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T&E TALK: Be Careful When Using Life Insurance in Your Estate Planning

Scott T. Ditman, CPA/PFS 05.01.2017 | T&E TALK

A life insurance policy can be an important part of your estate plan. The tax benefits are twofold: The policy can provide a source of wealth for your family income-tax-free, and it can supply funds to pay estate taxes and other expenses.

However, if you own your policy, rather than having, for example, an irrevocable life insurance trust (ILIT) own it, you’ll have to take extra steps to keep the policy’s proceeds out of your taxable estate.

The 3-year Rule Explained

If you already own an insurance policy on your life, you can remove it from your taxable estate by transferring it to a family member or to an ILIT. However, there’s a caveat. If you transfer the policy and don’t survive for at least three years, the tax code requires the proceeds to be pulled back into your estate and they may be subject to estate taxes.

Fortunately, there’s an exception to the three-year rule for life insurance (or other property) you transfer as part of a “bona fide sale for adequate consideration.” For example, let’s say you wanted to transfer your policy to your daughter. You could do so without triggering the three-year rule as long as your daughter paid adequate consideration for the policy.

Determining adequate consideration isn’t an exact science. One definition is fair market value, which is essentially the price on which a willing seller and a willing buyer would agree.

Triggering the Transfer-For-Value Rule

The problem with the bona fide sale exception is that, when life insurance is involved, it may trigger another, equally devastating, rule: the transfer-for-value rule. Under this rule, a transferee who gives valuable consideration for a life insurance policy will be subject to ordinary income taxes on the amount by which the proceeds exceed the consideration and premiums the transferee paid.

So, in the previous example, even if your daughter purchased the policy for the appropriate amount to avoid the three-year rule, she could be subject to some income tax when she receives the proceeds.

Recipe for Success: Selling to a Trust

It may be possible to avoid the three-year rule — without running afoul of the transfer-for-value rule — by selling an existing life insurance policy for adequate consideration to an irrevocable grantor trust. A grantor trust is a trust structured so that you, the grantor, are the owner for income tax purposes but not for estate tax purposes.

While there’s been talk of an estate tax repeal, it remains uncertain if and when that will happen. So if your estate is large enough that estate taxes could be an issue, it’s best to continue to factor that into your planning. Contact me if you have questions about how you should address your life insurance policy in your estate plan.  I can be reached at SDitman@BerdonLLP.com or call your Berdon advisor.

Scott T. Ditman, a tax partner and Chair, Personal Wealth Services at Berdon LLP, advises high net worth individuals and family/owner-managed business clients on building, preserving, and transferring wealth, estate and income tax issues, and succession and financial planning.

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