Are you married? If so, your surviving spouse can inherit all of your estate free of estate and gift taxes at your death (your spouse must be a U.S. citizen to qualify for the marital deduction). While this is a nice benefit, unfortunately it will not last forever. Once the surviving spouse dies, his or her estate may be subject to estate taxes depending upon the value of the assets in the estate. NOTE: If your spouse is not a U.S. citizen then your estate can be held in a Qualified Domestic Trust (QDOT) to avoid taxation upon the transfer to your spouse.

You can donate an unlimited amount of assets to a qualified charity free of estate and gift taxes.

IRC Section 6166 is a provision in the U.S. Tax Code that allows an executor of an estate to defer estate tax payments for that portion of an estate that is a closely held business or farm as long as those assets exceed 35% of the adjusted gross estate. Payments can be deferred up to five years; however, interest on the unpaid balance of the estate tax is due annually.

This section of IRS code is also known as the three-year rule. It essentially says if an individual dies within three years of transferring certain assets out of his or her estate then those assets are subject to federal estate taxes. It is important to avoid being subject to the three-year rule with regards to your life insurance. Many people use life insurance as an important estate planning tool by placing a policy in an irrevocable life insurance trust. To avoid being subject to IRC Section 2035 create the irrevocable life insurance trust and then have the trust apply for the life insurance policy instead of obtaining the policy first and then creating the trust.

You work a lifetime to accumulate an estate; however, at your death the assets you pass onto your heirs may be subject to federal estate taxes and state inheritance taxes. If your estate is subject to estate taxes, taxes are due usually within 9 months of your death. Life insurance can play an important role in estate planning by providing the income necessary to pay estate taxes and expenses and provide liquidity so those expenses can be paid. Some expenses that must be paid upon an individual's death may include:

• federal estate taxes
• state inheritance taxes
• probate fees
• legal and administrative fees
• debts
• funeral expenses

There are three options to pay estate taxes and expenses: use cash (it may be unlikely there will be much cash available), borrow the money (the money will have to be repaid with interest), pay the IRS in installments under IRC Section 6166 (only available for closely held family businesses or farms and there will be an IRS lien placed on the business), or pay now by purchasing a life insurance policy with the possibility of paying pennies on the dollar. Proper planning now may enable you to pass more of your estate to your heirs. Proper planning involves identifying estate transfer costs (federal estate taxes, state inheritance taxes, probate, etc.), using available tax breaks to reduce costs and determining the least expensive method of paying for remaining taxes and costs. The funded irrevocable life insurance trust can be one of the most cost-effective ways to pay for estate taxes.

The irrevocable life insurance trust (ILIT) is used to shield assets, in this case life insurance, by removing the ownership and control of the policy from the estate. Life insurance is a common tool used to fund estate taxes and expenses upon the death of an individual and the transfer of a large estate. For married couples, a joint life insurance policy is commonly used because it insures both lives and pays a death benefit upon the death of the second spouse (when estate taxes will be due). In addition, the annual premium for this type of policy is often considerably less than a policy purchased on one person's life. If the life insurance policy is not removed from the estate then the proceeds of the policy will also be subject to estate taxes.

Ideally the trust should be created before the life insurance policy is applied for. After the trust is created the trustee applies for a life insurance policy and makes the trust the owner and beneficiary. If a life insurance policy is already in existence before the trust is created, then the policy should be gifted into the trust by the policyowner. This is done by changing the owner and beneficiary of the policy to the trust. If a life insurance policy is transferred into a trust that was created after the policy was issued then the transfer is subject to the three-year rule. The three-year rule states that if a death benefit is paid within three years of the transfer then the proceeds will be included in the grantors estate and thereby subject to estate taxes. The premiums for the life insurance policy in an irrevocable trust are paid for by the trustee with gifts made to the trust by the grantor and spouse. The trustee administers the trust and any distributions. Upon the death of the second spouse, a joint life insurance policy (otherwise known as a second-to-die policy) will pay a death benefit to the trust. The trustee will then distribute the life insurance proceeds according to the terms of the trust document. This type of arrangement is valuable because it can provide the liquidity and income to pay the estate taxes and expenses immediately so that the estate can remain intact when passed to the heirs.

For individuals or couples who have ownership in a corporation, using split dollar funding enables a corporation to pay for the premiums of the life insurance policy in an irrevocable life insurance trust (premium payments by the corporation are non-deductible). Under the contributory plan, which is the most common form of split dollar funding, the corporation pays the premium and the trust pays the corporation for a portion of the premium. The trust's portion is usually the lower of the P.S. 38 rate (government established rate on the lives of two people) or an insurance companies joint life one-year term life rate.

A split dollar agreement is established by the creation of an agreement between the grantors employer and the trust. There are two different forms of split dollar agreements used depending on the grantors and spouses percentage of ownership in the corporation. A collateral assignment split dollar agreement is used if ownership in the corporation is less than 51% by the grantor and spouse. If ownership in the corporation by the grantor and spouse is 51% or more then a majority shareholder split dollar agreement is used. Upon the death of the second spouse (assuming a joint life insurance policy is used) the trust receives the death benefit of which a portion is used to pay back the corporation for the premiums it paid and the remainder can be used to pay for estate taxes and expenses.

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.

Life insurance proceeds are tax-free, right? Unfortunately, that adage is only half true. While life insurance proceeds are income tax free to your beneficiary(ies), they are generally subject to estate taxes. This can be very problematic given the fact that one of the great benefits of life insurance is the liquidity and income replacement it provides a family subsequent to the loss of a loved one and that the level of coverage your premiums are purchasing may be reduced by as much as fifty percent (50%) by the federal estate tax, thereby depriving your loved ones of the very protection you intended to provide. For example, if a life insurance policy provides a death benefit of One Million Dollars ($1,000,000), but before those proceeds can be distributed to the beneficiaries, the estate tax bill associated with that policy must be paid, and the tax rate for that estate is forty percent (40%) (current estate tax rates range from thirty-seven percent (37%) to fifty percent (50%)), the death benefit that will reach the beneficiaries is only Six Hundred Thousand Dollars ($600,000). The result is that the protection you intended to provide for your beneficiaries does not amount to the protection they actually receive. Why does this happen and, more importantly, what you can do to avoid making this mistake?

The IRS states that any life insurance policies over which you have “incidents of ownership” (i.e. the right to change the beneficiary and to make other decisions with respect to the policy) will be included in your estate for estate tax purposes. Essentially, any life insurance policies you own will be included in your estate and will be subject to estate taxes upon your death. The question is this: Is it possible to ensure the right people receive the proceeds upon your death but avoid including those proceeds in your estate by changing the owner of the policy? The answer is yes!

The solution is to make sure that, while the life insurance proceeds will be distributed to the proper individuals, but that you do not retain the ownership rights associated with those life insurance policies which would cause the inclusion of those policies in your taxable estate and therefore would result in a dilution of the protection following the payment of estate taxes. This is accomplished through the use of an Irrevocable Life Insurance Trust (ILIT). You create an ILIT and name someone you trust as the Trustee (i.e. spouse, sibling, etc.). After the ILIT is created, you make the trust the beneficiary of the policy and you assign the ownership of the policy to the trustee. The ILIT will receive the proceeds upon your death and will hold those proceeds for the beneficiaries of the trust (which you chose when you created the trust). For example, your ILIT can provide that your surviving spouse will benefit from the proceeds during his/her life and upon his/her death, the remaining proceeds will be distributed to your children, as you intended when you named your spouse as the primary beneficiary and your children as the secondary beneficiaries.

This plan works because after you assign the ownership of the policy(ies) to the ILIT, you no longer have any ownership rights with respect to the policy(ies) and, therefore they will not be subject to estate taxes upon your death. The IRS allows for this planning, but requires that the assignment of the ownership of the policy(ies) take place at least three (3) years prior to your death for the transfer of the ownership to take effect. Consequently, this planning should be implemented as soon as possible so the “three year rule” will be satisfied.

The purposes of your life insurance coverage are no different, but the estate tax results could not be more different. Because the ILIT owns the policy, it will not be included in your estate and will not be subject to estate tax on your death. Consequently, the value of the policy is passed to your beneficiaries undiluted by the estate tax. Let’s revisit the example from above: Without the planning, a One Million Dollar ($1,000,000) policy subject to a forty percent (40%) estate tax results in a realized benefit of Six Hundred Thousand Dollars ($600,000) to your beneficiaries. If an ILIT is used correctly, that same One Million Dollar ($1,000,000) policy will not be subject to estate taxes and the realized benefit to your beneficiaries will be the full One Million Dollars ($1,000,000). In a very real sense, this planning can and will save your loved ones hundreds of thousands of dollars.

Is an ILIT right for you? See an estate-planning attorney to find out.

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, Virginia. 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.

DISCLAIMER: 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:

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.

The federal estate tax is one of the biggest taxes most American’s will ever face. Current estate tax rates span between thirty-seven percent (37%) and fifty percent (50%). The IRS provides relief from federal estate taxes in the form of the estate tax exemption. The exemption is currently One Million Dollars ($1,000,000) and is scheduled to increase to One Million Five Hundred Thousand Dollars ($1,500,000) on January 1, 2004, and to Two Million Dollars ($2,000,000) on January 1, 2006. Every person is entitled to an exemption, which means not only can each person pass that amount estate tax free to their beneficiaries, but because married couples are entitled to use two exemptions, one for each spouse, they can pass the value of two exemptions estate tax free. In theory, this means that a married couple can protect Two Million Dollars ($2,000,000) now and will be able to protect even more in future years. Unfortunately, a huge percentage of married couples are on track to waste one of their $1,000,000 estate tax exemptions, which will cost their beneficiaries hundreds of thousands of dollars! Why is this?

If under a married couple’s estate plan (or lack thereof), all of the assets on the death of the first spouse pass to the surviving spouse, there will be no estate tax, assuming the surviving spouse is a U.S. citizen. This is because you can pass an unlimited amount to a surviving U.S. citizen spouse estate tax free. However, on the second death, the entire estate will be included in the survivor’s estate and will be protected only by the survivor’s estate tax exemption. The exemption of the first spouse to die was forfeited when he or she passed everything to the surviving spouse. Now everything over $1,000,000 will be taxed as follows:

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.

One of the biggest mistakes you can make in the area of estate planning is to assume you do not need to plan. If you think you are too young to prepare an estate plan or you think you do not have sufficient assets to warrant such a plan, you are making this mistake. Estate planning is much more than estate tax planning. Much of your estate plan will focus on providing you and your family with protection in the event of an unforeseen illness or accident and ensuring the well-being of your surviving family, rather than looking solely to managing large amounts of wealth upon your death. The following are examples of estate planning issues that require your attention regardless of your age or net worth:

• Incapacity Protection - Do you have a plan in place to ensure that financial, administrative and medical decisions can be made for you in the event you are incapacitated and are unable to make such decisions? If you do not, do you understand what will happen upon your incapacity?

  If you become incapacitated and do not have a succession of substitute decision—makers in place to pay bills, sign legal instruments, file tax returns and otherwise take over the management of your affairs, your family will have to petition the court to name a personal representative who will be given the authority to take such actions on your behalf. The problem with this process is that (1) it is expensive (there are substantial fees associated with navigating the court system), (2) it is time consuming (it will take time for the court-appointed personal representative to be identified and put in place) and most importantly, (3) it is out of your control (you will not have the ability to select your personal representative and will not be able to determine the extent and make-up of their powers to act for you). If, on the other hand, you have a plan in place whereby you have named a succession of decision-makers and have determined the powers those decision makers will have, the court (and the time and expense associated with the court’s process) does not have to be involved and you will maintain control over the process. One thing is for sure: You cannot afford to wait until you need this protection to put it in place!

  
  
• Providing for Minor Children- Do you have a plan in place that protects your minor children should something happen to you? Have you taken the opportunity to designate guardians for your minor children? Have you ensured that your children will be cared for and supported?
  

  If any of your children are minors upon your death, the court will name a guardian who will be responsible for caring for those children. To the extent that you have not provided the court with guidance as to the individual(s) you believe are most capable and appropriate to fill that position, the court will be trying to solve a mystery without any clues and may not select the individual(s) you believe are best suited for the job. On the other hand, you can take the opportunity now to designate who you would like to serve as guardian(s) in the event you have minor children upon your death. Just as with incapacity protection discussed above, the issue here is whether or not you retain as much control over the process and its outcome as possible. Take the opportunity to make your wishes known. Your children are too important to go unprotected.

  
  
• Providing for Your Surviving Spouse- If you were to die today, would your spouse be able to continue to make the mortgage payments, fund your children’s education and generally support himself or herself? Do you have sufficient life insurance coverage to guarantee the well-being of your loved ones? Your estate plan can ensure the proper treatment of your assets, including the treatment of your life insurance proceeds, and can protect your loved ones’ future.
  

A well-crafted estate plan incorporates the use of beneficiary designations (associated with your life insurance policies and retirement accounts), jointly owned assets and the distribution scheme created in your Last Will and Testament or Revocable Living Trust to ensure that the proper individuals receive the proper amount of assets at the proper time and under the proper circumstances. Such a comprehensive plan will ensure that your surviving spouse will have control over the assets and will be able to use those assets to support himself or herself and your children and, to the extent your children are to receive assets upon your death, will provide a mechanism for directing the distribution of those assets to them or for their benefit so that your children are not hurt by their inheritance. For example, your estate planning documents can provide that any distribution to a particular beneficiary under a certain age will be held in trust for that beneficiary and will be distributed within the discretion of the trustee of that trust until that beneficiary reaches the age where it is appropriate that they receive control over those assets. With this type of planning, you can protect your beneficiaries and their ambition. The future of your loved ones is far too important to leave unplanned.

These are just three examples of how estate planning is relevant to you whether or not you are young or old, rich or poor. Please see an estate planning attorney to get the protection you and your family need.

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, Virginia. 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.

A Buy/sell Agreement is a contractual agreement that provides for the continuation of a business in the event of the death or disability of a sole proprietor, partner or shareholder. An agreement may stipulate that, upon the death of a shareholder or partner of a company, the company or other partners buy back the deceased's interest in the business. Life insurance is commonly used to fund buy/sell agreements because it provides both liquidity and tax advantages in funding the transaction.

The following are important reasons to use a funded buy/sell agreement:

• Liquidity-A funded buy/sell agreement creates a market instantly for the deceaseds share of the business. Otherwise, if a funded buy/sell agreement were not in place, the purchase of the deceaseds stake in the business would have to come out of the companys working capital (if there was enough to fund the purchase). In addition, if an outside party were to purchase the deceaseds share, the timing of the transaction could result in a lower valuation of the company because of the death of a key owner and the fact that the deceaseds family wants to sell in a potentially soft market.
  
  
• Transition of Business-A funded buy/sell agreement assists in the efficient preservation and transition of the control and management of the business.
  
  
• Estate Planning-A funded buy/sell agreement can provide cash for potential estate taxes and settlement costs and establish a valuation of the deceaseds business interest for estate tax purposes.
  
  
• Cost-a funded buy/sell agreement funded with life insurance can be inexpensive (the cost for the purchase of a business is essentially the premiums paid for the life insurance policy).

Life insurance provides a simple way to administer a funding vehicle for the purchase of the deceaseds ownership according to the terms of the buy/sell agreement. The business also protects itself from any future drain on working capital, damage to its credit position and/or the legal or financial problems that could arise out of the companys inability to fund the buy/sell agreement with its own income.

Buy/sell agreements may be set up in conjunction with Sole Proprietorships, Partnerships and Corporations. The method for each is a little different. Below you will find a general description of the options available for each type of business.

Sole Proprietorship

If a sole proprietor has a key employee that has the desire to purchase the business in the event of the sole proprietors death, a buy/sell agreement can facilitate the key employee's purchase of the deceased's business. The sole proprietor and the key employee would enter into a buy/sell agreement, and the key employee would purchase a life insurance policy on the life of the sole proprietor. Pursuant to the buy/sell agreement, upon the death of the sole proprietor, the key employee uses the death benefit to purchase the sole proprietors business from his estate.

Partnership

Cross-Purchase Method
The Cross Purchase Method of entering into a buy/sell agreement works best if there are a small group of partners (preferably two). The partners enter into a buy/sell agreement and each partner buys a life insurance policy on each of the other partners lives. Pursuant to the agreement, upon the death of one of the partners, the surviving partners use the death benefit from the above-mentioned policies to buy the deceased partner's business interest from his or her estate. The surviving partners then own all of the partnership while the deceased partners estate receives the funds from the sale of the deceased partners share of the partnership.

Entity Method
The Entity Method of entering into a buy/sell agreement offers the advantage of simplicity over the Cross-Purchase Method if there are more than two partners or if there is a likelihood of more partners joining the business later. In this scenario, the partnership and each partner enter into a buy/sell agreement. The partnership buys a life insurance policy on each of the partners lives. Pursuant to the buy/sell agreement, upon the death of one of the partners, the partnership uses the death benefit from the above-mentioned policy to purchase the deceased partners business interest from his or her estate. The surviving partners then own all of the partnership while the deceased partners estate receives the funds from the sale of the deceased partners share of the partnership.

Corporation

Cross-Purchase Method
The Cross-Purchase Method of entering into a buy/sell agreement works best if there are a small group of shareholders (preferably two). The shareholders enter into a buy/sell agreement and each shareholder buys a life insurance policy on each of the other shareholders lives. Pursuant to the buy/sell agreement, upon the death of one of the shareholders, the surviving shareholders use the death benefit from the above-mentioned policies to buy the deceaseds shareholders business interest from his or her estate. The surviving shareholders will own all of the outstanding corporate stock while the deceased shareholders estate receives the funds from the sale of the deceased shareholders stocks.

Stock Redemption Method
The Stock Redemption Method of entering into a buy/sell agreement offers the advantage of simplicity over the Cross-Purchase Method if the corporation has more than two shareholders or if there is a likelihood that additional shareholders will join the business later. In this scenario, the corporation and each shareholder enter into a buy/sell agreement, and the corporation buys a life insurance policy on each of the shareholders lives. Pursuant to the buy/sell agreement, upon the death of one of the shareholders, the corporation uses the death benefit from the above-mentioned policy to purchase the deceaseds shareholders business interest from his or her estate. The surviving shareholders then own all the outstanding corporate stock while the deceased shareholders estate receives the funds from the sale of the deceased shareholders stock

Maybe your business is operated primarily by one person or maybe your company is run by a small team of executives whose expertise is the lifeline of your business. The premature death of a key person could signal the premature death of the business. With a Keyperson Life Insurance Policy, a business can increase the chances of survival if it were to lose a key member of the organization.

• cover business debt
• leave working capital for a surviving partner(s) to continue the business
• identify and hire a replacement for the key person
• provide cash for the business in case there is a major revenue shortfall because of the loss of the key person

The first factor to consider in setting up a Keyperson Life Insurance Policy is to determine how much death benefit is needed. The minimum usually considered is one times the key persons annual income, but other factors need to be considered. What if the business relationships of this person drive half of the companys revenues? How difficult and costly will finding a replacement be? Are there business debts that would place financial hardship on the company?

Once the death benefit amount has been determined, the business would purchase the policy on the key person. The key person would be the insured and the business would be the owner, payor and beneficiary of the policy. Permanent or term life insurance can be used as a key person policy depending on the needs of the business and how much they are willing to spend.