife, Dianne Smoot, was the named beneficiary of life insurance and retirement assets that were included in the taxable estate. The decedent and Dianne had divorced in 2006, but the decedent had not changed any of his beneficiary designations. Having lost a previous action in which the decedent’s son from a prior marriage claimed that Dianne was not entitled to the decedent’s retirement benefits, the son argued in this action that Dianne was responsible for paying her pro-rata share of the federal estate taxes. The tax apportionment clause in the decedent’s will provided for taxes to be pro-rated against those who received property included in his taxable estate.
The court held that federal law governed the tax apportionment concerning the life insurance proceeds. However, regarding the retirement benefits, the court noted that, under Georgia law, “[a]ll provisions of a will made prior to a testator’s final divorce…in which no provision is made in contemplation of such event shall take effect as if the former spouse had predeceased the testator…” According to the court, because the will made no provision in contemplation of divorce, the tax apportionment clause had to be construed as if Dianne had predeceased the decedent. Accordingly, the tax apportionment clause did not apply to her, with the harsh result that not only did the exwife receive the retirement benefits, but she received them tax-free because her step-son was saddled with the tax liability.
Although some states may have default laws that would have prevented this result (because designations are revoked in the event of divorce or because of default pro-rata tax apportionment provisions), this case is another stark reminder not to rely on state law but to carefully update beneficiary designations.
5. What is the Value of Life Insurance Policies for Divorce Settlement Purposes?
Oftentimes, parties have existing life insurance policies, the value of which is factored into the division of property between them. Under the right circumstances, practitioners can consider a life settlement: the sale of a life insurance policy to a third-party investor, to raise cash for the divorce settlement. The policy holder can receive cash for the life insurance policy in exchange for the investor taking over the premium payments and receiving the death benefit upon the death of the insured. A life settlement could potentially yield a greater return for the policy holder than surrendering the policy to the insurance carrier for the cash value. The amount of the life settlement depends upon the policy’s death benefit and the insured’s life expectancy. If the death benefit is substantial and the insured is in poor health, the value of the life settlement will be greater. In comparison, if the death benefit is not very large and the insured is healthy, the value of the life settlement might not be cost-effective.
When calculating the expected proceeds from a life settlement, practitioners should be mindful of the tax consequences. The methodology for calculating the basis of life insurance contracts was recently revised under the Tax Cuts and Jobs Act of 2017. The new favorable law provides that no adjustment to basis is made for mortality, expense or other reasonable charges incurred under a life insurance contract.
The tax treatment of life settlement proceeds is generally determined in three tiers:
- Proceeds received up to the cost basis of the policy are not taxed;
- Proceeds representing the difference between the cost basis and the policy’s cash value are taxed as ordinary income; and
- Proceeds received in excess of the policy’s cash value are taxed as capital gains.(12)
It will be important to value the proceeds from a life settlement after taxes to make sure the transaction is financially sound.
The Bottom Line: Collaboration Early and Often is Key
With many nuanced areas that cross professional disciplines, clients benefit when matrimonial, trusts & estates, accounting, and investment professionals partner throughout the whole divorce process – especially during the coronavirus pandemic.
(1)Woytas v. Greenwood Tree Experts, Inc., 237 N.J. 501, 206 A.3d 386 (2019)
(2)Orchin v. Great-West Life & Annuity Insurance Company, 2015 WL 5726334, 133 F.Supp.3d 138 (2015)
(3)Biakanja v. Irving, 49 Cal. 2d 647, 320 P.2d 16 (1958)
(4)Gallo v. Brady, 925 So. 2d 363 (Fla. Dist. Ct. App. 2006)
(5)Blair v. Ing, 95 Haw. 247, 21 P.3d 452 (2001)
(6)Mieras v. DeBona, 452 Mich. 278, 550 N.W.2d 202, at 209 (1996); In re Solomon Gaston Miller Trust, No. 341502, 2018 WL 6252061, at 7 (Mich. Ct. App. Nov. 29, 2018)
(7)Estate of Schneider v. Finmann, 15 N.Y. 3d 306, 933 N.E.2d 718 (2010)
(8)Calvert v. Scharf, 217 W. Va. 684, 619 S.E.2d 197 (2005)
(9)For example, the Uniform Probate Code, in effect in Alaska, Arizona, Colorado, Idaho, Massachusetts, Michigan, Montana, New Jersey, New Mexico, North Dakota, South Dakota, and Utah, revokes dispositions to and fiduciary nominations of the former spouse, as well relatives of the former spouse.
(10)Sveen v. Melin, 138 S. Ct. 1815, 201 L. Ed 2d 180 (2018)
(11)Smoot v. Smoot, 2015 TNT 69-13, No. 2:13-cv00040 (U.S.D.C. S.D. Ga. March 31, 2015)
(12)26 U.S.C.A. § 1016. See Rev. Rul. 2020-05
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Sharon L. Klein is President of Family Wealth, Eastern US Region, for Wilmington Trust, where she also heads the National Divorce Advisory Practice. She is a Fellow of the American College of Trust and Estate Counsel and a member of its Family Law Task Force, she chairs the Domestic Relations Committee of Trusts & Estates magazine, and sits on the Advisory Board of Family Lawyer Magazine. Beginning her career as a trusts & estates attorney, Sharon has over 25 years’ experience in the wealth advisory arena and is a nationally recognized speaker and author. https://www.wilmingtontrust.com/divorce/
This article was originally posted on the Family Lawyer Magazine