"Ability without ambition
is like a car without a motor"
As earlier discussed, the estate will need cash immediately to pay expenses and estate taxes. In this Chapter, shrinkage problems facing an estate, such as the need for liquidity in the estate; the method of taxation on life insurance and various ways to utilize life insurance so as to minimize depletion in the estate.
By reviewing the exhibits at the end of this Chapter, it is important to understand that some shrinkage is unavoidable. It should be kept in mind as the reasons for estate depletion are discussed, that as a planner, liquidity and the minimizing of estate shrinkage are of primary importance.
Some shrinkage is unavoidable but the amount of shrinkage depends on six factors:
1. Size of the estate.
2. Nature of the estate assets.
3. Debts left by the decedent.
4. Complexity of the estate.
5. Degree of Probate used.
6. Amount of taxed to be paid.
As discussed in earlier, just about everything owned by a decedent of any value will be included in his/her estate. Assets are usually divided into four categories,
(1) Personal Assets; (2) Business Assets; (3) Life Insurance, and (4) Government Programs. All such assets must pass through the "funnel" before family members receive the remaining assets.
As discussed in previous Chapters, the size of an estate is crucial in determining federal estate taxes. With the marital deduction and the unified credit the impact of such taxes has been minimized for the first to die in a marriage. However it is important to remember that many single individuals must prepare their estates carefully and those widow/widowers must take extra care with their estates.
The nature of the assets in an estate determines the manner in which property will influence the inclusion of assets in an estate. With the popularity of trusts and estate planning as a profession more and more people are beginning to examine the nature of such assets in order to help them avoid unnecessary estate shrinkage.
Statistics show that debts left by decedents usually average between 5-6% of the total estate. Automobile loan balances, credit card balances and other installment credit are all debts in this category. The largest debt is usually a mortgage balance which many times may be eliminated totally, provided that the estate has enough assets to retire it.
A. Funeral and Burial expenses are among those debts most commonly considered as a drain on estate assets. Costs for burial plots, tombstones, florists, etc. are subtracted from the value of the estate.
B. Last illness expenses. For a prolonged illness this type of debt may be of critical importance. Medications, doctors’ fees and miscellaneous expenses could all be major expenses of the estate.
C. Unpaid taxes come in the form of federal, state and local income taxes on the final year's income of the decedent. Do not forget real and personal property taxes.
D. Death taxes. Federal and state taxes are a major reason for depletion. These taxes can cause major shrinkage, especially in those large estates where very little estate planning has been accomplished. Since the federal estate tax rates are progressive, the larger estates are charged a higher percentage. Rates are anywhere from 37% and the tax itself must be paid within nine months of death.
The planner may recognize a distinct problem as the estate might not be able to produce the cash to pay the taxes. Fortunately, there are techniques that can be utilized to reduce the federal estate liability. One technique frequently used is the unlimited marital deduction (discussed in the previous Chapter) which permits any amount of property to be transferred to a surviving spouse at death, free of the federal estate tax. Numerous other tax saving techniques will be discussed in the following two Chapters).
E. Estate administration expenses. Estate Administration is the process of settling a deceased's estate, paying claims and closing the estate by making distributions of property and cash to beneficiaries. Paying an Executor or attorney to legally comply with estate settlement is a major expense. The need for specialists for advice such as accountants and property appraisers, could be another expense.
Other administration costs would be court costs if the Will is contested, costs of insuring estate property while the estate is open, the maintenance or repair of estate property, especially if it is to be sold; and the cost of brokerage fees or sale commissions on the sale of property. Of course the expenses will vary with each estate but the IRS studies have indicated that average estate administration expenses are 4 to 5% of estate assets.
The complexity of the estate will dictate as to the number of specialists need to open, settle and close an estate. The more complex an estate the more the expenses tend to be.
This is a constant concern for planners. As discussed in earlier Chapters, Probate will slow the settlement of an estate and with corresponding time delays, there will be estate shrinkage due to lost revenues. The next Chapter addresses the various options available to estate owner in order to neutralize this problem. In addition, the planner must be aware that there could be many hidden sources of shrinkage as well. "Fire" sale of assets which are needed to pay for expenses could render the Executor without any bargaining power. Many arts, antique, real estate and other dealers specialize in estate sales because of the bargains that can be obtained. The difference between the market value of assets and what the selling price of the assets is, is commonly known as liquidation prices. In actuality, the decedent's estate. (Heirs and beneficiaries) are the ones paying the price!
Other hidden factors that cause estate shrinkage would be inflation and out-dated Wills. Poor timing; investment prices are down when a decedent who owned many securities dies, and the selling of the securities could be devastating on the estate. The improper arrangement of life insurance ownership, beneficiary and settlement options could all effect the estate.
The death of an artist or author could actually increase the value of his/her works while the death of a business owner will often see values drop, as the expertise that the business owner brought to the business is now gone. The planner must look at all the facts and keep in mind that liquidity could be a cure-all for estate problems.
Estate debts, expenses and taxes must be paid in cash within a few months following death. Where is this cash going to come from? Obviously, this cash must be raised quickly following death. If the estate owner has not planned for this cash need, the Executor now must borrow, or have a "fire" sale. There is a better method.
Generating liquidity in an estate may be accomplished in two ways:
1. Create additional liquidity at death.
2. Minimize the need for cash at the time of death.
Most estate owners can achieve #2 by paying for funeral arrangements, etc., in advance. Many people purchase burial plans from a funeral home that provides complete funeral services and may even include the burial plot. The estate can also be planned, through the various strategies previously discussed, so that federal estate taxes are minimized. Since it is not possible to eliminate all shrinkage, the estate owner can see that enough liquidity is provided at death. The best way to accomplish this goal is to purchase life insurance.
There are many reasons for an estate owner to consider using life insurance in a estate planning. (For discussion of this subject in relation to 2001 Tax Act, see SUPPLEMENT section in the back of this text.)
Unfortunately many estate owners are convinced that their estates are liquid, that is, easily converted to cash. Estate liquidity simply means the ability of an estate to pay death costs from cash and cash equivalents following the decedent's death, when in effect, the estate contains many assets that are not liquid because of the nature of the assets, the prevailing interest rates, the liquidation price of a stock portfolio, etc. An estate can have substantial value but the biggest obstacle the estate owner faces is converting non - liquid property to a liquid asset. In reality, although the estate does have substantial assets, there may not be enough cash to pay obligations, taxes, debts and income to surviving spouses or dependents. The only solution to cover this need is to purchase a life insurance policy. In the past life insurance has been used to cover mortgages, provide needed funds in case of premature death, as a clean up fund to pay final bills for the deceased, as a retirement fund and as a way to fund buy-sell agreements for existing businesses.
The most practical reason that life insurance should be purchased by an estate owner is that life insurance offers the best solution to a critical problem and will deliver needed funds in the most economical manner. An Executor is faced with several costs upon the death of the decedent, as discussed earlier, but to reiterate:
Estate liquidity may come from various sources, savings and checking accounts, cashing in of securities (bad timing will affect this source), loans from friends or heirs of the estate owner-decedent. The only source of immediate liquidity that will be relied on to deliver when it is needed most would be life insurance. Life insurance is not subject to market conditions and instabilities. Saving accounts are quite useful as saving vehicles but the total funds available in these accounts probably will not be up to needed levels. Stock accounts historically have performed quite well but have had down cycles. Neither one can match the reliability that life insurance offers to the estate owner. The planner should also emphasize that life insurance is the most economical way to provide dollars in the future whenever they are needed the most. Premiums can be budgeted but the mere fact that, over the long haul, the cost of providing necessary funds will always be less than it would be to fund another investment into which money is periodically paid in order to arrive at the same dollar amount.
Liquidity is the most urgent need for all estate owners. It makes it possible for most, if not all, of a deceased's wishes to be carried out. Most often an estate owner's estate will be tied up in a home, business interests, or other property - all considered illiquid assets, without the cash needed, the property and business interest will be needed to be sold of quickly to generate the cash for estate taxes. This is the worst possible scenario as the Executor is forced to revert to a fire sale. As we look at the various advantages of life insurance, the planner should recognize an estate planning pattern that has developed with the advent of the unified credit. As previously discussed, the maximum unified tax credit ($192,800) effectively exempts $600,000 of estate assets from estate tax. Couple this benefit with the unlimited marital deduction, and the federal estate tax becomes of no concern for most people. However, there are still problems to be solved and there are a large, ever-increasing, number of people that have estate problems.
Admittedly, the first to die transfers assets to the surviving spouse and there probably will not be a taxable event to cause problems for the surviving spouse. The problem would then arise, more so because of the original estate has probably grown, when the surviving spouse dies. Strategies are discussed later, but it is important that the estate owner realizes that the problem has not been eliminated but rather delayed and thus, higher taxes will be payable upon the death of the surviving spouse.
The second–death liquidity problem is very important in limiting the depletion in the combined estate of two spouses. It can be illustrated by the following Consumer Application.
CONSUMER APPLICATION
Roger Wilson has an adjusted gross estate of $1,000,000 and is typical of older Americans, the wife, Jane, holds no separate property. Roger dies before his wife and leaves his entire estate to her, and then Jane dies years later. (For illustrative purposes ancillary costs associated with death are ignored)
When Roger dies, his estate is worth $1,000,000
The marital deduction equals 1,000,000
Therefore, Roger leaves no taxable estate, so there is no federal estate tax and the unified credit is not used.
There will be state death taxes and debts and expenses at Roger’s death, but they will be ignored for this illustration.
When Janes dies:
Jane’s estate totals (assuming no appreciation) $1,000,000
Marital deduction -0-
Total taxable estate $1,000,000
The (tentative) federal estate tax equals $ 345,800
The maximum available unified credit equals $ 192,800
Federal Estate Tax payable to Jane’s estate $ 153,000
The estate tax on this estate was simply postponed to the death of the second to die, as when the unlimited marital deduction is used, the tax liability at the second death will be the same regardless of order of death.
(All Federal taxes in this illustration could have been avoided by putting $600,000 (amount of unified credit) into a non-marital trust). The liquidity problem can be solved by Life Insurance, as discussed in this text.
There are seven reasons estate owners should include life insurance in estate planning:
CONSUMER APPLICATION
The following is an example from the files of an Estate Planner, who recognized it as the poorest example of “Estate Planning” they had ever seen!
Margaret is an heir to a large fortune and has an assessed net worth of over $25 million. She informed her estate planner that the I.R.S. would probably say that the estate was worth double that amount. However, she had purchased sufficient life insurance so that her children would have enough money and the government would not get all of her money.
However, she informed the Planner that she had instructed the children to keep the insurance money and let the government have the property.
Upon her death her property was worth $40 million. Her life insurance policies paid $20 million to her heirs outside of the taxable estate. Her children does as she asked and took the $20 million, and gave the rest to the I.R.S. to satisfy the taxes.
The I.R.S., as is its practice, auctioned off the property to the highest bidder, and received only $10 million from the property. They would come to the heirs for the other $10 million.
Since concerns of property distribution and the taxation of life insurance in an estate plan is of utmost concern we have devoted a section to this topic. We would like now to show how the ownership and beneficiary designations impact the role of life insurance liquidity in the estate plan.
Properly designated life insurance will do wonders for an estate plan. It will enable the Executor to sell any property or business interests in a timely fashion and prevent forced sales. It will save the burden of a long settlement period and reduce the overall shrinkage of an estate. Life insurance will provide two clear advantages.
1. It will provide cash for the decedent's estate when needed the most.
2. Will provide a way to retain the full value of assets in an estate.
The important aspect of life insurance is: who is the owner and who will receive the proceeds (beneficiary). There are five rules to follow when the planner is advising the client as to the owner-beneficiary designations:
The planner should present different situations when discussing the ownership question with clients. There is no defined rule. Every client is different and each client's objectives will vary also. The planner’s responsibility is to listen to the client's concerns and then make recommendations. All decisions should be based on the facts surrounding each particular situation. As we break down each situation, it is important that the planner understand the ramifications of each in order to advise a client as to the advantages/disadvantages of the client's specific objections.
The primary question will be "who should handle the proceeds at the client's death?” Putting such proceeds into the hands of someone who is trustworthy and competent will go a long way to having liquidity achieved in the estate.
Basically there are three designations seen during the course of estate planning. The impact of gifting life insurance and the assignment of a group life policy will also be discussed.
Small Estates. In a small estate naming the estate as beneficiary should not have any potential tax problems at death. Remember percentages of estate taxes range from 18-55% and start at $ 10,000 (after the unified credit of $192,800). If a married couple is involved, the unlimited marital deduction will further help reduce or negate entirely the estate tax consequences.
Larger Estates. By naming the estate as beneficiary could have severe repercussions - just the opposite of the intended objective. By including the proceeds in the deceased's estate more taxes would be paid and thus subject to Probate and to the claims of creditors. Thus, instead of reducing costs, life insurance, in this instance, could result in increased costs and liabilities.
Usually in this situation a spouse is named as the beneficiary. This arrangement does have some advantages and, of course, some disadvantages.
Proceeds would avoid Probate and usually are not subject to the claims of creditors. Many states exempt death proceeds payable to a surviving spouse from the state death tax. Consideration must be made before using this designation would be:
Disadvantages:
When the spouse is named, it is assumed that the proceeds will be used for their intended purpose, estate liquidity. However, the spouse is not legally obligated to use the proceeds in this way. The spouse could have other ideas on how to use the proceeds thus eliminating the primary purpose of the proceeds. The one way to prevent this situation is to have the policy require the spouse to use the proceeds for the estate's liquidity needs, and the proceeds will be considered "payable for the benefit of the estate.”
Usually seen in larger estates a trustee arrangement offers distinct advantages. The trustee will carry out the purpose of the policy-providing liquidity for the estate.
The trust agreement (discussed extensively in Chapter 9) will authorize the trustee to make loans to the estate and to purchase assets from the estate if the need arises. The Will of the insured should stipulate the relationship of the trustee and Executor.
The trust probably would be established during a lifetime. If the trust is irrevocable and owns the policy then the proceeds will escape inclusion in the insured's estate. The disadvantage to the insured is that there are fees involved.
Each life insurance policy has three “offices”: The insured, the owner and the beneficiary. Generally, but not always, the owner and the insured are the same. If life insurance is owned by the decedent, the life insurance proceeds are in the taxable estate, therefore a tax may be due.
When people who have a large taxable estate purchase life insurance to pay the tax, they often make the mistake of adding to their taxable estate by the purchaser of life insurance.
CONSUMER APPLICATION
Steve is widowed and has an estate valued at $10,000,000. Because he knows that the federal estate taxes could equal at least half of his estate, he purchases a $5,000,000 life insurance policy..
If Steve takes ownership of the policy (i.e. he is both insured and owner), his taxable estate has grown to $15,000,000 – with a resultant tax of $8,000,000.
But, if he creates a life insurance trust, gives the trust money, and lets the trust buy the life insurance policy, the trust is the owner, with the result now that substantial amounts of federal estate tax are saved.
Why? Because the Trust is the owner, and the owner, therefore, does not die.
Most clients will want to use their group life proceeds to create estate liquidity. The courts have allowed clients to absolutely assign all ownership rights to the group ownership out of their estates. This helps the estate as the proceeds are excluded from the insured's gross estate thus preventing more estate taxes!!.
Note: An employee will be taxed on the cost of coverage in excess of $50,000 as provided in IRS regulation under Section 79. Absolute assignment does not help in this situation.
As an estate planner, one must consider the various uses of life insurance as a liquidity tool. As we have seen, life insurance is a unique product which offers many advantages. This section will discuss the various settlement options available and the estate and income taxation of life insurance and annuities.
When the insured dies, the proceeds payable by the insurance company can come in five ways to the beneficiary. The beneficiary may receive benefits by the election of the following options:
The five settlement options are:
1. Lump sum option.
2. Fixed years option.
3. Fixed amount option.
4. Interest option.
5. Life income option.
If the beneficiary decides to forego the other four options and take a lump sum at death, the entire amount of such a sum would be received income tax free. It would make no difference if the benefit included double indemnity. The entire amount passes income tax free.
A Fixed Years Installment Option is when the beneficiary receives equal monthly installments for a fixed number of years. These proceeds would also pass income tax - free. Keep in mind that only the interest element of each payment would be taxable to the beneficiary.
The beneficiary leaves the principal with the insurer and receives a minimum rate of interest. The entire amount of the annual interest is taxed to the beneficiary as ordinary income and the principal would be tax free.
The beneficiary receives equal monthly installments for life. Pure life income payments stop at the annuitant’s death but with Life Income Certain the annuitant is guaranteed payments for a set period of time. On a Fixed Years Installment/Life Income payments, the proceeds that are part of each monthly payment is deemed a tax free return of capital while the balance (interest portion) is taxed as ordinary income. Joint Life Income would pay equal monthly installments on the lives of two beneficiaries. The survivor continues to receive payments for life after the first death.
The insurer keeps the principal, which earns interest at a guaranteed rate. Fixed amounts are paid to the beneficiary in monthly installments until the fund is exhausted.
Special note: Several categories of transferred assets are not included in this exempt group which includes the spouse of the insured; a corporation in which the insured is an employee or director but not a share holder or an office, and a co-share holder of the insured.
A life insurance policy is included in the insured's estate for federal estate taxation purposes if the insured had an incident of ownership in the policy at the time of the insured's death. Incidents of ownership include the following:
1. The right to change the beneficiary.
2. The right to borrow on the policy.
3. The right to assign the policy.
4. The right to surrender the policy.
5. The right to exercise any basic contractual right.
If the deceased possessed any of the above rights, the proceeds will be includible in the deceased gross estate. It does not matter whether the incidents were ever exercised or not!
In respect to life insurance transferred to a third party within three years of an insured's death, the general rule is that the transfer is automatically includible in the insured's estate.
If an individual owns a policy on the life of someone else and if the owner dies before the insured, the value of the policy must be included in the owner's gross estate. The value of such a policy is the replacement cost.
Proceeds would be included in the gross estate if the policy proceeds on the life of the deceased are paid to or used by the Executor or the Administrator of the estate. If the estate or the estate's Executor is the designated beneficiary of the proceeds, the proceeds are included in the deceased's gross estate, regardless of when the policy was taken out, or who paid the premiums, or who owned it.
If the proceeds are paid to an individual or a trust that is legally obligated to pay taxes, debts or other estate obligations, the proceeds will also be includible. At times the trustee of a living trust is only empowered to use trust assets to pay estate obligations not required to do so. In this situation, death proceeds of life insurance paid into the trust would only be includible in the gross estate to the extent the trustee exercised the power to pay estate obligations.
In most states, any proceeds payable to-or-for the benefit of the insured's estate are included in the decedent's estate. Proceeds payable to the surviving spouse are never part of the taxable estate due to the unlimited marital deduction. Four qualifications for the marital deduction are:
1. Lump sum proceeds are paid to the surviving spouse;
2. Non-refundable life income payments made to the spouse;
3. Settlement option used to hold proceeds for surviving spouse;
4. Surviving spouse has a general power of appointment.
Depending on the type of annuity, there could be a taxable event when an annuity is used in estate planning.
If the annuity is a straight life annuity with no survivor benefits then nothing is included in the deceased's annuitants gross estate. Since the monthly payment from the insurance company ceases at death there is no value of the annuity to be included in the estate.
For Refund or Period Certain annuities that do provide some type of survivor benefits after the first annuitants death, the amount included is the amount refundable or the cost of a comparable contract that would provide the remaining annuity payment. Keep in mind if the decedent only paid a portion of the premiums, then only that portion of the annuities value that is attributable to the deceased's contribution is included in the gross estate.
Wilfred purchased an refund annuity with his estate as beneficiary in case of his death. Wilfred dies and leaves his estate annuity proceeds that actuarially could be purchased for $70,000 (Present Value). Wilfred had paid premiums of $42,000 (60%) for this annuity. Therefore, only $42,000 is included in Wilfred’s gross estate.
Life insurance and estate planning go hand-in-hand. It is a major building block in the estate planning process and has often been referred as "Estate Planning Fuel.”
The following section has been divided into three parts:
1. The basis with regard to the role of life insurance plays in the estate planning process.
2. Life insurance under Economic Recovery Tax Act.
3. Keeping life insurance proceeds free of federal estate tax.
Within the estate planning process, life insurance should be purchased for two reasons, (1) to create an estate that does not exist; (2) protect an existing estate from losses that will be sustained through death taxes and the Probate process. (Supp.)
Life insurance purchased to create an estate should be looked upon as casualty insurance. Insurance purchased to replace economic loss resulting from the death of the family-bread-earner. The problem resulting from bread-earner's death is the replacement of lost income over a period of years. The solution that life insurance provides is to create a fund of dollars that can be used to sustain family members who do not have an alternative source of income for a projected period of time. The amount of life insurance purchased should be tailored to the family's lifestyle as it existed before the bread-earner's death. Most individuals today just do not buy life insurance up to their family's needed amount. Good estate planning dictates that all reasonably foreseeable needs must be anticipated and planned-for on a current basis. Maximizing life insurance coverage should be the goal of clients who need estate-creating life insurance.
As discussed before, this is a critical need especially for larger estates. This type of insurance situation will require the calculation of death taxes and the calculation of projected costs that are essential to the estate planning process.
Any person whose motivation in purchasing life insurance is to protect the estate, should first plan that estate to reduce or avoid every cost possible. After the projected costs have been reduced to the lowest dollar possible, life insurance should then be purchased to cover the remaining costs. The estate planning process creates the car, gas tank, and gasoline gauge. While the life insurance is the gasoline, in the right amount and in the right octane, the amount and type of life insurance must meet the designer's specifications.
Prudent estate owners should always plan to pay their estates debts with cash. If Estate property is to be sold then it should be sold at the highest possible price and should not be time constrained. Life insurance should be used to create instant estate cash. The more non-liquid the estate, the greater the potential need for life insurance.
In summary there are twelve key points to consider when discussing life insurance in the estate plan:
With the introduction of “interest-sensitive” and Universal Life policies which allow the Cash Values to grow at a rate based upon the level of interest paid on investments or cost-of-living indices, the exchange of older fixed-interest whole life policies for the “newer” generation of policies, has become very popular. It is important that such exchange falls under the IRS Code Section 1035, which allows for a tax-free exchange. The IRS establishes certain criteria for a policy exchange to fall within Section 1035 and if the exchange does not meet the requirements, the gain is treated as ordinary income and is taxed.
If there is a loan against the policy, this is a routine exchange. However, if there is a loan against a policy, there are no complications if the new policy has an equivalent loan against it. However, it usually is the case that the new policy does not have a loan against it. In that case, the IRS may determine that that is a taxable gain and subject to income taxes.
CONSUMER APPLICATION
Paul has an older whole life insurance policy with a face amount of $100,000. He had borrowed against it for college costs and presently the policy has a policy loan outstanding of $25,000.
If Paul should die without paying off the policy loan, the beneficiary would receive $75,000.
Paul’s insurance agent suggested that he exchange the policy for a Universal Life Insurance policy.
He exchanges the policy for a Universal Life Insurance policy. For the same amount of premiums that he is presently paying, Paul can have a $100,000 face amount policy without a policy loan. Obviously, Paul has gained on this exchange. This is called a “boot” in Internal Revenue parlance.
The IRS Code states that if other property were received as part of an otherwise tax-free exchange, any gain contained in the exchanged property must be recognized up to the fair market value of the “boot”. The loan that disappeared in this transaction is the “boot.”
According to the IRS Code, the receipt of boot will first result in a reduction of the policyholder’s basis in the new policy, and the gain will be taxable only if the “fair market value” exceeds the basis in the exchanged policy.
Paul’s basis is the total amount of premiums that he has paid into his old policy, in this case he had paid a total of $20,000 in premium. This leaves a total “boot” of $5,000. Therefore, Paul would have to pay tax on an ordinary income basis on the $5,000.
Paul’s agent had a couple of solutions:
Paul was rather disturbed over all of the “technicalities” that had arisen, however the agent pointed out to him that he still would be better off, as his old policy allowed his cash value to grow only at 3% per year, and by allowing his cash value to grow at the present interest rates, and to grow tax-free, plus the advantages that he would have by using a more “modern” type of policy in his estate planning, he is still “way ahead of the game.”
This section will discuss Economic Recovery Tax Act (ERTA) as it applies to life insurance purchased to protect an estate that has already been built.
Under the Economic Recovery Tax Act, people can leave their entire estate tax free to their spouses and can leave all or part of their exemption ($650,000) to non spouses. Now, most planning for U. S. citizens surviving spouses and other family members results in no tax liability on the death of the first spouse. This is true regardless of the size of the estate. The tax bite may be deferred to the second spouses’ death. A problem does exist. Most existing life insurance policies purchased prior to the Economic Recovery Tax Act (1986) with federal estate taxes in mind insure the life of the bread-earner spouse - usually the husband. If the husband does die first - the purpose for which the insurance was purchased may not materialize. There should be no federal estate tax on his death. A better idea would be to insure the younger of the two spouses. Premiums can be saved and regardless of whose life is insured, the proceeds can be available to pay the taxes resulting from the death of the surviving spouse. This is of massive importance where significant insurance programs are in place.
Many insurance companies provide a unique product called a Joint and Last Survivor Policy. This type of policy insures two lives and pays out death proceeds only on the death of the last of the two insured to die. As a method for only insuring the payment of death taxes, joint and last survivor policies have merit. However, if life insurance proceeds are needed for any purpose, insuring the younger spouse may be the alternative. The decision whether to insure the younger of the two spouses to purchase a Joint and Last Survivor Policy can generally be reduced to an economic decision based on the premium costs of each product. The planner must "price compare" for his/her clients as different companies have different premium structures for each of their insurance products.
The decision between these two products may not entirely hinge on economics. There may be spouses who will elect to insure their young spouses rather than elect the joint and survivor policy. If the younger spouses do die first, then the other spouse will have the insurance proceeds to use and invest.
As is apparent, the Economic Recovery Tax Act has definitely changed the rules and created a huge opportunity for planners. It is now imperative that anyone who has purchased life insurance pre - 1985 should have it reviewed and what better way to review its effectiveness than during an estate planning session?
Please remember that the discussion of the merits of Joint and Last Survivor insurance applies only to life insurance purchased solely to protect an estate already created.
Since the planner could be charged with improper policy comparisons, he/she should be particularly diligent while doing such comparisons. A complete analysis should be made of the relative costs between existing policies and new policies. Also if the new policy is less expensive - truly less expensive on an apples-to-apple basis - old policies should still not be canceled until the new policies are in force. The planner must be very careful to suggest to client’s that they should drop an old policy, as the client could be uninsurable or very highly rated due to health problems.
As life insurance proceeds provide the fuel that powers many an estate planning "car,” most of the time the fuel mixture is taxed at the "pump" before it finds its way into the estate planning "vehicle.” A disadvantage associated with the purchase of life insurance is that the life insurance proceeds usually increases the taxable estate of the policy owner. Upon the death of the insured owner, the life insurance proceeds will be included in the insured owner's estate for federal estate tax purposes. If the insured owns a life insurance policy on his/her life, all the life insurance proceeds will be included in his/her estate for a federal estate-tax purpose. In order to avoid federal estate tax many clients have the life insurance on their lives owned by their spouses or others; then upon the death of the insured, the policy proceeds will be paid to the owner's beneficiary federal estate-tax free.
The goal sought by insurance policy cross-ownership - to avoid federal estate tax on Life Insurance Proceeds - is a good one. But there is a better way to accomplish this goal. The planner can recommend the use of an irrevocable life insurance trust (ILIT) to own Life Insurance policies that insure an individual life. By using the ILIT, the insurance proceeds will be federal-estate-tax-free upon death. Also, if the client plans for the spouse, the ILIT will keep the proceeds out of the spouse's estate as well.
The ILIT is used to own an insurance policy whether it is purchased by the ILIT or given to it. The ILIT must be irrevocable. Once the trust is drafted and signed, it can never be changed. If the ILIT is not totally irrevocable or if the maker retains direct control over it, the insurance proceeds will not be federal estate tax free. By using an ILIT, three estate planning objectives are achieved:
(Please see SUPPLEMENT in back of text for application with 2001 Tax Act))
In summary please note that ILIT drafting is not for rookies and should be implemented by an Estate Planning Professional. One small mistake in an ILIT, and all the tax benefits can be lost. Remember, irrevocable means irrevocable!!
CHAPTER 8 - STUDY QUESTIONS
1. Estate shrinkage
A. is estate depletion.
B. is no longer a problem because of the marital deduction and unified credit.
C. is the result of improper administration of the estate by the executor/executrix.
2. The probate process
A. cannot be avoided.
B. can slow the settlement of an estate.
C. does not affect an estate if there is not a Will.
3. The biggest obstacle an estate owner faces is
A. liquidity.
B. deciding who is to receive his/her property.
C. where to have their estate probated.
4. If an estate has assets, but does not have the cash to pay obligations,
A. the executor/executrix can barter the assets for the debts.
B. the debts will be forgiven.
C. the estate owner can purchase a life insurance policy.
5. The Marital Deduction
A. postpones the estate tax until the death of the second spouse.
B. eliminates all estate taxes for both spouses.
C. combined with the unified credit eliminates all estate tax for widowed spouses.
6. A Life Insurance policy
A. owned by the decedent insured will not be taxed.
B. will provide cash for the decedent’s estate when it is needed the most.
C. Proceeds are tax free if the estate is the beneficiary.
7. When using life insurance in larger estates
A. the beneficiary should be the estate.
B. the beneficiary should be the spouse.
C. the proceeds should be paid using the fixed years option.
8. For estate planning purposes, life insurance should be purchased
A. so that upon the owner-insured’s death federal estate tax is avoided.
B. with the insured retaining the right to charge the beneficiary.
C. to create an estate that does not exist.
9. Life insurance proceeds payable on the death of the insured
A. are tax free.
B. must be paid in a lump sum.
C. are part of the estate and therefore are taxed.
10. If an individual owns a policy on the life of someone else
A. and the owner dies before the insured, the face amount of the policy in included in the owner’s estate.
B. the proceeds payable when the insured dies are tax free.
C. the insured can designate the beneficiary.
Answers to Chapter 8 Quiz: 1A, 2B, 3A, 4C, 5A, 6B, 7C, 8C, 9C, 10C.