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«Aggregated Summary of Reports Provided by ABA-PTL and ACTEC-Prac List serves 2015 Heckerling Estate Planning INSTITUTE Edited, Aggregation of On-Site ...»

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Session II-D Life Insurance as an Asset Class (Financial Assets Series) Lawrence Brody, Mary Ann Mancini, Charles L. Ratner This panel will discuss planning with life insurance in a post-ATRA world, including life insurance as an investment, reassessing the need for estate liquidity, techniques for paying large premiums on trust-owned policies, managing existing policies and programs, and addressing issues with existing policies in ILITs. This panel discussed planning with life insurance in a post-ATRA world, including life insurance as an investment, reassessing the need for estate liquidity, techniques for paying large premiums on trust-owned policies, managing existing policies and programs, and addressing issues with existing policies in ILITs. This Report covers the significant highlights.

Mr. Brody, Ms. Mancini and Mr. Ratner presented different considerations with regard to life insurance. Mr. Brody began the session with a discussion of the tax consequences of various transactions with life insurance and modified endowment contracts. Next, Mr. Ratner walked through the tax advantages of investing in insurance.

Ms. Mancini concluded the session by offering solutions for broken insurance trusts.

Mr. Brody’s presentation began with the definition of life insurance for tax purposes under Section 7702. The policy must be valid under applicable law and meet either the cash value accumulation test or the guideline premium test, both when the policy is issued and throughout the policy’s existence. The guideline premium test requires the ratio of death benefits to cash value to be at least as great as the 7702(d)(1) cash value corridor.

Variable policies must also be adequately diversified under Section 817(h). Private placement variable policies must further meet an investor control test.

Mr. Brody assured the audience that we do not each have to go through Section 7702 and perform the actuarial tests. Instead, the advisor can rely on the policy illustration.

Next, we turned to Modified Endowment Contracts (MECs) under Section 7702A, which applies to policies issued on or after June 21, 1988. If a client pays too many premiums too fast (usually within the first seven years of the policy), a MEC will be created. This is an actuarial calculation that can only be made by the carrier. The carrier should also be expected to monitor premium payments and reject any premium payment that would create a MEC. For income tax purposes, a MEC is still life insurance if it satisfied Section 7702, and it will qualify for the 101(a)(1) income tax free exclusion (but is subject to different tax rules when cash comes out of the MEC in various manners). Once a MEC, always a MEC. The contract cannot just be changed to get rid of MEC status.

The standard rule for insurance is that increases in the cash value of the policy are not taxable income unless and until it is accessed in a tax inefficient way (surrender, withdrawal in excess of basis, etc.). This rule also applies to MECs, assuming the policy still meets 7702(a) requirements.

Mr. Brody then turned to the tax consequences of policy dividends, loans, withdrawals, surrenders and lapses.

Policy dividends are generally nontaxable, until the basis in the contract is fully exhausted.

Loans against an insurance policy are generally not taxable income, even if the loan exceeds the owner’s basis in the policy. But, if the policy is transferred (even by gift) when the amount borrowed exceeds the basis, then it is treated as a part sale with taxable gain on the sale, and will be transfer for value (unless the transfer or transferee is exempt from the transfer for value rules).

Loans and withdrawals are not the same thing. Withdrawals can be made from universal life policies from the policy accumulation accounts. A policy withdrawal is generally not taxable; instead, if simply decreases the available accumulation account. One exception is the forced-out gain (“FOG”, which Mr. Brody noted was the perfect acronym) provision, which provides that if a withdrawal is made in the first 15 policy years and it does not reduce the death benefit, it is taxable income. See Section 7702(f)(7).

What about loans or withdrawals from MECs? Mr. Brody noted that these will generate taxable income to the extent the cash surrender value of the policy just before the loan or withdrawal exceeds the investment in the policy. Remember, in a MEC, basis comes out last, income comes out first. In order to protect against end runs around this, there is also a rule that if a MEC is pledged as collateral for a third party loan, that loan is treated as though it was a withdrawal from the policy, creating the same income tax consequences. Mr. Brody pointed out that the MEC consequences don’t end there. Under Section 72(v), there is a 10% penalty tax for any distribution, including a loan, from a MEC unless an exception applies, the most common of which is the taxpayer has reached age 59½. Note it says taxpayer, not policy owner. What if the policy is owned by a trust? It is not spelled out, but industry practice is to look to the grantor (if the trust is a grantor trust) and use the grantor’s age to determine if the penalty will apply.

When a policy is surrendered or lapses, amounts received are taxable to the extent the surrender proceeds exceed the investment in the contract. So surrendering the policy will always generate income to extent there are gains in the policy. Everyone assumes that surrender proceeds are taxed as ordinary income, not capital gains, because the sale/exchange component is not there (the policy was not sold, it just went away). Mr. Brody pointed to a potential argument for capital gain treatment: Section 1234A. This treats the expiration of financial instruments (like options) as capital transactions without a sale or exchange component. Could this apply to surrender of policy? Although there are no reported cases to this effect, Mr. Brody successfully settled a Tax Court case on this basis.

Be cautious when surrendering a policy with a loan against it; the amount of the loan will be included in surrender proceeds. This total in excess of the investment in the policy is the taxable portion, and your client might be surprised by a tax bill resulting from loan proceeds previously taken out (and not taxed at that time).

What about the sale of a policy? This will generally create capital gain (although gain in excess of basis, up to the surrender value, will likely be treated as ordinary income). Note that Rev. Rul. 2009-13 was specific to the life settlement market, and there are arguments both on both sides as to whether it would apply, for example, if the policy was sold to a relative or to a grantor trust.

Having had the tax consequences of insurance transactions explained by Mr. Brody, Mr. Ratner took to the podium to focus on the tax advantages of insurance as an investment.

Mr. Ratner noted that there are tax advantages with life insurance that cannot be obtained with any other investment.

Mr. Ratner began with three caveats. First, remember that a client’s happiness with a policy over the years does not usually hinge on the tax ramifications. Instead, the client is concerned with how the policy is structured, the bells and whistles on the policy, the amount of the premiums, etc. In other words, be cautious about focusing the client discussion entirely, or even mostly, on the tax implications and benefits of insurance. Second, calling life insurance something other than life insurance is a rouse. Third, do not talk about the availability of Section 1035 to exchange a policy as though it is as easy as getting your oil changed. There is no guarantee that the insured will be just as healthy in future years. There are costs involved. There could be loans against the policy. Treat the policy as though it could be the last policy the client is ever able to buy.

Mr. Ratner then reviewed various insurance products at a high level. He expressed that he has no preference as to type, it is just critical that the client gets all of the information. He believes there is a product for everyone. If someone walks away without a policy, it is probably because a) they do not want to take a physical, b) it is too complicated of a mousetrap, or c) they have unrealistic expectations.

He has observed the acute differences between the ways a liquidity buyer and an investor look at a policy’s cash value, premium, and death benefit. A liquidity buyer does not care about cash value, asks why the premium can’t be lower, and wants the death benefit. (Mr. Ratner explains a different version of the Theory of Relativity: if the check someone is writing is not going to benefit them, but instead will mostly benefit his relatives, the slower the check will be written.) On the other hand, an investor asks why it takes so long to get money into the policy, what if I change my mind, let me see the costs, why do I have to wait so long to take money out, why do I need such a large death benefit. The investor is also far more interested than the liquidity buyer in the post-sale services offered.

Mr. Ratner then turned to the types of life insurance products, and briefly described whole life term blend policies, current assumption/performance based universal life (CAUL), equity indexed universal life (EIUL), variable universal life (VUL), and private placement variable universal life (PPVUL). With regard to PPVUL, he emphasized the caveats from the beginning of his presentation. He cautioned that the tax discussion on this product must be short if the client is going to have the attention span and time to understand the product. Also, with regard to 1035 exchanges, who knows what the market for this product will look like in ten years.

No matter what you do:

1. Get the client to become invested in this process. Make sure they understand that a lot of work is going into this on the front end.

2. Make sure there is an early indication of underwriting classification. Without this, illustrations are meaningless.

3. Do not assume that the bid that comes back with the lowest premiums is the best deal. Ask why that carrier won. Look at the numbers behind the policy, and be sure to look at the strength and history of the carrier.

Ms. Mancini then transitioned to discussion to what to do when you a have strong insurance policy, but it is stuck in a trust that just is not working. Perhaps there has been a divorce or other change of circumstances that make the trust no longer desirable, or maybe the trust doesn’t have the “right” tax provisions. Ms. Mancini discussed four alternative methods to get a policy out of the trust and into the right hands, and pointed out that there are drawbacks to each method.

First, the trustee could sell the policy. The biggest advantage here is that the trustee can sell the policy to anyone, rather than being bound by the distributive provisions of the trust. The sale of a policy can bring up some issues.

What if the purchaser wants to buy the policy with a note? This could backfire in a few ways. The insured could die shortly after the sale, leaving the beneficiaries wondering why the trustee would have sold the note when the purchaser now has the death benefit in cash while the trust still holds a note. Or, the purchaser could fail to pay on the note, knowing that the trust no longer has any liquidity with which to pursue any action against the buyer. The trustee needs to make sure they take appropriate steps to have adequate security for the note and perhaps even some liquidity remaining inside the trust in order to protect itself from claims against the beneficiaries.

The sales price of the insurance policy can be another significant issue for a trustee. Ms. Mancini pointed out that a trustee must be able to show that the trust received fair market value for the policy. If the policy is sold for too little money, there is an argument that the trustee has made an impermissible distribution from the trust (assuming the purchaser is not a beneficiary entitled to distributions). If the policy is sold for too much money, has the purchaser made a gift to the trust? Ms. Mancini reminded the audience to take the transfer for value rules (and the exceptions) into consideration.

Second, the trustee could distribute the policy. This is clearly limited by the distribution provisions of the document. The distribution technique could be hindered by inappropriate eligible beneficiaries (i.e., minors or multiple owners who would want to split the policy), limited distribution standards (could the trustee consider the distribution of a policy as a distribution for the beneficiary’s “support”?). Ms. Mancini pointed out that if the distribution provisions are the problem with the trust to begin with, this is likely not a good solution.

Third, the trustee could decant the policy. This could occur pursuant to a decanting statute, terms of the trust agreement if the agreement provides for distributions to another trust for the benefit of the beneficiary, or by common law, i.e., the law of the state provides that a distribution to or for the benefit of a beneficiary includes the option to distribute to a trust for the beneficiary. But decanting is not a magic bullet. There are issues with notification requirements. For example, if a beneficiary who would not be a beneficiary under the receiving trust does not object, is there a potential gift? Also, remember that many insurance trusts have Crummey powers.

Watch out for hanging Crummey powers, and be sure to leave enough in the original trust to satisfy any outstanding withdrawal rights Finally, a provision to substitute assets could be utilized, if applicable. Ms. Mancini discussed the fairly recent Revenue Rulings that found that the right to substitute assets retained by a grantor is neither an incident of ownership over the insurance policy nor a retained interest that may cause estate inclusion of the policy. She pointed out that both Revenue Rulings discuss the right to substitute assets of “equivalent value” without defining it, but if you look back to the original case underlying these Rulings, the case referred to “equal value” which it expressly defined.

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