Three Buyers, One Insured, One Amount That Does Not Fit
Ravi and Tom are 50/50 owners of a two-partner consulting firm. Their buy-sell agreement values each partner's interest at $400,000. Ravi applies for a $1,000,000 life policy on Tom, naming himself owner and beneficiary; Tom signs the application. In the same month, the firm's bank requires $250,000 of key-person coverage on Tom to secure a new line of credit that will decline as it is repaid. Tom's wife, Aisha, also wants to buy $500,000 on Tom. Tom is 52, healthy, and earns $220,000 a year. Two years later Tom dies in an accident; the loan balance at that time is $110,000.
1. Is Ravi's $1,000,000 policy on Tom valid, given that the buy-sell values Tom's interest at $400,000?
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Insurable interest in a life policy is measured at the time of application, and Tom consented and signed, so the contract is valid: a business partner has an insurable interest in a co-owner whose death would trigger a buyout. The cover amount, however, is badly matched. The firm's own agreement says Ravi's economic loss would be $400,000, so $600,000 of the face amount covers a loss Ravi would not suffer. That excess is speculative and is exactly what attracts a wagering or stranger-originated-life-insurance characterization.
Practice point: because the insurer issued the policy with Tom's consent and the two-year contestability period has run, the death benefit is very likely payable in full - this is a risk-management and ethical failure more than a coverage defense. The policy should have been written at $400,000, or with a face amount that tracks the buyout formula as it is updated.
2. The bank wants to be beneficiary of the $250,000 key-person policy. How much can it actually collect, and how should the policy be structured?
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A creditor's insurable interest is limited to the debt, so the bank can collect only the balance outstanding at the insured's death - here $110,000, not $250,000. A creditor-beneficiary may not profit from the insured's death; the $140,000 excess belongs to the insured's estate or to a named contingent beneficiary.
The cleaner structure is for the firm (or Tom) to own the policy and name the firm as beneficiary, with the bank holding a collateral assignment limited to the outstanding balance. Alternatively, use a decreasing-term face that follows the amortization schedule. This keeps the insured's own beneficiary in line for any proceeds above the debt and avoids an overinsurance dispute.
3. Aisha wants to own and pay for $500,000 on Tom. May she, and what are the tax consequences of who owns the policy?
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Yes. A spouse has an unlimited insurable interest, but Tom must consent in writing and sign the application, and the arrangement must be genuine - Aisha owns the policy and pays the premium from her own funds.
Ownership drives the estate-tax result, not the beneficiary designation. If Aisha owns the policy and Tom holds no incidents of ownership, the $500,000 is received income-tax-free under IRC 101(a) and is excluded from Tom's gross estate. If instead Tom owns the policy and merely names Aisha as beneficiary, the proceeds are still income-tax-free to her, but the face amount is pulled back into his gross estate under IRC 2042 because he held incidents of ownership - a federal estate tax exposure that could run into six figures. Aisha should own it, or the couple should use an irrevocable life insurance trust.