Dear Clients and Friends:

An often-asked question is how can I make sure the life insurance benefits my family receives after my death avoids the federal estate tax. This is an important issue because, once the federal estate tax applies, the rates are high (beginning at 37% and going up to 55%).

Insurance on your life will be included in your taxable estate if either:

(1) Your estate is the beneficiary of the insurance proceeds, or

(2) You possessed certain economic ownership rights ("incidents of ownership") in the policy at your death (or within three years of your death).

Avoiding the first situation is easy: simply make sure your estate is not designated as beneficiary of the policy.

The second rule is more complex. Clearly, if you are the owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is. However, simply having someone else possess legal title to the policy will not prevent this result if you keep so-called "incidents of ownership" in the policy. Rights that, if held by you, will cause the proceeds to be taxed in your estate include:

• the right to change beneficiaries
• the right to assign the policy (or to revoke an assignment)
• the right to pledge the policy as security for a loan
• the right to borrow against the policy's cash surrender value
• the right to surrender or cancel the policy

Keep in mind that merely having any of the above powers will cause the proceeds to be taxed in your estate even if you never exercise the power.

Buy-sell agreements: Life insurance obtained to fund a buy-sell agreement for a business interest under a "cross-purchase" arrangement will not be taxed in your estate (unless the estate is named as beneficiary). For example, Al and Bob are partners who agree that the partnership interest of the first of them to die will be bought by the surviving partner. To fund these obligations, Al buys a life insurance policy on Bob's life. Al pays all the premiums, retains all incidents of ownership, and names himself beneficiary. Bob does the same regarding Al. When the first partner dies, the insurance proceeds are not taxed in his estate.

Life insurance trusts: A life insurance trust is an effective vehicle that can be set up to keep life insurance proceeds from being taxed in the insured's estate. Typically, the policy is transferred to the trust along with assets that can be used to pay future premiums. Alternatively, the trust buys the insurance itself with funds contributed by the insured. As long as the trust agreement gives the insured none of the ownership rights described above, the proceeds will not be included in his estate.

The three-year rule: If you are considering setting up a life insurance trust with a policy you own currently or simply assigning away your ownership rights in such a policy, please call me as soon as you can to affect these moves. Unless you live for at least three years after these steps are taken, the proceeds will be taxed in your estate. For policies in which you never held incidents of ownership, the three-year rule doesn't apply.

Please call my office at 315-363-3338 if you would like to discuss this area further.

Very truly yours,

G. William Hatfield
Certified Public Accountant
Certified Financial Planner