A Simple Plan to Avoid Estate Taxes

Do you expect Uncle Sam to show up for your funeral? Would you rather that he stay away?

If you die with a substantial estate, the federal government -- and maybe even your state government -- will want a cut of what you leave behind, very possibly stripping your estate of the fruits of a lifetime’s labor better left in the hands of your loved ones, or a favorite charity.

And what Uncle Sam doesn’t eat up, the lawyers will if your estate ends up in probate court, even if your estate is of modest size.

The good news is that there is a simple, innovative way to keep Uncle Sam from taking his cut, not to mention the lawyers, using life insurance. In essence, the strategy goes like this:

• You donate assets to your favorite charity such as real estate or appreciated stocks that would otherwise end up in your estate, subject to taxation.

• You get an immediate deduction against income taxes reflecting the value of the donation.

• You buy a life insurance policy on yourself with a death benefit equal to the value of the gifted assets.

• When you die, the insurer sends a check for the face amount to your beneficiaries free of taxation, probate costs, or lawyers’ fees.

As you can see, the strategy is as simple as it is elegant. In fact, given reasonably good health, you can put such a plan in place with a minimum of fuss and bother and live the rest of your life secure in the knowledge that everything you’re worked for will end up not in government’s coffers but rather in the hands of your favorite charity and the people you love.

The plan doesn’t work for everybody, however, and even if you are among those who might benefit from it, you must step carefully in implementing this tax-saving strategy, because if you slip up, you can jeopardize the whole idea.

For one thing, the strategy works best if you donate an asset with appreciated value -- meaning something that cost you considerably less than it’s worth now.  Any donation gets you a deduction against income taxes, but the higher the asset’s value, the bigger the deduction, and the greater the appreciation, the greater the tax savings.

The asset you donate could be virtually anything ranging from stock you bought at fire-sale prices years ago -- say, 10,000 shares of Microsoft bought just after the company went public in 1986 -- to your personal residence, commercial property, or even that valuable stamp collection in the closet or the vintage car you have under wraps in the garage.

Charities need cash, not property, so they commonly sell such donations, and so long as the proceeds of the sale equal the value of the donation, they pay no capital gains taxes on the transaction.

Let’s count the winners and losers to see how life insurance puts the losers back in the winners’ column.

You win by keeping the tax man away in two ways. You get that immediate deduction against income taxes, and you limit estate taxation by removing the donated asset from your estate. The charity wins by gaining an asset it can convert into cash without paying capital gains tax on the transaction.

The losers are your heirs, who now stand to inherit an estate whose value has dropped by an amount equal to the value of your donation.

They won’t stay losers for long, however, if you use the savings you’ve realized against income taxes to buy a life insurance policy with a death benefit equal to the value of the donated asset, payable to your heirs. Say, for example, you have donated commercial real estate worth $1 million to the charity. Because you’re in the 35 percent tax bracket, the donation saves you $350,000 in taxes ($1M x .35 = $350,000). Depending on your age and health, among other factors, you could use the tax savings to purchase a single-premium life insurance policy with a death benefit of $1 million, possibly more, payable to your hemit when you die.

Step carefully here, however. To do this right, you can’t own the insurance policy yourself, since if you died tomorrow, the death benefit could fatten your estate by $1 million, possibly becoming subject to estate taxation and, in any case, rendering your donation of the commercial real estate to the charity pointless.

Instead, you must name your heirs as owners and beneficiaries of the policy or, in the alternative, create a legal trust to own the policy, with your heirs as beneficiaries of the trust. This way the death benefit flows to your heirs, directly if they own the policy, indirectly if the policy is owned by a trust, and in either case tax free.

There is one other wrinkle on this prune. Depending on how big the premiums are for the insurance, it’s possible to trigger gift taxation if you pay them yourself. It’s also possible to avoid this problem with careful planning, for which you will probably need help from a good accountant or tax lawyer.

Juan Hovey wrote the “Finance and Insurance” column for the business page of the Los Angeles Times.