Leimbergservices.com



49th Heckerling Institute on Estate PlanningBrody, Mancini, Ratner --Life Insurance After ATRA – Wednesday AfternoonBy: Martin M. Shenkman, CPA, MBA, PFS, AEP, JDLife Insurance As an Asset Class.Using life insurance as an asset class instead of as a death benefit.Life insurance post-ATRA.As an asset class.Tax ment: Life insurance planning has become more not less complex. With an aging population the investment and long-term care features can be more important than estate tax planning features for the $10M and under client. The incredible complexity and almost infinite variations of policy design decisions make much of this an area beyond what many non-insurance advisers can navigate. Larry Brody suggested how many times in this presentation that the Code provisions he was referring to would be incomprehensible to an attorney? Consider expressly excluding in your retainer letter/engagement agreement insurance design/selection decisions. See the comments made in other presentations about not being liable if asset protection is so excluded in the engagement letter. Also carefully consider the cautions made by Skip Fox in his discussion of ethical issues in his Thursday morning presentation.How do you access a life insurance asset in the most tax advantageous manner?What is a life insurance policy for income tax purposes?IRC Sec. 7702(b)(1) the cash value accumulation test (CVAT).Guideline premium test (GPT) under IRC Sec. 7702(c)(2).A financial instrument will be considered life insurance for all income tax purposes if viable under applicable law and meets one of two actuarial tests when issued and throughout its existence.These endeavor to measure relationship between policy cash value and death benefit to make sure that there is adequate death benefit to warrant the favorable insurance characterization for tax purposes.Corridor test under IRC 7702In early years must be more death benefit to cash value then in later years. By age 95 cash value and death benefit can be the same yet it will still be considered life insurance.Separate rules exist for variable polices which must meet two additional tests. Must be adequately diversified under IRC Sec. 817(h) and for private placement policies an investor control test to be sure that the owner is not directing underlying investments has to also be met.Generally: The CVAT is used with traditional whole life polices and for survivorship policies; and The GPT is used with other types of policies like universal and variable policies.Policy illustrations will confirm if the policy meets these tests. You can rely on the policy illustration for this purpose.Client should not send in unscheduled premiums in early that could trigger a violation of one of these tests. They carriers should reject such payments.IRC Sec. 7702A added in 1988 defines a new subset of life insurance policies for income tax purposes, a modified endowment contract (MEC). Although this provision was directed at investment –oriented single premium policies it applies to all policies issued on or after June 21, 1988 that fail to meet the so-called “7-pay”. In many cases the test on an actuarial basis can be met in 5 years or less. They did not want the insurance industry selling 2 pay policies, etc. So the rule is that if payments are more than are needed to create policy going until life expectancy it will be a MEC. This is a complex calculation attorneys cannot make. Carrier should reject any check that creates a MEC unless the client expressly intended to create a MEC. Advisers should be able to rely on the carrier taking this precautionary action.A MEC nonetheless is still considered “life insurance” if it complies with Section 7702 so the death benefit will qualify for the income tax exclusion under 101(a)(1).Lifetime distributions from MEC policies do not receive the same favorable income tax treatment as lifetime distributions from non-MEC life insurance policies, they are instead treated like distributions from annuities.Once a policy is characterized as a MEC it will remain a MEC forever. If you do a 1035 exchange for a new policy the MEC taint will carryover.The increase in the cash value of the policy until accessed in a tax inefficient manner is not taxable income. This rule, as above, does not apply to MECs.The general rule of deferred taxation for cash value increases applies even to a life insurance policies that is a MEC assuming the policy continues to satisfy the definitional requirements above.Policy dividends are issued by insurance companies that issue participating polices, e.g. companies owned by policyholders. Dividends are returns of excess premiums and are generally not taxable, but they reduce your basis in the contract. Dividends only become taxable when your basis is reduced to zero. So when basis is exhausted through tax free dividends or other distributions, further dividends and distributions are taxable.Policy loans IRC Sec. 73(e)(5) if a policy meets applicable definition of life insurance and is not classified as MEC, a loan made against the policy will not be included in the policyholder’s taxable income even if the amount of the loan exceeds basis (investment in the contract), subject to one exception.If you have a policy and you borrowed in excess of policy basis, and you transfer it, even by gift, that transfer has two results. It will be treated as a partial sale so you will have gain on the sale. Unless the transfer or the transferee is exempt from the IRC Sec.101(a)(2) transfer for value rules, the transferee will not get the IRC Sec. 101(a) tax free receipt of death benefits. Be certain that the gift is made to a grantor trust so that these negative consequences can be avoided. There would be no gain on such a transfer.A policy loan is not a withdrawal rather it is a non-recourse loan form the insurance company, secured solely by the cash value of the policy. Loans are not taxable even if the loan exceeds investment.Universal life.Policy withdrawals. In addition to borrowing again the policy an owner of universal life can also make a withdrawal form the policy accumulation account or make a partial surrender. It is not a loan. There is no interest. It reduces the value of the cash account. A policy withdrawal is not taxable unless you exceed basis in the policy. So withdraw up to basis is income tax free, and thereafter use the withdrawal treatment/consequences as above.Be sure MEC rules are not applicable (not triggered).FOG if you make a withdrawal from a universal life policy in first 15 years – forced out gain 7702(f)(7) if reduce death benefit creates an income tax problem.A loan against a MEC or a withdrawal from a MEC.It is taxable income to extent cash value of policy exceeds the investment in the policy. So to the extent it exceeds basis in the policy there is gain.MEC policies do not follow the otherwise normal basis rule. MEC basis comes out last and income comes out first.Special rule if you loan or pledge or assign a MEC policy. It is treated as a distribution. This is done to prevent an end-run around the loan or distribution rules above. IRC Sec. 72(e)(10).Special loan or withdrawal rules for MECs under IRC Sec. 72(v) imposes a 10% penalty tax if occurs before taxpayer reaches age 59 ? (similar to IRA rules). Note that the term is “taxpayer” not policy owner. If the policy is owned by a trust who is the taxpayer? There is no answer. The industry practice is that if it is a grantor trust look through the trust to the grantor for the age test to see if the special penalty tax applies.Policy Surrender or Lapses.If a policy is surrendered or matures other than by reason of the insureds death, any amounts receive by the policy holder are taxable to the extent that they surrender proceeds exceed the investment in the contract. This is a basis like concept under IRC Sec. 72(e).Is the policy a capital asset? That should be clearly yes.Is there a sale or exchange? Not clear that this occurs if you surrender a policy. See IRC Sec. 1234A. This characterizes lapse of financial instruments (such as options) as capital transactions despite the lack of the usual required sale or exchange. Does that Section apply to the surrender of a life insurance policy? There are no reported cases but a Tax Court case that settled was settled on this basis. If a loan is outstanding when the policy is surrendered or is allowed to lapse the borrowed amount is added to the amount realized and becomes taxable income to the extent of the total cash value and the loan proceeds exceed the policyholder’s investment in the contract. See Barr .v. CIR, TC Memo 2009-250.If you surrender a policy you will get a Form 1099R from the carrier for all proceeds plus the loan amount.What about a sale of the policy? There is now a stable life settlement market. If someone doesn’t want a policy it could be sold to an unrelated investor. This should be treated as a capital transaction since the policy is a capital asset and the life settlement sale would provide the required sale or exchange (which is missing in the surrender or lapse) note that gain up to the cash surrender value is likely ordinary income as a substitute for interest based on old Supreme Court cases.Rev. Rule. 2009-13, 2007-1 CB 684 reaching both conclusions above and requiring the owners’ basis in the policy, as opposed to the investment in the contract. It has to be reduced by the cost of insurance (which is not defined) on the theory that a policy is made up of two parts: (1) a death benefit; and (2) cash value. The premiums pay for both of these components.Does 2009-13 apply outside of sales to the life settlement market? Not clear.Cash value insurance can play one or more roles in a personal financial plan.Provides enduring coverage without enduring cost.After some point in time if sufficient funding client will not have to continue payments, policy can “pay.”Clients are realizing they may want/need insurance for a longer time period then they anticipated in earlier plans (longer life expectancy).Provided flexibility on pension plan payouts (i.e., pension max).If permanent life insurance is paid up by retirement if you have a policy in place this technique is a lot easier.Provide funds for long-term care.Many policies offer ability to take down cash value to pay for long term care.If they don’t need the long term care portion they will use the death benefit.Be a vehicle for income tax deferral, conversion and diversification in the retirement/investment portfolio.Case for insurance as an investment.Cash value life insurance offers significant income tax advantages especially for those subject to the 3.8% Surtax on NII. Tax deferred growth of cash value, tax free access to cash value if the policy is not a MEC and tax free death benefit are all valuable.An individual who owns a policy might be able to redeploy or repurpose insurance for investment. Determine flexibility to increase premiums without underwriting. Reduce the death benefit for faster cash accumulation. Speaking of perspective, keep in mind that regardless of its purpose the insurance policy is an insurance policy! Some agents describe this to clients in a manner that almost suggests something else. “If you are not happy with it you can 1035 it.” Some agents suggest that clients need not worry if issues arise, the policy can readily be changed tax free in a 1035 exchange. This is misleading. What about underwriting? It is never guaranteed that in the future you will qualify for a new policy. What about the hit from acquisition cost on the new policies? What if there are loans on the old policies? This is not nearly as simple as many people make it seem to be.Products Generally.Various types of products.Whole life/term blendCurrent assumption universal lifeEquity indexed universal lifeVariable universal lifePrivate placement variable universal lifeAll policies encompass common factors: mortality, interest and expenses, the rest is packaging. Differences in the way the mortality, interest and expenses are packaged can, however, be very meaningful for those who are depending on the policy for certain results, especially over longer time periods. One type of policy is not inherently better than another type. However, one type of policy may be much more appropriate than another type for a given client and particular circumstances. Products are constantly evolving with features that blur the traditional lines of demarcation with respect to product characteristics.Not every client that considers insurance as an investment will buy it. They should not walk away because they don’t find a product. There are too many good choices from many good carriers. Reasons some clients won’t commit:Some walk away because they don’t want to take a physical. When shown illustrations, clients look at three columns: premium, cash value and death benefit. But the estate liquidity buyer and the investment-oriented buyer look at those columns differently. The liquidity buyer says “why can’t the premium be lower? I wish the cash value were higher, but it really doesn’t matter because I won’t own it. When I die, will the beneficiary get the death benefit plus the cash value?” It is unusual for the liquidity buyer to make a decision quickly, partly because the policy will be in an ILIT, which also adds some complexity to the whole process. The investment buyer looks at those same three columns and asks “Why does it take so long to get the money into the policy? What if I want to put more or less into the policy in the next few years? Why isn’t my early cash value higher? Why is the death benefit so high? I don’t want to pay for so much insurance.” This type of client/buyer also looks much more closely at how the policy works and its expense structure than the liquidity buyer. The investor is also more interested in the agent’s post-sale service than is the liquidity buyer.Whole life/term blend. A $1 million policy might, for example, be comprised of $500,000 whole life and $500,000 of term. The whole life portion offers guarantees, the term offers low cost coverage based on current assumptions. Dividends from whole life portion buy paid up additions that displace term. Typically designed with paid up additions rider or other mechanism to accelerate growth of paid up additions. Product can appeal to policyholders who like to “invest” their money in the general account of an insurer they admire.Current assumption universal life. Flexible premium product allows policy holder to set up premium to support the death benefit tomaturity, or to set premiums just to support the death benefit to a given age at or upon given assumptions. Must monitor and adjust the premium as circumstances permit. Insurer guarantees minimum interest and maximum the cost of insurance. Product appeals to those want utmost flexibility.Equity indexed universal life (EIUL) is essential akin to an CAULwith same concept of current versus guaranteed COIs. Insurer credits the cash value with the greater of a minimum guaranteed rate or a portion of the growth of an index such as the S&P 500. Crediting methodology typically involves such components as the return of the selected index, the measuring period of the return, the “cap”, etc. Product can appeal to those who want some participation in capital markets with limited downside from the guarantee. Variable Universal Life (VUL). Flexible premium product like CAULwith same concept of current vs. guaranteed COIs. Can invest the cash value among accounts that are like mutual funds and locate and reallocate them Need asset allocation, investment policy statement (IPS), monitoring, etc. VUL buyers who want to emphasize cash value growth will reduce death benefit to minimum. Cash value is not part of the insurer’s general account nor subject to insurance company creditors. Product may appeal to those who want premium flexibility and ability to more fully participate in the capital markets. Note that some suggest that VUL (and other policies) have “underperformed”. Mr. Ratner suggests that it’s more likely that these policies were either “under-described” or under-managed.Private placement variable universal Life (PPVUL). PPVUL is unregistered under federal and state securities laws. Available only to accredited investors under the 1933 Act or “qualified purchasers” under the 1940 Act. Compared to VUL, PPVUL is likely to have no surrender charges, offers the buyer the ability to invest the cash value in otherwise tax-inefficient hedge funds, and the ability to negotiate lower sales loads and broker compensation. The PPVUL buyer still has to deal with the the investor control and diversification rules. Life policy design for investment.Individual indicates how much he would like to pay annually or in aggregate. Individuals often want to get the money into the policy as rapidly as possible. But his can be counter-productive in light of MEC rules so have to look at alternatives, like a three-pay plan.Individual selects the type of policy he would like to purchase:General account whole life, term blend, CAUL, or EIUL.Separate account (VUL or PPVUL).In larger cases the individual may diversify among two or three types of products.Policy comparison. For example, which policy can generate the most income for X years start at age Y without requiring additional premiums to stay in force to age Z?Level the playing field.Life insurance as a trust investment. Many high net worth individuals use life insurance as trust investment for pure wealth transfer. They believe that the IRR on the death benefit may be as good or better on a risk and attitude-adjusted basis as anything else they would use for this purpose. This may be worthwhile use of the $5.43 million exemption. Policy selection and design implications -- individual or second to die policy is an important consideration for younger insureds, where there could be many years between deaths. Comment: Retaining appreciating low basis asset in the estate and instead funding an ILIT with a permanent life insurance policy that presents no basis step-up considerations can solve planning issues and complexity.What about an insurance policy that is working but it is held in a trust that is not working/viable.The insurance is viable but the trust owning it is problematic. What can be done? Solutions for a broken ILIT.When client or agent says the policy is working but client does not want to pay because no longer satisfied with the trust.If represent husband and wife and draft for insured spouse the definition of “spouse” can cause problems.What if there is a divorce? Some parties do not want that spouse to continue to be a beneficiary of the ILIT and not used a floating spouse clause. So the changes in a client’s life and circumstances can make the ILIT problematic. What if the ILIT was prepared by another attorney and there are problems that might result in estate inclusion?What can we do to get a good policy out of a bad trust? 4 alternatives:Sell it.Advantage is you can sell the policy to anyone.Sales have drawbacks. You may wish to sell to another trust with different beneficiaries, or an LLC, etc. Sale price may be significant and the desired buyer doesn’t have sufficient cash and may wish to use a note for the purchase. Now the old trust will hold the cash or the note. If insured dies the beneficiaries of the old trust have a promissory note and the buyer has the cash. These beneficiaries of the old trust may sue the trustee for having made the sale. There could be fiduciary issues.What if the trustee sells for a note but does not take adequate security and the buyer stops paying?How do you value policy? Forms 712 often have surprising values or multiple values. Trustee may need independent appraisal to support that it was real FMV for the sale price because of the fiduciary obligations. If the policy is sold for too little it could be an impermissible distribution to some third party. If the trust sells the policy for too much the beneficiaries may be happy but the buyer may be viewed as having received a gift from the trust and that could raise yet other issues.Consider using formula provisions for the sale to protect from gift tax audits.Consider filing a gift tax return and reporting this as a non-gift tax transfer, but trusts cannot make gifts so will this really work?Watch transfer for value rules. It is not a transfer to the insured. Is it a transfer to a partner of the insured or a partnership in which the insured is a partner? If the insured is a GP or manger of the LLC you may have 2042 incidence of ownership issues. Transfer to a corporation in which the insured is a shareholder may be an exception. Can you cure this later on by a subsequent transfer that fits into the exception?Distribute it under terms of the policy.If you review trust agreement to distribute you are limited to terms of the trust agreement. The trust might restrict distributions while the insured is alive. For example, only to the spouse the client does not want the policy to go to.There may be young children and you cannot distribute to them at that time.It can be difficult to distribute a policy out of the trust by having insurance carrier to issue three policies to replace one. Carriers may balk at this.You might be able to use an entity to hold the policy.Trust provisions may not be conducive to the distributions. There may be a HEMS limitation.Decant it.Three options. Statutory decanting if state law permits. More states are adopting statutes.Decanting under the terms of the trust agreement if trust provisions permit distributing to another trust. Common law decanting under state case law.Notification can be a problem. Most laws require notification of all beneficiaries and many clients will not want this. Don’t have consent by anyone to decanting since that may be viewed as a gift. Notification may suffice to satisfy a trustee rather than a consent to the decanting.Consider withdrawal rights. Many ILITs include withdrawal rights for annual exclusion and more. Some of these are hanging powers. Decanting and distributions you are moving assets out of the old trust. If the beneficiaries have realistic withdrawal rights have you made those academic? That might create a problem.Use the powers to substitute assets and substitute other assets that are more appropriate for the beneficiaries in the trust.This may be held by grantor.The insured grantor will get the policy back and it will be included in his or her estate.They may transfer thereafter to a new trust and start 3 year rule again.IRS has held that power of substitution will not itself cause inclusion. Rev. Rul. 2008-22 trust fund will not be included in grantor’s estate under IRC Sec. 2038 or 2036. Look at Jordhal case. The fact that the settlor can pull out policy if he or she has to put in equal value, should not impact beneficial interest of beneficiaries. In Jordhal it was putting back another insurance policy. In the two rulings the IRS said the trustee must make sure that there is equivalent value. Jordhal uses the phrase “equal value” which means equal cash value, equal death value and a similar form of policy. So substituting one insurance policy for another will be quite difficult.CITE AS:?LISI?Estate Planning Newsletter #2272?(January 16, 2015) at 2015 Leimberg Information Services, Inc. (LISI).?Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.? ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download