by Bruce Fenton

Congress has been asked to consider cutting estate taxes as part of its annual quest to provide tax relief to the masses. To some, cutting estate taxes is not relief for the “masses”—rather it appeals to the “classes” of wealthy with large enough wealth to qualify for this highest tax in the land.

However, it is the family business or farm owner and his trade associations that are pushing the legislative effort. Since a good part of their wealth is tied up in their business or farm, these groups face the unenviable prospect of having their survivors sell the business upon their death to pay estate taxes.

The problem is liquidity. Businesses, farms, and real estate are not liquid; yet, they can be highly valued in the estate which causes the tax to increase. Survivors have nine months from the date of the owner’s death to raise the cash to pay the taxes. This may require a forced sale of property, shutting down the family business, or taking on a large mortgage to meet the tax obligation.

An efficient way to raise the cash necessary to pay the taxes is by correct use of life insurance. A well thought-out life insurance plan can make the cash available—tax-free—to cover that tax check.

Several types of life insurance policies are available for estate protection plans.

A “First to Die” policy can be used by two non-related business owners to allow the family of the first to die to take cash for their business interest, leaving the surviving owner to run the business or farm intact.

A “Second to Die” policy is more often used by a married couple. Since the transfer of assets to a surviving spouse at the time of death is estate tax free, there is no need to purchase insurance to cover estate taxes after the first of the couple dies. However, when the second spouse dies, the couple’s combined estate will be subject to the estate tax. This plan provides the cash to pay the taxes due at the second death.

To be used correctly in estate planning, life insurance must be owned by someone other than the estate owner. Here is where most life insurance mistakes are made. Improperly owned life insurance in a taxable estate can add to the tax bill, not solve it.

If any incident of ownership, such as rights to change beneficiary, rights to cash value, history of making premium payments directly to the policy, or right to surrender the policy is retained by the estate owner, the proceeds of the life insurance will be taxed in his estate. If the estate has no ownership interest, the beneficiaries will receive the proceeds free of income and estate taxes.

The best way to ensure that life insurance is owned properly is to set up an irrevocable life insurance trust. The trustee (not the estate owner) applies for the life insurance on the life of the estate owner who will make gifts of cash or property to the trust. The trustee will use this cash to pay the insurance premiums. Upon the insured’s death, the insurance proceeds are paid tax-free to the trust. The trustee then distributes the proceeds according to the directions of the trust maker.

It is not uncommon for estate owners to attempt to avoid the costs of setting up a life insurance trust by having an adult child or children own the policy. This can be risky, since the ownership interests in the policy can be attached by the child’s creditors should financial problems arise in the future.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.