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AALU Piece: Avoiding 5 Common Mistakes in Life Insurance Planning

June 15th, 2017 No comments
TOPIC: “Trouble Ahead, Trouble Behind,” and You Know that Notion Never Crossed My Mind: Avoiding 5 Common Mistakes in Life Insurance Planning.


MARKET TREND:
As estate planning involving personal life insurance becomes commoditized, so does the chance that a minor oversight will have a major tax impact.

SYNOPSIS: According to experts, some of the most common mistakes in life insurance planning include: (1) failure to qualify gifts to irrevocable life insurance trust (“ILITs”) for the annual gift tax exclusion; (2) improper allocation of GST tax exemption to ILIT gifts; (3) retention of incidents of ownership in an ILIT – owned policy; (4) failure to understand the planning implications of a policy classification as a modified endowment contract; and (5) triggering tax on an otherwise non – taxable policy exchange under Internal Revenue Code (“Code”) §1035. Find out how to identify and avoid them.

TAKE AWAY: In a world of increasing commoditization, adding value is key. Advising on product selection and identifying common trouble spots in the development of a life insurance plan can offer advisors significant opportunities to provide value to their clients. Collaborating with other allied advisors early on in the client’s planning also can alleviate many of these problems without creating extensive delays to policy issuance. Life insurance is a core component of many estate plans and is often viewed as a relatively simple method to provide family security and estate liquidity at a client’s death. However, pressures to minimize costs, yet provide coverage, through sophisticated plans can lead to oversights that result in unexpected tax consequences. Here are some of the most common trouble spots that experts see when reviewing life insurance plans:

1.FAILURE TO QUALIFY FOR ANNUAL EXCLUSION GIFTS Many clients rely on the annual exclusion from gift tax (“annual gift exclusion”) to make gifts to their irrevocable life insurance trusts (“ILITs”) to fund premiums.[1] A gift only qualifies for the annual gift exclusion if the recipient has a “present interest” in the gift.  As gifts to ILITs typically do not satisfy this requirement, ILITs often contain “Crummey” withdrawal powers that allow designated trust beneficiaries to withdraw the gift from the trust, up to the annual gift exclusion amount for each beneficiary. The trustee typically provides the beneficiaries with notice of their powers to withdraw.  If unexercised within a set time (e.g., 30 days), the powers lapse, and the trustee invests or uses the funds (e.g., to pay policy premiums).The IRS continues to focus on the use of Crummey powers in ILITs, and failure to follow proper administrative procedures in handling these powers may result in (1) limits on the annual exclusion gifts a client can make to the ILIT beneficiaries, (2) characterization of all transfers to the ILIT as taxable gifts, (3) the imposition of gift tax, and/or (4) the loss of gift tax exemption.

  • Practical Insight:  ILITs are not “set it and forget it” propositions.  To ensure the intended tax treatment, clients and trustees must follow best practices (as discussed in detail in WRMarketplaces No. 13-08 and 14-04) in the on-going administration of ILITs funded with annual gift exclusions. As this is a common trouble spot, insurance advisors may want to initiate or maintain contact with clients by offering reviews of an ILIT’s policy administration.

2. IMPROPER GST TAX EXEMPTION ALLOCATION TO ILITSUnlike the annual gift exclusion, the annual exclusion from generation-skipping transfer (“GST”) tax requires that the trust receiving the gift must (1) benefit only one individual during his or her life (who is a skip person for GST tax purposes (e.g., a grandchild)) and (2) the trust assets must be paid to that individual during life or be includible in his gross estate at death.Accordingly, gifts to typical ILITs will not qualify for the annual GST tax exclusion, even if they qualify for the annual gift exclusion, because the ILITs have multiple beneficiaries and are drafted to prevent inclusion of the trust assets in a beneficiary’s estate. If not fully exempt, GST tax will apply to these ILITs when trust assets are distributed to a skip person or when the interests of all non-skip persons in the ILIT terminate.  In these cases, the so-called “automatic allocation” rules may help, as they automatically allocate GST exemption to any contribution made to a qualified “GST trust.”[2] The rules, however, are complex and generally only apply to contributions made after 2000.  Further, the taxpayer must confirm the trust’s GST status and independently track the GST exemption automatically allocated each year.

Example: John and Jane created a dynasty ILIT for their descendants in 1996 and funded it annually for 20 years with $40,000 in annual exclusion gifts to pay premiums on a survivorship policy.  The trustee has provided Crummey notices to the required beneficiaries, but John and Jane have not filed any gift tax returns allocating GST tax exemption.  Since the GST exemption automatic allocation rules only applied to their gifts from 2001 and after, no GST exemption has been applied to their gifts from 1996 through 2000.

Currently, the ILIT’s applicable fraction for GST tax purposes is .75 ($600,000 (amount of GST exemption allocated to the trust) over $800,000 (value of the property transferred to the trust)). The inclusion ratio is .25 (1 − .75). The applicable GST tax rate to the taxable distribution is .10 (40% top federal estate tax rate x .25).  Assume after their deaths and the deaths of their children, a taxable termination occurs on $12 million of trust value.  The GST tax would be $1.2 million ($12,000,000 x .10).

  • Practical Insight:  This is one of the most common, complicated, and expensive-to-fix trouble spots in ILIT planning.  To avoid this issue, clients who make annual exclusion gifts to GST-exempt ILITs should ensure the proper allocation of their GST tax exemption to those contributions, rather than relying on the automatic allocation rules.  This may include the filing of a federal gift tax return for the sole purpose of documenting the allocation of GST tax exemption, even if the client has not made any taxable gifts that would otherwise require a return. Proper reporting also requires communication among the client’s insurance, legal, and tax advisors to confirm the ILIT’s terms, its intended GST-exempt status, and the total annual contributions that will require allocation of GST exemption.

3. INCIDENTS OF OWNERSHIP IN ILIT-OWNED POLICIESAn insured that retains any “incident of ownership” over a policy at death, whether individually or through a trust, will trigger inclusion of the policy proceeds in his or her estate.  “Incidents of ownership” extend well beyond the mere holding of title to a policy and include, for example, the insured’s ability to change beneficiaries or to access policy cash value, including the power to pledge the policy for a loan (e.g., coverage on a business owner pledged as collateral for a line of credit).
This issue also frequently arises when an existing ILIT designed to own a policy on one spouse acquires a survivorship policy on both spouses.  Using the existing ILIT can seem an efficient way to reduce planning costs and minimize administrative hassles by consolidating the life insurance planning in a single trust.  However, single-life ILITs may (1) name one spouse as a trustee without restricting his or her ability to exercise incidents of ownership over insurance policies held by the ILIT or (2) provide a spousal beneficiary with a limited power to appoint trust assets to others. These powers can result in inclusion of the ILIT assets in the spousal trustee/beneficiary’s estate at death if the ILIT owns a survivorship policy (see WRMarketplace No. 13-44 for a detailed discussion of “incidents of ownership”).

  • Practical Insight:  Advisors and clients must proceed cautiously with regard to any powers provided to the insured under an insurance planning arrangement, and survivorship policies should be owned only by ILITs specifically drafted to accommodate survivorship coverage.

4. FAILURE TO UNDERSTAND IMPLICATIONS OF A MECFor most life insurance contracts, withdrawals of policy cash value by the policy owner are not taxable, up to the owner’s tax basis in the policy.  A different rule applies to life insurance contracts classified as modified endowment contracts (“MECs”).[3] Lifetime distributions from MECs are taxed as ordinary income until the distributions exceed the gain in the MEC.  Policy loans and pledges of MECs as collateral for loans are similarly taxed as MEC distributions.  Further, a 10% penalty tax is imposed on the includible amount of the MEC distribution (or deemed distribution), with limited exceptions (e.g., MEC owner is 59½ or older or disabled) (see WRMarketplaceNo.15-15 for a more detailed discussion of MECs).[4]MEC status generally is not an issue as long as a client does not want lifetime access to policy cash value and the policy otherwise satisfies the planning objectives (e.g., a policy acquired primarily for death benefit protection).  Yet, issues frequently arise with MECs because their implications as part of the overall life insurance plan have not been fully considered:

Example:  A spousal lifetime access trust (“SLAT”) owns a policy insuring Adam, the 55-year-old grantor of the SLAT.  The gain in the policy is $250,000 (the SLAT’s tax basis of $600,000 less policy cash value of $850,000).  To facilitate a distribution to Jack’s spouse, a SLAT beneficiary, the trustee takes out a $200,000 loan on the policy.  If the policy is classified as a MEC, the loan is deemed a distribution of $200,000, taxable as ordinary income.  Furthermore, a 10% penalty tax may apply to the includible amount of the distribution (10% x $200,000 = $20,000).

  • Practical Insights:  Given the potential adverse tax consequences of MEC status, the selection between a MEC and a non-MEC product should consider the following factors:
    • Need for Cash Value Access.  If the client does not anticipate taking policy loans or withdrawals during life, MEC status may not be important.  For lifetime access planning (such as with a SLAT), MEC status likely will not be preferred.
    • Split-Dollar Planning.  Given that pledges of a MEC as loan collateral are taxed as MEC distributions, MEC status is likely undesirable where the policy will be pledged as collateral for a split-dollar loan.
    • Desire for Future Flexibility.  Once classified as a MEC, a policy will remain a MEC, even if exchanged.  This can limit flexibility in product modification if the client’s circumstances change and access to cash value is desired.

5. CREATION OF “TAXABLE” 1035 POLICY EXCHANGES  Code §1035(a) allows the exchange of one life insurance contract for another, generally without the recognition of gain or loss upon the exchange (a “1035 exchange”).  This provision allows the deferral of taxation for individuals who merely exchange one policy for another better suited to their needs. 1035 exchanges are popular because they permit clients to adapt their long-term life insurance planning to changed economic and family circumstances, but they must be carefully implemented to avoid the following (see WRMarketplace No. 14-39 for a more detailed discussion of 1035 exchanges):

  • Different Insureds.  The exchanged policies must (1) have the same owner and (2) relate to the same insured.  Thus, a policy owner cannot 1035 exchange a policy for a new policy with a new insured (e.g., as may be allowed under a “policy exchange rider” that permits a business to switch the insured under a key-employee policy to replace a terminated or departed employee).  Nor can a single life policy be 1035 exchanged for a survivorship policy insuring the same individual and another person (such as a spouse).  This rule also prohibits a 1035 exchange of two single life policies insuring respective spouses for a survivorship policy insuring both spouses.[5]
  • New “Force-Out” Period.  A withdrawal of policy cash value in the first 15 years of a non-MEC contract that reduces the future death benefits may generate an immediate income tax liability.  The withdrawal is includable in gross income to the extent of the policyholder’s gain in the contract (excess of the policy’s cash value over the policyholder’s basis) up to a “recapture ceiling,” and may be referred to as “forced-out gain.” A policy received in a 1035 exchange is treated as a new policy for this purpose.[6]
  • Taxable BootAny money or other non-like kind property (“boot”) received in a 1035 exchange in addition to the new policy will not qualify for non-recognition treatment and may result in reportable gain to the taxpayer.  A common “boot” situation is the 1035 exchange of a policy subject to an outstanding loan.  The exchange generates boot if the loan is not carried over to the new policy, and policy cash values are used to satisfy the loan.

Example:  B owns Policy 1, with $100,000 of cash value, a $70,000 tax basis, and an outstanding policy loan of $40,000. B exchanges Policy 1 for Policy 2, issued without any loans. B’s amount realized is $100,000: $40,000 of boot (extinguished loan) plus Policy 2, with a cash value of $60,000.  B recognizes $30,000 of gain ($100,000 amount realized – $70,000 basis in old policy).

The boot treatment of policy withdrawals made within a short timeframe of a 1035 exchange (e.g., 6 months) to pay off a loan also can be problematic.  The IRS has indicated that policy withdrawals made to pay-off an existing policy loan, followed shortly by a 1035 exchange of the policy, constitute a single integrated transaction taxable under Code § 1035 and result in tax on the withdrawal as boot.[7]  Yet, the IRS reached a different result in a private letter ruling involving the proposed pay-off of a policy loan after a 1035 exchange by using withdrawals from the new policy.[8] Thus, clients and advisors should proceed cautiously whenever a policy considered for a 1035 exchange involves outstanding policy loans.

  • New MEC TestingIn addition, a new policy received in a 1035 exchange for a non-MEC policy must undergo a seven-pay test to determine whether it constitutes and will be taxed as a MEC. The risk of failing this test for the new policy may increase if there is a reduction in its death benefit compared to the old contract or if the owner contributes additional funds at the time of the exchange.[9]

TAKE AWAYS

In a world of increasing commoditization, adding value is key.  Advising on product selection and identifying common trouble spots in the development of a life insurance plan can offer advisors significant opportunities to provide value to their clients. Collaborating with other allied advisors early on in the client’s planning also can alleviate many of these problems without creating extensive delays to policy issuance.

NOTES

[1] Generally, a person’s first $14,000 (in 2017, indexed) of annual gifts to a donee is excluded from federal gift tax.

[2]  See Treas. Reg. §26.2632-1 for a definition.

[3]  A MEC is a life insurance contract that: (1) is entered into or materially changed after June 21, 1988, and (2) fails the “seven-pay test” (see Code §7702A).  A policy fails this test if at any time in the first seven years, the total premiums paid for the policy exceed the total net level premiums that would have been paid up to that point for a fully paid-up policy requiring seven level annual premiums (see Code §7702A(b); §7702A(c)).

[4] See Code §72(v)(2) for the applicable exceptions.

[5] See PLR 9542037. Interestingly, however, the IRS has privately ruled that, after the death of one insured, the exchange of a survivorship policy for a single life policy insuring the surviving insured qualifies as a 1035 exchange (see PLRs 201304003, 9330040, and 9248013 (all involved trust-owned policies).

[6]See PLR 9044022.

[7]See e.g., PLR 9141025.

[8]See PLR 8816015.

[9]See PLR 8816015.  Advisors also should pay attention to potential 1035 exchanges of policies issued before June 21, 1988, as they are grandfathered from MEC testing unless there is a material change, such as a 1035 exchange.

The WR Marketplace is created exclusively for William Boersma, Opportunity Concepts by experts at Greenberg Traurig and the AALU staff, led by Jonathan M. Forster, Steven B. Lapidus, Martin Kalb, Richard A. Sirus, and Rebecca S. Manicone. WR Marketplace #17-24 was written by Greenberg Traurig Shareholder Jonathan M. Forster.

The AALU WR Newswire and WR Marketplace are published by the AALU as part of the Essential Wisdom Series, the trusted source of actionable technical and marketplace knowledge for AALU members—the nation’s most advanced life insurance professionals.

DISCLAIMER

Reprinted by permission of AALU. This information is intended solely for information and education and is not intended for use as legal or tax advice.

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OC Consulting Group – What’s it about?

May 23rd, 2017 No comments

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Insurance By The Numbers

May 4th, 2017 No comments

Help Your Clients Understand What They Are Really Getting For Their Money

Have you ever been talking with someone intelligent who says something which makes you do a double take? I’m talking about the kind of thing which makes you assume you have misheard them because no one could really think that.

Here’s a case in point I often hear in reference to funding a traditional whole life policy. “I keep paying the premium, even though I don’t have to, because it grows the cash value so much.” What’s so crazy about this comment? For full post, click here…

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Giving a Life Insurance Policy to Charity

April 11th, 2017 No comments

Over the past number of months I’ve had a handful of cases come across my desk involving life insurance and charity. As is so often the case, some of the transactions ended up as case stud-ies in what to watch out for.

I understand that not everyone is going to have the same attitude regarding the intersection of life insurance and the non-profit sector but I am somewhat surprised at the black and white policies of charitable organizations I encounter at times. Many charities and non-profits have a policy to simply cash out life insurance policies which are donated. I can’t think of a more short sighted stance. Of course each and every transaction should be evaluated on it’s own merits relative to required premiums, guarantees, life expectancy, use of money, etc. It also doesn’t help that so many non-profits have been burned by life insurance over the years the same as so many consumers have. For full post, click here…

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Managing Life Insurance Like a Pro

March 6th, 2017 No comments

I often talk about “managing life insurance” and advisors occasionally ask me what that means or looks like. Fair question. There are multiple ways to manage life insurance, depending on what type of contract we’re talking about. Today I have a very simplistic and obvious example which is often overlooked.

The bottom line idea behind managing life insurance is the same as managing anything. To manage something is to handle it in a certain way, typically to improve results. We all try to improve the results of financial transactions by managing them, or hiring professionals to manage them, appropriately. For full post, click here…

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Always Say Never

February 7th, 2017 No comments

Sometimes dealing with the details of life insurance can be overwhelming for professionals who lack expertise in this particular market. I’ve written over and over again that it is more complex than most people realize. I can talk until I’m blue in the face about bringing this up for conversation while highlighting the dramatic mutual benefit to advisors and their clients. Only a minority will get on board.

I can’t give up on trying to urge advisors to do something which is so easy and so benign that they won’t fight it; something with such an outsized benefit that it would be silly not to layer it into every conversation. I think I have settled on something with a threshold so low it is a non-issue. For full post, click here…

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Dealing with Potential Estate Tax Change from a Life Insurance Perspective

January 31st, 2017 No comments

I rarely see someone pass up an excuse to not buy or to drop life insurance.  The talk about possible estate tax repeal is certainly one of those current excuses.  Life insurance is something most consumers feel is a need more than a want.  Without being forced into it by responsibility, a contractual obligation, etc, people are not generally lining up to buy it.  It is clearly something which is usually sold.  Rational people will differ regarding this as a reasonable perspective. For full post, click here…

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An Understandable Life Insurance Analogy

December 22nd, 2016 1 comment

There is such a lack of understanding about how life insurance actually works, not conceptually, but really works, that sometimes it is difficult to have a meaningful conversation because you have to back up so far to establish a point of commonality that it is difficult to do so.  Even when people understand that they don’t fully understand it, they still think they have a fundamental, base level understanding but even that is generally wrong.  It is not easy to destroy a foundation that someone believes is sound. For full post, click here…

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“Salvaging Loss in a Life Insurance Policy” Update

November 16th, 2016 No comments

Last month I wrote about the possibilities of salvaging basis on underwater life insurance contracts by utilizing annuities. The discussion included two different aspects of potential planning opportunities.

The first is the common practice of doing a 1035 exchange from a life insurance contract to an annuity. For policies in a gain position, this allows the gain to be deferred. For policies in a loss position, this may allow the salvage of the basis rather than wasting it. The remaining cash value exchanged into an annuity may appreciate tax free. For full post, click here…

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Skyrocketing Premiums

September 7th, 2016 No comments

Recently I read the August 13, 2016 New York Times on-line article “Why Some Life Insurance Premiums are Skyrocketing”. It sounded sensational enough to get my attention and there was a glint of a good message and it made a number of valid points but, based on what I understand about the market, it was also somewhat misleading. The misleading aspect of it centers on the purported cause of the skyrocketing premium increases. For full post, click here…

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