32 Irrevocable Life Insurance Trusts 2.1

Transcription

1 2 Income Tax Issues CHAPTER OVERVIEW This chapter discusses selected key income tax issues concerning life insurance and ILITs. 1 Recent changes in the Internal Revenue Code now permit an insured to receive life insurance proceeds income tax free under certain conditions, such as during a terminal or chronic illness. An ILIT drafted with sufficient flexibility can take advantage of these special benefits. The income tax aspects of life insurance must be understood if the death benefit is to be received income tax free. Thus, the transfer for value rule is extremely important and is an income tax trap for the unwary. This special rule, which can cause life insurance proceeds to be subject to income taxation is also important for understanding how to fix a damaged ILIT. See, Chapter 15, below. The grantor trust rules, among other things, provide tremendous flexibility, especially if the grantor wants to make additional tax-free gifts to the ILIT that are in excess of the grantor s gift tax annual exclusion amount, or if the grantor wants to transact with the ILIT on an income tax free basis. The grantor trust rules also provide flexibility in fixing a damaged ILIT. This chapter also contains a brief discussion of the tax-free 1 See, Norman H. Lane & Howard M. Zaritsky, Federal Income Taxation of Estates and Trusts (Warren, Gorham & Lamont of RIA, 3d ed & Supp. 2007); and Alan S. Acker, 852-2nd T.M., Income Taxation of Trusts and Estates, Bureau of National Affairs, Washington, DC, for an overview of the income taxation of estates, trusts, and beneficiaries. See also, Chapter 2 of Howard M. Zaritsky & Stephan R. Leimberg, Tax Planning With Life Insurance: Analysis With Forms 2d Edition, Warren, Gorham & Lamont, Boston, Massachusetts (Supp. 2007) for an overview of the income taxation of life insurance. 31

2 32 Irrevocable Life Insurance Trusts 2.1 exchange of a life insurance policy; the income taxation of policy dividends and loans; the income taxation upon the surrender, cancellation, or lapse of a policy; and the income taxation upon the sale of a policy. 2.1 LIFE INSURANCE PROCEEDS RECEIVED INCOME TAX FREE Generally, proceeds paid under a life insurance contract (as defined in IRC section 7702 concerning policies issued after December 31, 1984; and as defined in Helvering v. LeGierse, 312 U.S. 531 (1941) for policies issued before January 1, 1985) by reason of the insured s death 2 are not subject to income tax. 3 IRC section 101(a)(1). There is 2 Payment of life insurance proceeds due to an insured member of the uniformed services who is declared Missing In Action constitutes a payment by reason of the insured s death. Rev. Rul , C.B. 93. However, payment of life insurance proceeds to a creditor to discharge an indebtedness of the insured where the creditor is the policy owner, beneficiary, and makes all the premium payments, is not income tax free to the creditor; rather, the payment of the life insurance proceeds is a collection of the unpaid amount owed the creditor. In such an instance, the creditor s payment of premiums is typically deductible as a business expense. Rev. Rul , C.B. 31. See also, Landfield Finance Company v. United States, 418 F.2d 172 (7th Cir. 1969) (proceeds payable to a creditor in satisfaction of a debt owed to the creditor are not excludable from the creditor s gross income). 3 An exception to the income tax free receipt of life insurance proceeds applies to certain employer-owned life insurance ( EOLI ) contracts issued (or materially modified) after August 17, IRC sections 101(j) and 6039I. These Code sections were added by section 863 of the Pension Protection Act of 2006 (8/17/2006) and may affect life insurance funded buy-sell agreements (redemption and cross-purchase), deferred compensation agreements, and any other type of EOLI. Generally, under IRC section 101(j), when an employer (or an employer-related person) receives death proceeds from an EOLI policy, the proceeds will be ordinary income except to the extent of premiums and other amounts paid by the employer (or an employer-related person) for the life insurance contract. The new rules were added in an attempt to put an end to so called janitor life insurance, where employers (such as Winn-Dixie Stores, Inc.) were purchasing life insurance as an investment on its rank and file employees without the knowledge or consent of the insured-employee, and collect the death proceeds many years later typically after the insured was no longer an employee. Who constitutes an employee is rather broad under the under the new law, and may include common law employees, the self-employed, and independent contractors. See, Temporary Treas. Reg. 414(q), Q&A 7. Until Treasury Regulations for IRC section 101(j) are issued clarifying the definition of an employee or providing exemptions, it is suggested that the cautious-conservative advisor have his or her client operate under the broad definition of an employee.

3 2.1 Income Tax Issues 33 no limitation on the amount of life insurance proceeds that a beneficiary can receive income tax free. IRC section 101(a)(1) is an exception to the definition of gross income under IRC section 61(a)(10). Also, the related person definition in IRC section 101(j)(3)(A)(i) may be a trap for the unwary. In the absence of clarifying regulations (or technical amendments to IRC section 101(j)), the definition of a related person may be interpreted to include a relative (as defined in IRC section 267(b)) of the employer or a 50% or more owner of the employer, such as a co-shareholder, partner, member, or a trust controlled by the employer. Thus, a life insurance policy that is owned by or payable to an employerrelated person, may be treated by the IRS as being owned by the employer and be subject to the new rules. Therefore, life insurance-funded cross-purchase agreements may come within the ambit of IRC section 101(j), as may certain split-dollar plans, VEBAs, life insurance funded non-qualified deferred compensation plans, life insurance-funded rabbi and secular trusts, and life insurance contained in a qualified retirement plan. Consequently, the employee-notice and consent requirements and the IRS reporting requirements (discussed below) should be complied with when an employer-related person is the owner or beneficiary of the insurance policy on the employee s life. See, Steve Leimberg s Estate Planning Newsletter # 1044 (October 27, 2006) at In order for the EOLI to be excluded from income pursuant to IRC section 101(a), the following three employee-notice and consent requirements must be met: (1) before the issuance of the EOLI policy, the employee must be notified in writing that the employer (or an employer-related person) intends to insure the employee s life and the maximum face amount of life insurance that the employer (or the employerrelated person) might take out on the employee s life; (2) before the issuance of the EOLI policy, the employee provides written consent to being insured under the policy and consents that the coverage may continue after the insured terminates employment; and (3) before the issuance of the EOLI policy, the employee is informed in writing that the employer (or the employer-related person) will be a beneficiary of any proceeds payable upon the death of the employee. If it is subsequently determined that all three employee-notice and consent requirements were not met when the policy was issued, the problem can be corrected by cancelling the non-compliant policy and reissuing a new EOLI policy that is employee-notice and consent compliant. If all three employee-notice and consent requirements are met, the EOLI death benefit proceeds will be excludable from the employer s (or the employer-related person s) income pursuant to IRC section 101(a) if any one or more of the following four exceptions exist: (1) the insured was an employee within 12 months of his or her death; (2) the policy proceeds are paid to a member of the insured s family (within the meaning of IRC section 267(c)(4)), any individual who is the designated beneficiary of the insured under the policy (other than the employer (or possibly an employerrelated person)), a trust established for the benefit of any such member of the insured s family or designated beneficiary, or to the insured s estate; (3) the policy proceeds are used by the employer (or possibly an employer-related person) to redeem-purchase an

4 34 Irrevocable Life Insurance Trusts 2.1 Caution: Interest paid by the life insurance company because of a delay in payment of the life insurance pro- equity (or partnership capital or profits) interest in the employer owned by the insured, a member of the insured s family (within the meaning of IRC section 267(c)(4)), any individual who is the designated beneficiary of the insured under the policy (other than the employer (or possibly an employer-related person)), a trust established for the benefit of any such member of the insured s family or designated beneficiary, or by the insured s estate (and according to the Report of the Joint Committee on Taxation, it is intended that such amounts be so paid or used by the due date of the employer s income tax return for the year in which the life insurance proceeds are received); or (4) the insured was a director or highly compensated employee at the time the policy was issued. A highly compensated employee is a person who: (i) is a 5% or more owner of the business, (ii) is a director or officer of key management of the business, (iii) received in the prior year compensation in excess of $100,000 (for 2006), or (iv) anyone else within the top 35% of employees ranked by pay. Additionally, IRC section 6039I requires an employer (or an employer-related person) who owns one or more EOLI policies issued after August 17, 2006, to file an annual information report with the IRS. The report must state: (1) the number of employees of the employer (or possibly an employer-related person) at the end of the year; (2) the number of those employees insured under post-august 17, 2006 EOLI contracts at the end of the year; (3) the total amount of insurance in force under the post-august 17, 2006 EOLI contracts at the end of the year; (4) the employer s (or possibly an employer-related person s) name, address, taxpayer identification number, and the employer s (or possibly an employer-related person s) type of business; and (5) that the employer (or possibly an employer-related person) has a valid consent for each insured-employee, and the number of insured-employees for whom such consent was not obtained. Employers (or an employer-related person) owning life insurance policies that are subject to the new IRC section 101(j) rules must also maintain records necessary to determine whether the IRC section 101(j) requirements are met. The information-filing rules do not apply to an EOLI policy issued after August 17, 2006, pursuant to an IRC section 1035 exchange for an employer-owned policy that was issued before August 17, However, certain material increases in the death benefit or other material changes in an EOLI policy will cause a grandfathered policy to be treated as a new policy issued after August 17, 2006, and be subject to the new rules of IRC sections 101(j) and 6039I. But increases in the death benefit that occur as a result of the operation of IRC section 7702 (corridor or cash value tests) or the terms and normal operation of the existing policy (e.g., paid-up additions or as the result of market performance or policy design), if the insurer s consent to the increase is not required, will not cause a grandfathered policy to be treated as a new policy. See, Sebastian V. Grassi, Jr., New Rules Concerning Employer-Owned Life Insurance Affect Buy-Sell Agreements (With Sample Drafting Language), 21 Practical Tax Lawyer 7 (Winter 2007); and James Magner and Stephan R. Leimberg, Pension Protection Act Adopts Far-reaching New Rules for COLI, 33 Estate Planning 3 (October 2006).

5 2.2(b) Income Tax Issues 35 ceeds is subject to income tax. 4 IRC sections 101(c) and (d). Interest or dividends paid by the Veterans Administration on a United States Government Life Insurance policy or on a National Service Life Insurance contract (i.e., a U.S. military government life insurance policy) are however income tax free. 38 U.S.C. section 38 U.S.C. 5301(a)(1).; Rev. Rul , C.B. 18; Rev. Rul , C.B ACCELERATED DEATH BENEFITS AND VIATICAL SETTLEMENT PROCEEDS RECEIVED INCOME-TAX FREE 2.2(a) Accelerated Death Benefits Accelerated death benefits paid under a life insurance policy because of the insured being either terminally ill (i.e., death is reasonably expected to occur within 24 months) or chronically ill (i.e., meets the criteria established under IRC section 7702B(c)(2)) are generally not subject to income tax. IRC sections 101(g)(1) and (4). 2.2(b) Viatical Settlements Similarly, proceeds from the sale or assignment of any portion of the death benefit of a life insurance policy on a terminally ill (i.e., death is reasonably expected to occur within 24 months) or chronically ill insured paid by a viatical settlement provider (defined in IRC section 101(g)(2)(B)) are generally not subject to income tax. 5 IRC section 101(g)(2). 4 Typically a life insurance policy contains several death benefit payment options available to the beneficiary, such as: (i) lump sum payment, (ii) annuity for life payments, (iii) interest-only payments, (iv) income for life payments, and (v) installment payments. Each payment option may generate taxable interest that is earned on the delayed payment of the payment of the policy s death benefit. IRC section 101(c) and (d). Additionally, each payment option may qualify for the federal estate tax marital deduction if certain conditions are met. See, e.g., IRC section 2056(b)(6). 5 On December 11, 2006, the National Association of Insurance Commissioners ( NAIC ) took a major step toward ending investor-initiated life insurance purchases. NAIC s Life Insurance and Annuities Committee adopted amendments to its Viatical Settlements Model that would impose a five-year ban on an insurance policy that is financed with the specific intent to be sold to investors (typically hedge funds). The