Tax & Business Alert
– April 2022
Word count target: 420-440
Actual: 440 words
Abstract: Individuals
who have a life insurance policy probably want to ensure that the benefits their
families will receive after their deaths aren’t included in their estates. That
way, the benefits won’t be subject to the federal estate tax. This article discusses the ins and outs of life insurance
plans and estate taxes.
Shield
your life insurance from federal estate tax
If
you have a life insurance policy, be aware that the proceeds your beneficiary
receives could be subject to federal estate tax. That is, unless you take steps
to ensure that the policy isn’t part of your estate.
What
to do
Life
insurance proceeds will be included in your taxable estate if:
·
Your estate is the beneficiary of the
insurance proceeds, or
·
You possessed certain economic ownership
rights (called “incidents of ownership”) in the policy at your death (or within
three years of your death).
The
first situation is avoidable simply by making sure your estate isn’t the
designated beneficiary of the policy. The second situation is more complicated.
If you possess any of the incidents of ownership of the policy, the proceeds
will be included in your estate regardless of the beneficiary, even if someone
else has legal title to the policy. To avoid that result, you must not retain
the right to:
·
Change beneficiaries,
·
Assign the policy (or revoke an
assignment),
·
Borrow against the policy's cash surrender
value,
·
Pledge the policy as security for a loan,
and
·
Surrender or cancel the policy.
Note:
Merely having any of the above powers will result in the proceeds being included
in your estate, even if you never exercise the powers.
Possible
solutions
To
shield life insurance proceeds from estate tax, here are two options:
1. Buy-sell agreement. Life insurance may be purchased to fund a buy-sell agreement for a business interest under a “crosspurchase” arrangement. The proceeds won’t be taxed in your estate unless the estate is the beneficiary. Let’s say two business partners agree that the partnership interest of the first to die will be purchased by the survivor. To fund the obligation, each partner buys, pays all premiums for and retains all ownership rights on a policy on the life of the other partner. When the first partner dies, the insurance proceeds aren’t taxed in the estate of the deceased.
2. Irrevocable life insurance trust (ILIT). An ILIT can be established and be the owner of a life insurance policy, purchased with assets from the insured. As long as the insured has no rights of ownership in the policy, the proceeds of the policy won’t be taxed to his or her estate.
Three-year
rule
If you’re considering establishing an ILIT or assigning away
rights in a policy you own, we can help. However, unless you live for at least
three years after taking these steps, the proceeds will be taxed in your
estate. For policies in which you never held incidents of ownership, the three-year
rule doesn’t apply. Don’t hesitate to contact us with any questions about your
situation.
© 2022