Advanced Sales. White Paper: Valuation of Life Insurance Policies. Introduction. Number 19-1 February 1, January, 2012

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1 Advanced Sales White Paper: Valuation of Life Insurance Policies January, 2012 Contact Introduction us: Life insurance has become an important tool for advanced techniques used in the areas of estate planning, business planning, and executive benefits. Such techniques may include the transfer of an existing policy by gift or sale, or may include the use of a life insurance policy to create benefits for employment or retirement. In each of these situations, it is important to be able to provide an accurate valuation of the life insurance policy in order to determine the income, gift, generation-skipping transfer ( GST ), or estate tax consequences of the transfer or benefit at issue. Examples of such planning situations include: Transferring a policy to an individual as part of an estate plan (by sale or by gift); Transferring a policy into a trust for estate planning (by sale or by gift); Transferring a policy from an employer to an employee (by sale or as compensation); Life insurance on another insured held in a decedent s estate; Transferring a policy out of a qualified retirement plan (by sale or as a taxable distribution); Number 19-1 February 1, 2014 Transfer to an employee in connection with the performance of services (IRC 83); Permanent benefit life insurance used as part of a group life insurance plan (IRC 79); Sale of a policy as a life settlement or viatical settlement. Each of these planning situations has potential tax implications based upon the valuation of the life insurance policy involved. Whether an individual owes income, gift, GST, or estate taxes or whether the transaction can be structured without tax consequences depends on valuing the underlying life insurance policy in a manner acceptable to the IRS. The general rule for valuing property for tax purposes, according to the IRS, is to use the property s fair market value: The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. 1 Unfortunately, there is no generally accepted formula for determining the fair market value of an existing life insurance policy. Nor does the IRS provide a rule for valuation in all circumstances. So legal and tax advisors are left with the unenviable task of choosing between competing valuation methods, or worse, trying to establish an independent basis upon which to value a life insurance policy for tax purposes. 1 Treas. Reg (b), Treas. Reg ; cf. IRC 83(a) taxation on transfers of property in connection with performance of service based on property s fair market value.

2 The proper method for valuing a life insurance policy may depend on numerous factors including: (i) The type of policy being valued (i.e., term, whole life, universal life, etc.); (ii) The health of the insured; (iii) Whether the policy is recently issued; (iv) Whether further premiums are due on the policy; (v) Whether the policy is being transferred to or from a qualified retirement plan; (vi) Whether the policy in being transferred in connection with the performance of services; (vii) Whether the policy is being used as part of a group-term life insurance plan; (viii) Whether the policy is being transferred by gift or sale to an irrevocable trust; and/or (ix) Whether the transfer involves a gift or a sale between related parties. This White Paper is intended as a survey of guidance and potential standards for valuation provided by the IRS and is not comprehensive. It is up to professional tax and legal counsel to make a determination as to which valuation method to use in any given transaction. The General Rule: Fair Market Value As indicated above, the general rule for valuing property both for income tax purposes and for estate and gift tax purposes is that the proper value of property is its fair market value. 2 On the income tax side, when property is transferred from an employer to an employee in conjunction with the performance of services, the employee must recognize as ordinary income the amount by which the fair market value of the property exceeds the amount, if any, the employee has paid for the property. 3 Similarly, when a life insurance policy which is held in a qualified retirement plan is distributed to the participant, the fair market value of the contract at the time of distribution must be included in the distributee s income in accordance with the provisions of section 402(a). 4 The general rule of valuation for estate and gift tax purposes also relies on using a property s fair market value. The value of property included in a decedent s estate is its fair market value. 5 And when an asset is transferred as a gift, the value is likewise its fair market value. 6 For both estate and gift tax purposes, the regulations define fair market value as follows: The value of every item of property includible in a decedent s gross estate under sections 2031 through 2044 is its fair market value at the time of the decedent s death. The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of a particular item of property includible in the decedent s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate. 7 Thus, regardless of the type of transfer involved or the type of benefit being conferred, the appropriate value of a life insurance policy for tax purposes is generally the policy s fair market value the price at which a willing buyer would buy the policy from a willing seller assuming both parties have reasonable knowledge of the relevant facts. 2 See IRC 83(a), Treas. Reg (b), and Treas. Reg See also Guggenheim v. Rasquin, 312 U.S. 254 (1941). 3 IRC 83(a). 4 Treas. Reg (a)-1(a)(2). 5 Treas. Reg (b). 6 Treas. Reg Treas. Reg (b); Treas. Reg

3 Specific Rules: Some Situations Definitive Others Not Helping clients determine the appropriate valuation method to use for a life insurance policy has become extremely difficult. While the general rule of using a policy s fair market value applies to all types of life insurance policies and all circumstances, the IRS has promulgated various specific rules for determining policy value depending on whether the valuation is for income or transfer taxes, whether the policy is new or pre-existing, and the type of life insurance policy involved. There is a lack of consistency amongst the various rules and it can be challenging to determine which rule should apply to a given circumstance. Worse yet, there are a number of situations that don t appear to be covered by any specific rules. The following table lists examples of situations for which the IRS has or has not provided specific rules: Specific Rules New policies Paid-up policies Single premium policies Gift of existing whole life policies Transfer from a qualified retirement plan Transfer in connection with services performed Permanent benefit as part of group-term life plan No Specific Rules Gift or sale of existing term policies Gift or sale of existing UL, VUL, or IUL policies Gift or sale of policy where insured is no longer insurable Sale of a policy to an employee Where no specific rule applies, practitioners might consider using by analogy the rules applicable to other situations. But how do practitioners decide which specific rule to use? Should they always look to transfer tax rules when valuing a policy that has been gifted? Or if the policy is of a newer type such as a guaranteed death benefit product should the practitioner rely on the most recent set of policy valuation rules even though they were issued specifically for income tax valuations? At least one recent tax court case suggests that where there is no rule or regulation specifically on point, one cannot rely on any of the existing IRS rules. In the case of Schwab v. Commissioner, taxpayers and the IRS disagreed on the appropriate method of valuation for two variable universal life ( VUL ) policies that were subject to surrender charges. 8 The policies in question had been distributed to the taxpayers from a nonqualified welfare benefit trust. Both parties agreed that the taxpayers should recognize the full value of the policies as ordinary income, but they disputed whether the surrender charges should be considered when determining the policy values. 9 The IRS, arguing that the situations were analogous, wanted to apply the rule then applicable to distributions from qualified retirement plans (Treas. Reg (a)) which would disregard surrender charges when valuing a life insurance policy. The Tax Court, however, said the IRS could not rely on regulations which did not apply specifically to the case in question and that the regulations must be applied as written. 10 Instead, the tax court stated that in the absence of regulatory guidance, we hold that the amount actually distributed means the fair market value of what was actually distributed. 11 In other words, where there is no specific rule on point, practitioners are back to the general rule: The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts Schwab v. Commissioner, 136 T.C. 6 (2011). 9 Ibid. 10 Ibid. 11 Ibid. 12 Treas. Reg (b). 3

4 In practice this means that advisors and their clients have a difficult decision to make any time they are dealing with a life insurance transaction that is not covered by a specific rule or regulation. Based on the client s risk tolerance, advisors will have to prepare a valuation using either the most conservative valuation rule (i.e., the one that produces the largest tax value) or using a value that may not appeal to the IRS but that could be defended in court. Moreover, advisors cannot rely on an insurance carrier to provide the needed valuation. When an insurance company receives a request to provide a statement of the policy s current value, the insurance company is required to issue a Form 712 ( Life Insurance Statement ) to the policyholder. However, the Form 712 does not allow the insurance company the discretion to select the method of valuation to use for various circumstances. Rather, the Form 712 explicitly requires the insurance company to provide a calculation of the policy s interpolated terminal reserve value. Unless the transaction in question involves an existing whole life policy, the valuation provided by the insurance carrier likely will not reflect the applicable IRS rule or regulation. What is the Fair Market Value of a Life Insurance Policy for Estate and Gift Tax Purposes? Some of the basic principals for life insurance valuation are set out by the IRS in the estate and gift tax regulations: The value of a life insurance contract or of a contract for the payment of an annuity issued by a company regularly engaged in the selling of contracts of that character is established through the sale of the particular contract by the company, or through the sale by the company of comparable contracts. As valuation of an insurance policy through sale of comparable contracts is not readily ascertainable when the gift is of a contract which has been in force for some time and on which further premium payments are to be made, the value may be approximated by adding to the interpolated terminal reserve at the date of the gift the proportionate part of the gross premium last paid before the date of the gift which covers the period extending beyond that date. If, however, because of the unusual nature of the contract such approximation is not reasonably close to the full value, this method may not be used. 13 Here the basic framework for policy valuation is laid out in three distinct categories: (i) policies which are new or upon which no further premiums are due; (ii) policies which have been in existence for some time and for which the interpolated terminal reserve value is reasonably close to the full value ; and (iii) policies which have been in existence for some time and for which the interpolated terminal reserve value is not a close approximation of the policy s full value. So for transfer tax purposes, the basic framework for life insurance valuation separates life insurance policies into two basic categories: (i) those which are new or upon which no further premiums are due, and (ii) those which have been in force for some time and upon which further premium payments are to be made. New Policies, Single Premium Policies, and Paid-Up Policies The first type of policy valuation is based on the existence of comparable policies available for sale in the traditional life insurance marketplace. If a policy is new or if a policy has no further premiums due (i.e., is a single premium or paid-up policy), then the value is determined by what a life insurance company would charge for the policy in question. 13 Treas. Reg (a); see also Treas. Reg (a)(2). 4

5 In the case of new policies, the value of the policy is the price paid for the policy. This is demonstrated by the first example in the gift tax regulations: A donor purchases from a life insurance company for the benefit of another a life insurance contract or a contract for the payment of an annuity. The value of the gift is the cost of the contract. 14 When valuing a life insurance policy which is new (i.e., which has not been in force for some time ), the IRS sets the value at the purchase price of the contract. 15 What about 1035 Exchanges? When a life insurance policy is acquired in a 1035 exchange, the new policy rules should apply. This is a situation where fair market value can be determined by the price the insurance company would charge for the contract. 16 The regulations also look to the price of regularly sold life insurance contracts when establishing the value of a single premium or paid-up contract. So long as the contract has no further premiums due, valuation is based on the price the insurance company would charge for a single premium policy for a person the same age as the insured is at the time of the policy transfer. This situation is also covered by an example in the regulations: A donor owning a life insurance policy on which no further payments are to be made to the company (e.g., a single premium policy or paid-up policy) makes a gift of the contract. The value of the gift is the amount which the company would charge for a single premium contract of the same specified amount on the life of a person of the age of the insured. 17 So in the case of new policies and single premium or paid-up policies, valuation is based on the pricing of the insurance company. If it is a new policy, the value is what the insurance company did charge for the contract. If it is an existing single premium or paid-up policy, the value is based on what the insurance company would charge for a new contract providing the same coverage based on the attained age of the insured. Why doesn t the value reported by the insurance company on IRS Form 712 reflect the premium paid for a new contract, a single premium or paid-up policy, or the amount involved in a 1035 exchange? Policy owners and tax preparers often request verification of a life insurance policy s value from the insurance company as supporting documentation for a gift or estate tax return. Confusion will result when the value reported by the insurance company on the IRS Form 712 is significantly different from the premium paid for a new policy or 1035 exchange. When an insurance company receives a request to provide a statement of the policy s current value, the insurance company is required to issue a Form 712 ( Life Insurance Statement ) to the policyholder. However, the Form 712 does not allow the insurance company the discretion to select the method of valuation to use for various circumstances. Rather, the Form 712 explicitly requires the insurance company to provide a calculation of the policy s interpolated terminal reserve value. Where the transaction in question involves a new policy, a single premium or paid-up policy, or a policy recently acquired by a 1035 exchange, it is up to the tax return preparer to follow the guidance of the IRS regulations and determine if the value for the gift tax return (IRS Form 709) may be based on the policy s purchase price. 14 Treas. Reg (a), Example (1). 15 Treas. Reg (a). 16 Treas. Reg (a), Example (1). 17 Treas. Reg (a), Example (3). 5

6 Existing Policies Requiring Further Premiums: Interpolated Terminal Reserve For policies which have been in force for some time and on which further premium payments are to be made, valuation is based on the interpolated terminal reserve plus a proportionate part of the gross premium, so long as this provides an approximation of the policy s full value. 18 The value of a policy at the time of transfer is the policy s interpolated terminal reserve plus unearned premiums. The interpolated terminal reserve value is an extrapolation of a policy s reserve value at a given point in time based on the policy s reserve value at the point the last premium was paid and the projected reserve value for the point at which the next premium is due. Then, to arrive at the full policy valuation, add to this the proportionate amount of the premium covering the time remaining until the next payment is due. This calculation is demonstrated by Example (4) of Regulation (a): A gift is made four months after the last premium due date of an ordinary life insurance policy issued nine years and four months prior to the gift thereof by the insured, who was 35 years of age at date of issue. The gross annual premium is $2,811. The computation follows: Terminal reserve at end of tenth year...$14, Terminal reserve at end of ninth year...$12, Increase...$1, One-third of such increase (the gift having been made four months following the last preceding premium due date), is...$ Terminal reserve at end of ninth year...$12, Interpolated terminal reserve at date of gift...$13, Two-thirds of gross premium ($2,811)...$1, Value of the gift... $15, Accordingly, the value of an existing policy with ongoing premium is the policy s interpolated terminal reserve on the date of transfer plus unearned premiums. This amount can best be understood as the sum of the following values: (i) the policy s reserve value on the last premium anniversary, (ii) the proportion of the projected growth in the policy s reserve value earned thus far in the new policy year, and (iii) the proportion of paid premiums to be applied to the remainder of the policy year. Existing Policies: Other Types of Contracts The regulations adopting the interpolated terminal reserve method of policy valuation were enacted in 1963 a time when the only types of life insurance policies available were whole life and renewable term. 20 Whole life or ordinary life insurance is a permanent insurance product where the insured pays level premiums for life or until endowment. A whole life policy accumulates a reserve or cash value that gradually increases until it is equal to the face amount of the policy i.e., until it endows. Whole life policies have typically been designed to endow at age 100 (some are designed to endow at age 121 using the 2001 CSO mortality tables). The interpolated terminal reserve calculation provides a good measure of policy value based on the way whole life policies are designed. There is some question as to whether the interpolated terminal reserve method of policy valuation is appropriate for other types of life insurance contracts. Such a possibility may have been foreshadowed by the regulations which state: If, however, because of the unusual nature of the contract such approximation is not reasonably close to the full value, this method may not be used. 21 While the original intent of this provision remains unclear, its inclusion in the transfer tax regulations may have application today for life insurance contracts which are not term or whole life contracts Treas. Reg (a)(2) and Treas. Reg (a). 19 Treas. Reg (a), Example (4). 20 Treas. Reg , Treas. Reg ; see also McGill s Life Insurance, 6th ed., (American College, 2007). 21 Treas. Reg (a)(2), Treas. Reg (a).

7 The question becomes whether this statement should be applied to some or all of the various types of life insurance contracts that have been developed since the regulations were first issued: Universal Life. This type of insurance was first introduced in 1979 as a flexible alternative to ordinary whole life insurance. 22 Universal life insurance introduces the feature of flexible premiums and a cash value that can increase based on crediting rates higher than the guaranteed rate. The combination of these two factors offers the possibility that the policy owner may not have to pay the original level of premium for the full life of the contract. The policy owner has the option to select between having the policy structured as a fixed death benefit or having an increasing death benefit. Additionally, universal life insurance allows partial withdrawal of cash values without requiring a policy loan.23 Variable Universal Life. Variable universal life insurance adds an investment feature to the life insurance contract. Rather than relying on crediting rates backed by the assets of the insurance company, a variable universal life policy allows the policy owner to direct the net premiums to various subaccounts. Variable universal life insurance also allows for flexible premiums, level or increasing death benefits, and the ability to take partial withdrawals from the policy s cash values. 24 Because of the nature of the variable investment options, there is no guaranteed crediting rate for policy cash values and, in fact, it is possible for the policy to decline in value based on poor investment experience. Note: Before investing, clients should carefully consider their need for life insurance coverage and the charges and expenses of the variable universal life insurance policy. They should also consider the investment objectives, risks, fees, and charges of each underlying variable investment option. This and other information is contained in the prospectuses for the variable universal life insurance policy and the underlying variable investment options. Clients may obtain these prospectuses from their registered representative or by calling the insurance company and should read them carefully before investing. Guaranteed Death Benefits. A more recent development for life insurance products is to add a no-lapse guarantee or to provide a guaranteed death benefit. This new feature is designed to combat the problem of policy termination due to poor policy performance (i.e., a universal life policy where actual credited interest rates fall below illustrated crediting rates or a variable universal life policy that experiences investment returns below the illustrated rate of return). A guaranteed death benefit product generally promises that the policy death benefit coverage will remain in force for a certain term or the life of the insured so long as a specified premium is paid on time. This coverage is guaranteed regardless of the interest rates actually credited (for universal life policies) or the actual performance of the selected subaccounts (for variable universal life policies). The guarantee is based on the financial strength and claims paying ability of the issuing insurance company, who is solely responsible for all obligations under its policies. Each of these new life insurance product types offers features that add additional value to the contract. Universal life offers the policyholder flexibility in determining when and how much to pay in premiums on an on-going basis. Variable contracts offer policyholders the ability to direct net premiums to variable investment options that participate in the equity markets. And the recent development of guaranteed death benefit policies provides a guarantee of maintaining in force the death benefit even when the policy has no cash value. 22 McGill s Life Insurance, 6th ed., 5.17 (American College, 2007). 23 Policy loans and partial withdrawals may vary by state, reduce available surrender value and death benefit or cause the policy to lapse. Generally, policy loans and partial withdrawals will not be income taxable if there is a withdrawal to the cost basis (usually premiums paid), followed by policy loans (but only if the policy qualifies as life insurance, is not a modified endowment contract and is not lapsed or surrendered). 24 Policy loans and partial withdrawals may vary by state, reduce available surrender value and death benefit or cause the policy to lapse. Generally, policy loans and partial withdrawals will not be income taxable if there is a withdrawal to the cost basis (usually premiums paid), followed by policy loans (but only if the policy qualifies as life insurance, is not a modified endowment contract and is not lapsed or surrendered). 7

8 The question becomes whether the interpolated terminal reserve method of calculation can provide an adequate valuation for the various types of life insurance products which have been developed since the regulations were first adopted. While the interpolated terminal reserve method has generally continued to be applied to both universal life and variable universal life contracts for estate and gift tax purposes, the IRS has questioned its continued use when making determinations for income tax purposes. The IRS began questioning the interpolated terminal reserve method for certain types of contracts in a Notice issued in 1989 and has since adopted a new methodology for valuing life insurance contracts in employment and employee benefit settings. 25 To date, the IRS has not issued any similar guidance for valuing policies for estate and gift tax purposes. There is a strong argument to be made that policy valuations for estate and gift tax purposes should follow the guidance the IRS has given for income tax situations. First, the regulations themselves anticipate situations where contracts cannot be valued using the interpolated terminal reserve method. Second, the new guidance from the IRS on the income tax side is directed at the greater variety of life insurance products available in the market today. And third, the IRS has shown interest in the past of achieving consistency in valuations of life insurance for both income tax and transfer tax purposes. 26 Given these assumptions, practitioners providing valuations of life insurance policies for gift or estate tax purposes may want to consider following the guidance of Rev. Proc and use the higher of the value provided using the interpolated terminal reserve method or the value given by the PERC calculation (discussed below). Existing Policies: Other Circumstances Insured No Longer Insurable Having a policy which is not a whole life or term policy is one circumstance where using the interpolated terminal reserve method of policy valuation may not adequately reflect the policy s full value. 27 Another circumstance may be where the insured s health has deteriorated to the point where life expectancy is significantly less than for other persons of the same age. In such cases the life insurance policy may be seen as irreplaceable and the standard rules of valuation would not apply. The leading case involving such a policy is Estate of Pritchard v. Commissioner. 28 In that case, the insured, who had been diagnosed with cancer, sold his policy for its cash surrender value thirty days before his death. At the time of the sale, the policy s surrender value was a little over $10,000 and the death benefit was $50,000. His estate argued that the policy proceeds should not be included in his estate since the policy had been sold for full and adequate consideration. The Tax Court disagreed, holding that the policy s value should reflect the insured s drastically reduced life expectancy. One of the important elements to be considered in determining a value of a life insurance policy is its collectability. The nearer the insured approaches death, which is the event of collectability, the nearer the value approaches the face amount for which it was issued. In the instant case, the insured s health was in a desperate and hopeless, or at least a dangerous, condition, and death was known to be relatively imminent, i.e., his life expectancy was much less than that shown on the mortality tables as the life expectancy of an insurable man his age. Under these special facts, the cash surrender was wholly inadequate as a measure of [the policy s] worth at the time of the transfer. 29 Thus, where the insured s health is such that there is significantly diminished life expectancy, valuation of the policy must account for the increased likelihood of reaching the point of collectability. Where an insured s health is so poor that he or she is no longer insurable, the policy must be valued at an amount significantly higher than would be produced using the interpolated terminal reserve calculation See IRS Notice 89-25, Q&A-10; Rev. Proc ; and Rev Proc See Rev. Rul ( C.B. 18). 27 Treas. Reg (a)(2), Treas. Reg (a). 28 Estate of Pritchard v. Comm r, 4 TC 204 (1944); see also United States v. Ryerson, 312 US 260 (1941). 29 Estate of Pritchard, 4 TC 204, 208 (1944). See also PLR (holding that an insured s terminal illness made the policy s value significantly more than its reserve value).

9 In sum, for estate and gift tax purposes, there are at least five potential means of providing a policy valuation: 1. If the life insurance policy is new or recently purchased, use the purchase price as the policy s value. 2. If the policy is an existing single premium or paid-up policy, use the price of a new single premium policy for the same death benefit for a person of the insured s age as the policy value. 3. If the policy is an existing term policy or whole life policy on which premiums are still due, use the interpolated terminal reserve method to calculate the policy s value. 4. If the policy is an existing policy that is not a term or whole life policy, consider using either the interpolated terminal reserve method or the PERC method to calculate the policy s value. The more conservative approach would be to use whichever method produces the higher valuation. 5. If the insured s health has deteriorated and he or she is no longer insurable, use a valuation based on shortened life-expectancy and the probability of collecting the death benefit amount. What is the Fair Market Value of Life Insurance for Income Tax Purposes? Transfers of property in the employment context have been governed by IRC 83 since June 30, For transfers prior to February 13, 2004, the valuation of life insurance was based on its cash surrender value: In the case of a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, only the cash surrender value of the contract is considered to be property. 30 This is somewhat of a departure from the interpolated terminal reserve calculations the regulations apply to gift and estate tax transactions. Over time, especially as new types of products came out, this definition of value for life insurance contracts became easily subject to manipulation and abuse. Employers sought, and insurance companies delivered, life insurance products that would be designed to have suppressed cash values in the early years and normalized cash values three or four years into the contract. This allowed employees to use pre-tax money to fund the purchase of a policy inside of a retirement plan and then distribute the policy at a time when the cash surrender value was significantly less than the premiums paid for the contract. The IRS signaled its intent to curb these manipulations by announcing new rules for valuing life insurance contracts. In IRS Notice the IRS addressed the following question: What amount is included in a plan participant s gross income when the participant receives a distribution from a qualified plan that includes a policy issued by an insurance company with a value substantially higher than the cash surrender value stated in the policy? 31 In giving an answer to this question, the IRS first acknowledged that, at the time, Section 1.402(a)-1(a)(2) of the regulations required only that a policy s cash value be included in income. The IRS further noted, however, that according to Section (c)(2)(ii) of the regulations, cash value is best approximated and derived from the value of a policy s reserves. And so the IRS went on to state: Individuals who receive an insurance policy as a distribution from a qualified plan use the stated cash surrender value of the policy as its fair market value for purposes of determining the amount includible in their gross income under section 402(a) of the Code. However, this practice is not appropriate where the total policy reserves, including life insurance reserves (if any) computed under section 807(d), together with any reserves for advance premiums, dividend accumulations, etc., represent a much more accurate approximation of the fair market value of the policy than does the policy s stated cash surrender value Treas. Reg (e) pre IRS Notice 89-25, Q&A IRS Notice 89-25, Q&A-10. 9

10 Not fully satisfied with the definition provided under Notice 89-25, and perceiving continued valuation abuse for transfers of life insurance policies in the employment and employee benefit contexts, the IRS introduced the PERC calculation in After allowing time for comments, the IRS revised and finalized the PERC calculation to make some allowance for the impact of legitimate surrender charges. 34 These new valuation rules are to be applied within the contexts of IRC 79, 83, and 402 to all transfers of life insurance policies on or after February 13, What Is the PERC Calculation? The PERC calculation is given in Rev. Proc PERC stands for Premiums, Earnings, and Reasonable Charges. In its 2005 guidance, the IRS indicates that for income tax purposes, a life insurance policy must be valued at the higher of (i) the interpolated terminal reserve value, or (ii) the PERC value multiplied by an Average Surrender Factor (for which the IRS supplies a formula). 36 Where the transfer is governed by IRC 79 or 83, no adjustment to the PERC is allowed for policy surrender charges. 37 The PERC formula is expressed as follows: The PERC amount is the aggregate of: (1) the premiums paid from the date of issue through the valuation date without reduction for dividends that offset those premiums, plus (2) dividends applied to purchase paid-up insurance prior to the valuation date, plus (3) any amounts credited (or otherwise made available) to the policyholder with respect to premiums, including interest and similar income items (whether credited or made available under the contract or to some other account), but not including dividends used to offset premiums and dividends used to purchase paid up insurance, minus (4) explicit or implicit reasonable mortality charges and reasonable charges (other than mortality charges), but only if those charges are actually charged on or before the valuation date and those charges are not expected to be refunded, rebated, or otherwise reversed at a later date, minus (5) any distributions (including distributions of dividends and dividends held on account), withdrawals, or partial surrenders taken prior to the valuation date. 38 The earnings component for variable contracts also includes all adjustments that reflect the investment return and the market value of segregated asset accounts. 39 If the transfer involves a sale or distribution of a policy from a qualified retirement plan under IRC 402, the PERC amount may be adjusted to reflect some surrender charges. The largest discount allowed for surrender charges is 30% (meaning the policy s cash surrender value is 70% of the PERC amount (which gives a surrender factor of 0.70)). 40 The Average Surrender Factor is defined as the unweighted average of the applicable surrender factors over the 10 years beginning with the policy year of the distribution or sale. 41 For each policy year, the applicable surrender factor is the greater of either the actual surrender factor (determined by dividing the policy s cash surrender value for that year by the policy s PERC amount for that year) or Rev. Proc Rev. Proc ; Treas. Reg , , and 1.402(a) Rev. Proc Rev. Proc , Sections 3.02, 3.03, and Rev. Proc , Section 3.04(1). 38 Rev. Proc , Section Rev. Proc , Section Rev. Proc , Section Rev. Proc , Section Rev. Proc , Section 3.04.

11 Example: Consider a policy that is being transferred in its fourth year. The insurance company applies a surrender charge that is 100% in year 1 and then drops by 10% a year until the tenth year when there is no more surrender charge. The Average Surrender Factor could then be calculated using the following chart: Year: Surrender Charge: Surrender Factor: 60% 50% 40% 30% 20% 10% For this policy transfer, the Average Surrender Factor is 0.85 [( ) / 10]. Other Circumstances? The discussion on valuing life insurance policies for transfer tax purposes included two sets of circumstances that would require some method of valuation other than reliance on the use of the interpolated terminal reserve method: (i) drastically reduced life expectancy of the insured, and (ii) policies that include features beyond those of standard whole life policies. For income tax purposes, the use of the new PERC calculations addresses the issue created by new types of life insurance contracts, but what about the transfer of a policy where the insured is no longer insurable? Should these policies abandon the PERC calculation as well? While there is no case law directly on point, the rules for income tax valuation appear to allow use of the PERC calculation even in these circumstances. The IRS, in Rev. Proc , offers the PERC method of valuation as a safe harbor formula. So it would appear that so long as the transfer in question is one that falls under IRC 79, 83, or 402, then the taxpayer is entitled to rely on the values produced by the PERC calculation as sufficient for income tax purposes. In sum, when valuing a life insurance policy for income tax purposes, the following rules may be applied: 1. Transfer or distribution of a policy from a qualified retirement plan (IRC 402(a)). The policy value is the higher of the interpolated terminal reserve value or the PERC amount multiplied by the Average Surrender Factor. Conclusion 2. Transfer of a policy in the connection with performance of services (IRC 83). The policy value is the higher of the interpolated terminal reserve value or the PERC amount. 3. Valuation of a policy providing permanent benefits in a group-term life plan (IRC 79). The policy value is the higher of the interpolated terminal reserve value or the PERC amount. Proper valuation of a life insurance policy is important to ensuring that a policy transfer has no adverse estate, gift, GST, or income tax consequences. While the IRS has laid down the general rule that policy valuations should be based on fair market value, it is not always easy to determine what that value might be. For brand new policies, the value may be based on the purchase price. But for existing policies, several other rules come into play. Tax and legal advisors may rely on the PERC valuation method when dealing with income tax transactions. On the estate and gift tax side, there is no clearly established rule for all situations. While the tax regulations suggest using the interpolated terminal reserve calculation for existing term and whole life policies, advisors may want to consider using the PERC calculation for more modern life insurance products. The following table provides a summary of potential methods for valuing life insurance policies in various scenarios: 11

12 Estate & Gift Tax Valuations New Policies/ 1035 Exchanges Existing Single Premium or Paid-Up Policy Existing Term Existing Return of Premium Term Existing Whole Life Existing UL, VUL, and Other Policies Reduced Mortality Insured No Longer Insurable Purchase price of the policy. Treas. Reg (a), Example (1) Purchase price of new single premium policy for same death benefit for person of insured s attained age. Treas. Reg (a), Example (3) No definitive rule. May want to consider using unused premium. See, Schwab v. Commissioner, 136 TC 6 (2011) No definitive rule. Treas. Reg (a) indicates that the interpolated terminal reserve is the proper measure so long as this represents the policy s full value. Depending on circumstances, may want to consider using either: (i) cash surrender value, or (ii) interpolated terminal reserve + unused premium. Interpolated terminal reserve + unpaid premium. Treas. Reg (a), Example (4) No definitive rule. Treas. Reg (a) indicates that the interpolated terminal reserve is the proper measure so long as this represents the policy s full value. May want to consider basing value on the higher of: (i) interpolated terminal reserve + unpaid premium, or (ii) PERC Seek professional policy appraisal based on reduced life expectancy. Estate of Pritchard v. Commissioner, 4 TC 204 (1944) Income Tax Valuations New Policies/ 1035 Exchanges Transfer or Distribution from Qualified Retirement Plan (IRC 402(a)) Transfer in Connection with Performance of Services (IRC 83) Permanent Benefit in Conjunction with Group-Term Life Plan (IRC 79) Sale of Policy to Employee Purchase price of the policy. Guggenheim v. Rasquin, 312 US 254 (1941) Higher of: (i) interpolated terminal reserve + unpaid premiums, or (ii) PERC * Average Surrender Factor Rev. Proc ; Treas. Reg (a)-1 Higher of: (i) interpolated terminal reserve + unpaid premiums, or (ii) PERC Rev. Proc ; Treas. Reg Higher of: (i) interpolated terminal reserve + unpaid premiums, or (ii) PERC Rev. Proc ; Treas. Reg No definitive rule. Depending on circumstances, may want to use interpolated terminal reserve, PERC, or value of paid-up policy based on then existing cash surrender value. See, Schwab v. Commissioner, 136 TC 6 (2011) 12

13 These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax adviser. The Voya Life Companies and their agents and representatives do not give tax, legal or accounting advice. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone. You should seek advice from your tax and legal advisors regarding your individual situation. Life insurance products are issued by ReliaStar Life Insurance Company (Minneapolis, MN), ReliaStar Life Insurance Company of New York (Woodbury, NY), and Security Life of Denver Insurance Company (Denver, CO). Variable universal life insurance products are distributed by Voya America Equities, Inc. Within the state of New York, only ReliaStar Life Insurance Company of New York is admitted and its products issued. All are members of the Voya family of companies Voya Services Company. All rights reserved. CN /01/2014 Voya.com