News & Events

Handle Life Insurance With Care To Protect Proceeds From Taxes

November 09, 2009

If you’re like many Americans, you own life insurance policies to provide for your loved ones after you’re gone. Life insurance also can help you achieve other estate planning and business planning goals. Unfortunately, keeping life insurance proceeds free of income and estate taxes can get complicated. Let’s look at some ways you can protect them.

Look into an ILIT

If you own an insurance policy on your life, the proceeds will be included in your estate and possibly subject to estate taxes, even if you designate someone else as the beneficiary. To avoid this outcome, consider using an irrevocable life insurance trust (ILIT) to own the policy.

For this strategy to work, you can’t retain any elements of ownership in the policy, such as the right to change beneficiaries or borrow against the policy’s cash value. Your cash contributions to the trust to cover premium payments are considered taxable gifts, and a gift tax return may be required. But with proper planning, you can minimize or even eliminate gift taxes.

When creating an ILIT, watch out for the three-year rule, which, subject to certain exceptions, will draw the proceeds back into your estate if you transfer an existing policy to an ILIT less than three years before you die. You can sidestep the rule, for instance, by having the trust purchase the existing policy from you for the policy’s full fair market value, or by having the trust buy a new policy on your life.

Create the right buy-sell agreement

If you’re a shareholder in a closely held C corporation with a buy-sell agreement funded by life insurance, the way the agreement is structured has significant tax implications. If it’s a redemption agreement, in which the corporation owns policies on the shareholders’ lives and uses the death benefits to buy back their shares, the insurance proceeds may trigger the corporate alternative minimum tax (AMT). A cross-purchase agreement, in which each shareholder buys policies on the other shareholders’ lives, avoids this AMT risk. It also gives the remaining shareholders the advantage of an increased basis in the acquired shares, which will reduce any gain and the corresponding income tax liability on a subsequent sale of those shares. The number of policies involved in a cross-purchase agreement can make them somewhat unwieldy, but the potential tax advantages often outweigh the administrative burden.

Avoid “for value” transfers

The transfer-for-value rule creates an exception to the general rule that life insurance proceeds are income-tax free to the beneficiary. Under the rule, if you transfer a policy or an interest in a policy for valuable consideration, the proceeds may become taxable to the extent they exceed any consideration or premiums paid by the transferee. And transfers aren’t limited to sales: In certain circumstances, a simple change in beneficiary designations can trigger the rule.

The purpose of the rule is to deter speculation in insurance policies, but its language is broad enough to encompass seemingly legitimate transactions. For instance, if you transfer a policy to your child in exchange for his or her agreement to pay the premiums, you’ll trigger the transfer-for-value rule.

There are several exceptions to the rule including a transfer to a grantor trust, to a partnership or corporation in which you’re a partner or shareholder, or to one of your partners. But there’s no exception for transfers to a co-shareholder. So if you and another shareholder exchange policies on each other’s lives, the proceeds from each policy will be taxable.

Plan carefully

Without careful planning, life insurance proceeds can be subject to estate taxes, income taxes or both. The unwanted result? Your loved ones may receive only a fraction of the benefits you originally planned for them. That’s why it’s important to work with your financial or tax advisor to ensure the goals you desired when you first purchased life insurance are actually met.

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