Brown & Associates - Attorneys & Counselors at Law, P.L.L.C.

"USING LIFE INSURANCE AS AN ELEMENT OF ESTATE PLANNING"
(2/11/01)

As I discussed last week, there will probably be changes to the estate tax system over the next few months, if not years. These changes may cause us to rethink, or even eliminate, many of the more complex estate planning strategies we now use to avoid or reduce estate taxes. On the other hand, nothing has changed yet and we need to continue to march unless or until the rules do change.

What can you do if you have a Taxable Estate--one in which the value of your individual property and assets exceeds $675,000? How can you make sure there is enough money to pay any estate taxes that become due and still preserve your property for your spouse and children.

One common estate planning strategy is to buy enough life insurance so your family can pay any estate taxes that might become due at your death. If your estate increases in value, buy more insurance.

When should I consider life insurance in my estate plan?

First and foremost, you may need it for your family's financial protection. Second, you may want to use it as an "estate builder." Finally, you may need it for liquidity--to make distributions to your beneficiaries or to pay estate taxes if you will have a taxable estate. As to the latter, there are estate planning options that may allow you to "shrink" your estate to a non-taxable size. For example, you might make lifetime gifts to family members or form a limited liability company to qualify for significant valuation discounts, either of which might bring you under the taxable limit.

If you cannot reduce your estate to $675,000 and your assets are tied up in a business or real estate without a great deal of liquidity, life insurance might be just what the doctor ordered.

You certainly don't want your family to have to sell the farm or business or family heirlooms in order to pay estate taxes. If your beneficiaries want to sell, so be it, but you don't want them to have to sell. Who knows, values may be depressed in the area. You would rather they wait until they can get a fair price, rather than have to sell property for 30 cents on the dollar. And you don't want them to have to mortgage your home or their future just to raise enough money to pay the estate taxes, either. It's bad enough that you're gone. You should be easing their stress, not adding to it.

If I buy insurance, how do I know it will be used to pay the estate taxes?

You will probably want to create a trust and then have the Trustee (who can be you) buy life insurance on the trust creator (you). The life insurance proceeds should be made payable to "the then serving Trustee" of your trust. When you die, the life insurance company pays off on the policy and your Trustee has the life insurance proceeds to pay any estate tax that might be due. As a fiduciary of the trust, the Trustee is required to use the proceeds for the intended purpose.

Are there any special rules that apply to life insurance and trusts?

Almost anything you want to do is probably okay. If possible, I prefer that the Trustee not pay the estate taxes directly. Instead, I recommend he (or she) use the life insurance proceeds to buy assets from the estate and let the personal representative of the estate pay the estate taxes.

As an alternative, the Trustee can lend your estate enough money so the personal representative can pay the taxes. Be careful, though, if the beneficiaries named in your Will aren't the same ones you named in your trust. You don't want to pit beneficiaries against one another. Everyone loses in that situation. Whatever you do, document it so you have a clearly identifiable paper trail should anyone question your actions.

If you use either of these techniques, there should be enough money to pay the tax bill without the personal representative having to "sell off" the estate.

What if my assets are tied up in Individual Retirement Accounts or Pension Plans?

The estate tax bill can be a real problem for some of my clients whose estates are quite large, but consist almost entirely of non-liquid assets, such as farms or profit-sharing plans and IRAs.

If your estate consists of the latter, there aren't any assets for the Trustee to buy. Even worse, since an IRA or profit-sharing plan cannot be used as collateral for a loan, the Trustee may have a problem making an unsecured loan large enough to pay the tax bill. How do you get sufficient money into the estate?

There's an easy way around this problem if you plan for it in advance and if it also fulfills all your other estate planning needs. That is, you can have your trust terminate when you die. If you do, your beneficiaries will receive the insurance proceeds directly and can then use the money to pay the estate tax.

Back to my earlier question. How can I make sure they pay the estate tax?

This shouldn't be a problem if the beneficiary or beneficiaries under your Trust and under your Will are the same. They have an obligation to pay the taxes in order to receive the property. If you have named different beneficiaries, however, it could pose a problem. If part of the proceeds goes to your spouse and part to your kids--and the kids want to keep their share--your bereaved widow or widower might be left holding the bag.

What if I want the Trust to continue, not terminate?

This could be a problem. If your children are young, you might want the trust to control the funds until they are older and better able to manage their money. You may have a blended family with your children, your spouse's children, and children you've had together. Will you want the insurance proceeds to go to a former spouse who has custody of your children? Even if you and your spouse are raising your children from a first marriage, when you die there's a good chance your former spouse will receive custody--and control over the children's assets. That's probably not what you had in mind.

That's why this column is never a substitute for the advice of competent counsel. Sit down with an estate planning attorney who can evaluate your situation and help you design a plan that will meet all your needs.

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