Jerry Borrowman, CLU, MSFS Eight Common Errors Professionals Make With Life Insurance Transactions

Jerry Borrowman, CLU, MSFS Eight Common Errors Professionals Make With Life Insurance Transactions

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AGENDA: COMMON LIFE INSURANCE ERRORS* 1: Getting policies to the right person at the right time Transfer-for-value errors 2: I want to insure my son-in-law Goodman Violations 3: Insurable Interest: Charities May Not Qualify 4: Small premium, big inheritance. Gifts of life insurance Gift of a future interest (Crummey) 5: IRS to citizen: We know what you re thinking Three year contemplation of death rule. 6: Fair Market Value It may be rocket science, after all 7: The case of the disappearing asset SPIA - Life Combination to remove an asset from the estate 8: Stranger Initiated Life Insurance Beware trusts and other devices to get around state insurable interest restrictions * In some circumstances a transaction may be advisable or reasonable notwithstanding the potential disadvantages or risks

1-TRANSFER FOR VALUE Problem: Life insurance is property which means it can be sold. Doing so results in an income taxable death benefit (minus basis) unless one of 5 key exemptions is met. Examples: 1. Father sells policy to his son not exempt. He gives the policy to his son, it is exempt. 2. Client sells policy to an investor the death benefit is taxable to the extent it exceeds basis. 3. C Corp Buy-Sell with Trustee. Sale of policy on surviving owners lives by deceased owner s estate is NOT exempt. How best to structure a buy-sell agreement for co-owners in a C Corp? For tax-purposes a cross-purchase buy-sell is usually most effective. If, however, there are more than two owners this requires multiple policies (1 x n-1 = # of policies). 4 owners of C Corp. desire benefit of cross-purchase. Requires 12 policies. Potential solution is a trustee agreement This works great at first death but a problem may then arise when surviving shareholders wish to purchase the deceased shareholder s interest in the policies on surviving members. Possible Resolution: Prior to the first death the owners should form a legitimate partnership to qualify for the exemption to the transfer-for-value rules

2-GOODMAN VIOLATION Problem: When there are three different parties to a life insurance policy, the likely outcome is an unintentional gift of the death benefit, which creates a large taxable gift. Example: Father buys a term policy on son-in-law and names daughter beneficiary. At death this is a taxable gift of the death benefit from father to daughter. The father must file a gift tax return and either pay the tax due (at a potential 45% to 55% rate) or use his lifetime credit, which reduces the estate credit available at his own death. Possible Resolution: Father makes daughter the owner. Now the gift is the annual premium rather than the death benefit. If father doesn t trust daughter he can create a trust to hold the policy Family Split $ with the father retaining an interest in the permanent policy equal to premiums paid or cash value and endorsing the excess death benefit to daughter, then treating that as an annual gift of the premium.

#3 - INSURABLE INTEREST: CHARITIES MAY NOT QUALIFY Problem: Each state determines what parties have an insurable interest on a person s life. Some states do not consider a charity to have an insurable interest on the life of an individual. Example: Jerry Borrowman made a contribution of a single premium life policy to the American College, sited in Pennsylvania. Not a problem. If I wanted to make a similar donation to a Utah based school it would not qualify. Possible Resolution: Jerry applies for a life policy naming eligible beneficiaries. Later transfers the policy to a qualifying charity, along with a commitment to contribute an amount adequate to pay future premiums.

CASE STUDY A PERSONAL GIFT $20,027 In 2011 Jerry Borrowman made a personal gift to the American College. $100,000: This gift allowed the College to purchase a one-pay Guaranteed Protection Universal Life policy guaranteed to age 121. $13,418: The after-tax cost of the gift to the donor

4 -GIFTS OF A FUTURE INTEREST Problem: Gifts of life insurance premium to a trust or multiple individuals is not a present interest gift and not eligible for the Gift Tax Annual Exclusion Example: Grantor creates trust and makes gifts to it, mandating that gifts be used to purchase life insurance Possible Resolution: Add Crummey provisions to allow trust beneficiaries a period of time to withdraw the annual gift in cash. It s now a present interest gift. Trustee can then use gifts not withdrawn to pay premium. Note: Beware of indirect gift from one sibling to another. Potentially resolved by hanging powers

5 -THREE YEAR BRINGBACK RULE Problem: No death-bed transfers of life insurance. Death within three years of gifting a policy brings death benefit back into taxable estate. Example: Client owns a $10 million term policy. Moments before his death he changes ownership to his son. Goal have entire death benefit mature outside his taxable estate. This strategy fails because the IRS requires the executor to report the insurance that was owned and transferred for up to three years before death, and includes it in the estate. Possible Resolution: Intentionally defective grantor trust to structure the transfer of the policy into an exchange of property between the owner and himself for valuable consideration which means it is not a gift.

6 - VALUATION OF LIFE INSURANCE POLICIES Problem: Springing Cash Values created tax-avoidance opportunities. IRS Responded by requiring policies to be valued at Fair Market Value. Example: Calvin Client has an IRA with $1,000,000 and is now retired. He creates a solo 401(k) and moves the $1MM. Purchases a single pay universal life that has an end of year cash surrender value of $100,000. Purchases the policy for that amount and transfers to an ILIT. Four years later the cash value is worth more than $1,000,000. Calvin takes tax-free income for life. IRS now requires that it be reported for Fair Market Value rather than surrender value. Possible Solution: There is none. It is required that the policy be transferred at its fair market value. This is required for all transfers: gifts to charities; gifts to individuals, sale of the policy; distribution from pension plan, etc. Complicated by the various ways FMV can be determined: Interpolated terminal reserve; reference to premiums paid, accumulation value, and surrender value; value on the open market as a life settlement product, etc. May be well served to get an appraisal.

7 SPIA TO LIFE Problem: Client holds cash or cash equivalent that will be subject to estate tax at death, i.e. taxdeferred annuity, money market fund, zero coupon bonds, etc. At death the asset s value will decline in the hands of beneficiaries because of taxes imposed on Income in Respect of a Decedent (IRD) and estate taxes Possible Resolution: Purchase Life Only Single Premium Immediate Annuity Use increased cash flow to purchase life insurance owned by ILIT using annual Crummey gifts. At death the SPIA has no remaining value. The life insurance matures outside of taxable estate In many cases free cash flow can benefit the annuitant/grantor or increase the amount of tax-free death benefit received by heirs. Caution: Many advisers believe it s important to have SPIA and Life Insurance with separate companies, to have payout and premium amounts unequal to make certain that the client is transferring risk. Most companies will not, by company policy, take on both sides of the risk.

ANNUITY PAYOUT VS. LIFE INSURANCE PREMIUM* Age at Issue Annuity Payout Rate** Insurance Premium as % of Face Amt. Male Select Preferred Non-Tobacco *** Free Cash Flow After Premium 55 6.5% 1.3% 5.2% 60 7.0% 1.7% 5.3% 65 7.7% 2.2% 5.5% 70 8.8% 3.0% 5.8% 75 10.3% 4.2% 6.1% 80 12.5% 6.5% 6.0% 85 15.3% 11.3% 4.0% * Life insurance premium is stated as an approximate percentage of the face amount, i.e. a $1,000,000 ULGuard- 2 Male Age 55 Non-Tobacco has a no-lapse premium of $15,799.44 (approximately 1.6% of $1,000,000) ** Source: Annuity Payout Rate from www.annuityshopper.com Nov 2009 *** Source: MassMutual UL-Guard 2, Nov 2009 for class indicated.

8 STRANGER INITIATED LIFE INSURANCE Problem Older clients are being approached to allow investors to buy a life insurance policy on their life. In some cases the insurance is premium financed by a bank or investor pool. In others investors own a direct interest in the policy. After two years policy is sold to a life settlement company Pitch to the client is that they enjoy 2 years of free life insurance and in some cases are paid money to give up their insurability. A number of states have declared these programs to be in violation of their insurable interest laws. Insurance companies resist STOLI because it disrupts their risk profile, particularly at older ages. In turn this forces companies to raise premiums, harming legitimate customers at those ages. In spite of industry efforts, some promoters now use a trust to isolate the insured from the sale of the policy and to get around insurable interest laws. Fraud has been proved in some cases Even though held in blind trusts, there is a financial incentive to investors in the early death of a human being Resolution Do not encourage clients to enter these arrangements. may be taxable income for loans forgiven. Incentives may be taxable. Advise clients not to circumvent state laws, directly or indirectly Advise clients they give up. insurable capacity that they may need in the future CHARITIES ARE VULNERABLE IF THEY FACILITATE THIS TRANSACTION.

SUMMARY Life insurance is a great tool to help offset the financial loss experienced by a business or family at the death of an individual. Errors can expose the proceeds to unnecessary taxation. Unscrupulous promoters can take advantage of policy features, leading to restrictions by regulators or other damages