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Search the complete LISI, ActualText, and LawThreads archives. Search archives for: Newsletters Click for Search Tips Click for Most Recent Newsletters Steve Leimberg's Estate Planning Email Newsletter - Archive Message #1833 Date: From: Subject: 18-Jul-11 Steve Leimberg's Estate Planning Newsletter Brad Bauer on PITs: Partial Interest Transfers in a Life Insurance Policy In the June 2011 edition of Estate Planning, Dick Oshins and Brad Bauer co-authored an article titled Life Insurance Could be the Quintessential Value Shifting Device in which they maintained that transfers of a partial interest in a life insurance policy should be entitled to a reduction in value far exceeding that claimed when transferring minority interests in stock or an FLP or LLC, and LISI members are encouraged to view their article. Brad Bauer offered to expand that piece for LISI members. Brad, who maintains an insurance related consulting practice (bradbauer.net), was a 25 year veteran in Northwestern Mutual s Advanced Planning Division, heading up its publications and nationwide seminars for about 12 years, has authored numerous articles, and has made over 700 presentations on insurance-related planning. Now, here is his commentary: EXECUTIVE SUMMARY Transfers of partial interests in a life insurance policy have a value that may well be very small in comparison to the proportionate amount of the policy s living value. This is because the insurer s contract and internal rules, established without regard to policy valuation, prevent a joint owner from controlling or enjoying any economic benefits in the policy without the unanimous consent of all joint owners. This concept may be applied in a variety of settings. COMMENT: A QUICK HISTORY Transferring partial interests in a life insurance policy is hardly a new tax concept. Our clients have long made partial interest transfers. Common examples include a vacation home or a family business, where the donor intends the asset to be kept intact after the transfer for business or family planning reasons, because partial interests in a whole requires the donees to work together for a common objective as to the whole. It has been the same with life insurance, where, say, a parent doesn t want one child to be able to

terminate or dispose of a smaller policy on their own; so, the client bundles the ability of the kids to take any action on a single policy. There may be both family and business reasons for structuring the transfer in this manner, and historically transfer valuation has not been a factor in deciding to make several persons joint owners of a life insurance policy. WHY PARTIAL INTERESTS CAN BE PROBLEMATIC: When I first began, over a quarter of a century ago, to advise life insurance agents and attorneys about changes in policy ownership, I would fairly rail against transferring joint ownership interests, hinting that it may even be malpractice to suggest it without explaining the potential difficulties: Do you understand what joint ownership in a policy means? No one can act alone. Everyone is tied to the weakest link in the joint ownership chain, from paying premiums to selecting current policy options to choosing death benefit payments. This can cause serious and permanent problems among business partners or family members, who may end up hating each other and you. ONE MAN S TRASH IS ANOTHER MAN S TREASURE: Little did I realize that, all the while, I was formulating practically and precisely why, from a valuation standpoint, owning part of a policy is worth so much less than owning an entire policy of proportionately smaller value. Over the years I was initially surprised, then accepting, that some clients actually preferred joint ownership - for the very drawbacks I warned against. It has been some time now that I have come to view the circumstances of policy joint ownership not so much as a problem but as a reality: one that must be appreciated in full by both planners and their clients, and one that I still caution about today. FACT PATTERN Client, who owns a substantial cash value policy on her life, transfers 1/3 joint interests in the policy to each of three separate irrevocable trusts ( ILITs ) individually tailored for each child. She wants the entire policy to remain intact, as opposed to splitting it, so that there will be sufficient liquidity for the trusts, together, to buy a business from her estate and make cash available for estate taxes. She also avoids additional policy fees and ongoing paperwork by keeping the large policy whole rather than splitting it into three separate policies. The insurer s contract requires the unanimous consent of all joint owners to take any policy action or exercise any policy option, including: the right to borrow cash value, to select dividend options, to surrender the policy (in whole or in part), to exchange it for another, to designate or change a beneficiary, or to pledge the policy as security. This unanimity is required even if one joint owner wants to exercise any of the above on a pro rata basis.

ANALYSIS: Throughout this article you will see the term PIT. It is my acronym for a Partial Interest Transfer of a life insurance policy the value of which should be far less than the proportionate amount of the policy s living value. I use it not as commercial icon but to communicate in one term the meaning of a whole bunch of others, similar to, for the benefit of any philosophy friends, the use of the German Weltanschauung. Before getting to some points not covered in the original Oshins/Bauer article, a word about value and discounting in general. In my opinion, there is no such thing as a valuation discount. Value, to borrow the New York phrase, is what it is. Perhaps the best legal expression of is what it is is the willing buyer/willing seller test, and even this standard is necessarily artificial and hypothetical, similar to the mythical reasonable man. But it has served as a theoretically sound platform. Discounting, on the other hand, leans toward empirical gaming, with its dueling numbers and appraisers and comparables and percentages. Either mindset can be useful in trying to arrive imperfectly at the same thing: is what it is value. PIT valuation seems to fit better in the amorphous willing buyer/seller world. In fact, some appraisers have told Dick Oshins and me that, while they could calculate a 90 to 95% discount for a PIT, employing this method could appear somewhat absurd that it would make more sense just to assign a nominal value. We re back to it is what it is, which shouldn t be much when it comes to a PIT. The simple fact is that once you ve fragmented interests in a life insurance policy - the joint owners of which are tied chained -- to the intentions or intractability of others for the life of the policy, these reductions in fragmented value are serious and they are real. Also note that the restrictions that drive down the value of a PIT apply even if the portion transferred is a so-called majority interest. Discounting assumes that the property transferred is of a minority interest in, for example, stock or an LLC or FLP. All LISI members know the legal litany about lack of control and marketability appended to minority interests. These minority interest factors are still relevant to the PIT even if the interest comprises a majority of the policy ownership. If a client transfers a 2/3 interest in a policy, the same considerations which reduce the pro rata value of a 1/3 interest apply equally to the 2/3 interest. Documentation of a PIT Transfer. The mechanics are the same for a gift, sale, or an entity distribution of a PIT. The policyowner executes a change of ownership form which designates the joint owners. If there is not sufficient space to do so, a cover letter should be sent to the insurer explaining what the policyowner wants. The executed form should be delivered to the servicing agent or directly to the insurer s home office. When the change of ownership form is received by the insurer, it is effective as of the date executed. This form can be obtained from the policy s servicing agent or from the insurer s beneficiary and title or policyowner services area.

An appraisal is recommended to determine the value of each separate PIT interest. Typically the appraiser will want to know the insurer s calculation of the policy s value, which the insurer usually provides on a Form 712 [but more recently insurers are quite quick to point out that they are not stating the value of the policy for tax purposes]. The appraiser should also be made aware of any restrictions on policy actions that can be taken by a single joint owner. Using the Annual Exclusion for PITs. Under Reg. 25 2503-3(a), a gift of a life insurance policy is a gift of a present interest but that a future interest... may be created by the limitations contained in a trust or other instrument of transfer used in effecting the gift. And in fact, as the Oshins/Bauer Estate Planning article recites, a PIT has been held to be a gift of a future interest. Initially this doesn t sound good, as it appears to foreclose use of the annual exclusion. But the savvy planner will see something more to the point. Why is a PIT a gift of a future interest? Because the joint owners lack key rights of control and liquidation. This IRS supported position makes the exact point I am making: that the PIT has real and sweeping control and liquidation restraints which should significantly reduce value for purposes of a transfer tax. So what if the PIT may not qualify for the annual exclusion? Most clients can use the annual exclusion for other giving. On top of that, married couples have a combined $10 million exemption over 2011-12 for making lifetime transfers. Gifts of life insurance, heretofore an ideal asset for that use due to the leverage between the death benefit and living value, are even better where the PIT is employed. That being said, I think that the trust can be crafted to allow the annual exclusion for the value of the PIT without jeopardizing the reduced value. Sale of PIT Interests. The PIT concept is not limited to gifts. A sale also works, and perhaps even better. First, the client s gift of cash to each trust for the purchase clearly qualifies for the annual exclusion. Second, if the grantor is also the insured, a bona fide sale for an adequate and full consideration in money or money s worth accomplishes two things: the three year rule of Section 2035 [subs. (d) of which is quoted above] is negated, and; the transfer needn t be recorded as a discounted gift because the ILIT will have paid for the interest with cash or other property (although here I pass along the concern of some practitioners that not making the PIT a gift along with filing a discount-taking return may leave open the statute of limitations for an IRS challenge). A sale also raises issues of taxable gain on the transaction -- a realistic scenario for older policies where cash values often exceed the client s basis in the policy -- and income taxation of the death benefit to the purchaser under Section 101 s transfer-for-value rule. Both of these concerns disappear if grantor trust status exists with respect to the seller and the trust, no matter the identity of the insured.

Using the PIT Strategy for Policies in a Qualified Retirement Plan [ QRP ]. I thank Dick Oshins, co-author with me of the June 2011 Estate Planning article, for his idea, along with his insights, that this strategy can enhance pension rescue plans and planning with policies in Qualified Retirement Plans in general. The pension rescue is a fairly simple concept. The client contributes to a QRP which acquires some life insurance. The contribution is income tax deductible. The insurance is acquired from the QRP in the future when the value is relatively low. Pension rescue has been the subject of abusive practices where the policy was designed to have a springing value after the acquisition. But in my opinion, if proper guidelines are followed, there is some beneficial leverage in using a strategy of incubating a policy in a QRP and then at some later date purchasing it from the plan. In addition, there are many existing QRPs that own life insurance which was acquired to take advantage of the income tax deduction and subsequent sale by the QRP. After the purchase of the policy, the intention is to transfer the policy to a trust which is outside of the client s estate. During the period prior to the transfer to the ILIT, the policy is exposed to estate tax, and also to the same tax three years from the transfer, unless it is sold for adequate and full consideration [see section immediately above for selling a PIT interest. Advisors should review the benefits of doing the transaction prior to 2013 while the exemption is $5 million per individual. The transaction should be done as soon as possible with the goal of transferring the policy more than three years prior to death even if it was sold because of any uncertainties as to the valuation. In most instances, if the client acquires the policy from the QRP and then gifts it to separate trusts for each of the children, the client should not be at risk. If the IRS successfully asserts an undervaluation, the additional value can be protected by the exemption. A gift tax return must be filed, which has the advantage of starting the statute of limitations running. One caveat which Dick Oshins hastens to note is that acquiring the policy from the QRP by using the discounting strategies discussed in this article should not be attempted. Having the client or trust attempt to buy a PIT from the QRP raises a host of QRT fiduciary obligation and prohibition concerns. A prudent course is to have client buy the policy from the QRP, avoiding immediate income tax and transfer-for-value issues, and then give or sell PITs to separate trusts created for children. Usually by this time, the client would rather have separate trusts for each child, instead of a pot trust, while still having a single policy remaining intact. Client Retention of a Portion of the Policy. For example, the client may want to transfer 2/3 of a policy, using a reduced PIT value, while retaining ownership of the remaining 1/3. Some may have concern that this retention can cause estate inclusion of the transferred two-thirds, including the death benefit payable as to that portion, under Sections 2036 and 2038. Acknowledging that concern without conceding it, a sale, as opposed to a gift, should remove this potential effect. But legitimate concern still lingers that, under Section 2042(2), the entire death benefit can be included in the

estate because the insured has retained an incident of ownership with respect to part of the policy. One strategy within a sale context is to make the death benefit going to the other owners a debt against the insured s estate to offset any inclusion. Private Letter Ruling 90-26-041(March 30, 1990) is favorable here, but this outcome has not been formally blessed. Another strategy is to make the insured s spouse the policyowner prior to the transfer. Common Client Scenarios for Using the PIT Strategy. Policies purchased as part of a balanced investment portfolio. These policies are usually designed to generate large cash values quickly. But there usually comes a time when the client is better served, due to superseding estate planning goals, by transferring the policy to children or to trusts for their benefit. Business-owned policies acquired originally for an entity purchase plan. If the business determines that the policy is no longer needed or wanted, the entity s owners or the insured s children [or trusts for their benefit] may wish to buy joint interests in the policy. Policies owned jointly by spouses. In this case, each spouse actually owns a PIT interest. Each can give or sell their PIT at a reduced value to a single trust, assuming that the terms of that trust meet the couple s planning objectives. Policies owned by an ILIT gone bad. I ve seen this a lot over the years: the trust, for whatever reason, no longer fulfills the purpose the grantor had, or now has, in mind and the grantor doesn t want to fund the policy any more unless the situation can be remedied. Sometimes the only solution is to sell the policy to another trust or trusts created by the grantor. Of course, the trustee s scope of authority and fiduciary obligations take priority. In any of these scenarios the driving factor to transfer policy ownership, and how, should be to meet the client s overall planning objectives. Any benefit of a PIT is merely derivative. Conclusion. The transfer of partial interests in a life insurance policy to several persons or entities is not new, and it is not a premeditated valuation gimmick. In 27 years of working with life insurance, I have never seen anyone plan to buy insurance with the idea of, 10 or so years down the road, gleefully employing a PIT strategy. On the other hand, on countless occasions I have seen individuals, usually parents, transfer joint interests in a policy, old or new, to children for reasons wholly unrelated to, and with never a thought of, transfer valuation. The PIT is a Bobby Fischer chess move the placement of a piece that no one has ever done before but, once you ve seen it on the board, in my opinion makes all the strategic sense in the world. It s your move.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE! Brad Bauer CITE AS: LISI Estate Planning Newsletter #1833 (July 18, 2011) at http://www.leimbergservices.com Copyright 2011 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited Without Express Permission. 0 Comments Posted re. Post a comment on this newsletter:

Copyright 2011 Leimberg Information Services Inc.