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Don’t risk tax on life insurance proceeds: Set up a trust

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in Small Business Tax

Do you own a life insurance policy on your own life? If so, you could be asking for tax trouble. Reason: The proceeds from the policy will be included in your taxable estate unless you take action.

Strategy: Set up an irrevocable life insurance trust. Then transfer ownership of the policy to the trust. Accordingly, the life insurance proceeds are removed from your estate, perhaps saving your family tens or even hundreds of thousands of estate tax dollars.

This technique is typically used for an existing life insurance policy, but it also works if you have the trust purchase a new policy on your life (or the lives of you and your spouse).

Here’s the whole story: If an individual possesses any “incidents of ownership” in a life insurance policy on his or her own life—for instance, he or she has the power to change beneficiaries, borrow against the policy, or cancel it—the proceeds are included in the individual’s estate for federal estate tax purposes.

You can avoid this problem by setting up an irrevocable life insurance trust. If the trust owns the policy, the death benefits are out of your taxable estate. Also, a properly structured trust can keep the money away from spendthrift children and their spouses or ex-spouses. And the insurance money can be used to cover any other estate tax liability, leaving other assets intact for the family.

Caution: To shelter your estate from tax, a life insurance trust must be irrevocable. In other words, you can’t change your mind once you put it in place. Because you’re the insured individual, you can’t act as the trustee, either. Instead, you may name your child or children as trustees (or a bank or professional advisor). This gives your children control over the policy without the risks of direct ownership. As the owner of the life insurance policy, the trust pays the premiums. When the insured person passes away, the trust collects the life insurance proceeds, without owing estate tax.

In some cases, the trustee may use the insurance proceeds to buy illiquid assets, such as shares of a closely held company or real property, from your estate. This purchase is considered a tax-neutral exchange, so no tax will be due. Alternatively, the trust can lend money to your estate, secured by the estate’s assets.

In either case, the estate will receive cash that can be used to pay estate tax. Subsequently, the trustee can distribute the remaining trust assets to the trust beneficiaries, probably your children. Or, if you prefer, the assets can be maintained in the trust.

Bottom line: All the insurance proceeds are available to help cover any estate tax that’s due. Your family (via the trust) keeps complete control over your assets. No distress sale is necessary to raise money to meet estate tax obligations.

Note that the 2010 Tax Relief Act created a generous $5 million federal estate tax exemption. Furthermore, the exclusion is effectively doubled to $10 million for married couples, regardless of which spouse dies first. But these generous estate tax provisions are scheduled to expire after 2012. Thus, it’s still important for life insurance policy owners, especially those who are wealthy and own policies with six- or seven-figure payouts, to transfer ownership to a trust.

Tip: When you use a life insurance trust, the proceeds don’t have to pass through probate. But proceeds are still subject to estate tax if you die within three years of transferring ownership of an existing policy to the trust.

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