TOPIC 93: USE OF LIFE INSURANCE IN ESTATE PLANNING in VS .NET

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TOPIC 93: USE OF LIFE INSURANCE IN ESTATE PLANNING
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1 Advantages and disadvantage A Advantages (1) To provide an income to the decedent s family (2) To provide cash for payment of the decedent s debts, estate expenses, and taxes at a discount, and if arranged properly, with no associated probate costs or death taxes (3) To fund business continuation agreements B Disadvantage: If set up improperly, death proceeds may be included in the gross estate 2 Ownership and bene ciary designation A Selecting owner and bene ciary when the estate is less than the applicable exclusion amount (AEA) (1) No transfer taxes are expected, so there are no tax consequences (2) The selection is easy and exible B Spouse as owner and bene ciary when estate is likely to exceed AEA (1) Naming either spouse as owner or bene ciary of a policy on the life of a spouse will subject the proceeds to transfer taxation at least at the second death To minimize taxes, neither spouse should be designated owner or bene ciary of an insurance policy on the life of the other (2) A taxable gift occurs when the noninsured spouse is named owner and someone else is bene ciary To minimize taxes, name whichever spouse is selected as both the owner and bene ciary to avoid gift tax consequences C Child as owner and bene ciary (1) If a child is named owner and bene ciary, he or she can turnover the proceeds to provide liquidity to the estate However, any transfer of funds to the estate is treated as a gift unless the child is the sole bene ciary of the estate (2) To avoid making a gift, the child could purchase estate assets or lend money to the estate 3 Life insurance trusts Irrevocable trust as owner and bene ciary A Irrevocable life insurance trust (ILIT) is best choice (1) The trust must be irrevocable or IRC Section 2038 will draw the insurance proceeds into the trustor s estate (2) The trustor cannot be named as bene ciary because of Section 2036(a) The trustee is both the owner and bene ciary (usually the uninsured spouse)
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Topic 93: Use of Life Insurance in Estate Planning - 315 (3) A second-to-die policy should be considered if the sole purpose is to pay estate taxes at the death of the second spouse A term policy should be considered if the couple are younger and have less wealth and the purpose is to replace the nancial contribution of the deceased spouse B Impressive outcomes of an ILIT (1) Excludes the insurance proceeds from income taxation and estate taxation for both spouses (2) Excludes the insurance proceeds from the probate estates of both spouses (3) The annual exclusion can be used for gifts to the trust to pay premiums (4) Ensures that the responsible party will have the needed liquidity after death (5) Makes proceeds available to the surviving spouse for health, education, maintenance, and support 4 Gift and estate taxation A Estate taxation (1) The decedent s adjusted taxable gift includes the date-of-gift value less the annual exclusion for any life insurance policy the decedent transferred after 1976 and more than three years before death (Section 2001) (2) If the decedent owned a life insurance policy on the life of another person, the replacement cost of the policy is included in the decedent s gross estate (Section 2033) The three-year rule does not apply to a policy on another s life (3) Life insurance proceeds on the life of the decedent are included in the gross estate if the decedent made a transfer of any incidents of ownership in the policy within three years of death [Section 2035(a)] (4) Life insurance proceeds receivable by a personal representative or receivable by other bene ciaries are included in the gross estate if the decedent possessed any of the incidents of ownership at death (Section 2042) (5) The transfer must be complete and irrevocable The donor must give up all incidents of ownership (a) The insured must survive three years after the transfer of ownership in order for the insurance to be effectively moved from the estate [Section 2035(a)] (b) The proceeds of a policy may be included in a decedent s estate even though he or she possessed incidence of ownership in only a duciary capacity for example, as trustee (c) Paying premiums is not an incident of ownership B Gift taxation (1) Transfers of life insurance (a) Transfers of ownership during life will trigger a gift in the approximate amount of the cash value of the policy (b) Gift tax can arise at the death of the insured if the owner and bene ciary are different For example, assume a wife buys a policy on her husband and names her daughter bene ciary When the husband dies, she has made a gift to her daughter for the amount of the proceeds (c) If a donor makes a gift of a life insurance policy and then dies within three years of making the gift, the value of the proceeds will be brought back into the donor s estate
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316 - Estate Planning (d) Premiums paid within three years by the insured on a policy the insured does not own will not be pulled back into the estate under Section 2035 These premiums may constitute a taxable gift if they exceed the annual exclusion (e) A transfer by gift of a policy of insurance is subject to gift tax, based on the valuation of the policy at the time of the gift, not on the value of the proceeds at the time of death (2) Gifts of life insurance are valued under different rules: (a) If the gift is a paid-up life insurance policy, its value is the replacement cost for a comparable contract with the same company (b) If the gift is a new policy purchased for another person or is transferred immediately after purchase, the value of the gift is the gross premium paid by the donor (c) If the gift is an existing policy for which future premiums are payable, its value is the policy s interpolated terminal reserve plus the unearned portion of the paid premium (This means that the value of the policy s reserve at the date of gift plus the amount of the gross premium paid, which is not yet earned by the insurer, would be the value of the policy) Note that the portion of the premium the insurer has not earned yet by providing insurance coverage is really owed to the premium payer, who has already paid for the protection not yet received (d) Note: If a life insurance policy is transferred to an irrevocable trust, the transfer is a gift of a future interest to the bene ciary of the trust The value of the gift will be determined by whichever of the previous three rules would be applicable The donor-grantor cannot use the $11,000 (in 2003) annual exclusion, because a gift in trust is a gift of a future interest, not a present interest 5 Income taxation A The general rule is that the proceeds of a life insurance policy paid by reason of death are not includible in the deceased s or the bene ciary s gross income for federal income tax purposes B There is an exception to this general rule, the transfer for value rule If the life insurance policy is acquired by another for a valuable consideration, the difference between the policy s death proceeds and the purchaser s cost basis is includible in the bene ciary s gross income C The transfer for value rule does not apply to gifts of policies In addition, the rule does not apply to the following purchasers: (1) The insured (or the insured s grantor trust) (2) The insured s partner or a partnership in which the insured is a partner (3) A corporation in which the insured is a shareholder or of cer (4) The insured s spouse or incidental to a divorce (5) A purchaser whose adjusted basis is determined by reference to the transferor s adjusted basis D The IRS has issued regulations allowing chronically ill and terminally ill insureds to receive living or accelerated bene ts from their insurance policies, and bene ciaries can avoid income tax on the death bene t
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Topic 94: Valuation Issues - 317
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