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1 client who has a personally owned life insurance policy comes to you. You convince her to either sell or gift the policy to an irrevocable life insurance trust (ILIT). You need to get the value of the policy, so you call the insurance company. It quotes a value so high that you and your client get sticker shock! The gifting or sales strategy suddenly becomes unattractive, if not totally impossible. The above scenario isn t that unusual. Life insurance policies are often gifted or sold to accomplish a variety of estate-planning objectives, and the valuation can be critical to the transaction and its ultimate success. But the problem is that there s no recent guidance for valuing life insurance policies for gift and estate tax purposes. The regulations that do exist are 37 years old and don t relate to the majority of policies available today. And the valuation numbers obtained using those outdated methods can be in conflict with what a willing buyer and willing seller would actually negotiate. So what should an advisor or estate planner do? First, let s look at the history of the valuation of life insurance policies to understand why the existing methods are outdated for use with today s policies. Then, we ll examine potential solutions that offer a more realistic valuation approach for modern insurance policies. Employing more appropriate valuation methods can (hopefully) prevent sticker shock and help your client meet her estate planning objectives. The two Treasury regulations that apply to valuing life insurance policies, Treasury Regulations Sec- tions and , were last amended in In those days, insurance companies primarily sold (with minor variations) two types of products: annual renewable term (ART) insurance and whole life insurance. Calculating the value of those products was fairly simple. ART insurance had no reserves, so the value of the policy was determined by looking at the unearned premium at the time of the transfer. And it was simple to determine the unearned premium: You d take the premium already paid during that policy year and multiply it by a fraction. The fraction s denominator was the total number of months the premium covered, and the fraction s numerator was the number of months from the current date until the date the next premium was due. For example, it s July 1, and Bob wants to transfer his ART policy into an ILIT. He already paid an annual premium of $2,000 six months ago on Jan. 1. This premium covered the entire policy for all 12 months of the current year. The period remaining until the next premium is due is six months (that is, until Jan. 1 of next year). We compute the unearned premium as follows: $2,000 (premium) multiplied by 6 months (period remaining), divided by 12 months (number of months premium covers), or Unearned premium = $2,000 x 6/12 = $1,000. To calculate the value for whole life insurance that s been in force for several years or longer with premiums remaining, the insurance company would use the interpolated terminal reserve (ITR) value. In most instances, the cash surrender value of a whole life policy and the ITR are almost identical. That s because whole life has fixed premiums and a guaranteed death benefit, so the insurance company knows how much reserve it needs

2 on each policy anniversary based on the receipt of future premiums and the anticipated death benefit. The amount needed during the policy year is determined by taking the reserve at the end of the current policy year, the reserve at the end of the previous policy year and then interpolating from those reserves a value for the whole life policy. For example, the insurance company would first subtract the policy s prior year reserve from the reserve at the end of its current policy year. Next, it would multiply this difference by a fraction the numerator is how many months of the current year the policy was in existence, and the denominator is 12 (that is, a full year). The company would then add these results to the reserve of the previous year. This result is added to the unearned premium. (Finding the unearned premium for whole life is the same as finding it for ART above.) It s easier to understand these calculations with a concrete example, such as the one offered in Example 4 of Treas. Regs. Section Assume that four months into the policy year, an individual wants to gift his whole life policy. The reserve at the end of the current policy year is $14,601. The reserve at the end of the previous policy year is $12,965. The policy premium is $2,811. Here s how to figure out the value of the whole life policy: Step 1: Subtract $12,965 from $14,601: The result is $1,636. Step 2: Multiply the result by a fraction, with a numerator of 4 months and a denominator of 12 months: $1,636 x 4/12 = $545. Step 3: Add the result of step 2 to the end of the previous year reserve: $12,965 + $545 = $13,510. Step 4: Compute the unearned premium: $2,811 x 8/12 = $1,874. Step 5: Add the unearned premium to the results in step three to find the value of the policy at time of transfer: $13,510 + $1,874 = $15,384. Note that an insurance company would adjust this value for dividends that were accumulated, the cash value of any paid-up dividend additions and any loans plus accrued interest outstanding at the time of the transfer. A lot has changed over the past 37 years since the Internal Revenue Service promulgated Treasury regulations relating to the valuation of life insurance policies. First, ART is no longer sold. Equally as important, two new products with variations have come to the fore: (1) term with level premiums for a guaranteed period of anywhere from 10 years to 35 years, and (2) universal life (UL). In the first product, because of the guaranteed level term premium, an insurance company statutorily has to have reserves and those reserves are considerably greater than the unearned premium used to calculate the value of ART policies. (For example, I ve come across a 20-year level term policy for $7 million with annual premiums of $20,000 per year. The insurance company gave a reserve value of $400,000.) The second new product, basic UL, is a flexible premium policy and this makes valuation more complicated. The owner can decide how much premium he ll pay (known as the planned premium ). The planned premium can be any number from zero and up, depending on the length of time the policy has been in force. Finally, based on the premiums actually paid, policy expenses, mortality costs and earnings, the policy may run out of cash value or lapse unless a greater amount is paid in the future. While the expense charges and mortality costs have guaranteed maximums and the crediting rate on what s called the accumulation value has a minimum interest rate in the plain vanilla UL, the charges actually applied are usually lower and the interest credited usually higher. The accounting is done on a monthly basis and reflects all rates in effect for that particular month. Note that the mortality costs are based on an annual renewable term, with the rate charged based upon an insured s attained age. The charges are reported on a statement issued on the policy anniversary. To compete with UL, life insurance companies that offer whole life added new dividend options. Instead of buying a policy that s all whole life, it s now possible to buy a blend of whole life and term insurance supported by dividends. In effect, while still a fixed premium policy, the amount that a policy owner pays is

3 reduced because of the assumptions about future dividends amortized into the initial cost. Dividends aren t guaranteed and the mortality cost associated with the term insurance element is also an annual renewable term. There s a maximum guaranteed term rate, but the term cost charged to the policy dividends is usually less. The ability to purchase the extra insurance above the amount provided by the basic policy is based on the actual dividend paid. With decreasing interest rates, dividends in older policies have been reduced from what were projected, and therefore the amount of insurance may revert to something more than the whole life base, but not the full amount originally insured. An example is a policy with a $1 million total face value; $500,000 of that face value comes from the dividend-supported rider. Over time, if the dividends are less than projected, that $500,000 may decrease. In the past, the insurance industry used different standards to value policies, particularly in the context of determining the income tax consequences of distributions from retirement plans or as compensation. Prior versions of Treas. Regs. Sections and 1.402(a)-1(a)(2) used the cash surrender value to determine income tax consequences. Insurance companies, however, abused the strict use of cash surrender value by developing springing or suppressed cash value whole life policies. In springing or suppressed cash value whole life policies, the premiums were high and the cash value was initially low, until some point in the future at which time the cash value would rise dramatically. But before the cash value rose and after the bulk of the premiums were paid, these policies would be transferred from an employer to an employee or distributed from a qualified retirement plan to a participant, and the policy owner would use the low cash value figure as the value for income tax purposes. The recipient (that is, the new policy owner) would reap the benefit of the sudden increase in cash value but with income tax consequences based on a low cash value at the time of the transfer. The IRS addressed this abusive practice in Notice 89-25, recognizing that the cash value didn t accurately reflect the value of the policy, and instead used the reserve value for income tax purposes. The insurance industry developed a similar abusive strategy using UL contracts. Unlike whole life, a UL policy reflects two accounts in its reporting to the policy owner: the accumulation value (the changes in value in the contract) and the cash surrender value (the result of subtracting a surrender charge, which is the amortization of acquisition costs such as commissions over some period of time, from the accumulated value). Insurance companies would either make the surrender charge disappear quickly after the transfer of the policy or allow the full accumulated value to be exchanged into a new policy with lower surrender charges without underwriting. The IRS issued Revenue Procedure (which superceded Rev. Proc ) to address this abusive practice. Rev. Proc cites Proposed Treas. Regs. Section 1.402(a)-1(a)(1)(iii), which states:... a distribution of property by a trust described in section 401(a) and exempt under section 501(a) shall be taken into account by the distributee at its fair market value. In the case of a distribution of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, or any interest therein, the policy cash value and all other rights under such contract (including any supplemental agreements thereto and whether or not guaranteed) are included in determining the fair market value of the contract. This revenue procedure created a safe harbor formula that can be used as fair market value (FMV). The safe harbor formula defines FMV... as the greater of: A) the sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, and B) the product of the PERC amount (the amount described in the following sentence based on premiums, earnings and reasonable charges) and the applicable Average Surrender Factor described in section 3.04 of this revenue procedure. 1 For simplicity, in most cases the PERC value of a UL policy is the accumulated value previously described. In a recent Tax Court case, Matthies v. Commissioner, 2 the court held that the accumulated value, not the cash surrender value, was the appropriate value for a policy transferred from a profit-sharing

4 plan to a participant in This ruling was about a transaction that was done before the issuance of Rev. Proc The policy accumulated value (not surrender value) was exchanged into a new policy. In a more recent case, Schwab et al. v. Comm r, 3 the court created its own methodology in determining the value of a policy transaction that came before Rev. Proc It determined how long the policy would remain in force without any additional premiums and multiplied that by the term cost shown in the policy in effect using the unearned premium method to value term insurance. Some version of this approach seems to be a realistic way of valuing a policy. As shown, new products don t readily lend themselves to the previous valuation methodology. Guaranteed level premium term policies have a reserve. Insurance companies calculate reserves on UL and all its variants but there s no uniform reserving method. 4 Form 712, on which an insurance company reports the value of a policy either owned by a decedent on another, or being gifted from one party to another, specifically uses the ITR plus adjustment as the method to report the value. There s no room for discussion or negotiation if the value reported on a Form 712 is much higher than expected. Why? Because the reporting party is an officer of the insurance company, using a figure calculated by an actuary, with the entire process supervised by the insurance company s legal department to avoid liability. I had a client with a $4 million UL policy with a guaranteed death benefit, but no cash value. The client wanted to gift it to an ILIT. The insurance company came back with a value of $4 million the full death benefit despite the fact that according to mortality tables, his death wasn t expected for another 20 years! The client decided against making the gift. The use of the procedures on Form 712 don t relate to most policies sold today. They even conflict with the general regulations. For general gift and estate tax purposes, Treas. Regs. Sections and use the willing buyer, willing seller method of valuation. Treas. Regs. Section states: The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. The value of a particular item of property is not the price that a forced sale of the property would produce. Nor is the fair market value of an item of property the sale price in a market other than that which such item is most commonly sold to the public, taking into account the location of the item whenever appropriate. Looking at the willing buyer, willing seller paradigm, the only market for policies at other than the cash surrender value is the life settlement market, and policies actually sold are on older insureds whose health has changed from the time the policy was purchased. Settlement companies buy policies using an internal rate of return (IRR) to calculate what they re willing to pay. Currently, the IRR typically used is 15 percent or higher. Other than settlement companies, the only other potential buyers are individuals and the insurance companies (on surrenders). Would you buy a policy for more than the unearned premium or its cash surrender value? More importantly, will an insurance company offer the reserve amount for policies being surrendered? Of course not! The Treasury hasn t revisited life insurance valuation for gift or estate tax purposes since 1974, well before all the changes in life insurance products. In 1992, the Treasury did revisit the willing buyer, willing seller standard for valuing property in general but that was still almost 20 years ago. The Treasury has been approached recently to reconsider their methodology but there are no signs that it will do so. Can we use a different valuation technique, especially when the reserve number reported by the insurance company is so much more than the accumulated value, cash surrender value or the value a willing buyer would pay to a willing seller? Both Treas. Regs. Sections and offer potential solutions, and both regulations have almost identical language. Treas. Regs Section states:

5 As valuation of an insurance policy through sale of comparable contracts is not readily ascertainable when the gift is of a contract which has been in force for some time and on which further premiums are to be made, the value may be approximated by adding to the interpolated terminal reserve at the date of the gift the proportionate part of the gross premium last paid before the date of the gift which covers the period extending beyond that date. (Emphasis added) Since the regulations say may be approximated and don t definitively say must be approximated, that leaves the door open to other methods. Since an appraisal is required when gifting a life insurance policy to a charity (see Life Insurance Appraisals, by Alan Breus, this issue, p. 56) and the general regulation uses the willing buyer, willing seller paradigm that would be used in charitable gifts, this seems like a credible alternative to the outdated life insurance-specific Form 712 methodology. If the appraisal method is used for level premium term insurance and UL policies, it s prudent to include a qualified appraisal from an independent appraiser, who would determine valuation based on the willing buyer, willing seller standard. It s very important to use a credible and recognized appraisal firm so that there s no question as to the impartiality of the appraisal. When making a gift of a policy, file a copy of the appraisal with the gift tax return. There s no method to independently report the value of a gift of life insurance by any party other than the insurance company, except by reporting it on the regular gift tax return. It makes sense to also include a blank Form 712, with an explanation about why it wasn t used in the appraisal. To play it safe, report the position on Form 8275, a disclosure statement. This is an under-utilized form that allows a taxpayer to prove his claim without necessarily going through an audit. Filing Form 8275 in this situation will audit-proof the use of a blank Form 712 accompanied by an appraisal from a qualified appraiser. Filing Form 8275 should prevent the IRS from asserting a whole host of penalties if it were to prevail. If the policy is being sold and therefore no Form 712 is required, the appraisal should be kept as part of the documents relating to the transaction so that if a trust is the selling party, the trustee can demonstrate the reasonableness of the sale price, especially if the funder of the trust stated that there will be no more funding. If a gift tax return is filed to run the statute of limitations in connection with the sale, attach a copy of the appraisal (along with Form 8275). What are the risks of using an appraisal? If an appraisal is attached to a gift tax return and adequate disclosure has been made, the gift tax statute of limitations runs. If the appraisal is used, the policy is sold and the IRS contests the value of the gift in the future (especially if the insured dies within three years of the gift), it may argue that this was part sale and part gift. If the IRS argument is successful, the proceeds included in the decedent s estate would be that portion of the proceeds relative to the gift element as a percent of the entire proceeds. If the transaction involved is one of a sale from one ILIT to another, especially if the beneficiaries or provisions aren t the same, having an appraisal (and the trustee s rationale for selling at that price) will be vital if the transaction is contested. Until the Treasury or the IRS offers something different, it behooves us in serving our clients to offer valuation alternatives. Qualified appraisals are an accepted method of valuing property using the willing buyer, willing seller approach in the general regulations. When properly done and documented, qualified appraisals offer a meaningful alternative. The author thanks Melvin A. Warshaw of Financial Architects Partners in Boston for his assistance with this article.

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