Trust-Owned Life Insurance: Policy Review and Funding Techniques

Transcription

1 Print Trust-Owned Life Insurance: Policy Review and Funding Techniques By Mark W. McGorry and Stephen D. Lassar FEBRUARY High-net-worth individuals who need large amounts of life insurance should be aware of the considerable estate tax advantages of an irrevocable life insurance trust (ILIT). Within such an estate plan, life insurance can be used to accomplish the following goals: Payment of estate taxes; Estate equalization between heirs; Funding of state death taxes; Business continuity plans and funding of buy-sell agreements; and Charitable bequests. When life insurance is purchased by an ILIT, the trustees are the legal owners of the policy and are charged with the responsibility of carrying out the wishes of the grantor as specified in the trust instrument. These trustees also have the responsibility under the prudent investment rule, and associated state statutes where the trust is located, to create and follow procedures for proper administration and oversight of the trust s assets. Although trustees and their investment advisors are often well versed in what to do when the trust corpus is composed primarily of bank accounts, bonds, stocks, and mutual funds, they are usually at a complete loss as to how to evaluate and monitor the performance of a life insurance contract owned as an investment of the trust. There are three major areas with regard to life insurance policies that trustees should analyze: Factors to consider when evaluating the financial health of a life insurance policy; Techniques for paying premiums, especially when annual exclusions and lifetime exemptions may not be available; and Premium-funding techniques that integrate with other estate planning strategies. The Financial Health of a Life Insurance Policy Basic structure of permanent life insurance contracts. In the estate planning market, permanent life insurance policies purchased during the last quarter century have typically been whole life or universal life policies, or a blend of either whole or universal with term insurance. Whole life is a form of contract whose terms provide for a fixed guaranteed premium, a death benefit, and a cash surrender value, with the possibility of excess interest and mortality savings credited in the form of policy dividends. Dividends can be applied to increase the death and cash benefits or to reduce the premium outlays. Universal life policies typically do not carry a fixed premium or a guaranteed cash value schedule. Instead, they offer the option of a lower outlay from the time of issue by anticipating the possibility of interest rates in excess of the guaranteed rate and mortality expectations lower than those stated in the policy. As noted above, there is also a blended version of these policies that combines a base policy (typically, whole life) with a term insurance rider. Over time, the paid-up insurance purchased by dividends may replace most of the term portion, so that eventually the target death benefit consists entirely of the base whole life policy and the paid-up additions rider. Premium arrangements for permanent life insurance. Most policies are purchased for ILITs with the

2 intent that, regardless of whether the policy was a whole life, universal life, or blend, the policy would eventually build up sufficient value such that the internal policy credits would support itself without further contributions from the policy owner. During the last decade of sharply reduced interest rates, however, the internal credits to these policies have dropped significantly below those originally illustrated at the point of sale. The result is that policies take many more years of annual premium outlays than originally anticipated before they become internally self-sustaining, and required annual outlays increase significantly above the original scheduled premium levels. In the case of a whole life policy, with its fixed premium schedule, the premium cannot be increased in excess of that listed in the policy. Due to the lower dividend, however, a whole life policy may need to be paid for many more years than originally illustrated. In the case of universal life or blend policies that contain term insurance, there is typically an even greater increase in the number of years for which premiums must be paid. It is also not unusual for large increases in annual outlays to be required in order to avoid a lapse of coverage. These increases might be 50%, 100%, 200%, 300%, or even more. The internal financial structure of permanent life insurance. Individuals often ask why the required premium increase can be so drastic. In part it is due to the lower-interest-rate environment in recent years and the associated reduction to internal policy crediting rates. Lower crediting rates inside the policy ultimately require a greater contribution from outside the policy in the form of greater premium contributions. Over time, however, the greatest negative effect is the internal amount at risk of the policy. Exhibit 1 depicts a financially healthy policy and an unhealthy policy. The basic concept behind most permanent insurance policies is that, over time, the cash value associated with the policy will increase sufficiently such that the spread between the promised death benefit and the amount at risk will decrease. There is an internal charge to the policy for the cost associated with the amount at risk that increases naturally over time as the insured grows older, in much the same way as the cost of a term insurance policy eventually increases as the insured ages. If the internal interest credits are lower than originally illustrated, then the amount at risk will be higher than illustrated, and therefore the annual mortality charges for the amount at risk will be also be higher. The result is that in subsequent years the cash values will be adversely impacted by the higher-thananticipated internal mortality charges. This also means that the internal interest crediting rate will be on a lower than anticipated cash value, causing further assault on the cash value, a higher amount at risk, and higher associated mortality costs in later years. This downward cycle can continue such that the cash value, originally intended to be, in effect, a sinking fund to help support the insurance policy as the insured ages, will itself sink. Ultimately this can lead to a policy that operates like a yearly renewable term policy, with significantly increasing outlays each year. This can put the policy owner in the position of needing to make significantly higher outlays or risk losing the coverage. Worse yet, because these outlays can continue to grow each year, the owner is put in the position of a very uncertain cash outlay for an open-ended period of time until the policy either matures as a death claim, lapses, or is surrendered. This scenario can also cause significant gift tax issues. Potential Problems with Life Insurance Policies Example. Consider a trust that purchases a second-to-die whole life/term blended policy with a highly rated mutual life insurance company in 1991 on a married couple when the husband was 77 and the wife was 64. The policy has a target death benefit of $610,000, consisting of a base whole life policy of

3 $176,109 and a term rider of $433,891. The policy is intended to help meet estate-tax liquidity needs and is owned by an ILIT, with premiums to be funded through gifts to the trust from the grantors/insureds. Based on illustrations prepared in 1991, the couple expect that the term insurance would mostly be replaced over time with paid-up additional insurance purchased with the portion of the annual dividend not applied to the term insurance. In addition, the couple expect that after 10 annual payments of $10,000 per year the policy would be able to carry itself without further contributions from the trust. The trust stopped making payments after 10 years, and for the next five years the insurance company provides a form to the ILIT s trustee authorizing the insurance company to surrender sufficient dividend cash values to pay the current year s premiums. When the bill for May 2006 arrived, the couple received an unpleasant surprise: Instead of a bill for the usual $10,000, this bill was for almost $40,000. Moreover, when the couple contacted the insurance company, they learned that there were no additional dividends available to apply toward the premiums. What went wrong? After some investigation, the couple s advisor realized that because the wife received a Table C rating for medical history, the initial application was amended to increase the term portion of the policy in order to keep the premium in the $10,000 range. The initial application was for a blend of approximately 60% whole life base and nearly 40% term insurance, a moderately aggressive mix; however, it was ultimately issued as a blend of approximately 30% whole life base and 70% term insurance. For this aggressive mix to work as anticipated, the dividends from the whole life portion of the policy needed to support the anticipated offset of the premiums after the 10th year, as well as pay for the term costs and add sufficient paid-up additional insurance to replace the term insurance rider. As the years went by and dividends were consistently lower than originally anticipated, the original 10- year outlay program should have been adjusted. At the very least, the $10,000 annual payments should have been continued after the 10th year, so that the dividends could have continued to provide a death benefit from paid-up additional insurance. This would have kept the term insurance portion lower and helped mitigate the increasing term insurance costs. The large bill the couple received represented term insurance costs of approximately $30,000 on top of the $10,000 regular premium for the whole life portion of the policy. Even worse, a new illustration shows the anticipated outlay increasing by approximately $5,000 per year, so that at life expectancy for the wife, in her late 80s, the annual premium is approaching $100,000 per year, 10 times the original illustration. In addition, under a fairly common policy contract feature, the insurance company has the right to increase the term portion of the premium by almost 50%. Even if the policy were not already in an untenable position, it certainly would be if the company exercised its right to increase the term rate. Trustee s responsibility. In this example, the trustee and the grantor/insureds of the ILIT are in a very difficult position. The grantors must decide whether to continue funding this insurance. The trustee had the sole responsibility for this policy. Typically, the trustee is a family member or long-term trusted business or professional advisor. The relationship is usually so close that the trustee is serving without compensation, because all that has been asked is merely to maintain an account and then pay premiums. In fact, a trustee s job is much more involved than that, a fact that some trustees do not learn until they are sued by beneficiaries when the primary investment of the insurance trust, the policy, fails to deliver death benefits as expected. And the stakes in such a lawsuit can be high; the $610,000 policy in the example here is relatively small for an ILIT, but a $610,000 lawsuit against an individual trustee would

4 still be significant. The risk exposure could be very damaging to a trustee s personal financial wellbeing. Avoiding Problems Proper policy selection is critical. In every situation, the purchaser, whether acting in an individual or a fiduciary capacity, must make a best effort to match the insurance policy purchased to the needs of the policy owner. It has been the position of the authors for more than 20 years that many policies place too much of the long-term risk on the individual policy owner rather than the insurance company. This usually occurs when the premium structure of the contract depends largely on nonguaranteed factors. These features include the nonguaranteed element of not only the interest or return assumptions, but an even more critical element, the costs associated with mortality-related assumptions and costs. In a term insurance policy or rider, this refers to the term rates beyond the initial guarantee period; in universal life, it is the spread between the currently illustrated and guaranteed annual mortality charges for the amount at risk; and in a whole life policy, it is the mortality assumption element of the dividend calculation. In much the same way that an engineer must evaluate how a bridge will stand up to certain stresses, a purchaser of a financial investment be it stock, bond, or life insurance contract must consider the effect of various factors on the investments. Life insurance contracts can be illustrated to allow a purchaser to see the effect of various scenarios, including those in which interest rates are the lowest they can be and mortality charges and other expenses are the highest allowed under the terms of the contract. These illustrations cannot necessarily provide absolute assurance to the purchaser that a policy will not fail. This approach will, however, help the purchaser more reasonably evaluate the risk involved. In the current marketplace there are universal life policies that offer what is referred to as a secondary no-lapse guarantee provision. Basically, if a certain predetermined level of premium is paid for a certain period of time, the insurance company guarantees that the death benefit will stay in effect for a set period of time. The guaranteed coverage period provided by these contract provisions can even continue to age 100, 110, or 120. These contracts are popular for the high-net-worth estate planning market. When choosing a policy, this approach can be illustrated with different companies in various ways, all of which can provide a guaranteed death benefit for a selected period. Regular and continuous review. In addition to carefully choosing a policy, a policy owner should monitor its performance on a regular basis. It is generally considered sufficient to do a thorough review at least every three years. This may not be frequent enough, however, especially for older insureds. For example, if an insurance carrier exercised its contractual right to substantially increase the internal mortality or term insurance charges for a policy covering a 70-year-old, the policy might lapse in a couple of years, unless the payments into the contract are doubled or even quadrupled. As with most problems, early detection is critical. This would argue for annual reviews to calculate the premium level required to maintain the policy in force on a guaranteed basis for the intended period of coverage. If this calculated premium exceeds a level that the policy owner is willing to fund, several options are available. Replacing a policy. If an insured is insurable, the trustee policy owner may want to consider a possible replacement of the policy with a new one that has a secondary no-lapse guarantee provision. That policy could possibly be funded in whole or in part by an IRC section 1035 transfer of surrender value from the existing policy.

5 If a policy is no longer needed for its original purpose, the owner could consider terminating the policy in exchange for its cash surrender value or selling the policy in the secondary market (e.g., in a senior settlement). Another possibility would be to see if there is opportunity for financial arbitrage in the marketplace. The classic example of this is a life settlement arrangement in which the policy is sold and the proceeds invested (preferably under a tax-free IRC section 1035 arrangement) in a deferred annuity, which provides a guaranteed cash flow that can be matched on a net after-tax basis to the purchase of a new replacement policy with a no-lapse guarantee feature. The greatest arbitrage can be realized when the life settlement and annuity companies view the insured s actuarial life expectancy on a less favorable basis than did the company issuing the new life insurance. When all other options fail. Under circumstances in which the possibility of an economically favorable replacement is not available and the premium to guarantee the full death benefit is deemed too high, the trustee is faced with a difficult decision. In these circumstances, a trustee must consider how long the existing policy is likely to last on a guaranteed basis, based on the amount of premiums that will likely be available each year. The trustee will also need to gather some information on the life expectancy of the insured, based on actual medical history. When the insured has a medical history that falls outside the average life-expectancy tables, the trustee should consider getting a professional life-expectancy evaluation. The trustee can also consider reducing the death benefit to a level that will be sustainable on a guaranteed basis. No matter what course the trustee takes, it should be done with an eye toward setting a course as close as possible to meeting the grantor s goals for the benefit of the trust s beneficiaries. Although the trustee may not be able to plot a course that can guarantee a particular result, she must demonstrate that she has acted in a manner consistent with the fiduciary guidelines of the jurisdiction in which the trust is sited. Paying Premiums While Minimizing Gift Taxes A corollary concern is how to avoid payment of gift taxes when premiums can become quite large. One common method is to apply the annual gift exclusion to each Crummey beneficiary of a trust. This approach may be inadequate, especially if the trust has few beneficiaries or if annual gifts are being used for other purposes. Finally, an insured can apply a portion of the lifetime exclusion to the gift, but this may be impracticable for various reasons, particularly if the exclusion has already been used or is earmarked for another estate planning technique. One technique, which involves the use of loans by the insured/grantor to the ILIT (i.e., private financing), can mitigate or even eliminate gift, income, and estate tax issues involving the use of life insurance. The authors have used this technique since the 1990s and have further expanded it since the IRS s changes to the split-dollar regulations in September The following is a summary of the authors approach and how it can be a part of an effective estate plan: Loans to pay life insurance premiums will fall into one of two categories: Loans that bear interest at the applicable federal rate (AFR), which can take two forms: Loans that pay interest annually. Loans that accrue interest and are paid with principal at the end of the term loan. Loans that don t bear interest at the AFR, which can take three forms. These loans, known as below-market-rate loans, are governed by IRC section 7872, which imputes interest at the AFR for both income and gift tax purposes: Interest-free demand loans, where the interest is imputed on an annual basis at the short-

6 term AFR. Interest-free term loans, where the interest is imputed at the short-, mid-, or long-term AFR, but all of the interest over the expected term of the loan is discounted back to the present value and has tax consequences in the year of the loan. Hybrid loans, which have characteristics of both demand and term loans. Gift tax considerations. If not properly structured, a premium loan from the grantor/insured to the ILIT will constitute a split-dollar arrangement that falls into the split-dollar loan regime subject to the belowmarket interest rules of Treasury Regulations section To avoid gift tax consequences for foregone interest, the appropriate AFR should be charged. It may be necessary to make sure the loan is secured via a bare-bones assignment, meaning that the grantor/insured has no other rights in the policy, in order to avoid estate tax inclusion. Income tax considerations. In the case of a grantor trust, there should be no income tax consequences to either party, under the nonrecognition rule for transactions between grantors and their grantor trusts [Revenue Ruling (1985-1, C.B. 184)]. Estate tax considerations. Estate tax issues may arise from a loan from the grantor/insured to the ILIT. In addition to the IRC section 2042 issue discussed above, there is also the possibility of estate tax inclusion under IRC section Generally, however, this is unlikely to be an issue and should not result in inclusion of the policy for estate tax purposes. Planning considerations. In an era of low interest rates, it may make sense to lend the trust more than needed to pay current premiums as well as lock in low rates over the long term to help pay premiums in future years. If the interest is accrued, there will be both a smaller death benefit (assuming a level death benefit policy is issued) and a higher amount includible in the insured s estate. To mitigate this effect, it is worth considering applying for a policy that pays the initial death benefit plus cumulative premium payments. These policies, which are available as either single or survivor life, will require a higher premium than a level death benefit contract. Finally, it may be cost-effective for the grantor/insured to make the loans to the ILIT using funds obtained from a third-party lender at market rates. Loan Exit Strategies: Combining Premium Loan Arrangements with Other Techniques It is generally best to include within an estate plan a method for paying off the loans used by the trust for premium payments. The ultimate loan repayment would come when the policy matures as a result of the death of the insured. At that point, the death benefits can be available to repay the loan. If, however, the loans become quite large relative to the death benefit, this will reduce the death benefit that the trust can ultimately pay outside of the taxable estate. One potential solution is to take advantage of time-discounted estate planning techniques, which can ultimately mature with the ILIT as the remainderman. The techniques include grantor retained annuity trusts (GRAT), charitable lead annuity or unitrusts (CLAT or CLUT), and qualified personal residence trusts (QPRT). The following, shown in Exhibit 2, steps illustrate one such strategy: The grantor creates an ILIT, which in turn purchases life insurance on the grantor s life, with some or all of the premiums funded by loans from the grantor to the ILIT.

7 The grantor also establishes a GRAT that will pass the assets remaining at the end of the term to the ILIT. At that time, the ILIT can use the assets received from the GRAT to either pay down the loan or pay future premiums, or a combination of both if the ILIT trustee determines this would be the best approach. As noted above, this strategy can be used with short- or long-term GRATs, CLATs, or CLUTs, as well as fractional or total interest QPRTs. Each situation must be individually crafted for the specific individual. Best Practices Life insurance continues to be a viable economic planning tool in a variety of estate planning situations. The advice above represents best-practice approaches to help select and monitor appropriate life insurance contracts. It also provides several different alternatives for financing the payment of life insurance premiums when gift, income, or estate tax constraints are significant. The selection of the optimum technique will be dictated by the individual s goals, objectives, and personal situation. Mark W. McGorry, JD, CFP, CPC, CLU, AEP, is a managing director of Wealth Partners LLC, New York, N.Y. Stephen D. Lassar, JD, LLM, CPA, is managing director of the estate, trust, and succession planning division of CBIZ Business Solutions Inc., and a managing partner at the law firm of Goldfinger and Lassar, LLP. Close