You can look at life insurance as an estate management tool, or as a take-it-or-leave-it kind of proposition. And most estate-planning experts would just as soon leave it as take it.
That's not to say life insurance isn't an important part of your estate planning. It is. But simply owning a life insurance policy may have tax implications that weaken its effectiveness.
Why life insurance?
“Life insurance gives you almost immediate cash flexibility,” says Jim Libbin, New Mexico State University Extension farm management specialist in Las Cruces. Many ranchers can benefit from incorporating their operation as a limited liability company (LLC) or other business type. “As we get more and more complex business arrangements, especially with respect to farms and ranches, the time span for settling an estate is magnified,” Libbin says.
“It used to be that when a ranch owner passed away, we'd have an appraisal, set the value of the ranch, file a tax return and move on. But now you have to have an appraisal done and a business valuation done. The business valuation has to be done because the ranch isn't actually owned by the rancher. The rancher owns the corporation that owns the ranch.”
But, when the ranch owner passes away, the survivors still need to take care of the day-to-day, normal activities of the ranch until the estate is settled.
“So life insurance plays a key role in that liquidity aspect of the continuity of a business,” Libbin says. “I've seen businesses struggle in that time frame when they had plenty of cash and plenty of assets, but they weren't accessible because of the probate process.”
But if you own an insurance policy, your estate may bear a greater tax burden, says Wayne Hayenga, Texas A&M University Extension specialist and professor emeritus in College Station. “Your ownership of the policy will cause the insurance proceeds to be includible in your taxable estate, even though the proceeds pass directly to the designated beneficiary.”
If your surviving spouse is the beneficiary, the life insurance proceeds generally won't be taxed at your death because they'll qualify for the estate tax marital deduction, says Hayenga, who is also an attorney specializing in estate planning. “This option, however, merely defers the estate taxation of the proceeds until your spouse's death.”
An alternative is to have your children own the policy, but Hayenga says this may not be desirable if your children aren't fiscally mature or if you want your spouse to have use of the proceeds.
Irrevocable life insurance trust
That's where an irrevocable life insurance trust can help.
“The life insurance trust has become a popular estate-planning tool because it can be structured to give your spouse use of the policy proceeds while preventing the proceeds from being subject to estate taxes at either your death or your spouse's death,” Hayenga says. “In fact, the trust can be used to insulate the insurance proceeds from estate tax for multiple generations.”
The trust is funded by transferring existing policies to the trustee or transferring funds to allow the trustee to purchase a new policy. The latter alternative avoids the possibility that the proceeds could be drawn back into your taxable estate should you die within three years.
“You must also make periodic contributions to the trust in order for the trustee to make the premium payments,” Hayenga says.
The policies and funds transferred to the trust are taxable gifts by you to the trust's beneficiaries. Gift taxes can be reduced or eliminated, however, by drafting the trust so the beneficiaries have a right for a limited period of time, generally 30 days, to withdraw property transferred to the trust.
“It's not intended that the beneficiaries exercise this right, but it allows gifts to the trust to qualify for the annual $12,000/donee exclusion from gift taxes — $24,000 if you're married and elect to ‘split’ the gift with your spouse,” he says.
Following the ranch owner's death, the trustee will collect the insurance proceeds and invest them in income-producing assets. The income and principal may be used to provide for the support of the surviving spouse and children.
“Following your spouse's death, the trust may continue for the benefit of your children and grandchildren or may be distributed to your descendents when they reach specified ages,” Hayenga says.