(Letter given to Potential Clients. This Letter isn't intended to create an attorney-client relationship or to be construed as legal advice)
Even though the estate tax has been repealed, the repeal is effective only for 2010. The estate tax is scheduled to return in 2011, and may even return before then if Congress reinstates the tax retroactively.
Under the estate tax rules that are scheduled to apply after 2010, insurance on your life will be included in your taxable estate if either:
(1) Your estate is the beneficiary of the insurance proceeds, or
(2) You possessed certain economic ownership rights ("incidents of ownership") in the policy at your death (or within three years of your death).
Avoiding the first situation is easy: just make sure your estate is not designated as beneficiary of the policy.
The second rule is more complex. Clearly, if you are the owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is. However, simply having someone else possess legal title to the policy will not prevent this result if you keep so-called "incidents of ownership" in the policy. Rights that, if held by you, will cause the proceeds to be taxed in your estate include:
... the right to change beneficiaries,
... the right to assign the policy (or to revoke an assignment),
... the right to pledge the policy as security for a loan,
... the right to borrow against the policy's cash surrender value, and
... the right to surrender or cancel the policy
Keep in mind that merely having any of the above powers will cause the proceeds to be taxed in your estate even if you never exercise the power.
Buy-Sell Agreements
Life insurance obtained to fund a buy-sell agreement for a business interest under a correctly and appropriately structured "cross-purchase" arrangement will not be taxed in your estate (unless the estate is named as beneficiary). For example, say Al and Bob are partners who agree that the partnership interest of the first of them to die will be bought by the surviving partner. To fund these obligations, Al buys a life insurance policy on Bob's life. Al pays all the premiums, retains Page 2 of 3
all incidents of ownership, and names himself beneficiary. Bob does the same regarding Al. When the first partner dies, the insurance proceeds are not taxed in his estate.
Life Insurance Trusts
A life insurance trust is an effective vehicle that can be set up to keep life insurance proceeds from being taxed in the insured's estate. Typically, the policy is transferred to the trust along with assets that can be used to pay future premiums. Alternatively, the trust buys the insurance itself with funds contributed by the insured. As long as the trust agreement gives the insured none of the ownership rights described above, the proceeds should not be included in his estate.
The Three-Year Rule
If you are considering setting up a life insurance trust with a policy you own currently or simply assigning away your ownership rights in such a policy please call me as soon as you reasonably can to affect these moves. Unless you live for at least three years after these steps are taken, 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.