Overview of Tax Issues for the Insurance Planner Copyright 1996,   J. Raymond Karam I. Tax Overview A very important part of working with a life insurance client is in dealing with the various taxes which could be owed by the client's estate. The three main areas of taxation in the death situation are  estate tax, income taxes,and state inheritance tax. a. Estate Tax Property owned by the decedent at death is subject to the federal estate tax. The gross estate for federal estate tax purposes includes property gifted during life in which an interest is retained during life, jointly owned property, Life insurance proceeds, the decedent's half of community property, property in which the decedent retained the power to alter, amend, modify of revoke the ultimate disposition, and certain gifts or transfers made within three years of death. Estates are taxed at a high rate. Estates over $600,000 are taxed at a rate of 37% and the rate increases about 2-3% per every $250,000 of gross estate. 1. 706 Return Form 706 Federal estate tax return must be filed by decedents whose estates exceed $600,000 in value, inclusive of taxable lifetime gifts. The return calculates the estate tax by adding together the estate on hand at death and any taxable gifts made during life. This provides a uniform transfer tax schematic which generally taxes gifts and estates under the same rules. However certain distinctions do exist as discussed earlier under the topic of Lifetime Gifts. 2. Unified Credit Every citizen is entitled to a lifetime credit against estate and gift tax of $192,800. This permits $600,000 of estate value and lifetime gifts to be exempt from taxation. We refer to the $192,800 as the Unified Credit. We refer to the $600,000 as the "Unified Credit exemption equivalent amount". 3. Marital Deduction Gifts and property passing to a spouse at death are generally not subject to taxation by virtue of the "unlimited marital deduction". The theory behind the justification for this is that the property will be taxed at the death of the second spouse to die. Unfortunately, at the death of the second spouse to die, there will only be one unified credit left because the unified credit of the first spouse to die went unused and expires if not used at death. A technique known as marital deduction planning has come to be the cornerstone of modern estate planning. Under this method, both unified credits of the husband and wife are utilized permitting $1.2 million to ultimately pass tax free instead of a mere $600,000 as would be the case where each spouse leaves everything outright to the other spouse. The way this work is that the testator leaves a formula amount of approximately $600,000 to a trust over which the surviving spouse has the right to income and principal as needed for health, support, maintenance, and education. Because the surviving spouse is not given a general power of appointment; defined as a power to appoint the principal to their self, creditors, estate or estate's creditors other than subject to an ascertainable standard; the property will not be included in the surviving spouse's estate upon the subsequent death notwithstanding the fact that the surviving spouse controlled and enjoyed the property. The trust, often called a "bypass trust" uses the unified credit of the first spouse to die so that it is not lost, squandered or wasted. The taxable estate of the second spouse to die is lighter by $600,000. 4. Life Insurance Proceeds Life insurance proceeds are included in the decedent's gross estate for federal estate tax purposes if the proceeds are payable to the estate or if the decedent insured possessed incidents of ownership in the policy. A policy acquired during marriage is presumed to be community property in which case one half of the proceeds are includible in the federal taxable estate. If a policy is separate property, the community estate will have a reimbursement right for the amount of the premiums paid. A policy transferred within three years of death or premiums paid within three years of death will be included in the estate for estate tax purposes. In most cases, the beneficiary of the policy is the spouse of the insured, in which case the unlimited marital deduction prevents the proceeds from being taxed at the death of the insured. The funds are still subject to taxation in the estate of the second spouse to die. A popular device for removing life insurance from both estates is the irrevocable life insurance trust. This method is a variation of the "bypass trust" described earlier. This plan usually involves purging any ownership interest in the spouse of the insured by way of a partition agreement converting ownership of the policy into the separate property of the insured spouse. The insured spouse then transfers the policy to an irrevocable trust for the benefit of the surviving spouse for life, with remainder after the surviving spouse's death to the children. The trust has the same qualities as the "bypass trust" described earlier, such as the absence of a general power of appointment, which cause it to avoid inclusion in the surviving spouse's estate. Unlike the bypass trust described in the discussion on marital deduction planning, the irrevocable life insurance is not limited to the $600,000 exemption equivalent amount. Instead the gifts to the trust from the separate property of the insured for payment of premiums, as well as the cash surrender value of the policy when initially transferred, are treated as taxable gifts subject to the $10,000 annual exclusion from gift tax and the unified credit. If the insured dies within three years of creating the irrevocable life insurance trust, the proceeds will be included in the decedent's gross estate for federal estate tax purposes. This may be avoided by making the initial application for insurance in the name of the trust. In this way, there never occurs a "transfer" for purposes of the rule requiring policy transfers within three years of death to be brought back into the estate for estate tax purposes. If this is not possible due to insurability reasons or for some other reason, it still makes sense to attempt the irrevocable life insurance trust because the worst thing that can happen is that the policy will be included as if you've done nothing at all, and the best thing that can happen is that the insured survives for three years and the policy is excluded from estate taxation. b. Income Tax The estates of decedents usually have two income tax reporting responsibilities. First is the final individual return for the decedent. Next, if the decedent's estate earns income while it is being administered, it must file an income tax return as a trust annually during the pendency of the administration. 1. Decedent's Final Return The final income tax return of the decedent is due on April 15 of the year following the death of a decedent. The return must be filed by a decedent's personal representative. It reports all income of the decedent up to the date of death. A surviving spouse may file a joint return with the deceased spouse in which case the year ends of both will be the end of the surviving spouse's tax year. A surviving spouse may use the lower joint return rates for two years after the year of death if providing an abode for a son or daughter. 2. Income Taxation of Estates A decedent's estate must file a Form 1041 Trust income tax return for each year in which it has gross income of $600. The tax year of the estate for income tax year is the calendar year. A personal representative may elect to have a fiscal year beginning on the anniversary of the date of death. As a trust, a decedent's estate will be subject to income tax brackets that are highly compressed. Income over $1,500 is taxed at the 28% bracket, and the rates move up rather quickly until income over $7,500 is taxed at the 39.6% "millionaire rate". A trust or estate receives a deduction for income which it distributes to beneficiaries. In this manner if the trust retains the income, it will be taxed on it; but if the beneficiary receives the income, the beneficiary will be taxed on it. c.  State Inheritance Tax In Texas, the state inheritance tax is a "soak up" tax which means that it is based upon the credit for state death taxes paid allowed by the federal system. In this way, the Texas inheritance tax never amounts to an additional tax but rather carves out a portion of the federal tax for the state. Therefore if no federal estate tax is due, no Texas inheritance tax is due. II. BUY SELL AGREEMENTS In a sophisticated economy, multiple ownership of business is quite commonplace. The shared ownership is usually taken for granted until for reason of death, disability, divorce or retirement, succession of the ownership interests is called into question. A successful means of addressing these eventualities is the use of Buy Sell Agreements. Under a common form of buy sell agreement an entity is given the option to purchase the ownership interests of a departing owner upon the happening of some triggering event such as death, disability, divorce, intended sale, termination or retirement. If the entity does not exercise the option, it is then incumbent upon the remaining ownership holders to do so. The funding of the purchase may be provided for by the use of life or disability insurance. The entity will purchase the coverage, and upon death or disability receives the proceeds tax free to redeem the ownership interest. In the case of death, the ownership interest will generally receive a tax free step up in basis so that there will be no gain to the owner upon sale of the interest to the entity. This attractive tax advantaged transaction results in bringing peace of mind to all concerned by removing the unwanted business associate, providing her (or him) with a welcome cash buyout, and concentrating ownership in the surviving business members. In situations where it is not feasible to insure against the eventuality, such as with divorce or termination, the buy sell agreement may provide for a deferred payout of the buyout price. A secured promissory note will be delivered to the seller usually secured by the stock or other ownership interests in the entity or the assets or both. III. INCOME TAX CONSEQUENCES AND USE OF INSURANCE IN BENEFITS PLANNING Life insurance benefits received by reason of the death of the insured are generally not included in the gross income of the insured. This rule applies regardless of whether or not the proceeds are payable in a lump sum or in installments. Interest paid on installments is taxed however. Life insurance proceeds received by a corporation may be subject to the corporate alternative minimum tax. An important exception to this is the transfer for value rule which causes taxation of life insurance proceeds when the policy has been acquired for valuable consideration. The recipient would be taxed on the proceeds to the extent that they exceed his investment in the policy. The transfer for value rule does not apply to a transfer where the transferee would have the same basis in the policy as the transferor's basis, as would be the case in a gift of the policy. Nor does the rule apply in case of a transfer to a policy owner's related entity (eg. controlled corporation or a partner of the transferor. The payment of premiums on life insurance are generally not deductible to a corporation. Nor is interest on a loan used to acquire life insurance. A common exception to this rule is group term life insurance in which payments for coverage of up to $50,000 are deductible to the employer and not taxable to the employee. A corporation may also deduct premiums in a case where they are taxed to an employee as a bonus or compensation. In this case, the premium payments are deductible as ordinary and necessary business expenses under Section 162 of the Internal Revenue Code. This would be justified in circumstances where the payment is to reward or otherwise motivate an executive or valuable employee. Disability insurance premiums are generally not deductible when paid, nor are benefits includible in income when received. These premiums may be deducted in an accident or health plan, however. These are covered by ERISA. Executive benefits can take the form of deferred compensation.  The more well known variety of deferred compensation are the qualified plans. These are very strict plans that have a plethora of requirements, not the least of which is nondiscrimination in favor of key employees. The principal advantage of these types of plans is the deductibility of employer contribution coupled with deferral of recognition of income by the employee until the money is distributed The most common forms of qualified deferred compensation are IRA's, SEP's, Profit Sharing Plans, Money purchase pension plans, 401(k) plans, Keogh or HR-10 plans, and ESOP's. These are the subject of probably the most vast and complicated area of the law and are far and well beyond the scope of this article. Under an alternative, less rigid approach deferred compensation can take the form of nonqualified deferred compensation. This type of deferred compensation does not have the as powerful a tax punch as the qualified plans with their deductibility and deferral. However, these do permit discrimination in favor of an executive or highly valued employee. The employer may not take a deduction until the money or benefits have been received by or are available to the employee. in order to be available to the employee, a present interest in property must be transferred. The employee recognizes income when the benefits are no longer subject to the risk of forfeiture by the employee and are transferrable. Life insurance is often used as a means of providing benefits under either qualified or non qualified plans. Variations on this theme are found in the Rabbi Trust and its opposite, the secular trust. Under the Rabbi Trust, the beneficiary is permitted deferral of a funded amount because the trust is subjected to the claims of creditors of the employer. It is therefore viewed as a grantor trust of the employer who is then taxed on the continuing income. In the secular trust the property is not subject to the claims of the employer's creditors, and is therefore "funded" and accordingly deductible by the employer and taxable to the beneficiary. It too is a grantor trust with the grantor being the beneficiary who is then taxed on the continuing income of the trust. Annuities are an excellent savings and investment vehicle because of their tax deferral treatment. Prior to 1993, annuities, unlike life insurance were not protected from the claims of creditors, unless they were a provided under a plan or program in use by an employer. This meant an ERISA plan. Amendments to Article 21.22 of the Texas Insurance Code extended the exemption from creditors to all annuities, thereby elevating them to an extremely favorable status. This is magnified by the introduction of variable annuities which permit the ownership of mutual funds within the annuity. Perhaps the most studied benefits technique of all time is the "split dollar" arrangement. The essence of this plan is that the employer will pay a portion of the premium on a policy for the employee's beneficiaries. The employer's share of the premium is the amount  the increase in cash value of a policy. This amount is treated as a loan from the employer and is repaid upon collection of the proceeds. The employee pays the balance of the premiums, usually from compensation received from the employer or when the employer pays the employee's share, it is treated as compensation to the employee. IV. FAMILY LIMITED PARTNERSHIPS The use of Family Limited Partnerships in estate planning has been gaining increasing popularity. The technique offers potential estate tax savings as well as asset protection from creditors. Estate Tax savings can be realized from the ability to value an asset portfolio at a discount by virtue of its being held in a family limited partnership. The discounts are based on lack of marketability, minority ownership, and the lack of liquidity. Conservative valuation practices can easily yield a 35% discount. Because the discount is based in part on minority ownership, in order to fully utilize the technique the assets or transfers should be less than 50% at the point when they are measured for estate or gift purposes. Since all assets are transferred to the family limited partnership, all that is owned by the transferor is an interest in the family limited partnership. An owner may then transfer less than 50% of the total and be availed of the 35% valuation discount. Likewise upon death, if the owner of the family limited partnership interest owns less than 50% of the whole, it will be valued at the 35% discount. Given this, an estate of $1 million could, with the proper program of gifting and retention of less than 50% ownership, be compressed to $650,000 in value for federal estate and gift tax purposes. In addition, the $10,000 annual exclusion can be leveraged into approximately $15,000 of underlying assets because of the discount. The family limited partnership offers protection from attachment of the family limited partnership interest or the underlying assets by creditors of the owner. The Uniform Limited Partnership Act provides that a family limited partnership interest may not be attached or alienated except as provided in the agreement creating the family limited partnership. The agreement will typically provide that a "super majority of interest holders is required for alienation or attachment of an interest. The creditor's only remedy is then a "charging order" that provides that a creditor will be entitled to the debtor partner's distributions if, as, and when paid. Under such a cloud, the partners will not allow any distributions. Money or property may still be bailed out as compensation which is exempt from garnishment in Texas. Almost as if to add insult to injury the tax code will cause taxation of partnership income to the creditor though no actual money or property is received. The family limited partnership can also provide an attractive alternative to the irrevocable life insurance trust, especially in cases where the insured does not wish to completely part with control as is necessary in an irrevocable life insurance trust. The family limited partnership will own the policy and the insured will either gift partnership interests or money with which to finance premium payments to the objects of his bounty. These gifts will be sheltered by the $10,000 annual exclusion, and in the case of a gift of partnership interests, will be subject to the 35% valuation discount. The insured may be the general partner of the family limited partnership and continue to rule the roost. Family limited partnerships are excellent vehicles for the preservation of a family enterprise or dynasty. A business or empire may be preserved for a long period of time while slices of the asset pie can be passed on to successive generations outright or in spendthrift trusts as the overall estate plan may require.