Wills and Trusts

Wyatt, Tarrant & Combs, LLP


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Policy Owner Received Insurance Proceeds Even Though Beneficiary Designation Wasn’t Changed

In Kowalski v. Jackson National Life Ins. Co., et. al., 2013 WL 5954380 (S.D. Fla. 2013), Edward Kowalski owned a policy on his mother, Florence, and he was the beneficiary. He died and his wife, Lisa, became the owner but never changed the beneficiary. For three years Lisa paid the premiums until Florence died. The court noted that Lisa thought she was the beneficiary, could have made herself beneficiary because she was the policy owner and thus awarded the proceeds to Lisa, rather than Edward’s estate, on an unjust enrichment theory.

Turney P. Berry

Louisville, Kentucky


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Dividends Are Not Incidents of Ownership

ILM 201328030 concludes that a decedent who maintained life insurance policies solely for a former spouse and who had no rights over the policies other than to receive the dividends would not have an incident of ownership. The ILM relied on Bowers stating:

The Tax Court considered the question of whether “dividends paid on an insurance policy” is an economic benefit that would cause the value of the insurance proceeds to be includible in a decedent’s gross estate in Estate of Bowers v. Commissioner, 23 T.C. 911 (1955). In Estate of Bowers, the decedent agreed to carry life insurance on his life payable to his former wife as part of a settlement agreement in a divorce. The court held that the right to dividends, which may be applied against a current premium, is nothing more than a reduction in the amount of premiums paid rather than a right to the income of the policy. Id. at 917. See Estate of Jordahl v. Comm’r, 65 T.C. 92, 99 (1975) (stating that “it is well established that, since dividends ‘are nothing more than a reduction in the amount of premiums paid,’ the right to dividends is not an incident of ownership.”) (citations omitted). Cf. Schwager v. Comm’r, 64 T.C. 781, 792 (1975) (finding that while certain powers may be retained which will not constitute incidents of ownership, such as the right to receive policy dividends, the ability to bar the change of beneficiary to a part of the policy does constitute a substantial incident of ownership).

In this case, pursuant to the settlement agreement arising from his divorce, Decedent agreed to maintain life insurance policies for the sole benefit of Former Spouse. Although the dividends from the policies “belonged” to Decedent in a technical legal sense, the mere right to the dividends, by itself, is not an incident of ownership that would cause the value of the insurance proceeds to be included in Decedent’s gross estate under § 2042(2).

Turney P. Berry

Louisville, Kentucky


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Insured Relinquishes Roles as Trustee and Trust Protector to Avoid §2042

PLR 201327010 is an excellent review of the law of incidents of ownership. The insured’s wife owned policies on his life that at her death passed to “family trust” in which the insured was a beneficiary, had a broad testamentary special power of appointment, was trustee, and “trust protector” with the power to remove and replace trustees. The ruling summarizes the law on fiduciary powers and incidents of ownership as follows:

Section 20.2042-1(c)(4) provides, in pertinent part, that a decedent is considered to have an “incident of ownership” in an insurance policy on his life held in trust if, under the terms of the policy, the decedent (either alone or in conjunction with another person or persons) has the power (as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment thereof, even though the decedent has no beneficial interest in the trust.

Rev. Rul. 84-179, 1984-2 C.B. 195, considers whether, for purposes of § 2042(2) and § 20.2042-1(c)(4), a decedent possessed incidents of ownership in a life insurance policy on his life if the decedent transferred all incidents of ownership to his spouse. In the ruling, the decedent’s spouse designated their adult child as the policy beneficiary. Subsequently, the spouse died and under her will a residuary trust was established for the benefit of the child. The decedent was designated the trustee of this trust. The insurance policy on the decedent’s life was part of the residuary estate, and passed to the residuary trust. As trustee, the decedent had broad discretionary powers in the management of the trust property and the power to distribute or accumulate income. Under the terms of the policy, the owner could elect to have the proceeds made payable according to various plans, use the loan value to pay the premiums, borrow on the policy, assign or pledge the policy, and elect to receive annual dividends. The will precluded the decedent from exercising these powers for the decedent’s own benefit. The decedent paid the premiums on the policy out of other trust property and was still serving as trustee when he died.

Citing the legislative history of § 2042(2), the ruling concludes that a decedent will not be deemed to have incidents of ownership over an insurance policy on the decedent’s life where the decedent’s powers are held in a fiduciary capacity, are not exercisable for the decedent’s personal benefit, where the decedent did not transfer the policy or any of the consideration for purchasing or maintaining the policy to the trust from personal assets, and where the devolution of the powers on the decedent was not part of a prearranged plan involving the participation of the decedent. Further, the ruling continues, the decedent will be deemed to have incidents of ownership where the decedent’s powers are held in a fiduciary capacity and the decedent has transferred the policy or any of the consideration for purchasing and maintaining the policy to the trust. Moreover, where the decedent’s powers could have been exercised for the decedent’s benefit, they will constitute incidents of ownership in the policy, without regard to how those powers were acquired and without consideration of whether the decedent transferred property to the trust. Thus, if the decedent reacquires powers over insurance policies in an individual (non-fiduciary) capacity, the powers will constitute incidents of ownership even though the decedent is a transferee.

The fiduciary powers gave the decedent incidents of ownership. In addition, the testamentary special power of appointment was an incident of ownership.

The solution was to divide the trust so that the insurance was owned by one trust – over which the insured gave up all his rights – and the remaining assets by another in which the trustee stayed involved. There was no risk of capital gains under §1001 and Cottage Savings because the beneficiaries of each trust were the same.

Turney P. Berry
Louisville, Kentucky


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Federal Law Preempts State Law Revoking A Former Spouse as Beneficiary

SECTIONS 61, 83, 409A, 2042 AND 7872 – LIFE INSURANCE

Federal employees receive a life insurance benefit under FEGLIA, the Federal Employees Group Life Insurance Act. FEGLIA provides that the proceeds are paid to the named beneficiary and preempts state law with respect to beneficiaries. Virginia provides that divorce automatically revokes beneficiary designation and provides that if such provision is preempted then the former Spouse must pay the amount received to the person who would have received the proceeds but for the preemption. Writing for a unanimous Supreme Court, in Hillman v. Maretta, 133 S.Ct. 128 (2013), Justice Sotomayor held that provisions was preempted too because it interferes with the scheme Congress created.

A similar issue has arisen over the years with prenuptial agreements attempting an end-run around the requirement of ERISA that only spouses may waive rights to retirement plans. Callahan v. Hutshell, Callahan & Buchino, PSC Revised Profit Sharing Plan, 813 F.Supp. 541 (W.D. Ky, Feb. 18 1992) vacated by unpublished 6th Cir. opinion, 14 F.3d 600 (6th Cir. Dec. 20, 1993).

A different twist arose in Hardy v. Hardy, 963 N.E.2d 470 (In. 2012), where the Indiana Supreme Court held that FEGLIA does not preempt a state law claim over a beneficiary designation. The opinion states:

In this case, an insured held a life insurance policy issued as part of a federal employee benefit plan. When the insured divorced from his first wife, the divorce decree and property settlement required the insured (1) to maintain the life insurance policy and (2) to designate the first wife and their grandchildren as equal beneficiaries. Subsequently, the insured remarried, designated his second wife as the sole beneficiary to the life insurance policy, and increased the insurance coverage. After some time, the insured and second wife divorced. When the insured died, the second wife remained the sole beneficiary on the life insurance policy.

The first wife and grandchildren filed suit, asserting equitable claims over the life insurance proceeds. On cross-motions for summary judgment, the trial court determined that federal employee benefit law preempted the equitable state law claims and that the policy proceeds accordingly belonged to the second wife.

We hold that the Federal Employees’ Group Life Insurance Act does not preempt the equitable claims and that the first wife and grandchildren are entitled to a constructive trust over at least a portion of the proceeds.

The Court further discussed the preemption question as follows:

Mary Jo [second wife] directs us to several FEGLIA provisions and the United States Supreme Court’s decision in Ridgway v. Ridgway, 454 U.S. 46, 102 S.Ct. 49, 70 L.Ed.2d 39 (1981), to support her position that FEGLIA precludes a court from imposing a constructive trust on life insurance proceeds. She also cites federal decisions that have ruled in favor of preemption.FN4

[FN4] E.g., Metro. Life Ins. Co. v. Zaldivar, 413 F.3d 119 (1st Cir.2005); Metro. Life Ins. Co. v. Sullivan, 96 F.3d 18 (2d Cir.1996); Metro. Life Ins. Co. v. Christ, 979 F.2d 575, 578 (7th Cir.1992); Dean v. Johnson, 881 F.2d 948 (10th Cir.1989); O’Neal v. Gonzalez, 839 F.2d 1437 (11th Cir.1988); Metro. Life Ins. Co. v. McMorris, 786 F.2d 379 (10th Cir.1986).

Phyllis [first wife] and the grandchildren acknowledge that federal court decisions, including Metropolitan Life Insurance Co. v. Christ, 979 F.2d 575 (7th Cir.1992), have decided that FEGLIA preempts equitable state law claims. But they point to numerous state courts that have reached a different result. FN5

[FN5] E.g., In re Anderson, 195 Ill.App.3d 644, 142 Ill.Dec. 79, 552 N.E.2d 429 (1990); McCord v. Spradling, 830 So.2d 1188 (Miss.2002); Kidd v. Pritzel, 821 S.W.2d 566 (Mo.Ct.App.1991); Sedarous v. Sedarous, 285 N.J.Super. 316, 666 A.2d 1362 (1995); Eonda v. Affinito, 427 Pa.Super. 317, 629 A.2d 119 (1993); Fagan v. Chaisson, 179 S.W.3d 35 (Tex.App.2005).

After careful consideration of the two distinct analyses on this issue, we choose to follow the majority of state courts in finding that there is nothing within FEGLIA or elsewhere preventing a state court from imposing a constructive trust on FEGLI proceeds. Accordingly, we conclude that FEGLIA does not preempt an equitable state law claim for a constructive trust, notwithstanding (1) FEGLIA provisions relating to the designation of beneficiaries; (2) FEGLIA’s preemption clause; and (3) Ridgway, 454 U.S. 46, 102 S.Ct. 49.

The court distinguished the Supreme Court’s holding in Ridgeway:

In Ridgway, the United States Supreme Court considered whether SGLIA (Servicemembers’ Group Life Insurance Act) precluded the imposition of a constructive trust. 454 U.S. at 47, 102 S.Ct. 49.Ridgway involved a divorce decree that ordered the insured to maintain life insurance policies, including a SGLIA policy, for the benefit of the three children from the first marriage. Id. at 48, 102 S.Ct. 49. After the divorce, the insured remarried and essentially designated his second wife as the beneficiary of his SGLIA policy. Id. at 48–49, 102 S.Ct. 49. After the insured died, both the first and second wives filed claims for the SGLIA proceeds. Id. at 49, 102 S.Ct. 49. Subsequently, the first wife, on behalf of the three minor children, filed suit, seeking to enjoin the payment of the SGLIA proceeds to the second wife. Id. Ultimately, the United States Supreme Court decided that SGLIA preempted equitable state law claims. Id. at 60, 62, 102 S.Ct. 49. The Court found that the beneficiary designation controlled, and thus the second wife was entitled to the proceeds. Id. at 62, 102 S.Ct. 49.

Although FEGLIA and SGLIA share similarities, there is one significant difference between the two Acts. Ridgway’s language on this difference is instructive.

In Ridgway, the Court determined that SGLIA’s order of precedence conferred a right on an insured to designate his policy beneficiary. Id. at 55–57, 102 S.Ct. 49. As discussed above, section 8705 of FEGLIA also confers this right on an insured. But Ridgway also extensively discussed SGLIA’s anti-attachment provision, which provided that SGLIA policy proceeds were exempt from creditors and “any ‘attachment, levy, or seizure by or under any legal or equitable process whatever,’ whether accomplished ‘either before or after receipt by the beneficiary.’ ” Id. at 61, 102 S.Ct. 49. The Court found that a constructive trust on the SGLIA proceeds would operate as a prohibited “seizure” of the SGLIA proceeds, in contravention of the anti-attachment provision. Id. at 60, 102 S.Ct. 49. Furthermore, “ Ridgway expressly stated that if Congress chose to avoid the result in that case, it could do so by enacting legislation which did not include an anti-attachment provision.” Kidd, 821 S.W.2d at 571 (citing Ridgway, 454 U.S. at 63, 102 S.Ct. 49).

Mary Jo argues that although Ridgway discussed the anti-attachment provision, it was one of two separate bases for preemption. Mary Jo asserts that because SGLIA’s order of precedence alone was sufficient to find that SGLIA preempted equitable state law claims, it is of no import that FEGLIA lacks an anti-attachment provision. The Court of Appeals agreed with Mary Jo’s contention, citing numerous federal decisions, including Christ in support. Hardy, 942 N.E.2d at 846–47.

In response, Phyllis and the grandchildren note that Ridgway (and Christ ) were decided before 1998. In 1998, subsection (e) was added to section 8705 to provide, as discussed above, that dissolution decrees could alter FEGLIA’s order of precedence where the decree was forwarded to the appropriate office prior to the insured’s death. Phyllis and the grandchildren argue that “[t]his provision is further evidence that the FEGLIA order of precedence is not about who ultimately receives the proceeds after they are paid … but rather is about a concern for administrative efficiency in the payment of claims.”

We first note that SGLIA does not contain a method, like section 8705(e) of FEGLIA, by which a decedent’s designation of beneficiary can be overridden. We also note that the purpose behind SGLIA is quite different than FEGLIA. As explained above, FEGLIA’s primary purpose revolves around administrative efficiency. On the other hand, when enacting SGLIA, Congress “ ‘spoke[ ] with force and clarity in directing that the proceeds belong to the named beneficiary and no other.’ ” 454 U.S. at 56, 102 S.Ct. 49 (quoting Wissner v. Wissner, 338 U.S. 655, 658, 70 S.Ct. 398, 94 L.Ed. 424 (1950))

Ultimately, the lack of an anti-attachment provision within FEGLIA, the divergent purposes underscoring FEGLIA and SGLIA, and the 1998 amendment to section 8705 of FEGLIA compel us to conclude that Ridgway is not controlling here. The order of preference in FEGLIA is an administrative tool to allow for the efficient payment of FEGLI proceeds. We realize that some decisions have interpreted Ridgway differently, but we respectfully disagree.

Will Hardy survive Hillman? It would seem unlikely.

Turney P. Berry
Louisville, Kentucky


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Valuation of Life Insurance For Purposes of Distribution from an Employee Benefit Plan

SECTIONS 61, 83, 409A, 2042 AND 7872 – LIFE INSURANCE

In Michael P. Schwab v. Commissioner, 715 F.3d 1169 (9th Cir. 2013) affirming Schwab v. Commissioner, 136 T.C. 120 (2011) the court determined that the value of surrender charges must be considered when calculating the fair market value of variable universal life policies distributed from a multi-employer welfare benefit trust. The court described the policies as follows:

The policies were of a type called variable universal life, a relatively new type of contract for this old industry. A key characteristic of universal life-insurance policies is that they disconnect to some degree a life-insurance feature (i.e., payment of money upon death) from an investment feature (i.e., the use of premiums to acquire assets that fund the insurance payment). The insurer selling a universal-life policy typically segregates payments from its customers in separate investment accounts from which it makes deductions to pay for the insurance component of the policy. At death, the customer’s beneficiary gets what’s left in the separate account. Under a variable universal life-insurance contract, the customer typically can choose from a menu of different investments (often set up to closely resemble mutual funds) with varying returns and thus varying payouts upon death, though there is (as was true under the contracts here) a minimum death-benefit guaranty.

The court specifically refused to adopt either the government position that surrender charges never affect value or the taxpayer’s position that such charges should always count but rather should be considered. Section 402 of the Code is the governing provision describing fair market value for such purposes.

Turney P. Berry
Louisville, Kentucky