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CFP - Estate Planning (10% of the exam) - Section G.58

Sources for estate liquidity

Meeting estate taxes, debts and expenses without a forced sale: life insurance held in an irrevocable trust, Section 303 stock redemptions, Section 6166 installment payment of estate tax, special-use valuation and asset sales. Items pick the source that fits an estate's asset mix.

Internal Revenue Code Section 303Internal Revenue Code Section 6166Irrevocable life insurance trust

Practice question for this objective

Free sampleEstate Planningmedium

Dmitri, aged 58 and in good health, owns a haulage business worth 7,000,000 dollars that makes up almost all of his estate. His planner projects a substantial federal estate tax at his death and warns that the estate will hold almost no cash. Dmitri wants a plan that produces cash for the estate without adding anything to the taxable estate and without his children having to sell the business. His planner proposes that an irrevocable trust apply for, own and pay the premiums on a new policy on his life, with the trustee given power to purchase assets from his estate and to make secured loans to it. Why does this structure produce liquidity without increasing the estate tax bill?

  • AThe proceeds are brought into Dmitri's gross estate because he is the insured, but the estate then claims an offsetting deduction for the amount the trustee applies towards the settlement costs and the tax
  • BThe trust rather than Dmitri owns the policy and he holds no incidents of ownership in it, so the proceeds fall outside his gross estate, and the trustee reaches the estate by buying assets from it or lending to it rather than by paying its tax Correct
  • CDmitri should own the policy himself and name his estate as the beneficiary, since proceeds paid straight to an executor reach the settlement costs faster than proceeds routed through a separate trust
  • DThe trust deed should oblige the trustee to pay Dmitri's estate tax and funeral costs directly, because a binding direction of that kind is what keeps insurance proceeds outside a deceased insured's taxable estate
Life insurance owned by an irrevocable trust stays outside the taxable estate while the trustee supplies liquidity by buying estate assets or lending to the estate. Life insurance proceeds are included in a deceased insured's gross estate where the insured held any incident of ownership in the policy, or where the proceeds are receivable by or for the benefit of the estate. A trust that applies for the policy itself, owns it from the outset and pays every premium avoids both triggers, so the death benefit is not taxed in the insured's estate. Having the trust take out a new contract also sidesteps the three year rule that would apply to an existing policy the insured had transferred. The second half of the design matters just as much. If the trust deed directed the trustee to settle the estate's tax and debts, the proceeds would be receivable for the benefit of the estate and the inclusion the plan was built to avoid would happen anyway. Instead the trustee is given discretionary power to buy assets from the estate at fair value and to lend to it on commercial terms. Both are dealings between separate parties, so the executor ends up holding cash, the trust ends up holding business assets or a secured note, the shares stay with the family and nothing is added to the taxable estate.

Why A is wrong: Estates do deduct debts, funeral costs and administration expenses, so the idea of an offsetting deduction sounds familiar, but no deduction exists for insurance proceeds applied to tax and the inclusion would enlarge the very liability the plan is meant to fund.

Why B is correct: Ownership by the trust from the outset keeps the death benefit out of the taxable estate, and purchases and loans are arm's length dealings that hand the executor cash without creating any obligation on the trust to discharge the estate's liabilities.

Why C is wrong: Naming the estate certainly delivers the money to the executor with the least friction, which is why clients ask for it, but a policy the insured owns with proceeds payable to his executor is fully included in his gross estate and taxed there.

Why D is wrong: Paying the tax is the practical outcome everyone wants, so a clause compelling it looks like tidy drafting, but proceeds that must be used to discharge the estate's own obligations are treated as receivable by the estate and are pulled back into it.

See more CFP practice questions, answers explained.

Exam traps in Estate Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

  • Have the company redeem enough of the estate's shares under Section 303 to fund the 1,150,000 dollars, so that the estate receives sale or exchange treatment on the redemption instead of dividend treatment

    Why it is wrong: A Section 303 redemption is a genuine liquidity tool for exactly this shareholding, which makes it attractive, but it raises the cash immediately from a company that has very little of it and gives the executor no deferral of the tax at all.

  • Gift the shares to Ravi now so that he takes Owen's 200,000 dollar basis and claims the loss on a later sale

    Why it is wrong: This applies the carryover basis rule that governs gifted property which has risen in value, but property standing at a loss uses a dual basis, and for working out a loss the donee's basis is the value at the date of the gift, so the 80,000 dollars of pre-gift decline is available to nobody.

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