Many people assume that because death benefit proceeds from a life insurance policy are generally not considered taxable income to the beneficiary, a life insurance policy is out of the reach of the Internal Revenue Service (IRS). However, when the policy's death benefits are added to the appreciated value of your home and savings, it may come as a shock to find that the value of your estate may exceed the $2,000,000 applicable exclusion amount for 2008 (scheduled to increase to $3.5 million by 2009 based on the Economic Growth and Tax Relief Reconciliation Act (EGTRRA)).

Taxpayers should be aware that that federal estate taxes are scheduled for full repeal in 2010. However, EGTRRA contains a "sunset" provision, whereby all provisions automatically expire in 2011, effectively reinstating the prior levies unless Congress acts in the interim.

Although the unlimited marital deduction allows spouses to transfer assets between them without assessment of estate taxes, non-spousal heirs face the possibility of seeing a life insurance policy inflate an estate's value past the scheduled exemption amount in the year of death.

One Strategy: A Credit-Shelter Trust

One way to get the life insurance policy out of your estate is to use a type of bypass trust, known as a credit-shelter trust. Essentially, a trust is a contract between a named donor, a managing trustee, and a beneficiary

For estate conservation purposes, a trust could be set up to maximize each spouse's applicable exclusion amount, perhaps sheltering more assets from estate taxation than may be possible through use of just the unlimited marital deduction. At the death of one spouse, an amount equal to his or her applicable exclusion amount could pass to a trust to benefit the surviving spouse, with the remainder of the assets passing outright to the spouse. Then, at the death of the surviving spouse, assets in the credit-shelter trust could be paid to the couple's children—without being subject to federal estate tax. Any assets outside the trust upon the surviving spouse's death, and therefore potentially subject to estate tax, could be further sheltered by the second spouse's applicable exclusion amount for that year.

Another Approach: An ILIT

When children are the beneficiaries of a life insurance policy, and the owner wants to exempt the policy from the estate's total worth, an irrevocable life insurance trust (ILIT) is another approach. Keep in mind, however, the term "irrevocable" means beneficiaries may not be changed and that loans may not be paid out from the policy once it is put into the trust. Putting a hefty life insurance policy into such a trust could help beneficiaries finance the purchase of a family business or pay estate taxes. However, funding an ILIT may result in gift taxes due.

Park Your Policy in the Right Spot

A trust, depending on the type, can help reduce or defer taxes on high-value assets such as a life insurance policy. More broadly, a trust can be the means to ensure the policy's benefits go directly to the correct beneficiary. With the flexibility of trusts, however, comes complexity. It is always best to consult with an estate attorney who is also experienced in tax matters before proceeding.

Key Person Insurance Protecting Your Most Valuable Assets

As a business executive, suppose you were to arrive at your desk one morning only to be informed that your key sales manager had died unexpectedly during the night. Have you ever considered how such a turn of events might affect your company? Along with losing a valued member of your management team, you would also be losing the manager's skill, "know-how," and, perhaps, the important business relationships he or she had cultivated over the years.

Navigating the Shoals

Although you can't prevent the sudden and unexpected loss of a critical employee, you can receive compensation through key person insurance. A key person policy covers or "indemnifies" a company against the loss of a valued team member's skill and experience. The proceeds can help provide funds to recruit, hire, and train a replacement; restore lost profits; and reassure customers and lenders that business operations will continue and funds will be available to help repay business loans.

Generally, the company owns the policy, the premiums are not deductible, and the death proceeds are received by the company free of income taxes (although there may be alternative minimum tax (AMT) consequences for businesses organized as C corporations).

Charting a Course

Needless to say, it is not easy placing a value on a key employee. Generally, there are three different approaches to determine the amount of insurance that is necessary.

One of the most common methods is called the "multiple" approach. This method uses a multiple of the key person's total annual compensation, including bonuses and deferred compensation. The disadvantage to this approach is that the estimate, typically for five or more years' annual compensation, may or may not relate to actual needs. The popularity of this method may simply be a reflection of the difficulty business executives have in quantifying a key employee's value.

A more sophisticated method is the business profits approach. This method tries to quantify the portion of the business's net profit that is directly attributable to the efforts of the key person and then multiplies that amount by the number of years it is expected to take for a replacement to become as productive as the insured. For example, if the estimate of net profit attributable to the key employee is $250,000 annually, and it is estimated that it would take five years to hire and train a replacement, then, the policy's face amount would be $1.25 million under this method.

A third method determines the present value of the profit contributions of the key employee over a specified number of years. This quantity is then used as the face amount of the policy. For a simplified example, with anticipated profit contributions of $250,000 per year for the next five years and a discount rate of 8 percent, the policy's face value would be about $1 million. This method assumes the insurance proceeds can be invested at some rate of return and will be expended over a period of years. Business executives should consult with their insurer regarding the company's specific "rule of thumb" approach.

Regardless of which method is best suited for your business, key person insurance is a vital component to consider in protecting your business from the loss of your most valuable assets—the people who help it grow and prosper. In addition to providing cash to recruit, hire, and train replacements, the proceeds can also be used to help restore lost profits, maintain customer satisfaction, and lender obligations.