Steve Leimberg's Estate Planning Email Newsletter - Archive Message #1077
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Date: |
22-Jan-07 |
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From: |
Steve Leimberg's Estate Planning Newsletter |
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Subject: |
Key 2006 Life Insurance Trends, Developments and Rulings |
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Lee J. Slavutin, MD,
CLU is a principal of Stern Slavutin-2 Inc., an insurance and estate
planning firm in New York. Dr. Slavutin has
published over 100 articles on insurance and estate planning topics for CCH,
Warren Gorham and Lamont, Practitioners Publishing Company (PPC), New York
Law Journal and others.
EXECUTIVE SUMMARY: This commentary summarizes some of the more important trends, developments, rulings, and legislation in the life insurance field during 2006. LIFE INSURANCE FOR ESTATE TAX LIQUIDITY: Current law calls for the repeal of estate and generation skipping (GST) taxes in 2010 and reinstatement of those taxes in 2011. Democrats now have control of the House and the Senate. Permanent repeal of the estate tax is therefore unlikely in the next two years. Most planners are assuming that Congress will do nothing or late in 2007 increase the estate tax exemption (now at $2 million per person) to somewhere between $3 and $5 million. The use of life insurance as an estate liquidity solution remains very viable. The number one product sold for estate liquidity today is universal life with a secondary guarantee, although there is nothing secondary about the guarantee! Advantages of this product: · Premium is significantly lower than whole life policies. · Premiums and death benefits are guaranteed, regardless of investment performance or mortality experience. · Policy usually does not accumulate much cash value over the long term. · Premiums must be paid precisely on time, without using the grace period, for many policies. · Limited upside potential. If interest rates increase in the future, the policy cash values and/or death benefits may not increase significantly. · Policy loans may cause the policy to lose its original guarantee. The policy is inflexible because premiums must be paid on time to preserve the guarantee and little or no cash value accumulates long term to serve as a buffer. It is essential that clients understand this. As many advisors have warned us, this is a potential source of litigation against insurance brokers where proper disclosure was not made and clients are stuck on a train they can't get off. This product functions like "term insurance for life", has little or no cash value and has an inflexible premium structure. However, its pricing is very competitive compared to other permanent insurance products and the premium is guaranteed not to change. For more on this topic, see Malarkey and Leimberg, "Innovative Planning With `No Lapse Guarantee' Life Insurance", Estate Planning Journal, July 2005 and Zaritsky and Leimberg, Tax Planning With Life Insurance Analysis and Forms (800 950 1216).
ESTATE INCLUDIBILITY: POLICY REFORMATION
The IRS ruled favorably in a case where the insurance broker had mistakenly listed a husband and wife as owners of a new second-to-die policy. The married couple sought and received a ruling from the IRS that a reformation of the policy, to reflect the applicants' original intent that the policy be owned by a trust, would not have adverse estate tax consequences (PLR 200603002 at LISI Estate Planning Newsletter # 922).
MANAGING ILITs Insurance trusts usually have only one asset . the life insurance policy. That asset needs to be managed. Trustees have a fiduciary obligation to the beneficiaries to prudently manage the trust's assets. State law varies and advisors to the trustees should check local law regarding fiduciary responsibilities. Trustees should monitor three key areas: 1. The financial strength of the insurance company For example, has the insurer been downgraded? We have recently experienced the failures of major insurers (Executive Life, Mutual Benefit, Confederation Life) and must remain constantly vigilant about the insurer's long term strength and ability to pay claims. 2. The suitability of the policy. Is the amount of insurance still appropriate? Is the product a good fit for the client's needs? For example, term insurance is not a good long term solution for estate liquidity, because term insurance will often term-inate before the client! 3. The performance of the policy. Many universal life policies purchased in the 1980s and early 1990s were funded on an assumed interest rate of over 8%. Those same policies today are crediting interest to the cash value at 4% to 5%. We have reviewed these old universal life policies in insurance trusts and found many that will lapse without value when the client reaches his 70s or early 80s. Many of these clients are completely unaware of this impending disaster. In some cases, it will be necessary to increase premiums or replace the policy with a universal policy with guaranteed level premiums and lower costs, if the client is still insurable. The trustee typically should ask the insurance broker for updated financial rating information on the insurance company and updated policy in-force illustrations. These reviews should be conducted annually and fully documented, with letters to the clients summarizing the results. For more on this topic, see S. Leimberg and A. Gibbons, "Performing Due Diligence With Respect to Life Insurance Trusts is Critical", Estate Planning, May 2003, Vol. 30, No. 5, Pg. 248.
GRANTOR INSURANCE TRUSTS: A Crummey
powerholder would ordinarily be treated as a
grantor with respect to the property he can withdraw from the trust. This
means that the original grantor of the trust and the Crummey
powerholder would be grantors with respect to
different portions of the trust and therefore liable for any tax on income
generated by their respective portions of the trust. The IRS clarified this issue in a private letter ruling (PLR 200603040 discussed in LISI Estate Planning Newsletter # 921.) The IRS concluded that the original grantor's power under section 677 of the Code "trumps" the Crummey powerholder's right under Code section 678, and the entire trust is a grantor trust with respect to the original grantor. Advisors sometimes (erroneously) assume that an insurance trust is automatically a grantor trust with respect to the grantor for income tax purposes. These trusts are often called "defective" grantor trusts because, for income tax purposes, the trust does not exist and income flows to the grantor who is treated as the trust's alter ego. An insurance trust that allows its income to be used to pay insurance premiums, without the consent of an adverse party, is usually regarded as a grantor trust with respect to its income portion, but not with respect to trust principal (Code section 677[a][3].) In some estate planning techniques, such as a sale of property to a defective grantor trust, it is important that the entire trust is treated as a grantor trust. The payment of insurance premiums provision alone may not be enough. Adding another provision, such as the power to substitute assets of equal value, will help assure that the entire trust will be considered a grantor trust. This issue of insurance-based grantor trusts is discussed in an IRS Field Attorney Advice (20062701F, released 8/4/06 LISI Estate Planning Newsletter # 1011.)
FIXING AN ILIT In some states (for example Alaska, Delaware, New York, and Tennessee), the trustee is allowed to appoint property from one irrevocable trust to another irrevocable trust, provided that the interests of the beneficiaries are not reduced and that the trustee is allowed to invade principal. This transfer generally is
tax neutral and allows the client to get out of a poorly drafted trust
without having to buy a new policy. The existing policy is transferred from
one trust to another. [EDITOR'S COMMENT:
BEWARE:
The movement of life insurance from one trust to another is neither
simple nor without danger. The
pre-condition that requires that the interests of the beneficiaries not be reduced
is not an easy one to meet - particularly if the insured dies (unexpectedly
or not) soon after the transfer or if the trustee fails to consider the
original trust's beneficiaries' "V-8" argument: "I could'a had ..." not only if the insured dies but if
the insured lives and the beneficiaries' interests are not the same in trust
two as they are in trust one and the quid pro quo for the transfer does not
take into consideration what competitive bidding through life settlement
companies would have obtained.] PLAIN VANILLA LIFE SETTLEMENTS: By "plain vanilla" life settlements, I mean the sale of an old policy that is no longer needed or wanted by the client. For example, a client sells his business and no longer needs buy-sell insurance; a key employee retires and the key employee policy is not necessary; a real estate developer liquidates his investment and estate tax liquidity insurance is no longer critical; etc. Today life settlements are a legitimate and valuable planning tool. According to one survey quoted in an A. M. Best publication, the average annual growth rate in the number of transactions exceeds 40% annually. Vanilla life settlements should not be confused with the life settlements proposed in connection with the investor-initiated (stranger owned) life insurance (see below) discussed in numerous LISI commentaries. The bottom line is very simple: clients, with the right profile (see below) may realize substantially more net after-tax cash than by surrendering their policies. The ideal client: over age 70, some health impairment (e.g. history of heart disease, cancer), who has a universal life policy with little cash value. Where we are seeing
problems is in the unethical implementation of a legitimate transaction by
some insurance and settlement brokers. This is partly the result of
inadequate regulation in an immature industry. New York Attorney
General Spitzer recently sued Coventry First, a major player in the
settlement market. Spitzer alleged that Coventry, a life settlement buyer, made
secret payments to life settlement brokers. In exchange for these payments,
the brokers allegedly suppressed competitive bids from other life settlement
companies, thus defrauding policy holders (http://www.oag.state.ny.us/press/2006/oct/oct26a_06.html
- see LISI
Estate Planning Newsletter # 1045). Clearly, the client should protect himself by using two or more settlement brokers and requiring full disclosure of all bids. A good discussion of the whole process can be found at http://www.whatsmypolicyworth.com/. See also S. Leimberg, A. Gibbons, and M. Babitz, "Life Settlements and the Planning Opportunities They Offer", Estate Planning, Vol. 30, No. 10. Oct. 2003, Pg. 517; Leimberg, Whitelaw, Weber, and Colosimo, "Life Settlements: Risk Management Guidance for Advisors and Fiduciaries", Estate Planning Journal, Vol. 33, No. 8, August 2006, Pg. 3; Leimberg, Whitelaw, Weber, and Colosimo, "Life Settlements: Risk Management Guidance for Advisors and Fiduciaries", Estate Planning Journal, Vol. 33/No.9, Sept. 2006, Pg.3; and J. Magner and S. Leimberg, "Life Settlements Transactions: Important Tax & Legal Issues Advisers and Fiduciaries Must Consider", Insurance Tax Review, Dec. 2006, Pg. 807. PLAIN VANILLA PREMIUM FINANCING: By "plain vanilla" premium financing, I mean that an ILIT borrows money to fund the purchase of estate tax insurance that has a legitimate long term purpose for a family/business. The ILIT is borrowing the premiums to avoid taxable gifts of large premiums. The lender is inside (family member or family business) or outside (bank, insurance company). Plain vanilla premium financing should not be confused with non-recourse premium financing used to propel investor-initiated life insurance (see below). An exit strategy should be planned, so that the loan can be repaid, if necessary, before the insured dies. For example, a GRAT could be created and funded with S corporation stock and the ILIT could be named as the remainder beneficiary of the GRAT. When the GRAT terminates, its assets will be merged into the ILIT and the ILIT may now have enough money to repay the loan and fund future premiums. For more on this topic, see Leimberg and Gibbons, "Premium Financing: The Last Choice--Not the First Choice", Estate Planning Journal, Jan 2001. LISI will be providing readers with a detailed discussion of the pros and cons of premium financing by Jeff Podraza, Vice President of ING LifeDesign's Philadelphia office within the next week.
SPLIT DOLLAR MODIFICATION Do not modify an existing split dollar arrangement unless you are forced by Sarbanes Oxley or you are prepared to deal with the tax rules imposed by the 2003 regulations. In some split dollar plans, the existing insurance policy is performing poorly and it may make economic sense to replace it with a better policy, even though this action will likely be regarded as a material modification and change the tax treatment of the plan. For more on this topic, see Zaritsky and Leimberg, Tax Planning With Life Insurance Analysis and Forms (800 950 1216).
INSURABLE INTEREST: State law governs the insurable interest determination. The relationship of the owner and beneficiary of the policy to the insured individual is examined when the policy is first underwritten. In most cases there is a clear family or business connection between the insured individual and the owner/beneficiary. After the policy is issued and has been in effect for some time, the insured individual can change the beneficiary and the insurance company will typically not question the insurable interest at that time. In the Chawla case, the insurable interest of an insurance trust was questioned. This case involved terrible facts (misrepresentations on the insurance application about the insured's health). The Fourth Circuit Court of Appeals affirmed the district court ruling regarding the misrepresentations on the insurance application, but vacated (but did not reverse) the portion of the district court order addressing the insurable interest issue. The Maryland legislature enacted a dubious legislative fix for the decision in Chawla, which became law on June 1, 2006. From a practical point of view, it is relatively rare for an insurance company to raise questions about insurable interest after a policy is issued. Yet insurable interest was raised by the insurer in Chawla, mainly because the insured individual lied on the application about his medical history, and the insurer was looking for all possible reasons to deny the claim. A superb commentary
on Chawla can be found in the article by Mary
Ann Mancini and Howard Zaritsky,
"Insurable Interests: Apres Chawla, le Deluge?", 32
ACTEC Journal 194 (2006).
INVESTOR (STRANGER) OWNED LIFE INSURANCE: There are other
transactions where the insurable interest issue may be raised. These are the
so-called SOLI (stranger-owned life insurance) and IOLI (investor-owned life
insurance) transactions (see below). In the last few years, a new mode of premium financing- life settlement combinations has been promoted which has caused considerable controversy. The proposal has been marketed as "free life insurance." In general, these "free insurance" arrangements work as follows: 1. A client over the age of 70 is approached to buy a large life insurance policy (typically $5 million or more), to be owned by a trust. 2. The trust/policy-owner may benefit the client's family or a combination of the client's family and a group of unrelated investors (strangers), and this is sometimes known as stranger-owned life insurance (SOLI) or "investor-owned life insurance" (IOLI) or Speculator-Initiated (SPIN) life). 3. The client may be offered money or other assets upfront to enter into the arrangement. 4. The premiums will be financed for two years, or a few months beyond, by loans from a bank, hedge fund or some other institution. Interest on the loan is usually accrued. The loan is sometimes non-recourse or quasi-nonrecourse. 5. At the end of the two year period, the plan is to sell the policy to third party investors ("Non-vanilla life settlement"). It is hoped by the insured that the life settlement proceeds on the sale of the policy will be not only sufficient to repay the loan and the accrued interest but also provide a considerable profit. (The "stranger/investors" of course, also anticipate a considerable profit). Numerous issues have been
raised about these transactions, especially the "insurable
interest" or lack thereof. The strangers/investors have no family or
business relationship to the insured client and are motivated only by the possibility of profit.
This is wagering on the insured's life. The New York Insurance Department
reviewed one of these transactions and ruled that there was no insurable
interest and that the transaction was not permitted, i.e., was not
"insurance",
under New York Insurance Law (Opinion from the Office of the
General Counsel, 12/19/05, "Life Insurance Transactions.") (http://www.ins.state.ny.us/ogco2005/rg051215.htm) See LISI's Estate
Planning Newsletter # 914. Most major life insurance companies will ask specific questions on the application to see if the transaction is IOLI or SOLI and will not issue policies under such arrangements. One major insurer has served notice to rescind a $1,000,000 policy issued under an IOLI plan. The Departments of Insurance in Louisiana and Utah have issued bulletins raising concerns about possible violations of the insurable interest law (LISI Estate Planning Newsletter, # 1013, and LISI Estate Planning Newsletter # 1027). Lawyers and accountants should be extremely cautious in advising clients who have received such proposals. Fraud and misrepresentation have been raised as possible issues when the insurance application does not properly disclose the nature of the transaction. If there is fraud, then the insurer can deny the claim and, one group of authors have pointed out that the insured client may be liable to indemnify the investors from any loss resulting from the misrepresentation. For more on this topic, see
Leimberg, "Stranger-Owned Life Insurance
(SOLI): Killing the Goose that Lays Golden Eggs", Estate Planning,
January 2005, Vol. 32, No. 1, Pg. 43; Leimberg,
"Stranger-Owned Life Insurance (SOLI): Killing the Goose that Lays
Golden Eggs", Tax Analysts/The Insurance Tax Review, Vol. 28, No. 5, May
2005; Jones, Leimberg,
and Rybka, "'Free' Life Insurance: Risks and
Costs of Non-Recourse Premium Financing, Estate Planning Journal, Vol. 33,
No. 7, July 2006, Pg. 3. INVESTOR-OWNED LIFE INSURANCE AND CHARITIES: The Pension Protection Act
of 2006 added Code section 6050V, which requires tax exempt
organizations to file an information return when they acquire an
interest in a life insurance policy that is funded and partly owned by
private investors. This provision applies to policies acquired after August
17, 2006. For more on this topic, see Leimberg, "Stranger-Owned Life Insurance (SOLI): Killing the Goose that Lays Golden Eggs", Estate Planning, January 2005, Vol. 32, No. 1, Pg. 43; Leimberg, "Stranger-Owned Life Insurance (SOLI): Killing the Goose that Lays Golden Eggs", Tax Analysts/The Insurance Tax Review, Vol. 28, No. 5, May 2005; Jones, Leimberg, and Rybka, "'Free' Life Insurance: Risks and Costs of Non-Recourse Premium Financing, Estate Planning Journal, Vol. 33, No. 7, July 2006, Pg. 3, and and Zaritsky and Leimberg, Tax Planning With Life Insurance Analysis and Forms (800 950 1216). CODE SECTION 101(j) - EMPLOYER OWNED
LIFE INSURANCE - MAJOR CHANGES! Abuses in some COLI (corporate-owned life insurance) programs, where numerous rank and file employees were insured without knowledge or consent, led to the enactment of Code section 101(j), as part of the Pension Protection Act of 2006. Under the new and now effective Employer-Owned Life Insurance law, an employer-owned life insurance policy will retain its special tax treatment (income-tax-free death benefit) ONLY if it meets the notice and consent requirements (described below) and one of the following two conditions: 1. The insured person was an employee at any time during the 12-month period before his death; or is, at the time the contract is issued, a director or a highly compensated employee. 2. The death benefit is paid to a member of the insured person's family, a beneficiary designated by the insured, a trust for a family member or designated beneficiary, or the insured's estate; or the death benefit is used to buy an equity interest in the employer/business from a family member, a designated beneficiary, a trust for a family member or designated beneficiary, or the insured's estate. Notice and consent
requirements: BEFORE the insurance policy is issued: 1. The employee must be informed in writing that the employer intends to insure his life, and the maximum amount for which he could be insured. 2. The employee must provide written consent to being insured and that such coverage may continue after he terminates employment. 3. The employee must be informed in writing that the employer will be the beneficiary of the death proceeds.
The new law is effective for policies issued after August 17, 2006. The new law will not apply to a new policy issued under a tax free exchange with a pre-8/17/06 policy (Code section 1035) provided that the new policy has the same death benefit and is not materially different from the old policy. In addition, the new law enacted Code section 6039I, which requires an employer to file a return and keep records, if the employer owns life insurance contracts on employees and if the policies were issued after August 17, 2006. The return will be prescribed by regulations and will include information on the number of employees insured, the amount of insurance, and that valid consents were obtained. The employer's records must document compliance with Code sections 101(j) and 6039I. The new section 101(j) clearly applies to policies owned by the employer and issued after 8/17/06, which are used for key person insurance and buy-sell agreements. It may also impact new policies used in split dollar plans, qualified retirement plans, VEBAs, Rabbi trusts, and secular trusts.
For more on this topic, see LISI Estate Planning Newsletter # 1005 , LISI Estate Planning Newsletter # 1044 , Magner and Leimberg, "COLI Under the Pension Protection Act", Estate Planning, October 2006, Vol. 33, No. 10, Pg. 3 and Zaritsky and Leimberg, Tax Planning With Life Insurance Analysis and Forms (800 950 1216).
DEMUTUALIZATION: The Federal
Court of Claims, in Fisher v. U.S., __ F. Supp. 2d. __ (No. 04-1726T,
Cl. Ct. Nov. 15, 2006), has refused to grant summary judgment either to the
taxpayer or the government on the issue of the taxation of the proceeds of
sale of stock received by a trust as the result of the
"demutualization" of a mutual life insurance company. The
Court held that the proceeds were not received under a plan of life insurance
(and thus, were not excludable from income to the extent of the taxpayer's
basis in the policy), but it refused to rule on the amount of the proceeds
that were subject to tax. It remanded to trial the issue of whether the
taxpayer had basis in the stock it received in the demutualization as the
result of rights surrendered in the demutualization. LISI will be providing a more detailed commentary on this topic in the next few weeks. See also Zaritsky and Leimberg, Tax Planning With Life Insurance Analysis and Forms (800 950 1216).
PENSION SUBTRUSTS: The pension subtrust idea is that you can create an ILIT inside a qualified pension plan/trust and that ILIT can buy insurance on one of the participants in the plan. The subtrust concept was promoted as a way to have your cake and eat it too: the policy is funded with pre-income tax dollars (except for the small PS 58/Table 2001 portion) and the death benefit is excluded from the participant's estate. It has been around for about 20 years. Many of us have argued about the pros and cons but the IRS remained silent . no published rulings. Sometime in late 2006 an
unpublished TAM on a pension subtrust started
circulating. In the TAM the IRS disqualified a defined benefit plan because
it contained a subtrust which discriminated in
favor of a highly compensated employee and violated the incidental benefit
requirement of section 1.401-1 of the regulations.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE Lee Slavutin
CITE AS: Steve Leimberg's Estate Planning Newsletter # 1077 (January 22, 2007) at http://www.leimbergservices.com Copyright Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited - Except With Specific Permission. |
