Advanced Markets Central Intelligence

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1 IN THIS ISSUE ZARRELLA V. PACIFIC LIFE INSURANCE COMPANY FORMER WACHOVIA MANAGER SENTENCED TO 84 MONTHS U.S. TREASURY RESPONSE TO REQUESTS FOR CLARIFICATION FROM SENATORS Advanced Markets Central Intelligence June 2011 PLR IRS OBITER DICTA CONCERNING GRANTOR TRUST OWNED IRA SENATORS QUESTION IRS INVESTIGATION OF CONTRIBUTIONS TO 501(C)(4) ORGANIZATIONS PLR MARITAL TRUST SEVERANCE AND DISCLAIMER A GIFT IN ITS ENTIRETY Advanced Markets Central Intelligence Zarrella v. Pacific Life Insurance Company, Case No CIV (S.D. FL May 31, 2011) In our April, 2011, Central Intelligence, we examined Pratul M. Patel v. Pacific Life Insurance Company, 2011 U.S. Dist. LEXIS (Texas), and Zarella v. Pacific Life Insurance Company, Civil Action No. 010-CV-60754, March 5, 2011 (Florida) (Zarrella I). In each of these, the court dismissed the case against Pacific Life Insurance Company for failure to present sufficient evidence to support the allegations that Pacific Life promoted and marketed a plan that it knew or should have known was abusive or illegal. The following Zarrella v. Pacific Life Insurance Company (Zarrella III) is the second amended complaint after two prior dismissals. Facts: In 2003, Taxpayer corporation purchased nine life insurance policies from Pacific Life to fund the corporation s 412(i) plan. As we discussed with respect to Patel and Zarrella I, in 2004, the IRS issued Rev. Ruls and , which set forth certain features that the IRS would consider illegal if made part of a 412(i) plan. The court dismissed Taxpayer s initial case for failure to support the elements alleged, and gave Taxpayer leave to amend its complaint, which it did (Zarrella II). The court then dismissed the complaints of Zarrella II without prejudice. As part of its current amended complaint, Taxpayer served Pacific Life with an extensive request for documents, including documents that Pacific Life assert to be protected by attorney-client privilege. Taxpayer asserts that Pacific Life waived its attorney-client privilege by making public its 2002 opinion letter concerning tax implications of such plans. Holding: The court held that Pacific Life never suggested that the 2002 opinion letter was protected by attorney-client privilege, and thus its release of the letter does not constitute a waiver of attorneyclient privilege with respect to any other documents. As this holding affects only the request for documents, it remains to be seen how the court holds on the primary arguments of Zarrella III. Stay tuned. Page 1 of 6. Not valid without all pages.

2 Former Wachovia Manager Sentenced to 84 Months Linda Speaks Tribby worked for Wachovia Bank in Virginia (and its predecessors) for more than 25 years. She was sentenced by U.S. District Judge Liam O Grady to a prison term of seven years for stealing more than $14.1 million from her clients. Ms. Tribby rose to the position of business-relationship manager with Wachovia in Loudoun County, Virginia. The case alleged that Ms. Tribby marketed to her clients a wealthmanagement account product, which she claimed produced tax-free income for the owners. Wachovia offers no such product. The case alleged that Ms. Tribby then falsified accounts and statements to continue the ruse with the duped clients and even paid periodic interest to lend credibility to the scheme. Ms. Libby stated that she began the fraud in order to fund cancer treatments for her grandfather. She used the stolen assets to purchase a helicopter, 200 acres of land in New York and 100 acres in Nevada, a luxury motor home, two zebras, a peacock, and an emu. She purchased a house for her daughter attending college in West Virginia. Wachovia was acquired by Wells Fargo in 2008, and Ms. Tribby s fraud was discovered by an internal Wells Fargo investigation. U.S. Treasury Response to Requests for Clarification from Senators Pat Toomey and Robert Casey, Jr. In Rev. Rul , IRS provided guidance on the amount of income and character of income to be recognized in cases involving surrender or sale of life insurance contracts. This revenue ruling allows cost of insurance to create basis which reduces gain in the case of a surrender of a life insurance policy but not in the case of a sale. Rev. Rul addresses, among many issues, the tax implications of the sale of a term life insurance policy to an unrelated buyer (a transfer for value under IRC 101), including basis in such a policy that may be applied against the death benefit. This revenue ruling states that such a purchaser may offset the taxable gain on the death benefit by the full purchase price plus any additional premiums paid, apparently without regard to costs of insurance. On May 3, 2011, Senators Robert Casey (D-PA) and Pat Toomey (R-PA) requested clarification by the U.S. Treasury of the inconsistent tax treatment between sales of life insurance to a third party and surrenders of such policies to the issuing insurance company under these revenue rulings, stating that the rulings rather than providing clear guidance, may have created confusion in the marketplace. Many may find the subsequent response from the Treasury on June 1, 2011, unsatisfactory, as it largely repeats without further explanation the content of the cited revenue rulings. The response states that the distinction in treatment between surrenders and sales is the result of IRC 72(e) applying to surrenders of life insurance contracts but not to sales of such contracts, which the response states are governed by general tax principles and case law. Thus, the inconsistency remains unreconciled and arguably unexplained. PLR Interesting IRS Obiter Dicta in PLR re Grantor Trust Owned IRA Facts: Taxpayer established an IRA with Company N. Subsequently, Taxpayer was diagnosed with muscular dystrophy and became disabled for Social Security purposes and eligible to receive Medicaid and other public benefits. On Taxpayer s petition, a court of proper jurisdiction issued an order authorizing the creation of a special needs trust for the benefit of Taxpayer during his life. Taxpayer (and the trustee of the Page 2 of 6. Not valid without all pages.

3 newly created trust) executed paperwork to transfer the IRA amounts to the trust, intending that the amounts continue to be held as an IRA. Instead of setting up an IRA in the name of the trust, Company N transferred the amounts that were in the IRA to an account in the name of the trust. Company N issued an IRS Form 1099 for the transferred amounts. Taxpayer (and trustee) requested a waiver and grant of an additional 60-day period to roll over the amounts transferred to an IRA. The request was granted. Discussion: On its face, this private letter ruling is not especially shocking or exciting. In the paragraph preceding the holding that grants Taxpayer a fresh 60-day rollover period, however, the Service states, Company N, the financial institution which accomplished the transfer, correctly noted that an individual retirement account cannot be set up and maintained in the name of a trust, and appropriately issued a federal Form 1099 treating the Date 3, 2008 transfer as a taxable distribution. This statement is true in large part because in order to qualify as an IRA, the IRA must be for the exclusive benefit of an individual and that individual s beneficiaries; in short, it must be owned by natural persons. While prima facie the statement in the PLR appears to be an affirmative statement of law, it is interesting because of IRS Revenue Ruling 85-13, which, in pertinent part, stands for the proposition that a grantor trust cannot be treated as a separate taxpayer for any income tax purpose. In other words, under Rev. Rul , an IRA owned by a grantor trust would already be treated for all income tax purposes as owned by the grantor, a natural person. Accordingly, in numerous previous private letter rulings, the Service accepted the ownership of an IRA by a grantor trust based on the grantor trust rules (IRC ) and Rev. Rul See, e.g., PLR and PLR Because no discussion accompanied the statement above, it is not possible to know how the Service intended to distinguish the facts in this private letter ruling from those in similar previous PLRs. Stay tuned for more developments. Listen to our JHAM Radio broadcast with Bernard Krooks, Partner, Littman Krooks LLP, and Randy Zipse, VP and Senior Counsel, Advanced Markets Group, on Planning with Special Needs Trusts. To see all of the JHAM Radio broadcasts, go to and click on Advanced Markets Group. Senators Question IRS Investigation of Contributions to 501(c)(4) Organizations The IRS is apparently examining five donors who made transfers to IRC 501(c)(4) organizations (social welfare organizations) and did not report the transfers as taxable gifts. Transfers such as these were the subject of a 2010 Supreme Court decision in Citizens United v. Federal Election Commission (FEC), 558 U.S. No , 2010 (concerning Hillary: The Movie, and holding generally that corporations and unions have the same political speech rights as individuals under the First Amendment). IRC 501(c)(4) provides generally that civic leagues or organizations not organized for profit and operated exclusively for the promotion of social welfare are exempt from income taxation if no part of their earnings inures to the benefit of any private shareholder or individual and the primary activities of which are not political campaigning. Six U.S. Senators (Orrin Hatch, (R-UT), Jon Kyl (R-AZ), Pat Roberts (R-KS), John Cornyn (R-TX), John Thune (R-SD), and Richard Burr (R-NC)) on the Senate Finance Committee requested an explanation from the IRS of this apparent examination, suggesting that the investigation is politically motivated and that such activities risk chilling political speech. The request seeks the release of the names of individuals involved in the decision to undertake the examination and any related information. Page 3 of 6. Not valid without all pages.

4 PLR Marital Trust Severance and Disclaimer a Gift in Its Entirety Facts: Taxpayer died survived by her Spouse and two children. Taxpayer s marital trust provides that trustees are to pay income to Spouse at least annually and the trustees have absolute discretion to distribute all or part of the principal to Spouse at any time. Assets remaining at Spouse s death are to be distributed to Taxpayer s issue as directed by Spouse. If Spouse fails to exercise this limited power of appointment at his death, then the assets are divided into equal shares, one such share for each living child and one such share for each deceased child leaving issue living at the time of Spouse s death. Executor of Taxpayer s estate proposes to sever the marital trust into two separate trusts (Trusts I and II), each with the same provisions as the original marital trust. Spouse intends to immediately disclaim his interest in one of the resulting severed trusts (Trust I). State law in the relevant jurisdiction sets forth (1) that a trust may be divided into multiple separate trusts if the result does not impair the rights of any beneficiary or adversely affect achieving the purposes of the trust; (2) provisions for making a qualified disclaimer of an interest in trust; and (3) that a disclaimed interest passes as if the disclaimant died immediately before the interest was created. Ruling: Spouse and Executor requested numerous rulings in this PLR. The IRS held that under these facts, the severance will not result in a disqualification of the marital trust or either of the resulting trusts as qualified terminable interest property (QTIP) trusts under IRC 2056(b), nor will the ultimate termination of Trust I cause Trust II to be disqualified as a QTIP trust. Furthermore, the disclaimer by Spouse of Trust I will not result in Spouse being deemed to have made a transfer of Trust II, and thus no transfer taxation is incurred with respect to Trust II. Because no transfer is deemed to have occurred with respect to Trust II, IRC 2702 is not implicated, so the value of the assets in Trust II, retained by Spouse will not be affected. (IRC 2702 provides special valuation rules for interests transferred to family members in trust, to prevent abuse of valuation discounts based on retained interests. Generally speaking, a retained interest that is not qualified for purposes of IRC 2702 will be valued at zero, often resulting in the gift of the non-retained interest transferred to family members to be valued at its maximum possible.) Page 4 of 6. Not valid without all pages.

5 CASE IN POINT: ENTITY PURCHASE BUY-SELL ARRANGEMENT Initial Call to Advanced Markets: January 2011 Insured Profile: 3 owners of an S corporation valued at $1.5 million Concern: Funding buyout of a deceased owner s stock Initial Discussion: In January 2011, a producer called Advanced Markets looking for ways to fund a Buy- Sell Arrangement for a small construction company. The company s 3 owners each held varying percentages of ownership. The owners were interested in a Buy-Sell arrangement, and the producer wanted to show them a cost-effective method of funding the plan, without using term insurance. Solution: The Advanced Markets Consultant (AMC) recommended the company consider setting up an Entity Purchase Buy-Sell Arrangement, also known as a stock or Entity Redemption Arrangement. An Entity Purchase Arrangement was more suitable than a Cross-Purchase Arrangement in this situation because it required fewer policies (3) compared to the latter (6). The business owners liked the fact that the life insurance proceeds would increase the basis of the remaining shareholders stock in the S corporation. The AMC recommended using a new John Hancock current assumption product, which offered low cost premiums with greater cash value potential and life expectancy guarantees in this case. The company owners liked the fact that potential cash value could provide flexibility to meet possible future business needs and obligations or to fund an early buyout of an owner s share in the event of disability or early retirement. Using the proprietary JH Solutions estate and business planning software, the AMC illustrated the Entity Purchase concept in the traditional Buy-Sell module. Summary: The AMC was able to show the producer a cost-effective way to fund a buy- sell arrangement using permanent insurance that also brings more flexibility to the clients, a winning proposal. Case Closed: March Page 5 of 6. Not valid without all pages.

6 ONE YEAR LIBOR RATE As of June 8, 2011: 0.72% PRIME RATE As of June 8, 2011: 3.25% IRC SECTION 7520 RATE June % May % April % The 7520 rate is used to value GRITs, QPRTs, CRATs, CLUTs, CLATs, private annuities, life interest, remainder and reversionary interests. To value a charitable gift for income, gift, or estate tax charitable deduction purposes, use either the rate for the month of the actual gift/transfer or the rate from either of the two previous months (use the highest of the three months for the largest charitable deduction). APPLICABLE FEDERAL RATES JUNE 2011 Annual Semi Annual Quarterly Monthly Short-term AFRs loans (3 years or less) 0.46% 0.46% 0.46% 0.46% Mid-term AFR (More than 3 years up to and including 9 years) 2.27% 2.26% 2.25% 2.25% Long-term AFRs (More than 9 years) 4.05% 4.01% 3.99% 3.98% For more information on various planning topics or to request the John Hancock Advanced Markets suite of marketing and educational tools, including the JH Solutions concept software, please call John Hancock s Advanced Markets Group at and press #4. REMINDER: Electronic Distribution of Advanced Markets Group Materials is Available. Central Intelligence and its companion piece, Sales Strategy, are printed on a quarterly basis. If you d like to receive Central Intelligence on a monthly basis, it is available by . To receive the monthly edition of Central Intelligence, please send a request to advancedmarkets@jhancock.com. In addition, monthly editions of Central Intelligence and Sales Strategy are available on our website at The Advanced Markets Group also sends a monthly electronic newsletter which features a popular estate or business planning concept. To be included on this distribution list, please send an to advancedmarkets@jhancock.com. Central Intelligence is produced by John Hancock s Advanced Markets Group. We can be reached at (888) , option 3 or option 4; 197 Clarendon Street, C-07-01, Boston, MA 02116; Based on 2008 VBT Primary Table. Life Expectancy (LE) tables are based on actual mortality experience collected from sources such as the life insurance companies and the Social Security Administration. LE tables show the average probability of death by a certain age. The LE data provided is not necessarily indicative of life expectancy, and the insured may live longer than indicated by the table. The LE tables used are not tailored to a particular situation or risk class; rather, they are based on population averages and are presented to help form a generalized idea of potential ages at death. Loans and withdrawals will reduce the death benefit, cash surrender value, and may cause the policy to lapse. Lapse or surrender of a policy with a loan may cause the recognition of taxable income. Policies classified as modified endowment contracts may be subject to tax when a loan or withdrawal is made. A federal tax penalty of 10% may also apply if the loan or withdrawal is taken prior to age 591/2. Cash value available for loans and withdrawals may be more or less than originally invested. Withdrawals are available in the 2nd policy year. Guaranteed product features are dependent upon minimum premium requirements and the claims-paying ability of the issuer. Insurance policies and/or associated riders and features may not be available in all states. This material does not constitute tax, legal or accounting advice and neither John Hancock nor any of its agents, employees or registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Comments on taxation are based on John Hancock s understanding of current tax law, which is subject to change. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisors. Insurance products are issued by: John Hancock Life Insurance Company (U.S.A.), Boston, MA (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY John Hancock All rights reserved. MLINY /11 Page 6 of 6. Not valid without all pages.