Tax-free Life Insurance Strategy Gets Even Better

JOE HAD JUST gone to the big business in the sky. His wife had preceded him two years earlier. Joes son Sam called me looking for some post-death-tax planning. It turns out a $1 million life insurance policy on Joes life was the key issue. Over the years Joe had paid $220,000 in premiums. When Joe died the cash surrender value of the policy was $459,000. (Remember, when you die the CSV dies with you.)

JOE HAD JUST gone to the big business in the sky. His wife had preceded him two years earlier. Joe’s son Sam called me looking for some post-death-tax planning.

It turns out a $1 million life insurance policy on Joe’s life was the key issue. Over the years Joe had paid $220,000 in premiums. When Joe died the cash surrender value of the policy was $459,000. (Remember, when you die the CSV dies with you.)

Joe had an investment of $459,000 and an insurance policy of only $541,000 (the difference between the $1 million death benefit and the CSV). Even worse, if the $1 million death benefit is included in Joe’s estate, the estate tax would be $550,000. Joe’s heirs would get only $450,000 ($9,000 less than Joe’s $459,000 investment.)

Well, Joe was a planner. Six years before he died, he transferred the policy to an irrevocable life insurance trust. An ILIT — when you follow a ton of rules — keeps life insurance proceeds out of your estate. Good move, Joe.

But wait! The last four years of Joe’s life, he lent the ILIT the money to pay the premiums and took back notes from the trustee as evidence of the loans.

Now the big issue: Did Joe’s lending money to the ILIT to pay premiums cause that $1 million policy to be taxable in his estate? If so, $550,000 is lost to the IRS. (One of the technical traps concerning an ILIT is the incident of ownership rule. Violate the rule and your hoped-for protection from the ILIT fails.)

The IRS nails you with a violation of the incidents of ownership rule if you create an ILIT and retain certain powers. For example, any one of these would be a terrible mistake: the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan or the right to borrow against the CSV.

The IRS decided (in Letter Ruling 9809032) that the loans were not an incident of ownership. When the taxpayer in the Letter Ruling died, five notes, with interest at prevailing rates, were included as an asset in his estate. Joe’s real-life facts are almost identical to the Letter Ruling facts. Result: Joe’s $1 million insurance proceeds are tax-free!

An ILIT is a wonderful tax tool. Lending money to your ILIT (instead of gifting the funds) to pay the insurance premiums provides great flexibility. Life insurance is the backbone of most estate plans because if done right, everything is tax-free under the law.

Right info beats IRS

Joe was frustrated. He has been working on a handful of seemingly unsolvable tax problems involving his family for almost two years. A friend told him to take a look at my Web site: www.taxsecretsofthewealthy.com.

Joe read more than half the Web site. For the first time he saw a glimmer of hope. One area of the Web site deals with “Your concerns.” Following is what Joe typed into the space provided, and I received as an e-mail: Concern 1: Estate tax; Concern 2: Buy-sell; Concern 3: Removing real estate from S Corp.; Concern 4: Saving tax on sale of major asset with zero basis.

Joe (age 56) was in business (Success Co., a C corporation) with his two brothers: Moe (58) and Roe (63). Each had different agendas. Roe wanted to sell out his entire interest in the business. Joe and Moe wanted to stay in business together. Moe wanted to take his share of the sale of a major asset (actually a $21 million selling price offered for a piece of real estate with a $1.2 million tax basis) out of the business. Joe wanted to keep half his share ($3.5 million) and give the other half to charity.

We put together four separate plans: one for each of the three brothers and a comprehensive plan for Success Co. (that bought out Roe, and a buy/sell agreement for Joe and Moe that provides for the company’s continuation, as well as a succession plan).

Everything we did — except the special buy/sell agreement — was already up on the Web site. We first applied the Strategies explained on the Web site to accomplish the specific Goals of each brother based on the Assets each of them and Success Co. owned. Actually, once we determined all their exact goals, it was easy to complete the plans.

You are welcome to call me with your questions (847/674-5295).

Irving Blackman can be reached via e-mail at [email protected].

TAGS: Taxes