Most people have an aversion to life insurance salespeople, they can be aggressive and often unpleasant. But don’t let that negative sales culture prevent you from recognizing the role that life insurance can play in your estate and exit planning.
But even if you have a fairly modest business and estate, life insurance can play an important role. Of course, life insurance can increase the size of your estate should you pass early. And for young families in need of a breadwinner, life insurance can provide invaluable financial protection in the event of premature death.
In large estates (businesses) life insurance can be quite useful by providing the liquidity necessary to pay estate taxes and provide liquidity without having to sell off assets. Further, life insurance does not have to go through the time-consuming administrative process (probate) before it becomes available. It can be a fast source of cash for the survivors. Including the business, thus preventing unnecessary business disruption.
For valuation purposes, the cash value of a life insurance policy owned by the business is included in the value of the business.
Everyone wants to reduce estate taxes. A tax issue occurs when the insurance proceeds are included in the estate for estate tax purposes. That translates to additional tax liability.
The basic rule is that the estate will include the value of life insurance if the proceeds are paid directly to the decedent’s estate or the proceeds are paid to other beneficiaries. The decedent needs to have what is called the “incidents of ownership” of the policy.
This means more than just legal ownership of the policy. It includes the power to change beneficiaries, surrender/cancel the policy, assign the policy (pledge) for a loan, and so on. There are other items that count as “incidents of ownership” too, some not very obvious and direct. This includes when a person owns a company that has a life insurance policy on key managers. Or if the decedent transferred transfers ownership of the policy to another within three years of death.
Maybe the most common way to keep life insurance out of the estate is using a life insurance trust. This is initiated by first getting a policy, then transferring all incidents of the policy to an irrevocable trust which is named beneficiary on the policy. This will work if the person lives even just one day longer than three years after the transfer – i.e. the three-year rule mentioned above.
The trust itself can’t acquire the policy, it must be transferred. The trustee must also be completely independent of the decedent.
The insurance trust can hold several policies, It can coordinate the investment, collection, and distribution of the proceeds of these policies. It can hold assets other than that of life insurance. And it can receive assets “poured over” to it by the decedent’s will.
Life insurance is just one element of an estate and exit plan. The entire plan needs to be considered together, including all relevant factors.
