Insurance Planning. Best Practices for Helping Clients with Complexity - It Takes a Team - The Georgia Society of CPAs Estate Planning Conference

Transcription

1 Insurance Planning Best Practices for Helping Clients with Complexity - It Takes a Team - The Georgia Society of CPAs Estate Planning Conference July 31-August 2, 2014 The Ritz-Carlton Lodge, Reynolds Plantation Greensboro, GA Gary T. Bottoms, CLU, ChFC 180 Cherokee Street Marietta, GA gbottoms@thebottomsgroup.com Copyright 2014 The Bottoms Group, LLC. All Rights Reserved.

2 Gary Bottoms, CLU, ChFC Gary Bottoms is President of The Bottoms Group, LLC. The firm is specialized in the insurance related aspects of estate planning and employee benefits. He is also a Principal of TBX Benefit Partners, a subsidiary of The Bottoms Group focused exclusively on the unique employee benefit needs of employers with more than 5,000 employees. He is a graduate of the Georgia Institute of Technology. He also holds the Chartered Life Underwriter designation and the Chartered Financial Consultant designation from the American College. Professional Involvement A past president of the Atlanta Association of Insurance and Financial Advisors. From this organization, he received the Harry I. Davis Award which is given to one member annually who represents the highest ideals and principles of the financial services profession. Gary is one of only 39 other Atlanta professionals who have achieved this distinction over the years. A member of the Association for Advanced Life Underwriting, which is an invitation only organization, composed of professionals serving the high-end marketplace. For this group, he serves as a key liaison with two members of the United States Senate. A past board member of the Atlanta Estate Planning Council and past president of the North Georgia Estate Planning Council. Author of Getting It Right, a book about estate planning, life and relationships. Community Involvement Gary has served as the Chairman of Cobb Community Foundation, The Cobb Schools Foundation, the WellStar Health System Foundation, The Center for Family Resources and President of the Rotary Club of Marietta. Gary is a member of the 2014 Board of Directors for the Cobb Chamber of Commerce. He is a former member of the Board of Trustees for the Cobb County Government Employees Pension Plan. He is also a former member of the Board of Trustees of the Georgia Tech Alumni Association and a recipient of the Volunteer of the Year Award. He has been involved in numerous other civic, church and community endeavors and was selected to be the 2012 Marietta Citizen of the Year. Gary and his wife, Melissa, are graduates of Leadership Georgia. They have been married for 39 years and have three adult children and one grandson. They attend Buckhead Church in Atlanta.

3 Insurance Planning Best Practices for Helping Clients with Complexity Table of Contents Page I. The Impact of Estate and Insurance Planning 1 A. Overview 1 B. Non-tax Estate Planning Needs Related to Life Insurance 1 II. Life Insurance Products 2 A. Some History 2 B. Regulatory Changes 4 C. Attributes of the Various Product Types 4 D. Changing Life Insurance Needs Over Lifetime 5 III. The Underwriting Process 7 A. An Informal Application 7 B. Tentative Underwriting Decisions 7 IV. Leverage Created by Life Insurance 8 A. The Death Benefit Offers Substantial Leverage During the Early Years Of the Policy 8 B. Impact on Portfolio and Wealth Transfer Hypothetical Case Study: Mary Howard 9 C. Shift from Estate Tax Planning to Income and Asset Security Planning 10 D. Internal Rate of Return Actual Cases 11 V. Product Suitability 14 A. Life insurance Product Evolution 14 B. The Uniform Prudent Investor Act 14 C. Steps Toward Establishing Suitability 16 D. Reasons to Have Life Insurance Reviewed Regularly 17 E. Suggested Discussion Points for Reviews 18 VI. Life Insurance Planning Tips 18 A. Review the Tax Implications of a Policy Loan Prior to Any Policy Surrender, Transfer or Exchange 18 B. Consider Potential Transfer for Value Issues Prior to Any Policy Transfer 19 C. The Value of 1035 Exchange 20 D. Section 1035 Exchange Requirements 22

4 E. Policy Ownership and Beneficiary Designations 23 F. Premium Gifts to Joint Owners 25 G. Corporate-owned Policy Payable to Personal Beneficiary 26 H. Exchange of Policies for Buy/Sell Purposes 27 I. Consider Tax Issues and Structuring for Key Person Business-owned Life Insurance 27 J. Gift Transfer of a Policy with a Loan 29 VII. Life Insurance Policy Valuation 31 A. Value of a Life Insurance Policy for Income Tax Purposes 31 B. Value of a Life Insurance Policy for Gift Tax Purposes 31 C. The Secondary Market for Life Insurance a Willing Buyer And a Willing Seller 31 D. Policy Value Actual Case 32 VIII. Long Term Care Insurance 33 A. Pressures on Traditional Stand Alone LTC Insurance 33 B. Income Tax Implications for Individual LTC 34 C. Hybrid/Linked-benefit LTC Policies 35 D. LTC Riders on a Life Insurance Policy 37 E. Qualifying for Long Term Care Benefits 38 F. Trust-owned Life Insurance Policies with LTC Riders 38 IX Long Term Disability 39 A. Proper Amount and Strong Definitions 39 B. A Disability Income Structure for the Self-Employed 41 X. Generational Impact 41 A. Key Ingredients: Love, Communication and Trust 41 B. Communication 41 XI. CPA Tax Return Checklist 42 Endnotes 44 Appendix 46 White Paper: Life Insurance Choices An Introduction to the Various Options By Gary T. Bottoms, CLU, ChFC

5 Insurance - Best Practices for Helping Clients I. Introduction to the Impact of Estate and Insurance Planning A. Overview 1. From an estate and insurance planning standpoint, what we do or don t do can affect multiple generations. We are in a position to encourage our clients to make decisions and take actions that will enable them to possibly avoid future regrets for themselves as well as their families. 2. With a changing tax and market environment, coupled with increasing complexity, clients now, perhaps more than ever, desire a unified planning approach presented by a coordinated team of advisors. The CPA, attorney, insurance advisor and possibly others working together creates credibility, helps develop trust, and shortens the plan development and implementation timeline. 3. A team approach in life insurance planning is growing in importance. Treating the acquisition of life insurance as a stand-alone transaction may hinder clients from attaining their overall wealth management goals. 4. Successful, overall insurance planning depends as much on proper maintenance of the plan as it does on proper implementation. Posttransaction support, including reviewing and providing updates on policy performance, and monitoring the cost of insurance is essential. 5. Changes in the federal transfer tax laws are causing a shift in focus to the non-estate tax considerations of estate and life insurance planning. Also, planning will now be much more income tax driven because of the rising income tax obligations of our clients. B. Non-tax Estate Planning Needs Related to Life Insurance 1. Provide liquidity for business succession 2. Provide cash for earnings replacement and family protection 3. Provide cash for inheritance equalization and blended family planning 4. Provide cash for philanthropic objectives 1

6 5. Provide accumulated cash for supplemental retirement needs Exhibit 1 - American s Top Financial Concerns Money for a comfortable retirement 67% Paying for long-term care services Supporting self if disabled Paying for medical expenses Paying my mortgage or rent Burdening dependents financially if I die prematurely 42% 39% 58% 57% 57% 0Source: LIMRA II. Life Insurance Products A. Some History 1. In the 1970s, the two most prominent types of life insurance were whole life and annually renewable term insurance. In the mid-1980s, when prevailing interest rates were as high as 18%, life insurance companies were crediting guaranteed policies with much lower rates. This caused thousands of astute policy owners to transfer the accumulated cash value in their whole life contracts into higher yielding bank deposit instruments. 2. In order to stop these outflows, the life insurance industry created a new product called universal life insurance. These policies paid an interest rate based upon prevailing market interest rates instead of a fixed rate, as had been the case in their traditional whole life contracts. If interest rates increased, then the scheduled premium could be decreased or remain unchanged and the policy coverage would likely remain in force. What was not clearly understood, however, was that if interest rates decreased, then the length of time the coverage would remain in force could be reduced, or a greater annual premium deposit may be required in order to prevent an early lapse of coverage. 2

7 3. Due to the historically predictable nature of life insurance, consumers were largely unprepared for the attention that would be required for this new generation of product. Few policy owners or trustees clearly understood that the policies carried performance risk. This inattention coupled with steadily declining interest rates created an environment whereby unpleasant surprises occurred such as early policy lapses, and decisions related to increased plan premiums became necessary. 4. It has been our experience that abrupt changes rarely occur with existing life insurance contracts. The long-term effect of a gradually decreasing interest rate, or gradually increasing cost of insurance, may not be readily apparent until some point in the future. In some older insurance contracts, the guaranteed minimum crediting rate may approach, or exceed the current portfolio earnings rate for the company and therefore begin to squeeze or even eliminate the company profit margin. In these situations, insurance companies have three basic choices: a) Do nothing and hope portfolio rates rise in the near future b) Reduce the amounts credited to contract cash value c) Increase the cost of insurance charges subject to contract maximums Exhibit 2 Historical Whole Life Dividend Rates

8 B. Regulatory Changes 1. Actuarial Guideline 38 (AG38) sets insurance carrier reserve requirements for all universal life insurance policies that have secondary guarantees. These products, called no-lapse guarantee policies, have guaranteed rates and are typically designed to pay a death benefit through a specified cut-off age. As a result, they have little to no cash value and are a lot like term life insurance policies. Nevertheless, policies of this type can be vital tools in high-networth estate planning. a) The National Association of Insurance Commissioners approved changes in AG 38 that increase the reserve requirements on no lapse guarantee policies. The new changes affect older policies issued from July 1, 2005 through December 31, 2012, as well as newly-issued policies from January 1, 2013 onward. AG 38 s increased reserve requirements mean higher costs of doing business for no lapse guarantee carriers. These carriers can recover the increased cost of new policies by raising rates on newly-issued products, modifying, or even discontinuing, for new applicants, the no lapse guarantee products they offer. However, because no lapse guarantee rates are guaranteed, insurers can t simply recover their increased costs of maintaining the older policies by increasing those policies rates. Instead, to help recoup the increased costs of maintaining older policies affected by AG 38, carriers are employing a variety of strategies including increasing the rates on non-no lapse guarantee policies. b) The continuation of a low interest rate environment coupled with the implementation of AG 38, has reduced the number of carriers offering the product, and increased premiums for the products still being offered. The higher premiums for the product coupled with the lack of cash value available has contributed to an industry shift, to a degree, back to cash accumulation orientation. 1 C. Attributes of the Various Product Types 1. For a given assortment of needs, the criteria for choosing a product will depend upon how long the coverage needs to remain in force, the policy owner s tolerance for risk and desire for policy guarantees, and whether the objective is maximum death benefit, maximum cash accumulation or some combination in between. 4

9 2. For an introduction of the various product choices, please see the appendix which contains a white paper on the subject. 3. For larger amounts of coverage, as well as for more flexible products with lesser guarantees, we typically recommend that diversification among carriers be considered. And, depending upon the client s needs and objectives we may also recommend diversification among various product types. Exhibit 3 - Industry Estimates of Annualized Premium Market Share by Product D. Changing Life Insurance Needs Over Lifetime 1. The need for life insurance death benefit will likely change over time. For the typical family, the need may be greatest in the early years when young children are present and the financial needs are significant because of many future years of needed support, educational expenses and an assortment of unforeseen costs. During these years term insurance may be an important element of the life insurance portfolio, 5

10 and the plan may be to discontinue this coverage when this phase of life is past. 2. After the children are out on their own, the planning objectives generally shift towards ultimate retirement and financial security related to a desired future stream of income. During the early years of this timeframe a continuing amount of term insurance may be desired into retirement. Compared to prior generations, the current early retirees seem to maintain an active lifestyle along with the associated expenses and possibly debts. 3. Based upon our experience, most of our clients have a desire to maintain a base level of life insurance designed to stay in effect for life. This insurance coverage is a conservative asset class and the ultimate use for the capital created by the death benefit may be unknown at the time the policy is implemented. The cash may be used to reimburse the estate for the expenses of final extended illness, philanthropy, additional inheritance for children or grandchildren and so forth. This is in addition to providing additional capital for the security of a surviving spouse. 4. As noted above, the amount and type of insurance appropriate will depend upon the circumstances of the client. The need may be related to the payment of estate taxes, or an assortment of other needs. The process to determine the appropriate amount and mix of coverage can be made based upon some assumptions and a present value analysis of the future need for cash. PERMANENT AND TEMPORARY COMBINATION OPTIONS Exhibit 4 - Sample Life Insurance Portfolio Over Lifetime $500, year term $250, year term $250,000 Universal Life DEATH BENEFITS To Age 70 To Age 80 Age 86 Life Expectancy Lifetime Based on the assumption that the need will decrease over time, a $1,000,000 need might be met with three different types of life insurance, each designed to remain in effect for a certain period of time. 6

11 Since the 1970s, technology has enabled the creation of flexible life insurance products, and the new generations of product require more attention and management. Many of the new flexible products have planned premiums that are set by the policy owner and based upon assumptions related to interest rate assumptions, future cost of insurance and other factors. A process is necessary to determine type and amount of coverage. Executive Summary If the actual performance is less favorable than the assumptions used to determine the planned premium, it is best to consider adjustments to the planned premium so the coverage lasts as long as it s needed. The low interest rate environment has increased scrutiny by regulators related to capital requirements necessary to back the policy guarantees. Choices related to life insurance features and types have multiplied and the ability to design coverage around the client s objectives has increased. III. The Underwriting Process A. An Informal Application 1. In our practice, we generally do not complete an application for life insurance until we become relatively certain of what the underwriting outcome will be. Many of our clients are older and have ongoing medical issues and it s important that we ask underwriters with multiple carriers to review the parameters of the case. Therefore, we obtain a signed authorization enabling us to request medical history and we securely submit this to various carriers for a tentative decision. Once we have several acceptable tentative offers we can create the numbers necessary to make a decision and move forward with the actual application. 2. The underwriting parameters used by the life insurance underwriters vary somewhat from carrier to carrier. For example, some carriers may be more aggressive with older applicants while others may prefer younger applicants. Some may allow credits for favorable lifestyle habits such as exercise and others may be more favorable toward certain types of medical conditions than others. 7

12 B. Tentative Underwriting Decisions Exhibit 5 is a summary of tentative offers received from 14 major insurance carriers on an actual case. We have indicated the result and included comments from the best three and the least favorable three carriers. Please notice that the results range from absolutely the best elite offer to a highly rated and expensive offer. Exhibit 5 Informal Underwriting Inquiry Life insurance carriers have numerous underwriting categories that determine the premium so it s helpful to determine the underwriting premium class prior to the purchase decision being made, particularly for older clients who may have ongoing medical issues. Executive Summary An informal underwriting process is advantageous for the client whereby medical history is submitted to several insurance companies so that a tentative underwriting decision can be made prior to an actual application being submitted. Underwriting criteria varies from insurance company to insurance company regarding certain types of medical history, height/weight, tobacco use and so forth. IV. Leverage Created by Life Insurance A. The Death Benefit Offers Substantial Leverage During the Early Years of the Policy The value of the death benefit in the early years is substantially more than the value of the premiums that may have been placed in an investment account (non life insurance assets). The advantage may decrease over time if the non life insurance assets increase in value. At some point, the value of non life insurance 8

13 assets may exceed the death benefit. The point at which this occurs is often called the crossover point. Life insurance offers an advantage when the crossover point occurs after a client s life expectancy. Exhibit 6 Crossover Point B. Impact on Portfolio and Wealth Transfer - Hypothetical Case Study: Mary Howard 1. Mary s concerns: Mary is a 65-year-old widow with a portfolio 2 worth $6 million that is comprised of real estate and equities. While she expects to receive a 7% return over time, she is concerned that her portfolio may not perform as expected and her heirs might receive substantially less than expected. 2. Mary s wealth transfer strategy: By allocating a small portion of her portfolio to purchase a life insurance death benefit, Mary may mitigate market losses and add a stabilizing element to the wealth ultimately transferred to her family provided the policy remains in force. If Mary s portfolio does not perform as expected, the life insurance death benefit may potentially offset the risk of underperformance. 3. Mary s potential results: To address her concerns, Mary annually allocates 1% of her portfolio ($60,000) to purchase a life insurance death benefit of $3.7 million. 3 While her portfolio is reduced by the amount of the life insurance premiums, the life insurance death benefit adds a stabilizing element to her wealth transfer strategy. Moreover, Mary may have increased the amount of wealth transfer to her beneficiaries. For 9

14 example, at life expectancy (year 18), Mary s beneficiaries are better off by $1,864, Exhibit 7 Hypothetical Case Study C. Shift from Estate Tax Planning to Income and Asset Security Planning 1. Traditionally, for the affluent, a major focus of the use of life insurance in estate planning has been to cover the need for federal estate tax liquidity. With the increase in the federal estate tax exclusion, as adjusted for inflation, that need is been dramatically reduced. 7 There s been a gradual shift in recent years from estate tax planning to a process to determine an individual s or family s personal objectives related to taking care of themselves and those they care about from a standpoint of family security, harmony and legacy. 2. A significant fear, even among the affluent, is a concern about outliving one s assets. Medical science is extending life expectancies and most have noticed in recent years that volatility with regard to financial assets can cause fortunes to decrease. These dynamics have increased the interest in retirement security as well as planning for long-term care during an extended illness. Recent increases in the federal income tax showed that those planning for retirement face higher income and capital gains tax rates, plus an additional 3.8% tax on net investment income. 3. The financial environment created in recent years along with the higher rates of taxation make life insurance more attractive as an asset class. This is because of the potential for a tax-deferred inside build-up of cash values. At retirement, an individual can begin to access cash values as a supplemental source of retirement income through withdrawals up to the individual s basis and then through policy loans, assuming a non- 10

15 modified endowment contract situation. In addition, there is the appeal of income tax-free death benefits for the insured s heirs. 4. To address the concern related to long-term care planning, life insurance products are being designed to provide a combination of death benefit protection and long-term care funding, if needed. This is an attractive melding of features since the insured has available long-term care protection for themselves, if needed, and death benefit protection for their family, if not. Either way, capital is created as long as the policy is kept in force. 5. Return of premium coverage can maximize the efficiency of life insurance contracts by boosting the internal rate of return. The return of premium feature can be chosen as a rider or as a death benefit option within a life insurance contract. With this feature, the policy returns premiums a policy owner has paid for coverage over the life of the contract by providing an additional death benefit generally equal to a percentage of the premium paid, up to 100%. D. Life Insurance Internal Rate of Return Examples 1. Case history - this client was the spouse of a deceased business owner who was in her 60s. The initial purpose for the coverage was to create liquidity for estate taxes. An ILIT was formed and the trustee implemented a $6 million yearly renewable term policy. Because of increasing premiums after a number of years the trustee later converted the coverage to whole life insurance. The annual premium for the whole life insurance was in excess of $200,000 annually, and the trustee wished to lower the annual outlay and was open to lowering the amount of coverage because of the gradual changes underway with the estate tax liability. At age 79, the whole life policy was exchanged utilizing the provisions of section 1035 for a universal life policy with an extended guaranteed death benefit. The cash placed in a new policy effectively bought down the annual premium necessary to sustain the policy. Therefore, they retained the $6 million amount. She died at age 90 and the internal rate of return for the universal life policy at death was 8.41%. Based upon a hypothetical 40% tax bracket, a taxable investment would need to have earned around 14% annually to match this result. 11

16 Exhibit 8 IRR/Spouse of Deceased Business Owner 2. Case history - this client was a young professional and implemented a $1 million yearly renewable term policy. A few years later he wanted to increase his coverage to $2 million and the plan was to get a new $2 million policy and discontinue the original $1 million policy. The underwriting for the new $2 million policy was difficult because some irregularities appeared in his blood tests. He implemented the new $2 million policy and then decided to keep the original $1 million in force. About five years later he was diagnosed with a serious disease and died a few years after that at the age of 52. The internal rate of return for the $3 million was 30.96%. Based upon a hypothetical 40% tax bracket a taxable investment would have had to earn around 50% annually to match this result. Exhibit 9 IRR/Young Professional 12

17 3. Case history - this client owns a business and the business owned a whole life policy that was originally designed to accumulate cash. Upon review of this policy, the declining need for the accumulated cash caused the client to exchange the policy, utilizing section 1035, for a guaranteed death benefit universal life that required no ongoing annual premium. About 10 years later, he felt he had no need for the death benefit protection and asked about the advantages and disadvantages related to keeping the policy or discontinuing it. His basic choices was either surrender the policy and receive $79,078 in cash with a portion of the proceeds being subject ordinary income tax, or allow the policy to continue. He had no pressing need for the additional cash in his business. We ran the numbers to determine the internal rate of return necessary to create the $400,000 death benefit at his projected life expectancy. The rate of return necessary on the cash if it was invested elsewhere was 8.44%. He decided to leave the policy in place. In a hypothetical 40% tax bracket, a taxable investment would have to earn around 14% annually to match this projected result. Exhibit 10 IRR/Business Owner In recent years there has been a shift away from estate tax planning to planning for future streams of income and financial security for businesses and individuals. Executive Summary Higher income tax rates have increased the attractiveness of the tax-deferred cash accumulation and tax-free death benefit attributes of life insurance making it an attractive conservative asset class. A useful measure of the value of life insurance to survivors and heirs is the Internal Rate of Return at life expectancy. The details of term conversion rights are important. 13

18 V. Product Suitability A. Life Insurance Product Evolution 1. The evolution of life insurance products over the years has accentuated the need for scrutiny related to the products chosen to accomplish the objectives of our clients. Life insurance products and the structure for owning them are becoming increasingly popular and sophisticated. The acquisition of life insurance has moved beyond simply a transaction involving a product to an ongoing process of management that includes many moving parts and flexibility that will ultimately determine the result for the beneficiaries. 2. Due to the pace of what we do as well as the litigious environment in which we work, it is prudent to have systems in place to document our client s rationale for decisions made as well as the reasons for our recommendations. Since we are unable to see into the future, many of our recommendations are based upon weighing the pros and cons of various choices. For example, if a change of course is available to our client and no suggestions or recommendations are made, this could be harmful in the future to the beneficiaries. On the other hand, if a change of direction is recommended, a future environment may be created whereby the beneficiaries the challenge the decision. B. The Uniform Prudent Investor Act 1. The UPIA, which most states have adopted some version of, provides that: A trustee who invests and manages trust assets owes a duty to the beneficiaries of the trust to comply with the prudent investor rule... A trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution. Accordingly, litigation targeting trustees of ILITs for breaches of fiduciary duty has increased as life insurance products have become more complex. Several recent cases targeting ILIT trustees illustrate that ILITs present unique fiduciary challenges in terms of administration and asset management. The growing complexity of life insurance products, along with the administrative requirements to preserve an ILIT s intended tax 14

19 benefits, can make ILIT trust administration far more complicated than anticipated, particularly for non-professional trustees. 2. French V. Wachovia is illustrative of the complex environment present for clients, their beneficiaries and advisors. James French was a wealthy businessman who created a trust for his children. The trust owned two life insurance policies on French and his wife. The first was a $5 million whole life policy insuring French and the second was a $5 million whole life survivorship policy on French and his wife. a) French appointed Wachovia Bank as the successor trustee for both trusts and then requested a review. Wachovia Bank enlisted its affiliate, Wachovia Insurance Services, Inc. to help with the review. French s legal counsel, who had life insurance planning experience, was involved with the review. During this review, Wachovia pointed out that the premium on the survivorship policy was set to increase by $40,000 per year. Wachovia recommended that French exchange the two whole life policies into two universal life policies with no-lapse guarantees. The new policies recommended would maintain the exact same death benefit as the original policies and include a lower annual premium. If this new and lower annual premium was paid as scheduled, the death benefit would be guaranteed. French s legal counsel provided a written memo analyzing the pros and cons of the exchange, including the poor cash values and flexibility often associated with no lapse guarantee policies. Prior to the exchange, Wachovia Bank disclosed the relationship with the entity serving as the broker which was an affiliate. b) Transitioning to this new structure for the insurance would involve a reduction in the available cash value when compared to their current policies. This negative was carefully considered and perceived to be acceptable because the French's had other significant cash assets and needing access to policy values was not anticipated. The primary goal was to protect and guarantee the future death benefit. c) During the decision process, written documentation was created so that it would be clear with regard to the details of the transaction that was contemplated for over eight months. Several months after the exchange was implemented, the four beneficiaries filed a lawsuit against Wachovia. They claimed that Wachovia had failed to invest the trust assets properly, caused 15

20 the trust to lose money without reason, and had made the transaction to benefit themselves because they earned a commission on the exchange. They alleged that Wachovia had violated their fiduciary duty as trustee. d) Ultimately, the trustee, Wachovia Bank prevailed in court. They were able to show that the exchange made sense for the French s stated goals and was authorized by the trust document. The exchange resulted in lower premium payments and a guaranteed death benefit. Loss of cash value would be a problem if the French s were planning on surrendering the policies early or if they needed to tap into these cash values via a policy loan. Wachovia was able to clearly show that they made this recommendation to benefit the trust, not just to earn a commission. It was also noted that the ILIT beneficiaries cannot use hindsight to claim that they now preferred to have policy cash value. C. Steps toward Establishing Suitability 1. Suitability, by definition, is the requirement to determine if a life insurance product is appropriate for a given client, based on the client s goals and financial situation. In other words, suitability is a matter of both matching product attributes to client objectives and measuring product qualities against peer-group product alternatives. Investigating suitability, therefore, involves measuring strengths and weaknesses of at least five major factors, as follows: a) Financial strength and claims paying ability b) Cost competitiveness c) Pricing stability d) Cash value liquidity e) Historical performance of invested assets underlying policy cash values 2. In August, 2012, the office of the Comptroller of the Currency (OCC) issued revised guidelines which direct financial institutions serving as trustee of an insurance trust to treat life insurance as they would any other asset. This means life insurance, just like stocks, bonds and real estate, needs to be actively managed. Providing a policy performance 16

21 evaluation and monitoring every one to three years, depending on product type, is the only way to determine whether a life insurance contract issued several years earlier is in danger of expiring prematurely. D. Reasons to Have Life Insurance Reviewed Regularly 1. Policies may not be performing as projected due to market downturns over the past few years or due to historically low interest rates. a) Policies may be at risk of lapsing, leaving the beneficiaries with nothing, and a potential liability to the advisory team for failing to properly monitor the policies. b) The policy owner may have to make larger planned premiums than expected to keep the policies in force, which could possibly cause the policy owners to exceed their annual gift tax exclusions and/or their personal budget. 2. Newer products may have been developed that might be more costefficient or offer better guarantees. a) It may be possible to pay less premium for the same coverage or obtain more coverage for the same premium. b) Guaranteed death benefit universal life, which is a relatively new type of life insurance product in the marketplace, can often provide the same guaranteed death benefit as whole life at a lower cost. 3. Underwriting changes may have occurred. a) What was once considered rated for underwriting purposes might be standard today and cost less. b) Improved health or lifestyle changes may have occurred, providing the potential for better underwriting offers and lower premiums. For example, tobacco use habits may have changed. 4. The amount of life insurance needed might have changed, making current coverage insufficient. Or, perhaps the need for life insurance coverage may have decreased. 5. Changes in insurer financial ratings could put the policy at risk because the company backing it is at risk. 17

22 E. Suggested discussion points for reviews: 1. Have there been significant changes in your family life? Have you married, divorced or added another member to your family? 2. Have there been changes to your employer-sponsored benefits? 3. Has your net worth increased or decreased significantly? 4. Is your retirement plan adequate to fund your future as well as those dependent upon you? 5. Are your policies performing as projected? 6. Have there been changes in the financial rating of your life insurance policies carrier? 7. Are there newer insurance products that are more cost-efficient or that offer better guarantees? 8. Could you benefit from new riders that offer more appropriate features, such as return of premium, guaranteed death benefit protection or longterm care coverage? 9. Does term insurance coverage and conversion rights meet your future needs? 10. Is your policy s premium scheduled for a significant change? Management responsibilities for policy owners and fiduciaries responsible for performance have increased over the years because of premium flexibility and sensitivity to market returns. Executive Summary Determining suitability and whether or not a life insurance product and the surrounding strategy is appropriate has grown in importance when considering the client s needs and objectives. Periodic reviews are advised which would include the changing objectives of the client, and current reprojections of future policy values along with other factors. VI. Life Insurance Planning Tips A. Review the Tax Implications of a Policy Loan Prior to Any Policy Surrender, Transfer or Exchange 1. The complete surrender of a policy generates ordinary income to the extent the amount received exceeds the owners investment in the 18

23 contract (i.e. premiums paid less prior amounts received under the policy that the owner did not include in gross income). 2. Discharge of a policy loan upon surrender a policy (or the transfer of a policy subject to a loan to a person other than the owner s grantor trust) will result in income taxable at ordinary income rates if the total loan exceeds the investment in the contract. 3. Because of the flexibility of life insurance coupled with rising income tax rates, the popularity of cash accumulation within a life insurance policy to supplement retirement income is growing. Systematic cash withdrawals from the policy can be arranged. Typically a cash withdrawal up to the amount of policy basis with cash loans thereafter is the strategy. Some insurance companies have created systems to assist with the management of these withdrawals with re-projections of future values. Further, some insurance carriers offer an over loan solution by offering a small paid-up policy so that the policy does not lapse and create taxable income. This management is important because if assumptions are not met and the cash is depleted causing the policy to lapse during life, the income tax on the gain will be incurred. 4. Consider tax consequences of loans, withdrawals or pledges related to a modified endowment contract (MEC). For most life insurance contracts, owners may withdraw from the cash value of the policy, income tax-free, up to their investment in the contract. A different rule applies to modified endowment contracts and taxes lifetime distributions as ordinary income until they exceed the gain in the contract. Policy loans and pledges of collateral for loans are similarly taxed as distributions. An additional 10% penalty tax also may be imposed on the amount of the distributions included in gross income. There are limited exceptions to the penalty, including distributions made on or after the policy owner reaches age 59 ½. B. Consider Potential Transfer for Value Issues Prior to Any Policy Transfer IRC Section 101(a)(1) provides that gross income generally does not include death benefits paid under a life insurance policy. In the case of a policy transferred for valuable consideration, however, IRC Section 101(a)(2) provides that the only amounts excludable from gross income upon receipt of the death benefit is the total consideration, subsequent premiums and other amounts paid by the transferee for the policy. 19

24 Several types of transfers are excepted from the transfer for value rule, including a transfer the policy to the insured (including to the insured s wholly owned grantor trust), a transfer to the partner of the insured, a transfer to a partnership (including an LLC taxed as a partnership) or corporation in which the insured is a partner or is an officer or shareholder and a transfer where the transferee s tax basis is determined, in whole or in part, by the transferor s basis (i.e. a gift). C. The Value of 1035 Exchanges 1. It is relatively common knowledge within the financial industry that section 1035 of the Internal Revenue Code allows both life-insurance-forlife-insurance and annuity-for-annuity exchanges without incurring immediate tax liability on any gains in the old investment. 2. Thus, the primary benefit of the 1035 exchanges is that no gains are recognized on the surrender of the contract. 8 a) The new contract retains the tax basis of the old contract. b) While a large lump sum paid into a life insurance contract may cause a new life insurance contract (new policy) to be a modified endowment contract, that is generally not the case with a lump sum deposited in a new policy via a 1035 exchange What is less well-known is that the section also allows a taxpayer to exchange a life insurance policy for an annuity. Thus, for instance, if estate tax laws have rendered a current life insurance policy unnecessary, consideration may be given to exchanging the policy for an annuity, which will still preserve the original policy's cost basis. As a result, the client will have a more flexible investment vehicle, in the form of an annuity, while deferring tax on the policy s gains. 4. Conversely, and just as importantly, a 1035 exchange can be used to preserve any loss that the old insurance policy incurred. For example, an unnecessary policy with a cost basis of $100,000 and a surrender value of $50,000, the annuity received after a 1035 exchange will have a cost basis of $100,000, effectively rendering the first $50,000 in future gains on the annuity tax-free. 5. It is important to remember that annuities cannot be exchanged for life insurance. Additionally, the procedural requirements for section 1035 exchanges must be strictly followed in order to reap the tax benefits. For example, if a life insurance contract is surrendered and the owner receives a check for its cash value and then remits the surrender value to 20

25 the new insurance company, the transaction falls outside the scope of a 1035 exchange. 6. A number of tax issues with the new policy deserve consideration: a) If the 1035 exchange is done during the first seven years of the original policy, a reduction in death benefit may trigger modified endowment contract status. b) Future premium payments into the new policy must satisfy the 7-pay test. c) After the exchange, a new 15-year period starts for forced out gains purposes under IRC section 7702(f)(7). Forced out gains is the taxable income that may result of cash is drawn from the policy and the death benefit is reduced during the first 15 policy years Exchange of a Policy with a Loan a) Situation: The insured has an old $500,000 whole life policy that he would like to 1035 exchange for a new universal life policy. The policy has a gross cash value of $150,000 and a policy loan of $50,000 (thus, the net cash value is $100,000). Cumulative premiums (i.e., basis) paid are $75,000, so the policy has $75,000 of gain. The insured intends to transfer the net cash value to the new policy and not carry over the policy loan. b) Problem: If the insured goes through with this exchange, he will incur $50,000 of taxable income. This is because the extinguished loan ($50,000) is considered boot as part of the exchange and is taxable to the extent of gain ($75,000) in the policy. The insured is in effect exchanging a policy with a gross cash value of $150,000 for a policy with a gross cash value of $100,000. Instead of receiving $50,000 of cash as part of the exchange, which would clearly be identified as boot, the insured is relieved of his obligation to repay the $50,000 policy loan. Many policy owners are unaware of this tax result until they receive a 1099 from the insurance company, at which point it is too late to correct the problem. c) Solutions: Pay off the loan prior to the exchange. This should generally be done using the policy owner's own out-of-pocket funds. It may be possible for the policy owner to take a withdrawal of basis from the policy in order to repay the loan. 21

26 D. Section 1035 Exchange Requirements However, if this is done in close proximity before the exchange, the IRS may consider it to be a step transaction and attempt to assert that there is taxable boot. Another solution may be to transfer the loan as a part of the exchange. The IRS has indicated in several private letter rulings 10 that the exchange of a policy with an outstanding loan for another policy subject to the same indebtedness constitutes a valid 1035 exchange. 1. Legislative history indicates section 1035 is intended to permit the deferral of taxation for individuals who merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain To qualify for tax-free exchange treatment, both the owner and the insured of the new life insurance contract must be the same as the owner and insured of the surrendered life insurance contract. 12 Keep in mind that 1035 exchanges are permitted only if the exchange does not delay the receipt of benefits by the taxpayer. Common scenarios illustrating the application of the same insured requirement of 1035 exchanges are demonstrated by the following: a) Second-to-die to Single Life: In two private letter rulings, PLRs and , the Internal Revenue Service noted that when a second-todie policy was exchanged after the death of one insured for a policy insuring only the survivor, the new policy was insuring the same single life and thus was an acceptable 1035 exchange. b) Single Life to Second-to-die: The exchange of two single life policies for one survivor life policy does not conform to the same insured requirements of section Similarly, one survivor policy cannot be exchanged for two single life policies. In PLR , the IRS concluded that exchanges involving policies insuring a single life for a policy insuring two lives does not qualify for nonrecognition treatment under IRC section In the letter rulings the IRS sets forth five examples, none of which qualify for nonrecognition treatment because the insured s in the old contract was not identical to the insured s in the new contract: (1) Spouse A exchanges a policy insuring only Spouse A s life for a policy that insures the lives of both Spouse A and Spouse B. (2) Spouse A exchanges two life insurance policies, one that insures Spouse A and another that ensures Spouse B, for a single secondto-die policy insuring the lives of both Spouse A and Spouse B 22

27 (3) Spouse A and Spouse B jointly exchange separate policies, each of which insures the life of one spouse for a single jointly owned second-to-die policy that ensures the lives of both Spouse A and Spouse B. (4) A trust owns and exchanges a policy insuring the life of Spouse A for a policy that insures the lives of both Spouse A and Spouse B (5) A trust owns and exchanges two life insurance policies, one of which ensures Spouse A and the other of which insures Spouse B for a single second-to-die policy insuring the lives of both Spouse A and Spouse B. c) Life Insurance to Annuity. When exchanging from a life policy to annuity, the annuitant must be the same as the insured and the old life policy. If exchanging from an annuity to another annuity contract, the obligee in the new annuity contract must be the same as the obligee in the surrendered annuity contract. The meaning of the term obligee is somewhat uncertain and could mean the owner or the annuitant. As a result, many carriers require the owner and annuitant to remain the same in the new contract as they were in the old contract. 3. A number of questions surrounding the requirements of 1035 exchanges deserve mention, including: a) Type of policy: The IRC does not distinguish between types of permanent contracts (i.e. variable universal life, whole life for universal life) for 1035 exchange purposes. 13 b) Death benefit: Nonrecognition treatment does not require that the values of the policy acquired be the same or similar to the values in the policy exchanged. As such, the death benefit on the acquired policy may be either more or less than the death benefit of the exchanged policy. The acquired policy's death benefit must be sufficient relative to its cash value in order to qualify it as life insurance under IRC section 7702 in order to preserve certain tax benefits available, including an income-taxfree death benefit. c) Number of contracts. Just as IRC section 1031 applies to like exchanges of multiple business or investment properties, IRC section 1035 applies to exchanges of multiple life insurance and annuity contracts. 14 (See, e.g.irc Section 7701 (m) (1), which cross-references Title I of the United States code, which in turn provides that in determining the meaning of any act 23

28 of Congress, unless the context indicates otherwise, words importing the singular include and apply to several persons, parties, and things.) 4. Examples of transactions receiving nonrecognition that otherwise met the requirements of IRC section 1035 (i.e. same insured/owner) include: a) Two life insurance contracts for one life insurance contract b) Two life insurance contracts for one annuity contract 15 c) Consolidation of two existing annuities into one 16. The taxpayer s basis in the new annuity will equal his combined basis in both consolidated contracts. In this ruling, the taxpayer consolidated two existing annuities into one; there was no new annuity issued as part of the transaction.) d) One annuity contract for two annuity contracts 17 e) One annuity contract for one annuity with a term insurance rider 18 E. Policy ownership and beneficiary designations. 1. Improper beneficiary and ownership designations can have adverse and sometimes significant income, estate and/or gift tax consequences to clients. Following are some traps to avoid: a) Goodman triangle (1) Situation: Parent (unmarried) wants to purchase $1 million of death benefit for the benefit of both her adult children (C1 and C2). She would like to avoid adverse estate tax consequences by having a policy owned outside her estate. Therefore, she would like C1 (the more responsible child) to own the policy insuring her, with both C1 and C2 as the named beneficiaries. She plans to pay the $22,000 annual premium directly to the insurance company. (2) Problem: There are actually two problems with this fact situation. (a) The more obvious one has to do with the gift tax consequences of her payment of the insurance premium. The premium payment is an indirect gift to C1. Since C1 is the sole owner of the policy, only one annual gift tax exclusion is available, meaning that one-half the premium payment will be a taxable gift. If structured properly, for example, if 24