By: Jim Picerno
Director of Analytics, The Milwaukee Company
Should wealthy individuals own life insurance? It’s tempting to answer “no,” but that can be short-sighted when you consider that liquidity issues can complicate end-of-life financial issues for affluent families and business partners.
To sort out what’s at stake, it’s helpful to review life insurance’s advantages in the cause of leaving money to heirs. One big advantage: generally speaking, insurance proceeds are not subject to income taxes.
Estate taxes, however, are another matter. Insurance proceeds are includable in the insured person’s taxable estate for federal estate tax purposes, if the insured had an ownership interest in the policy within 3 years of his or her date of death. Note, however, that for 2021 federal estate tax kicks in only after the decedent’s taxable estate exceeds the federal exemption amount, which stands at $11.7 million in 2021, and rising to $12.06 million in 2022. Married couples can double those amounts.
The potential estate taxation of life insurance can be easily sidestepped by making sure the insured does not own an incident of ownership in the policy within 3 years of his or her death. Usually this can be accomplished by establishing an irrevocable trust to acquire and own the policy. The trust agreement can name the persons you wish to benefit from the policy as the trust beneficiaries.
Life insurance may also make sense for well off individuals when a large portion of wealth is tied up in a privately held business. In those cases, critical liquidity needs can arise in the months following the death of the owner or other key personnel. Life insurance can provide the cash needed in timely manner. It can also help facilitate the transfer of wealth to family members who are not active in the business when the business owner dies.
In some cases, the plan is to keep the business, which can create even more liquidity challenges when a closely owned business has more than one shareholder. Peter Smiley, an attorney who specializes in estate and tax planning for O'Leary-Guth Law Office, S.C. and also consults with The Milwaukee Co. on estate planning issues, says that a pre-arranged buyout of the estate of a deceased shareholder that is funded with life insurance can provide a solution to this potential problem.
Deciding whether to invest in life insurance, and how to structure the ownership of an insurance policy, requires careful review of a family’s finances and objectives. Simply put, there are no cookie-cutter solutions.
This much is clear: rejecting life insurance policies out of hand because you assume that your heirs will be fine without it may end up creating headaches for your family and/or business partners down the road.
 Subject to limited exceptions, the so-called “transfer-for value rule” causes insurance death benefits to be taxable if the owner of the policy sells it to someone else before the insured person dies. However, the acquirer’s basis in the policy (that is, the amount paid for the policy plus any subsequent premiums paid into the policy after the transfer) is not recovered tax-free
 Some states also levy a separate estate tax and/or an inherence tax.