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Estate Planning

: North Carolina Estate Planning Blog

Life Insurance to Pay a Future Bill

By Greg Herman-Giddens

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Second-to-die insurance is traditionally purchased by affluent married couples. How it works: The insurance proceeds are paid out upon the death of the second spouse when the funds are often needed to pay taxes.

Just As the Name Implies

   Second-to-die life insurance doesn't pay off until the death of the second policyholder. Why is it needed? Let's say you own several million dollars worth of assets. By law, you can leave the entire amount to your surviving spouse with no estate tax consequences. But those assets then become part of your spouse's estate and could be taxed after death at rates of up to 35 percent in 2011 and 2012.
   The proceeds from a second-to-die policy can be used to pay the tax bill.
   Estates of up to $5 million can be sheltered from estate tax in 2011 and 2012.

Unfavorable Rule for Corporate-Owned Life Insurance

    For corporate owned life insurance (COLI) issued after the August 17, 2006, enactment of the Pension Protection Act, an unfavorable provision generally requires businesses to include death benefit proceeds (in excess of premiums paid) in taxable income.
    Exceptions apply in the these situations:
    1. The insured individual was employed within 12 months of the date of death.
    2. The death benefit proceeds are paid to buy back certain equity ownership interests.
    3. The insured individual was a "highly compensated employee" when the COLI contract was issued (defined as someone who is a more-than-5 percent owner, a director, or any employee ranked in the top 35 percent by pay).

But second-to-die insurance can also be used by the co-owners or partners of a business operation. In this scenario, the insurance proceeds are paid upon the second owner's death.

One IRS ruling gives a little more flexibility to policyholders of second-to-die insurance, which is also called "survivorship insurance" in some circles. Specifically, the ruling may allow you to transfer ownership of your policy and get the proceeds out of your taxable estate.

Tax Basics

Generally, life insurance proceeds paid directly to you because of the death of the policyholder are not taxable. However, your taxable estate will include proceeds from a life insurance policy on your life if the money is paid to the estate (or if it's received by someone else for the benefit of the estate). Also, the proceeds are included in your taxable estate if you possess any "incidents of ownership" in the policy, such as the right to change the beneficiaries or borrow against the policy.

If you want life insurance proceeds to avoid federal estate tax, you may want to transfer ownership of your life insurance policy to another person or entity. (See lower right-hand box if the entity is a corporation.)

You can transfer the ownership rights in an existing policy, but the proceeds are still taxable under federal law if you die within three years of the transfer -- and possibly under state law too.

In the IRS private letter ruling, a couple transferred a second-to-die life insurance policy to an irrevocable trust and named their daughter, who is executor of their estate, as the trustee. They also granted their daughter discretion to use the proceeds to pay estate tax, inheritance tax and other taxes due because of death, but she is under no compulsion to do so.

Result: The IRS said that the life insurance proceeds will not be included in the estate of the second spouse to die, even though the funds could be used to pay estate tax. (IRS PLR 200147039)

Check with your estate-planning attorney to learn whether second-to-die insurance is right for you or whether transferring ownership of a policy is a smart move. Keep in mind that transferring ownership may also have gift tax consequences.

Source: TrustCounsel''s 2/8/11 BizActions eNewsletter.

Full post as published by North Carolina Estate Planning Blog on February 10, 2011 (boomark / email).