503-888-0952 russ@pike-legal.com

DON’T MAKE UNCLE SAM THE BENEFICIARY OF YOUR LIFE INSURANCE

 Death — One of the Certain Events to Happen

Death is Certain

Life insurance is a unique animal.  Life insurance is better than a sure thing. You bet that you will die and the only question is when. Accordingly, life insurance can create an estate with monthly payments.  If set up properly, life insurance has tax advantages, and it can provide liquidity for many different needs at the time of death. As discussed previously life insurance can be used for a business buy-out.

 If You Purchase Life Insurance While You are Young, Your Family, Accountant, Tax Planner and Estate Planner Will Thank You

The particular reason for purchasing life insurance depends on the business owner and her family’s life circumstances, goals, and financial circumstances.  For business owners, the most frequent reasons are: 1) to fund a buy-sell agreement; 2)  to pay off business loans; 3) to provide funds to pay off the mortgage at death, 4) to payoff  income and estate taxes; 4) to pay last medical and funeral expenses; 5) income replacement for retirement through cash values; 6) liquidity provided from life insurance can avoid at the time of death the fire sale of assets to pay taxes and estate costs, 7) provide funds for your children’s college education; 8) provide liquidity to repay loans and other debts owed by decedent; 9) provide for the orderly transfer of a business interest at death; 10) remove assets from the estate and help fund an estate freeze; and 11) help equalize inheritances when some children have a business interest and other children are not interested in maintaining the family business.

Did You Know That Life Insurance is Not Tax Free, but It Can Be If You Do This One Thing

One misconception about life insurance is that it is tax free. Although the general rule is that life insurance proceeds are income tax free to the beneficiary, life insurance proceeds may be subject to federal estate tax, state inheritance tax, gift tax and generation skipping tax. The general rule is that life insurance proceeds are subject to estate tax if the decedent’s estate exceeds the exemption amount and if the policy holder has “incidents of ownership”, or the proceeds are payable to the estate. “Incidents of ownership” include the situation where policy holder reserved the right to select dividend options, or change premium payment schedules.

 Even with respect to income tax, when distributions during life are made from permanent life insurance from the cash surrender value, the amount of money received above the basis in the policy can be taxable income depending on other factors such as the holder’s right to change beneficiaries, to borrow the cash value, and change options.

Your Options to Make Life Insurance Proceeds Non-Taxable

Life Insurance for Your Family Not the IRS

Under IRC 2042 the gross estate includes the proceeds of life insurance on the life of the decedent to the extent that the proceeds are received by the decedent’s estate or the decedent’s beneficiaries and, the decedent possessed “any incidents of ownership.”  The term “incidents of ownership” includes the right of the insured to change the beneficiary, to surrender or cancel the policy, to revoke an assignment, to pledge the policy for a loan, to borrow from the cash value of the policy, and maintaining a reversionary interest.

There are several options for avoiding ownership of the policy and inclusion in your estate when you die. You can give the policy to another person or you can create an irrevocable life insurance trust (“ILIT”) and transfer ownership to the ILIT.  An insured cannot be trustee of the ILIT if he wants the proceeds to be outside his estate. However, an independent trustee of the ILIT is considered the owner of the insurance policy.

The ILIT trustee can use proceeds to purchase the closely held business interest from the estate at the owner’s death. The closely held business interest is held intact and managed by the trustee for the benefit of the named beneficiaries.  The ILIT provides additional benefits in the form of creditor protection, transition to family members at death, and avoidance of estate and generation-skipping tax. An insured cannot be trustee of the ILIT if he wants the proceeds to be outside his estate. However, an independent trustee of the ILIT is considered the owner of the insurance policy.

Who Do You Want to be the Trustee?

The ILIT trustee can use proceeds to purchase the closely held business interest from the estate at the owner’s death. The closely held business interest is held intact and managed by the trustee for the benefit of the named beneficiaries.  The ILIT provides additional benefits in the form of creditor protection, transition to family members at death, and avoidance of estate and generation-skipping tax. During the lifetime of the insured, the Trustee can make investments, discretionary distributions to the trust beneficiaries, convert policy to cash and distribute the proceeds, borrow against the cash value, and elect how to treat dividends. Therefore, who you select to be the Trustee of the ILIT is an extremely important decision.

Family Member, Friend, Associate or Corporate Fiduciary as Trustee?

 Business owners often select a family member or other individual to act as the trustee.  The other option is a corporate fiduciary who will have to fulfill fiduciary obligations for a fee.  Because the trustee may be directed to purchase an interest in the closely-held business, as a business owner you should exercise caution in your selection of the fiduciary who can also oversee your business.  While a family member may better understand family dynamics of the individual beneficiaries, a corporate fiduciary may be better able to handle the duties of trustee as well as management of the business interest.  Regardless of whether the trustee is a family member or professional fiduciary, the trustee selected will step into the shoes of the business owner when required.

Should You Fund an Insurance Trust with a New or Existing Policy?

An ILIT can be funded with an existing policy or a new policy. A life insurance policy is considered a gift when transferred after the initial purchase.  The value of the gift is the interpolated terminal reserve in the policy at the time of transfer. This amount will be provided by the life insurance company on request.

You may have federal gift tax consequence if the amount exceeds the annual exclusion, which in 2017 is $14,000. However, if your estate, including your business interest is less than $5.49 million, the gift can be part of your lifetime exclusion amount. While there is no gift tax in Oregon, you may want to remove the life insurance policy from your estate because Oregon has a much lower inheritance taxable threshold. To transfer a life insurance policy, you must do it with forms approved by the insurer to make the transfer is effective.

Can You Make It 3 Years? The Three Year Claw Back Rule

Sometimes 3 Years Can Seem Like a Long Time

Whether the transfer is made to another person or to an ILIT, if you are transferring an existing policy and you die within 3 years of the date of the transfer the policy, the IRS wins and you lose. Your policy proceeds are pulled back into your estate for federal estate tax purposes and for Oregon inheritance tax purposes as if you had remained owner of the policy. As a closely held business owner you will remain subject to the three-year rule with respect to a group policy after assigning your rights to an ILIT if the business retains ownership rights.

Designation of Beneficiaries- Have You Checked or Updated Your Beneficiary Designation Lately?

A Will controls the disposition of life insurance proceeds only if the estate is the designated beneficiary. Otherwise, the beneficiary designation in the policy will control. The beneficiary designation in the policy should be consistent with your Will or Trust and meet your estate planning goals.

I Cannot Own the Policy, But I Still Have to Pay the Premiums?

Yes, you will have to pay the premiums, but not to the insurer. You should not continue to make premium payments directly to the insurance company after transferring a policy to an ILIT. Payments must be made to the ILIT trustee, who will exercise Crummy powers, before making payments to the insurer.  Some insurance policies contain provisions that dividends or cash value can be used to pay premiums.  When dividends or cash value are used to pay premiums, they are not treated as gifts to the ILIT and may eliminate the need for exercise of a Crummy power. Don’t worry about Crummy powers, if you go the ILIT route your estate planner will explain how it is about a court case, not a description of the quality of the power.

I Don’t Want to Use My Personal Funds to Pay Life Insurance Premiums for a Policy I Don’t Own, Can I Fund The Premiums  with My  Business Interest?

You may provide funding for the ILIT by selling all or a portion of your business interest to the trustee.  This is usually accomplished by a recapitalization of the business with voting and nonvoting shares. As the business owner you would retain control through retention of the voting shares with the non-voting shares being transferred to the ILIT.  This strategy has the double benefit of reducing the value of your estate, while providing distributions from the business to pay the insurance premiums.

I Get It – I Have to Give Up Control to Save Taxes and Make Sure the Policy Proceeds Go to My Family and Not the IRS

To be certain to minimize taxes, make a transfer and take the life insurance proceeds out of your estate, give up control and do not retain any “incidents of ownership”. Changing or naming beneficiaries, borrowing against the policy, surrendering, converting or canceling the policy, paying premiums or selecting payment options are all considered “incidents of ownership” which will draw the policy proceeds back into your estate when you die. While life insurance policies, if set up correctly, can be an excellent way to pass assets tax free to your beneficiaries, to be certain of avoiding having the proceeds included in your estate, you must give up control. For example, give up “incidents of ownership” using an ILIT.  Once the ILIT is established and funded the terms of the ILIT cannot be changed.  Further, you cannot be the trustee of the ILIT or the person who controls the policy.

Is It Worth the Effort?  Yes. 4 Taxes Saved So the Money Goes to Your Family.

Creating an ILIT requires following strict rules and forces you to maintain a system to pay the premiums annually while avoiding gift taxes.  Once you have established an ILIT, the trustee of the ILIT will be the owner of the policy and the beneficiary will be the ILIT. The transfer of ownership is irrevocable and you will not be able to borrow on the existing life insurance policy or else it will be considered a part of your taxable estate upon your death.

Funds will have to be transferred into an ILIT bank account run by the trustee with a tax payer identification number for the ILIT to pay the initial premium for the purchase of the life insurance policy and to fund the annual premium payment each year with further gifts. The transfer of funds to an ILIT may trigger a gift tax and require you to use a portion of your lifetime gift exclusion. If the amount needed to pay the annual premium is significant, then the ILIT may be set up as a Crummy Trust where you gift money to the trust for the benefit of the beneficiaries, which are usually your children or spouse, with the idea that the beneficiaries will benefit from the proceeds at your death. However, in order to make the gifts non-taxable when you gift money to the ILIT, notice has to be provided to the beneficiaries and the beneficiaries allowed a reasonable time, usually 30 days, to take the gift out of the trust or let the right to remove the gift lapse and the trustee can then pay the life insurance premiums.

While this is a lot of work it can save you 40% federal estate tax and 10-16% Oregon inheritance tax, avoid gift tax, and freeze values of assets used to obtain the cash to fund the ILIT. The large potential tax savings reward the effort by the business owner required to comply with the ILIT tax rules.

What Happens if I Still Owe Estate Taxes When I Move On?

As part of your ILIT trust document, the trustee should be required to first pay estate taxes due, state inheritance taxes due, and any other expenses out of the proceeds. To the extent that there are funds remaining after expenses and taxes are paid, those will be distributed to the beneficiaries of the trust according to the terms of the trust instrument.

Planning With Life Insurance Can Save You Big- Use a Professional to Make Sure It Is Done Right

Stop Wasting Time Get Your Business Transition Planning Done As Fast As Possible

This chapter has only addressed some of the issues which can be resolved using life insurance to attack the strain of lack of income, and payment of estate and gift taxes. Only an estate planning professional can help you determine the appropriate type of insurance for your particular needs and which planning techniques are appropriate for your situation. As with planning for retirement benefits, insurance planning and business succession planning require close cooperation between your financial consultant and your estate planning attorney.

Russ Pike is an engaging speaker, author, and passionate estate and elder law attorney. Russ is known for understanding his client’s needs and explaining complex areas of the law in a way that non-lawyers understand. Russ helps his clients by providing strategies and plans that will not only minimize taxes and protect assets, but will also ensure that wealth is transferred to the person intended. Russ works closely with families to minimize the occurrence of those situations you have heard about where family members are at each other’s’ throats over their inheritance. Russ is the author of two books, “Estate Planning for the Not Yet Wealthy” and “I Wasn’t Ready Yet! Survivor’s Guide to Handling a Loved One’s Estate.

If you would like to learn more about the planning options available to you, pick up the phone and give Russ a call at 503-888-0952 to schedule a free consultation. During the consultation, which usually cost $295, you will have all your questions answered and receive at least one actionable strategy that you can implement.