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Saturday, November 21, 2009
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Advanced Life Insurance
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Call us at (800) 940-3002
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Funding the Estate Tax – The IRS Wants Cash
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DISCLAIMER: The purpose of this article is to provide general information
which is subject to change and is specific to state law. The author and
ReliaQuote are not providing legal advice. If you have a specific legal
issue, you should consult a lawyer who is licensed to practice law in your jurisdiction.
If a decedent dies with a taxable estate, the due date for the estate tax return
is the date that is nine (9) months from the decedent’s date of death. Even if an
extension is filed to extend this deadline, the payment of the estate tax itself
must be paid on the initial due date. What this means is that ready or not, the
estate is required to create immediate liquidity at least in the amount of estate
taxes due. One would think that an estate large enough to require the payment of
estate taxes would have sufficient cash or marketable securities which could be
sold to fund the payment of the estate tax bill. Very often, however, taxable estates
are comprised significantly of real estate, retirement accounts, business interests
or other assets that either cannot be liquidated within this time period or cannot
economically be liquidated within such time, and the family is left scrambling to
gather the funds to pay the estate tax. What happens if the estate is comprised
of such inherently illiquid assets and there is very little cash or marketable securities
with which to pay Uncle Sam? Will the surviving family members be forced to sell
those illiquid assets, potentially at fire-sale prices, to create the necessary
liquidity?
Let’s look at an example:
Assume that John and Jane Doe have an estate with a value for estate tax purposes
of Four Million Dollars ($4,000,000) and that the estate is comprised of the following
assets:
Value of Real Estate: $1,500,000 Value of Interest in Family Business: $1,000,000
Value of Retirement Accounts: $1,500,000 Total $4,000,000
Approximate Estate tax upon the second death: $930,000
(assuming John and Jane utilized both estate tax
exemption amounts)
John and Jane do have life insurance policies, which will generate proceeds that
will provide for the well-being of the surviving family members, but those policies
are owned by Irrevocable Life Insurance Trusts (ILITs) and will not be subject to
estate taxes. (For more information regarding this estate tax planning technique,
see the article entitled “How to Make Life Insurance Completely Tax Free.”) While
these policies will distribute liquid assets to the family members, John and Jane
set the level of their coverage such that, to the extent those proceeds are used
to pay estate taxes, the protection they intended for their family will be eroded.
Given the above hypothetical situation, John and Jane’s children will be forced
to choose one of two options, neither of which achieves the result John and Jane
desired:
Option #1: John and Jane’s children can use the proceeds from their parents’ life
insurance policies to pay the estate tax. The problem with this option is that Uncle
Sam is now receiving $930,000 of the death benefit John and Jane intended for their
children.
Option #2: The children can take distributions from the retirement accounts (which
would result in a severe income tax even before the estate tax is paid), sell one
of the pieces of family property within the nine-month period (potentially at a
fire-sale price), and/or attempt to sell the family business (also potentially at
a fire-sale price) to raise the $930,000. Again, the problem with this option is
that the children would be forced to rush the distribution/sale of these assets
in a considerably unfavorable manner in order to fund the estate tax.
Is there anything else that can be done to ensure the presence of liquid assets
available to fund the estate tax so the children will not be faced with choosing
between two unfavorable options?
There is a solution and it is found in a life insurance policy, which is taken out
solely for the purpose of funding the estate tax. Life insurance, in addition to
being a good tool to provide
support
for loved ones, is a perfect mechanism to provide liquidity for an estate facing
an impending estate tax bill. John and Jane Doe did have life insurance coverage,
but that coverage was intended to benefit the family, not Uncle Sam. John and Jane
could have taken out a separate policy, in addition to the policy earmarked for
the family’s benefit, which would provide liquidity for the estate tax upon their
deaths. For example, they could have taken out a second-to-die life insurance policy,
which would have provided the cash needed to pay the tax.
This solution is much better than the two options discussed above in that (1) the
children will still receive the proceeds from the existing term policies and will
be able to enjoy those proceeds for the rest of their lives, and (2) the retirement
accounts and real estate can be managed by the children as they deem appropriate
and will not have to be liquidated to create liquidity.
Be careful! It is important when considering the use of life insurance, to fund
the estate tax or for any other reason, to ensure that the proceeds from your policies
do not themselves add to the estate tax bill. If a life insurance policy is taken
out to provide liquidity, it must be done carefully, to avoid including those proceeds
in the survivor’s estate and resulting in an increase the estate tax due.
Please see an estate-planning attorney to determine how life insurance can help
fund estate taxes upon your death and how you should structure the life insurance
to fit with your overall estate plan.
This article was written by C. Daniel Vaughan, Esq. C. Daniel (Dan) Vaughan is an
estate planning attorney with the law firm of Vaughan, Fincher & Sotelo PC in
McLean, . He is licensed to practice law in Virginia and other members of his group
are licensed to practice in Virginia , Maryland and the District of Columbia . The
group is focused on developing and administering comprehensive estate plans tailored
to individual needs and circumstances. Dan can be reached at (703) 506-1810 or by
e-mail at dvaughan@vfspc.com.
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