Report No. 10 (Wed. 1/16)
As we have done in January for the last eleven years, and again with the
permission of the University of Miami School of Law Center for Continuing
Legal Education, we will be posting daily Reports to this list containing
highlights of the proceedings of the 42nd Annual Philip E. Heckerling
Institute on Estate Planning that is being held January 14-18, 2008 at the
Orlando World Center Marriott Resort and Convention Center in Orlando,
Florida, a new venue for the Institute starting in 2007. A complete listing
of the proceedings will be published here and is also available on the
Institute's Web site at http://www.law.miami.edu/heckerling.
We also will be posting the full text of each of these Reports on the ABA
RPPT Section's Web site, as we have since the 2000 Institute. Those Reports
can be found at URL http://www.abanet.org/rppt/meetings_cle/heckerling. In
addition, each Report can also be accessed at any time from the ABA-PTL
Discussion List's Web-based Archive at URL
http://mail.abanet.org/archives/aba-ptl.html.
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This Report covers the 2nd Fundamentals Program on the Fundamentals of Life
Insurance that was held on Wednesday afternoon. We anticipate that the next
Report will cover a missing session from Tuesday afternoon and the balance
of the Wednesday sessions, including the ever popular Q&A session.
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Fundamentals Program #2 - Fundamentals of Life Insurance in Estate Planning
- What You Need to Know and What You Think You Know
Wednesday, January 16, 2008
Presenters: Lawrence Brody and Mary Ann Mancini
Reporter: Craig Dreyer
Mr. Brody opened the discussion noting the various developments in types of
insurance created in the recent time period. He noted many types of life
insurance have an implicit financial risk that most clients are not aware of.
Ms. Mancini then proceeded to discuss the various code sections involving
life insurance. She noted the first part of the outline has more
information on policy and policy product. The second portion of the
outline is estate planning with life insurance. She also highlighted that
planning the investment portion of the policy is often as important as
planning the death benefit.
She noted that life insurance is made up of two components. 1) The death
benefit for designated beneficiaries. 2) The investment feature behind a
policy. Whole life is an example of an insurance policy with an investment
feature. In order to qualify as an insurance policy one must be careful
the investment portion is not too large which disqualifies it as a life
insurance policy. The rules for qualifying as an insurance policy are laid
out in IRC section 7702. It provides that to qualify as life insurance 1)
a contract must be valid under state law as an insurance contract; and 2)
it must meet the cash value accumulation test and the guideline premium
test (based on actuarial computations). The best way to see if a policy
qualifies is to see if the terms of the policy require it to meet the
requirements of section 7702.
A modified endowment contract "MEC" has different income tax consequences
than other policies due to the investment feature in the policy. These
polices are designed to have cash front-loaded to grow the investment
portion of the policy. They are defined under 7702A. She noted if an
investment portion is too large you can run into trouble. The MEC allows
more premiums on a cumulative basis than would be required to pay up the
policy at the end of a seven year period. Due to this investment feature,
the income tax treatment differs from other insurance policies.
The rules for insurance policy income taxation are found in section
72(e). This section governs what happens if a policy is sold, surrendered,
or a loan is taken out. Life insurance is an attractive investment due to
the cash buildup feature inside the policy that is not subject to income
tax as long as held in the policy. This is referred to as the tax-free
buildup in the policy, which can create large amounts of appreciation. The
buildup of cash value is included in taxable income of owner if the policy
ever fails to meet section 7702. Section 7702 was enacted in 1984, so it
applies to policies after 1984. Policies after '84, if they fail to meet
the 7702 tests in a subsequent year, have the entire inside buildup in
prior years accrued forward to be taxed. The insurance protection portion
that represents the amount of premium allocable to the death benefit can
also be taxable income if the policy fails to satisfy the test under
section 7702. If one needed to acquire a policy in same year with insured
in same age, how much would it cost to get the pure death benefit. This is
the cost of current life insurance. Table 2001 was part of notice 2001-10
providers this cost. Additionally, one can also go back to same insurance
company and if they have a rate generally available to the public, for a
pure death benefit then one can also use this rate as the current cost of
life insurance. If one takes out a policy loan, you are borrowing money
from the insurance company and they use the policy as security for the
loan. The loan can only be paid from the policy proceeds upon death. Thus,
this will limit lending levels in loans. If there is a policy loan and one
takes out cash, the policy loan will not be included in taxable income even
if it exceeds the policy contract.
Investment in a contract is defined under 72(e)(6). It is a very similar
concept to basis. She also noted if insurance is transferred to a grantor
trust it is ignored for income tax purposes. So normally one does not worry
about transferring policies with policy loans. However, if the trust is
separate taxpayer there may be tax.
MEC rules differ from regular insurance contracts. The first rule in a
MEC is if you pull out money in the form of a loan, it is includable in the
income of the owner to the extent of cash value above the contract, which
comes out first. The investment in the contract comes out second, but will
be tax-free. Congress did this to ensure MEC's were used as insurance and
not used for investment purposes. If an owner makes a policy loan from an
MEC, the owner has taxable income and if the owner is under 59 ½, they also
pay a penalty of 10% unless it is under disability or it is drawn out in a
series of equal payments.
Outright policy withdrawals from insurance contracts are not a loan. If an
owner makes a policy withdrawal the money will be tax free to the owners to
the extent of the investment in the contract. Any amount above the amount
invested is taxable. The MEC's pull out income first and then
principal. Policies often mature as people outlive policies. At time
policy matures or someone surrenders a policy the people get the cash value
in the policy with cash value policies. Just like policy withdrawals, the
amount that exceeds basis is taxable income.
The sale of policies in life settlements and viatical settlements does not
fall under section 72 explicitly. It is an unclear area for tax
treatment. However, section 1035 permits tax-free exchanges of
policies. Old and new policies must be on the same insured. Thus one
cannot use a tax-free exchange to change a single life policy for a second
to die policy. If an owner receives any boot in the exchange, then the
boot will be subject to income tax. Additionally, she noted a tax free
section 1035 exchange will not be effective if it transfers a policy to a
non-US citizen.
If an insured dies with a death benefit under section 101(a)(1), the death
benefit proceeds are not subject to income tax. However she noted, the
death benefit can be subject to income tax in two instances. First, under
a transfer for value rules under section 101(a)(2). There are exceptions
under transfer for value rules if the transfer is to the
insured. Furthermore, she noted the IRS recently said if a transfer for
value was to grantor insurance trust then it will fall within the first
exception to transfer for value rules. The second exception is if the
recipient's basis in the policy is determined in whole or in part to a
transferor's basis. This can be done by gift or part sale and part gift
such as transferring the policy with a policy loan in which case loan
amount must be less than transferor's value of the contract so the
recipient determines part of value of contract under transferor's
basis. The third exception is transfers to a partner, partnership under
which partner is insured, or to a corporation for value if the insured was
a shareholder or officer of the corporation. She notes if an individual is
director or employee and not a shareholder the rules do not apply. The
second instance of being subject to income tax is under employer owned life
insurance policies. She noted the famous Wal-Mart case where the death
benefit was paid to employer and not the families. In response congress
passed section 101(j) that subjects certain corporate owned policies to
income tax on the death benefit, if notice and consent of the employees is
not given along with other additional requirements.
Mr. Brody then continued to discuss the basic vocabulary of insurance
policies. He discussed Risk Shifting, Risk Sharing, Moral hazard, Adverse
Selection, and Insurable Interest. He reiterates that beyond traditional
whole life policy, there is financial risk associated with insurance
policies. One must be sure clients place too much credence in
illustrations. He noted an important question to ask with term policies is
how long the term policy can be renewed, and how long the policy can be
converted to a permanent or level plan.
With a permanent insurance policy the pricing consists of three parts: (1)
a mortality charge, generally based on the mortality tables which will be
updated in 2009 to reflect a lower mortality rate from the 1980 tables, (2)
expense loading, including sales commissions, underwriting, and
administrative expenses; and (3) investment experiences or returns (on the
savings). He also noted that persistency is the amount of time the policy
is on books. Policies often take into account lapse to lower
pricing. This is one reason why life insurance companies are against life
settlements and sales to financial companies. He also noted the client and
advisors must understand the limitations of illustrations, a client may not
want the best case policy, but may want to pay more to ensure it is still
there. One may look for a company with reasonable results, may want to
hedge bets with multiple policies and pay more in beginning to pay less
later in life. He noted that illustrations are like an investment broker
predicting the value of a stock in 50 years. With permanent insurance
policies they are using an increase in cash value to pay premiums if the
rates decrease. An important question to ask is if there is a commitment
to fair treatment of in force policyholders.
The whole life policy has a fixed premium due each year. There is a fixed
death benefit. This can increase through the use of dividends to provide
additional term insurance. Only borrowing can decrease the death benefit.
This policy can be maintained for life, but many policies can have
additional premiums that continue or return when investment returns
decrease. If premiums are paid the death benefit is guaranteed. The cash
value is subject to claims of creditors of insurance company and the same
is true of universal life polices, but variable policies cash value is not
subject to the creditors of the insurance company. A whole life policy with
a term policy rider provides the benefit of lower premiums, but increases
risks.
Universal life policies grew out of the traditional whole life
policies. It went one step beyond whole life by not guaranteeing the
entire amount of the interest. One receives fixed income interest rate
minus costs to manage. Thus the risk was spread out. These can have level
or increasing cash benefits. With an increase in cash value there is a
higher premium. Also they are general accounts and subject to the claims
of creditors of the insurance company. These also allow flexible premiums
within some broad guidelines to remain under section 7702. In addition to
borrowing without surrendering, one can withdraw from the accumulation
element at no interest, but there is no interest received on the amount
taken out. A term rider can blend universal and term policies. Mr. Brody
also discussed the effects of decrease in interest rates and it shows that
the policy can terminate. Thus, the policy requires ongoing monitoring to
ensure it remains in effect.
With a variable policy the insurer does not retain any risk. Funds are
offered under the policy and the owner may choose multiple investment
options. In these policies complex diversification and owner control rules
ensure the owner does not make investment decisions for the funds
themselves but can only choose the type of investments. There is a
potential for increased return if the equity returns are higher than fixed
returns. In a variable policy one wants a tax inefficient investment
policy with high returns. The SEC is also involved in the regulation. This
type of insurance must be continuously monitored.
In a survivorship insurance policy the death benefit will pass only on a
second death, usually between a husband and wife. Policy payments continue
after death of the first spouse. This type of insurance is used primarily
for estate planning and business planning. Additionally, upon divorce a
policy can be split a policy into two separate coverage without
underwriting, one can add a first-death term benefit, can provide automatic
increase in cash benefit on first death, and can vary death benefits as
time goes on. The benefit of second to die policies is that they are
cheaper than insurance on a single person.
Ms. Mancini then discussed estate taxation of proceeds. She discussed how
section 2042 determines whether a death benefit is included in the estate
of the owner. Under section 2042(1), if proceeds are obligated to be paid
to the estate, than that amount even if the owner and beneficiary is an
insurance trust, will cause estate tax inclusion, which is why insurance
trusts allow payment to an estate or purchase of assets for fmv and it is
not a mandate or requirement. She also notes that divorce settlement
agreements requiring maintenance of an insurance policy on a spouse
requiring payment on death to the spouse brings the insurance policy into
the estate of the decedent.
Under section 2042(2) death benefit can be subject to estate tax regardless
of whether the insured owns the policy or not, but if they have economic
benefits over the policy. If so, the death benefit payable is included in
the insured's estate. Economic benefit includes the power to borrow
against the policy, change the beneficiaries, and withdraw funds. Even
indirect control such as if insured is trustee of trust, or corporation
holds the policy and the insured is the majority shareholder of the
corporation can create inclusion.
Additionally, section 2035 provides if an individual holds a power during
lifetime within three years of his or her death relating to section 2035,
even though not held at death, if transfer was not for full and adequate
consideration the power pulls the asset back into the estate. Section 2035
includes section 2045 powers. These proceeds come back into the estate for
estate tax purposes. The proceeds will be paid to the beneficiary, but may
leave the estate without money to pay the tax. Full and adequate
consideration is the face amount of the policy. It is difficult to
determine the fair market value of a policy under section 2035. This is
important to determine when taking into consideration the within three
years of death estate inclusion rule.
For gift tax purposes one must use fair market value of an insurance policy
for under regulations 25.2512. The regulations provide the fair market
value is the replacement value on the date of the gift, but this is not a
simple answer. If the insured purchases policy and gifts immediately, the
value is the initial premium. However, if insured held policy and then
got sick what is the replacement value? Regulations make clear all the
rules fall by the wayside if they don't approach reasonably close value to
fmv of the policy. If insured is terminally ill the value is likely very
close to the death benefit. To determine the replacement cost one must
take the sum of 1) the interpolated terminal reserve value of policy
received from insurance policy, and the portion of the year's premium or
prepaid premium and dividends and take out any loans. Additionally, the
fmv of policy must be reasonably close to such value. Under the gift tax
regulations valuation safe harbor rev. proc 2005-25 only applies to section
83 and qualified plan policies, but should not be ignored for other
reasons. Cash value is the cash value without taking into account
surrender charges imposed on the policy. The life settlement market may
have impacted the value under gift tax regulations since a new market
creating additional value has been created.
A transfer of a policy to an irrevocable trust is a gift. The transfer of
money to a trustee to pay a premium is a gift, but the gift to trust is a
future interest. It is important to make a present interest gift so that we
can obtain the $12,000 annual exclusion. In order to create such a present
interest gift one must force on the transfer a particular condition to
create a present interest gift. The Crummey case provides that if a
transferee has unilateral right to money transferred to trust and for a
reasonable period of time, the gift is considered a present interest gift
notwithstanding the gift to trust. The common method to do this is to
provide withdrawal rights for 30 days by notice. If the beneficiary of a
trust is a sole beneficiary and the gift is included in the estate of the
beneficiary at death, it will also be treated as annual exclusion for GST
purposes. If not an annual exclusion gift must use exemption. The
beneficiaries right to withdraw is a general power of appointment, so when
there is a lapse, they have also made a gift to the trust. This is a
future interest gift to trust. The insurance trusts often include language
to create an incomplete gift if the right lapses. She noted that if one
actively releases power of appointment, the five or five power would be
deemed to be a full gift of a future interest and not qualify for the
annual exclusion. So one must not release such a power prior to lapse. The
second way to address this future interest gift is with a hanging power,
which is more common in GST trusts. Instead of beneficiary LPOA every
year, one hangs the power and it continues on for multiple years. When
policy is planned to have the premium vanish or the cash value is large
enough to let the 5% amount grow so large it covers the hanging amounts.
Mr. Brody then continued by discussing leveraging techniques to pay
premiums. The two techniques he discussed were split dollar and premium
financing. Both techniques essentially allow a third party to advance money
to trust, which the trust will pay back. He noted both have a fatal flaw
if the client decides to live too long. Thus, one needs an exit strategy
when using these techniques in trust. He mentioned using a side fund in
the trust to ensure the trust could repay the loan or using split dollar
advances without taking money out of the policy. He noted premium
financing with commercial interest makes sense for older person in single
life policies, as term policies are too expensive. An exit strategy is to
leverage trust with things other than the policy. One can sell trust
assets for a note; use GRAT's or other techniques to get assets into the trust.
The question and answer session brought up discussions relating to premium
financing that can be used at a lower AFR, instead of outside commercial
financing agreements. Using hanging crummy power could lead to trustee
liability, as there may not be enough cash to make the premium payment. It
was noted; the rights to withdraw must be realistic. To pay premiums the
trustee must also be able to satisfy the liability and the trustee may be
able to borrow against policy to satisfy it. It was discussed that a split
policy funded in a trust by a corporation would be treated as compensation
to the employee and then a deemed gift to the trust from the employee. If
the insured loans money for a trust to pay premiums they must not have an
unrestricted collateral assignment. They should do so on an unsecured basis
to avoid the risk of inclusion in the estate. There was also a discussion
of the grantor rules and the reciprocal trust doctrine for insurance trusts.
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THE REPORTERS
Our on-site local reporters who are present in Orlando this year are Gene
Zuspann Esq. of Zuspann & Zuspann in Denver, Colorado; Joanne Hindel Esq.
of Fifth Third Bank in Cleveland, Ohio; Jason Havens Esq. of Howard, Mobley
& Havens PLLC in Florida and Tennessee; Kimon Karas Esq. of McCarthy,
Lebit, Crystal and Liffman Co., LPA in Cleveland, Ohio; Bruce Stone Esq. of
Goldman, Felcoski & Stone, PA in Coral Gables, Florida; Craig Dreyer Esq.
of McDonald Hopkins LLC in Cleveland, Ohio; Carol Sobczak Esq. of The Law
Offices of Carol A. Sobczak in St. Helena, California; Ronda Martinez Esq.
of Fifth Third Bank in Southfield, Michigan; and Mike Stiff Esq. of
Hutchins & Stiff LLC in Denver, Colorado. The editor again this year will
be Joseph G. Hodges Jr. Esq, a solo practitioner in Denver, Colorado, who
also is the Chief Moderator of the ABA-PTL List.
_________________________________________
GENERAL INFORMATION ABOUT INSTITUTE:
Inquiries/Registration:
Philip E. Heckerling Institute on Estate Planning
University of Miami School of Law
Center for Continuing Legal Education
P.O. Box 248087
Coral Gables, FL 33124-8087
Telephone: 305-284-4762 / FAX: 305-284-6752
Web site: www.law.miami.edu/heckerling
E-mail: heckerling@law.miami.edu
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8701 World Center Drive
Orlando, FL 32821
Telephone (407) 239-4200, FAX (407) 238-8777
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NOTICE: Although audio tapes of all of the substantive session at the Miami
Institute currently are only made available to Institute registrants for
purchase, the entire proceeding of the Institute are published annually by
Lexis/Nexis. For further information, go to their Web site at
http://www.lexisnexis.com/productsandservices. The text of these
proceedings is also available on CD ROM from Authority On-Demand by
LexisNexis Matthew Bender. For further information, contact your sales
representative, or call (800) 833-9844, or fax (518) 487-3584, or go to
http://www.bender.com, or write to Matthew Bender & Co., Inc., Attn: Order
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