Effective Planning with Life Insurance

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1 Effective Planning with Life Insurance The Tax Considerations... Ken Knox, CLU, ChFC Regional Director The Penn Mutual Life Insurance Company TM_Sept17

2 Retirement Planning

3 Case Scenario #1... Client (age 52) owns a $5,000,000 policy on his life; paid $500,000 in premiums since he purchased the policy; policy has a current cash value of $3,000,000. The policy is a modified endowment contract (MEC). Client wants to transfer ownership of the policy to an irrevocable trust life insurance trust (ILIT) for the benefit of his children, to remove the proceeds from his taxable estate at death. His CPA has advised him to take out a loan from the policy, prior to the gift, in order to minimize the gift tax value.

4 Case Scenario #1 (cont.)... Client also wants to accomplish a tax free exchange of the existing policy (insuring his life) into a survivorship policy coinsuring his and his spouse s (age 50) lives, to provide adequate estate liquidity needed at second death. Client has another $1,000,000 policy inside his profit sharing plan with a policy cash value of $200,000, which he also wishes to remove from his taxable estate via transfer to the ILIT. Client has inquired as to how future premiums might represent a deductible expense to him.

5 Modified Endowment Contracts...

6 Question #1 What are the income tax implications of creating a modified endowment contract ( MEC )? What amounts distributed from a MEC are subject to the preage 59 ½ penalty tax? Does the cash value in a MEC policy grow income tax deferred? Are the death proceeds of a MEC policy subject to income tax?

7 Answer... Income taxation of MEC policy: Any distributions from a MEC (withdrawals or loans) are taxable as ordinary income to extent of gain - basis is not recovered first. Collateral assignment of MEC policy results in current and on going recognition of gain. 10% penalty tax applies if insured is under age 59 ½ (applies to gain only). Both non-mec and MEC policies offer tax deferred cash build up inside the policy. Proceeds of non-mec and MEC policies are paid income tax free (unless transfer for value has occurred).

8 Tax Free Policy Exchanges...

9 Question #2 Can a tax free policy exchange be accomplished with... A life insurance policy for an annuity, or an annuity for a life insurance policy? A single life policy for a survivorship life policy, or a survivorship policy for a single life policy? A policy subject to a loan?

10 Answer... Permissible tax free exchanges: Life insurance policy for life insurance policy (but not annuity for life insurance). Annuity for annuity. Endowment policy for endowment policy. IRC 1035 tax free exchange requirements: Same insured/annuitant and owner on both sides of the transaction (same economic position ). Outstanding loan triggers income tax equal to the lesser of loan or gain, unless either: Loan is repaid prior to the exchange, or New policy is subject to same loan ("carries" loan).

11 Policy Loans...

12 Question #3 What are the potential income tax consequences of... A transfer of a policy with a loan? A lapse or surrender of a policy with a loan? A policy subject to a loan upon the insured s death?

13 Answer... Transfer of policy with loan: Income recognized to extent loan exceeds basis (greater of loan or gain). Discharge of liability is treated as consideration received ( transfer for value ). Lapse or surrender of policy with loan: Income recognized to the extent the loan plus remaining cash value exceeds basis. Policy subject to loan upon insured s death: Death proceeds are reduced by value of outstanding loan. Remaining proceeds are received income tax free.

14 Qualified Plan Distributions...

15 Question #4 How is a life insurance policy, which is distributed from a qualified retirement plan, taxed to the plan participant? How is a life insurance death benefit, which is distributed from a qualified retirement plan, taxed to the plan beneficiary? Are the death proceeds (of a qualified plan owned policy) subject to estate tax?

16 Answer... Lifetime distribution of policy from qualified plan: Value of policy (minus basis) is taxable income. 10% excise tax if insured/plan participant under age 59 ½. Fair market value: greater of interpolated terminal reserve value (cash surrender value) plus unearned premium, or 70% of PERC amount (gross cash value). Annual current insurance cost (IRS Table 2001 rate) is annual taxable income, and becomes insured s basis in the policy. Distribution of death proceeds from qualified plan: Portion of proceeds equal to policy cash value is taxable income - income in respect of a decedent ( IRD ); remaining portion of proceeds is income tax free.

17 Premium Deductions...

18 Question #5 Under what circumstances are life insurance policy premiums income tax deductible?

19 Answer... Policy premiums paid by an individual or business are generally not income tax deductible... Exceptions: Group term life insurance premiums. Premiums paid as compensation to an employee (provided reasonable and not excessive). Contributions to qualified pension plans. Charitable contributions.

20 Estate Planning

21 Case Scenario #2... Client (age 60) owns: $1,000,000 survivorship policy ($12,000 annual premium) co-insuring client and spouse (age 60); $500,000 policy ($10,000 premium) insuring his life; and $500,000 policy ($7,000 premium) insuring his spouse's life. On his attorney s recommendation, client is considering transferring all three policies to an irrevocable life insurance trust (ILIT) to remove them from his taxable estate at death. Client and spouse want to keep the planning simple, and prefer to have their two most financially responsible children own the policies, for the benefit of all four of their children.

22 Case Scenario #2 (cont.)... Client is making regular annual gifts to the children, and understands he may incur gift tax on policy gift, and future premiums gifts, if annual gift exclusion and lifetime exemption limits are exceeded. He was also informed that the death proceeds will be included in his taxable estate, if he does not survive three years following the policy transfers. Client has asked if it would be better to sell to the policies to the trust, rather than gift them to the trust. He inquired whether his spouse could be included as an ILIT beneficiary, in order to provide her with policy access if needed or desired.

23 Incidents of Ownership...

24 Question #6 Under what circumstances will life insurance death proceeds be subject to estate tax in the insured's estate?

25 Answer... Life insurance policy proceeds included in insured s estate if: Proceeds are paid to insured estate. Insured possessed incidents of ownership at death, or transferred incidents of ownership within 3 years of death. Incidents of ownership include: Ownership of policy. Right to name or change beneficiary. Right to surrender or cancel policy. Right to assign policy, or revoke assignment. Right to receive policy loans, or pledge policy as collateral for loan.

26 Question #7 How must an Irrevocable Life Insurance Trust ( ILIT ) be structured and funded to exclude the death proceeds from the taxable estate?

27 Answer... Insured cannot possess incidents of ownership in the policy: Insured cannot be an ILIT beneficiary or trustee. Cannot retain right to revoke or amend trust. Non-insured spouse can have limited beneficial interest in ILIT, without estate tax consequences - provided: Interest is limited to a life estate all income and discretionary principal subject to ascertainable standard (e.g., health, education, maintenance, support). Beneficiary spouse should not be a co-grantor, or make gifts to trust (e.g., split gifts ). Non-insured spouse can serve as ILIT trustee or co-trustee: Discretionary distributions should be limited to an ascertainable standard.

28 Question #8 Does the three year rule apply to a transfer of ownership in a life insurance policy... On one s own life? On another individual's life? By gift? By sale?

29 Answer... Three year rule applies to the insured's gratuitous transfer (i.e., gift) of a policy within three years of death: Results in inclusion of death proceeds in the insured's taxable estate. Rule applies to a gift of a policy owned by the insured on the insured's life: Does not apply to a gift of a policy insuring someone else s life. Rule does not apply to a sale of a policy for full and adequate consideration: Sale of a policy has potential transfer for value implications.

30 Gift Tax...

31 Question #9 Is the annual gift tax exclusion available for... A gift of a policy or premium to an Irrevocable Life Insurance Trust ( ILIT )? A gift of a policy, or premium, to two or more joint policy owners? How is a gift of an existing life insurance policy valued for federal gift tax purposes?

32 Answer... Gift of policy or premium to ILIT: Trust must incorporate crummey provisions (i.e., beneficiary withdrawal rights over trust contributions) to meet present interest gift requirement. Hanging power overcomes 5 by 5 limitation. Gift of policy to joint policy owners: Annual exclusion not available for gift of policy to joint owners (present interest gift requirement cannot be met). Policy gift tax value is generally equal to the interpolated terminal reserve value.

33 The Gift Tax Triangle...

34 Question #10 What is the gift tax triangle and under what circumstances can the triangle occur?

35 Answer... Gift tax triangle is created where the policy owner, insured and beneficiary are three different parties: Example: husband is insured; policy owner is wife; and policy beneficiaries are their children. Example: parents are insureds; policy owners are children A and B; and policy beneficiaries are children A, B, C and D. Gift tax consequences: upon insured s death, policy owner makes a gift of the death proceeds to the policy beneficiary.

36 Charitable Planning

37 Case Scenario #3... Client (age 73) is considering ways to provide a generous legacy to his alma mater. The university has approached him about acquiring a life insurance policy on his life, which would endow the university will a leveraged legacy upon his death. Client has been a regular contributor to the university, making periodic gifts of cash and marketable investments. He also owns an existing life insurance policy with a face value of $1,000,000, cash value of $150,000, and basis of $400,000.

38 Case Scenario #3 (cont.)... Client received this policy as a distribution from his deferred compensation plan at retirement, and has been taking annual loans from the policy to cover post retirement income needs. This policy has an outstanding loan of $500,000, and he is concerned about his tax consequences in the event of a future (and likely) lapse. He feels it would make sense to donate this policy to the university. He is interested in the tax benefits the planning would afford him, but is also interested in retaining access to policy cash (if future needs arise). Client is looking for advice on the best way to meet his, and the university's, objectives and needs.

39 Charitable Gifts and Bequests...

40 Question #11 What are the income, gift and estate tax advantages of naming a charity... The owner of a life insurance policy? The beneficiary of a life insurance policy?

41 Answer... Charity owned life insurance policy: Income tax deduction for policy premiums: Income tax deduction subject to 50% of AGI limitation (with 5 year carry forward for any unused deduction). Unlimited gift tax deduction for premium gifts (no gift tax). Proceeds excluded from insured s taxable estate. Donor owned life insurance policy (charity beneficiary): No income tax deduction for premium gifts. Policy premiums not gifts. Unlimited estate tax deduction for proceeds passing to charity (eliminates estate tax).

42 Question #12 How is a charitable gift of a life insurance policy valued? What charitable deduction limitations apply?

43 Answer... Donor's charitable income tax deduction is either: The policy cash value, or The donor s cost basis Whichever is less. Income tax deduction is restricted to the donor s cost basis, if the policy cash value exceeds premiums paid.

44 Charitable Gifts and Policy Loans...

45 Question #13 What are the potential tax consequences of a charitable gift of a policy which is subject to a loan?

46 Answer... Charitable donation of a life insurance policy encumbered by policy loan is problematic... Transfer will be considered a bargain sale, and donor will recognize gain. Loan on the policy may result in disallowance of deduction for the policy gift: If there is an outstanding loan on the policy, the donor is considered the policy beneficiary. Potential self dealing issues.

47 Business Succession Planning

48 Case Scenario #4... A (age 45) and B (age 47) are equal owners in a C corporation and a partnership. C corp. owns a $3,000,000 life insurance policy on each of their lives, with cash values of approx. $300,000, and basis (premiums paid) of $150,000. The policies were acquired by C corp. to fund a stock redemption agreement for A s and B s stock, as well as fund deferred compensation survivor benefits for their families. On the advice of their CPA, A and B are considering switching from a stock redemption plan to a cross purchase plan, in order to avoid potential AMT on the C corp. s receipt of the death proceeds.

49 Case Scenario #4 (cont.)... The C corp. is the beneficiary of a portion of the proceeds on each policy (amount required for stock redemption), and the shareholder s family is the beneficiary of the remaining proceeds. A and B also cross own policies on each other s lives, to fund their partnership buy-sell agreement; the face value of each policy is $1,000,000, with cash value $200,000, and basis of $100,000. Upon retirement from the partnership, they intend to acquire ownership of their own policies to use for estate liquidity and survivor income. They've designated each other s families as beneficiaries on the partnership policies.

50 The Transfer for Value Rule...

51 Question #14 What is the transfer for value rule, and under what circumstances can it be triggered? Who are "exempt transferees"?

52 Answer... Consequences of transfer for value rule: Death proceeds exceeding cost basis (premiums paid) is income taxable - if policy is transferred for valuable consideration. Consideration can consist of more than just money and can be implied from in many circumstances and contexts. Exceptions ( exempt transferees )... Transfer with carryover basis (e.g., gift of policy). Transfer to insured, or to insured s grantor trust (e.g., ILIT). Transfer to partner, or partnership, of insured. Transfer to corporation in which insured is shareholder or officer.

53 Question #15 What are the transfer for value implications of switching from an entity purchase buy-sell arrangement to a cross purchase buy-sell?

54 Answer... Under a properly structured cross purchase arrangement - the policies are cross-owned by the shareholders or partners. Transfer of an entity owned policy to a shareholder (who is not the insured), is a transfer for value without an exception. Shareholders (unlike partners) of the insured are not exempt transferees. Transfer of cross owned policies to a corporation in which the insured is a shareholder or officer, or to a partnership of the insured, meets an exception to the transfer for value rule. Limited liability companies (which elect to be taxed as partnerships) are likewise exempt transferees, as are LLC members.

55 Question #16 What are the potential tax implications for cross purchase shareholders or partners when they swap policies at retirement?

56 Answer... Cross-owned life insurance policies swapped at retirement... Example: A transfers policy owned on B s life to B; B transfers policy owned on A s life to A. Transfer constitutes sale or disposition of policy: Transferors A and B recognize gain on policies upon transfer (if cash value exceeds basis). Basis in policy received becomes basis in policy transferred (plus any gain recognized on the transfer). Constitutes transfer for valuable consideration : Insured is an exempt transferee - proceeds remain income tax free.

57 The Income Tax Triangle...

58 Question #17 What is the income tax triangle and under what circumstances can the triangle occur?

59 Answer... Income tax triangle is created where the policy owner, insured, and beneficiary are three different parties: Example: shareholder is insured; corporation is policy owner; shareholder s family (or ILIT for their benefit) is policy beneficiary. Example: employee is insured; corporation is owner; corporation and employee s spouse are policy beneficiaries. Income tax consequences: upon insured s death, policy owner makes income taxable transfer of proceeds to policy beneficiary: Characterized as either compensation or dividend (depending upon circumstances and context).

60 Selective Benefits Planning

61 Case Scenario #5... C corporation, S corporation, and partnership all wish to provide retirement benefits for certain key employees. They are considering the relative advantages and disadvantages of various selective employee benefit plans. They are also considering the advantages of a life insurance funded plan. S corporation and partnership are especially interested in (passthrough) deductible contributions, and control over the timing of employees receipt of their retirement benefits.

62 Case Scenario #5 (cont.)... C corporation is especially interested in the ability to recover the plan contributions, particularly in the event of an employee's termination of employment. All wish to ensure the life insurance death benefits (proceeds) remain income tax free. They are looking for advice on their planning and funding options, including relative tax benefits to employer and employee.

63 Corporate Owned Life Insurance...

64 Question #18 Are the proceeds of a corporate owned life insurance policy always received income tax free?

65 Answer... IRC 101(j) applies to all business owned policies issued after 08/17/06 - proceeds exceeding premiums paid are taxable to employer (unless specified requirements and exceptions are met): Insured must be given notice and consent. Employer must comply with annual IRS reporting and record keeping requirements. One of three exceptions must be met: Insured employed 12 months prior to death; or insured director or highly compensated employee when policy issued; or proceeds payable to insured s family member, trust for family member, or insured s estate. Note: IRC 409A also imposes strict requirements for all deferred compensation arrangements, and penalties for failure to comply - including retroactive constructive receipt of benefit (tax at time of intended deferral), income tax and penalty tax.

66 Business Premiums...

67 Question #19 Can a business deduct the premium for... A deferred compensation plan? A split dollar plan? An executive bonus plan?

68 Answer... Business cannot deduct a premium if it directly or indirectly benefits from the life insurance policy. Deferred compensation premiums are not deductible: Business is policy owner and policy beneficiary. Split dollar premiums are not deductible: Business is policy owner ("economic benefit" regime), or has a collaterally assigned interest in the policy ("loan" regime). Executive bonus premiums are deductible (provided reasonable and not excessive): Policy is employee owned. Business cannot be a policy beneficiary, or have a collaterally assigned interest in the policy.

69 Question #20 Can a business recover it s premium outlay from the death proceeds of... A deferred compensation plan? A split dollar plan? An executive bonus plan? Are the proceeds recovered income tax free?

70 Answer... Deferred compensation: Business is policy owner. Business can overfund policy to recover it's premiums; proceeds recovered by business are income tax free; proceeds received by employee s beneficiary are income taxable (i.e., deferred comp. benefit). Split dollar ( loan regime vs. economic benefit regime ): Business recovers premiums from policy cash value or death proceeds; proceeds recovered by business, or received by employee's beneficiary, are income tax free. Executive bonus: Employee is policy owner. Employee s beneficiary receives proceeds income tax free; any proceeds recovered by employer are income taxable, since employer received tax benefit (tax deduction) for premiums.

71 This presentation has been prepared based on Penn Mutual's current understanding of federal estate, gift, GST and income tax laws. Any changes in these laws may result in a conclusion different than what is represented. Please consult qualified legal and tax advisor regarding the client s specific situation. Please note that an irrevocable trust is a legal arrangement that may result in the inability to change the trust in the future, requires relinquishing control over the trust assets, must be properly administered, and has other significant consequences. Before implementing any plans based on specific circumstances and objectives, the client should consult with a personal legal, tax, and financial advisor. For advisor use only. Not for use in sales situations. Penn Mutual Life Insurance Company 600 Dresher Road, Horsham PA

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