Deciding to Let Uncle Sam Get His Share

Sometimes the traditional strategies to reduce estate taxes are not practical or appealing.

It might be difficult to give away an asset in increments over the years to make tax-free gifts.

Or you might want to retain control of your assets for life. There are a lot of reasons why someone might not want to reduce the value of an estate enough to avoid estate taxes.

In these and other cases, you might decide not to look for ways to reduce gift and estate taxes. Instead, you decide to let life insurance pay the taxes.

Let’s use the case of Max and Rosie Profits. Max is a successful business owner. His business is worth $20 million.

Instead of planning to remove the business from his estate, Max decides to retain ownership of the business and estimates the maximum tax the estate will have to pay.

Max must be sure to estimate the growth in value of the business over his life expectancy or at least the period he is likely to retain full ownership.

He decides to buy permanent life insurance to cover this tax bill. He doesn’t want to buy term insurance, because that eventually will expire.

The estate tax isn’t likely to expire, so Max needs insurance that will be in effect indefinitely. A permanent life insurance policy with a cash value is required to meet Max’s goals.

There is an additional step Max must take to get the maximum benefit of this strategy.

Life insurance is included in Max’s estate when he has any “incidents of ownership” over the policy.

If Max buys and holds a policy and names his estate or children as beneficiaries, then the insurance proceeds will be part of his estate and subject to estate taxes.

Max will have to buy even more life insurance to pay the additional estate taxes on the life insurance.

A better solution is for Max to set up an irrevocable life insurance trust. The trust has an independent trustee who is empowered, but not required, to buy permanent insurance on Max’s life.

The trust agreement provides that any insurance benefits will be distributed to Max’s estate to pay the taxes and other expenses. Any additional amounts will be paid to other beneficiaries designated by Max.

The results are that Max’s business and other assets stay intact and the estate taxes are fully paid.

A life insurance policy can meet estate planning needs whenever an estate is composed of assets that cannot be divided through gifts or other means over the years, or when the assets are illiquid and you do not want to risk having them sold at firesale prices after your death.

Ideal users of this strategy are owners of businesses, real estate, collectables, or investments that are illiquid or highly volatile.

Instead of reducing the estate tax bill, you are deciding to pay the tax but are looking for a way to pay it at a discount.

You have to be medically-qualified to buy the life insurance. Many people are able to buy, say, a million dollars worth of life insurance by paying much less than a million dollars in premiums over their lifetimes.

If that is your case, you can use life insurance to pay estate taxes in advance at a discount.

There are a couple of alternatives to an irrevocable life insurance trust. One method is simply to have individuals other than you own the insurance policy.

A policy could be owned by one or more of your children or your spouse. You make annual gifts directly to them, and they pay the premiums.

This avoids the cost and hassle of setting up the trust and also avoids having to qualify for the Crummey provision.

There are two potential disadvantages.

One risk is your annual gifts might not be used to pay policy premiums. There is no legal requirement that the gifts be used that way (or they wouldn’t be gifts).

A second risk is that the policy beneficiaries might pocket the insurance proceeds after you die instead of using them to pay estate taxes.

Another alternative for owning the policy is a partnership or limited liability company. The principles here are essentially the same as for a trust.

Using a partnership to own life insurance still is a fairly new strategy and the tax rules are not always as clear cut as for the trusts.