3 Gift Tax Issues CHAPTER OVERVIEW This chapter discusses selected key gift tax issues concerning life insurance, including the gifting of an existing policy to an ILIT, and the payment of life insurance premiums. 1 The starting point for gifts and life insurance is to determine the value of the policy that the insured wants to transfer either outright or in trust. Once a gift of a policy has been made (or if the grantor s ILIT has acquired a policy), the grantor has to determine how to pay the life insurance premiums in a tax-efficient manner. An ILIT can be funded or unfunded. A funded ILIT is where the trust owns a life insurance policy and the grantor transfers income producing assets (preferably rapidly appreciating income producing assets), such as a large amount of cash, marketable securities or a limited liability company that owns rental property, and the income from the transferred asset (such as the interest, dividends, or rental income from the limited liability company, etc.) is used by the trustee to pay some or all of life insurance premiums. See, Chapter 14, below, for additional ways to fund an ILIT. Also, if the ILIT is an intentionally defective grantor trust, the ILIT will not have to pay any income tax on the income earned by the income-producing assets; instead, the income tax will be paid by the 1 See, Chapter 3 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 gift taxation of life insurance. See also, Lischer, 845-2d T.M., Gifts, Bureau of National Affairs, Washington, DC, for a general overview of gifts. 119
120 Irrevocable Life Insurance Trusts 3.1 grantor. Consequently, the ILIT trustee will have more tax-free income available for life insurance premium payments. See, section 2.7, above. An unfunded ILIT is where the trust holds only a life insurance policy, the insured makes annual gifts (typically cash gifts) to the ILIT, and the trustee uses the annual gifts to pay the life insurance premiums. The most efficient way for most insured-grantors to pay the ILIT life insurance premiums each year is to use their gift tax annual exclusion amount. Thus, a fundamental gift tax issue concerning the use of an ILIT is: When does a grantor s gift to an ILIT constitute a gift of a present interest that is eligible for the gift tax annual exclusion? If the gift to the ILIT is not a gift of a present interest, then the gift is classified as a gift of a future interest and the grantor will have to apply some or all of his or her lifetime gift tax applicable exclusion amount (currently $1 million) to the future interest gifts. A closely related issue to qualifying a gift to an ILIT for the gift tax annual exclusion is how to structure the beneficiary s right to the gift amount so that the ILIT trustee can use the gift amount to pay premiums and do so without the beneficiary creating an adverse gift, estate, or GST tax issue for him or herself. Granting the beneficiary a Crummey withdrawal right over the gift amount and allowing the gift amount to lapse within amounts specified by the Internal Revenue Code helps to solve this dilemma. This chapter will also help practitioners draft an ILIT that avoids adverse gift tax consequences for both the grantor and the ILIT beneficiaries. 3.1 VALUATION OF LIFE INSURANCE POLICIES The gift tax value of a life insurance policy is the replacement cost of the policy at the time of the gift. Treas. Reg. 25.2512-6(a). The manner by which the replacement cost is determined, however, varies depending on the nature of the policy. 2 Generally, the replacement cost is established through the sale of the particular policy by the insurance company or through the sale by the insurance company of comparable policies. Because valuation of an insurance policy through sale of comparable policies is not possible when the gift 2 See, Leimberg, Policies for Valuation of Life Insurance, 139 Trusts & Estates 46 (March 2000).
3.1 Gift Tax Issues 121 is of an existing policy that has been in force for some time and on which further premium payments are to be made, the value of an existing policy is its interpolated terminal reserve at the date of the gift plus the unused portion of the last-paid premium. A policy s interpolated terminal reserve value is available from the life insurance company by requesting IRS Form 712. The policy s interpolated terminal reserve value is generally greater than the policy s cash surrender value. For annual renewable term insurance or group term insurance, the gift tax value is the unused portion of the last-paid premium. The gift of a group term policy on the day before its premium due date has no ascertainable value. Rev. Rul. 76-490, 1976-2 C.B. 300. See also, Treas. Reg. 1.79-3(d)(2). Thus, the transfer of a group term policy (to the extent the transfer is not prohibited by the master policy or by state law) or an annual renewable term policy on the day before its premium due date should result in the policy being valued at zero for gift tax purposes. See, Rev. Rul. 84-147, 1984-2 C.B. 201 concerning the valuation of a group term policy. For level premium term insurance (where the premium is level for a fixed term of years), the gift tax value may be the policy s replacement cost. In the early years, the replacement cost for level term life insurance should be less than the annual premium. However, after approximately 40% to 50% of the policy s term has expired, the replacement cost will probably be greater than the annual premium. Near the end of the term, if the insured is no longer in good health, the replacement cost may be significantly higher. Because a level term policy has no cash value, a gift of as level premium term policy on the premium due date should result in the policy being valued at zero for gift tax purposes. However, if the insured is terminally ill, the gift tax value, even on its premium due date, may need to be determined by soliciting viatical or life settlement offers. These may be the best indication of the policy s fair market value. For permanent (or cash value) life insurance (other than a single premium policy or paid-up policy) the gift tax value is the policy s interpolated terminal reserve at the date of the gift plus the unused portion of the last-paid premium, plus accumulated dividends, less any outstanding loans amounts against the policy. Treas. Reg. 25.2512-6(a), Example 4. (In many cases, however, the value
122 Irrevocable Life Insurance Trusts 3.1 of the policy can be reduced or even eliminated by loans against the policy, and by gifting the policy as close to the premium due date so as to reduce the amount of the unearned premium.) Caution: If the loan amount exceeds the donor s basis in the policy, the donee s basis in the policy is not the donor s basis, but rather the amount of the loan assumed by the donee, in which case the transfer for value rule under IRC section 101(a)(2) may be triggered. See, section 2.5, above. For a universal or variable policy where the owner is no longer paying premiums and for a whole life policy where the premium are offset by policy dividends, the value of the policy is its interpolated terminal reserve at the date of the gift. For a single premium policy or paid-up cash value policy, the policy s gift tax value is the amount that the insurance company would charge for the same policy on the life of a person the same age as the insured at the date of the gift. Treas. Reg. 25.2512-6(a) Example 3. When the policy has been in existence for some time, it may not be possible to use the replacement cost method just described. Instead, the policy is usually valued at its interpolated terminal reserve. Rev. Rul. 78-137, 1978-1 C.B. 280. Generally, policies that have a large cash value are not good candidates for transfers to an ILIT because the death benefit may be not much greater than the gift tax value of the policy. Furthermore, the donor will be giving up direct access to the policy s (significant) cash value. For a newly purchased cash value policy (presumably less than one or two years old), the gift tax value is its cost, i.e., actual premiums paid. Treas. Reg. 25.2512-6(a), Example 1. Split-dollar insurance arrangements entered into before September 18, 2003 (and not materially modified after September 17, 2003) are valued in the same manner as cash value life insurance policies (discussed immediately above) less the employer s ownership interest in the policy at the date of transfer. Rev. Rul. 81-198, 1981-2 C.B. 188. 3 3 For split-dollar arrangements entered into or materially modified after September 17, 2003, the economic benefit regime applies if the employer, donor, or other person is the owner (with an endorsement of the death benefit to the trustee of the
3.1 Gift Tax Issues 123 Practice Point: Rev. Proc. 2005-25, 2005-17 I.R.B. 962 provides guidance on how to determine the fair market value of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection for purposes of applying the rules of IRC sections 79 (employer provided group term life insurance), 83 (property transferred to a person in connection with the performance of services), and 402 (distributions from qualified retirement plans). 4 Presumably, the IRS would allow this guidance to apply to other situations as well, although the purpose of this guidance was to prohibit the perceived abuses of purchasing life insurance policies with so-called springing cash values; and to put an end to so-called pension rescue plans, 5 which use artificially depressed values of a life insurance policy to take assets out of a taxable account on a favorable basis. Thus, the guidance generally results in higher values for the policy. irrevocable trust). The loan regime applies if the trustee is the owner (and the employer or corporation has a collateral assignment). [See, Treas. Reg. 1.6122(d) - (g); 1.787215(b)(1).] Although the final regulations do not discuss expressly the gift tax consequences of a policy transfer under the economic benefit regime or the loan regime, the preamble to the final regulations states that the gift tax consequences of the transfer of an interest in a life insurance contract to a third party will continue to be determined under established gift tax principles notwithstanding who is treated as the owner of the life insurance contract under the final regulations. [T.D. 9092, 2003-2 C.B. 1055, 1063.] The preamble cites Revenue Ruling 81-198 [19812 C.B. 188] for this proposition. Consequently, new split-dollar arrangements will continue to be valued for gift tax purposes in the same manner as a brand new policy or an existing policy, less the employer s, donor s, or other person s ownership or collateral assignment interest in the policy at the date of transfer. Donald O. Jansen, Giving Birth To, Caring For, And Feeding The Irrevocable Life Insurance Trust, 41 Real Property, Probate and Trust Journal 571, 590 (Fall 2006). See also, Lawrence Brody and Charles L. Ratner, Today s Split Dollar, 146 Trusts & Estates 38 (May 2007). 4 See, Stephan R. Leimberg and Charles L. Ratner, Valuation of Life Insurance: Rev. Proc. 2005-25 Provides New Guidance, 32 Estate Planning 13 (August 2005). 5 See, J. Maxey Sanderson, Pension Rescue, 142 Trusts & Estates 46 (May 2003); Natalie B. Choate, Life Insurance In The Retirement Plan, 142 Trusts & Estates 50 (May 2003).