Common techniques and situations where life insurance is required!

When you apply for life insurance with a trust, how is it set up? What are some of the ramifications? 

Basically, a life insurance policy is purchased by the trust and is owned by the trust.  The Grantor pays the premium in the form of gifts to the trust.  By doing so, the life insurance is not part of the estate, the benefits are tax-free, and if done correctly, premiums are considered present interest gifts in most cases.  The combination of the trust (Irrevocable Insurance Trust), and the Life Insurance maximizes and leverages the amount of property which can pass to the estate!   

• The Trust needs a Tax ID (EIN) from the IRS since this is a tax paying entity 

• A non-interest-bearing checking account in the name of the trust is needed to deposit cash into to cover the premium payment.  
• The Grantor makes gifts to beneficiaries of the trusts. Gifts are deposited into the checking account. Gifts are normally within the annual exemption limit. 

Life Insurance and Business Succession Planning.  

• Equalization when leaving a business to family members when some of the members will receive the business while others will not.  Life Insurance can be the equalizer for the other children not receiving business interests.  
• For businesses that are heavy in real estate, the life insurance can guarantee liquidity to cover maintenance expenses and lost cash flow. 

• Life Insurance is a component of most buy and sell agreements to ensure the surviving partner has liquidity to buy out the interest of the deceased family member. 

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Types of Insurance:  Whole life, 2^nd to die. What are the benefits of each?  

• Second-to-die/survivorship life insurance can be in the form of a whole life or Universal life insurance policy.   It covers two lives and is paid at the survivor’s death.  It is normally when the capital requirements are needed at the death of the survivor.  Based on the mortality of two lives, it provides a discount for the insurance.  However, after the 1^st insured dies, the premiums are normally needed, so a consideration would be the cash flow after a death of either one of the insureds.  However, if the capital requirement will be at the 2^nd death, this type of policy is less expensive than buying two policies.   
• Whole Life Insurance and Universal life are designed to stay in force for the insured’s lifetime. Whole life has guarantees, while Univeral life is albeit more flexible. It has the potential to cost more to keep in force for the whole of life.  However, universal life does offer guaranteed death benefit plans. Whole life and Universal Life can be used when the capital is needed for the lifetime of the insured.  
• Term insurance is designed to last for a specific period before it expires.  Although term insurance is the least expensive initially, with outlay, it can become the most expensive over time.   However, it is a great plan to own when you have defined the capital exposure needed for a specific period and no longer. An example would be a bank loan for a brief period, a potential exposure or need not lasting for more than 20 years.   

Is life insurance death benefit tax free?   Most of the time if arranged correctly.  However, there are a few exceptions when life insurance is not tax–free.   

• Paid directly to the designated beneficiary (trust or individual) it will be paid tax free.   

• The unholy triangle:  owner –dad; Dad gifts the policy ownership to daughter.  Daughter names her daughter as beneficiary.  At dad’s death there is a gift from Daughter (owner) to her daughter as the named beneficiary.  
• Transfer for value:  This is when a policy is sold to another person as owner and paid to a non-exempt class, the policy will be taxable on the proceeds in excess of what the policy was sold for.  

• Owner A, sells, his policy to his brother-in-law. At A’s death, the proceeds will be taxable in excess of what the brother-in-law paid towards the policy.  
• However, if the brother-in-law was a Corportation (office of), a partner, a partnership, there would be no income taxes.  
• Or anyone whose basis is determined by reference to the original transferor’s basis.  

• The insured (or insured’s spouse or ex-spouse if incident to a divorce under Sec 1041) 

Avoiding the three-year look-back period when existing insurance is transferred to a trust.  

• If the policy is already owned the insured can gift the policy to the trust, making a lifetime gift to the trust, the trust can then buy the policy for the interpolated reserve value of the policy  
• Set up the trust before the purchase of the life insurance. Have the trust buy the policy, the trust would be the original owner and beneficiary.  

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What changes can be made to an irrevocable trust when the estate planning has changed?  

• Decanting the trust varies from state to state. Decanting techniques can pass the assets into a new trust and take advantage of enhancements that may have appeared in the trust code since the original trust was created.  
• Establishing a new trust for the life insurance:  The funding must be valued at the value of the old trust (namely the interpolated reserve value). It requires an exchange of assets. The trustees would also sign a contract of sale when the life insurance is transferred.  Certain procedures need to be in order.  

These are a few of the areas professional planners should be aware of when working on the estate of their clients.  These are some of the more complicated planning techniques, which come up often and are critical to making sure advisors are aware of the potential tax traps.   

I have found it best to work with the “team” of the client’s advisors so there is less of a chance to make mistakes when planning the estate of the business owner.   

To receive our FREE Estate Planning Guide for Business owners, BUSINESS OWNERS ESSENTIAL R-6:  CLICK HERE FOR THE DOWNLOAD. ON the drop-down menu pick R-6 Business Owners Essentials.