The CPA s Guide to Financial & Estate Planning Planning with Life Insurance Presented by: Steven G. Siegel, J.D., LL.M. (Taxation)
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About the PFP Section & PFS Credential The AICPA Personal Financial Planning (PFP) Section is the premier provider of information, tools, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and/or investment planning advice to individuals, families and business owners. (Learn more at aicpa.org/pfp.) The Personal Financial Specialist (PFS) program allows CPAs to gain and demonstrate competence and confidence in providing estate, tax, retirement, risk management and/or investment planning advice to individuals, families and business owners through experience, education, examination, and a resulting credential. (Learn more at aicpa.org/pfs.) #AICPApfp 4
Today s Speaker Steve G. Siegel, JD, LLM The Siegel Group #AICPApfp 5
Life Insurance and the Income Tax Personal Financial Planning Planning Section Section #AICPApfp
Income Tax Treatment of Death Proceeds Amounts paid under a life insurance policy by reason of the death of the insured generally are not taxable to the beneficiary, whether paid in a single sum or otherwise An exception applies if the life insurance policy was transferred for a valuable consideration #AICPApfp 7
Transfers for Consideration If a life insurance policy is transferred for valuable consideration, the amount of death proceeds excludable from the income of the beneficiary generally is limited to the amount paid for the transfer of the policy plus the premiums and other amounts later paid by the transferee The transfer-for-value limitation does not apply 1) Where the transferee's basis in the policy is determined in whole or in part by reference to the transferor's basis or 2) Where the policy is transferred to the insured, a partner of the insured, a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer #AICPApfp 8
Transfers for Consideration The transfer-for-value rule extends to more than outright sales of life insurance policies The IRS has indicated that a sale of a policy from one wholly owned grantor trust to another would not trigger the transfer-for-value issue #AICPApfp 9
Life Settlements The Purchaser The typical life settlement involves the sale of an existing policy that has been owned for several years From the perspective of the purchaser, in a life settlement arrangement, the purchase of the policy was a transfer for a valuable consideration The exclusion for amounts received by reason of the insured's death was limited to the sum of the actual value of the consideration paid for the transfer and other amounts paid by the purchaser #AICPApfp 10
Life Settlements The Purchaser The purchaser had to include in gross income the death benefit received minus the amount excluded The entire amount was ordinary income #AICPApfp 11
Income Taxation of Lifetime Proceeds Redemption proceeds that are received in a lump sum are excludable from income up to the amount of premiums paid less dividends received while the policy was in force, cost of waiver of premium, double indemnity premium, and disability income rider premiums Only the excess is taxable #AICPApfp 12
Life Settlements The Seller Where there is a surrender by the insured of a cash value life insurance contract, the insured must recognize income on the surrender of the contract based on the excess of the cash surrender value over the investment in the contract Where there is a sale, rather than the surrender, of a life insurance contract, it is necessary to determine the amount realized from the sale and the insured s adjusted basis in the contract #AICPApfp 13
Life Settlements The Seller The amount taxable as ordinary income on a sale of the policy is limited to the amount that would be recognized as ordinary income if the contract were surrendered This would be the inside build-up under the contract Where a term life insurance policy is involved, the cost of the insurance was presumed to equal the monthly premium under the contract, so that the insured s adjusted basis in the contract is the total premiums paid, less the cost of insurance protection #AICPApfp 14
Life Settlements The Seller From the perspective of an institutional investor in a life settlement transaction The purchaser s basis in the policy is the amount paid to the insured to acquire the policy, plus premiums paid to keep the policy in force #AICPApfp 15
Withdrawals and Loans Policy withdrawals, whether by loans or otherwise, are generally not taxable unless and until the insured has fully recaptured his investment in the contract #AICPApfp 16
Life Insurance Dividends Dividends paid on life insurance policies generally are not subject to income tax except to the extent that they cumulatively exceed the amount paid in premiums on the policy #AICPApfp 17
Tax-Free Exchanges of Insurance and Annuity Policies Code Sec. 1035 provides that no gain or loss will be recognized on the exchange of A life insurance policy for another life insurance policy, or for an annuity contract The IRS has interpreted Code Sec. 1035, to apply to exchanges of multiple annuities #AICPApfp 18
Gifts of Life Insurance and the Gift Tax Personal Financial Planning Planning Section Section #AICPApfp
Generally The value of a life insurance policy for gift tax purposes is low compared with the ultimate value to the donee A gift of life insurance along with a transfer of all incidents of ownership to a beneficiary other than the insured's estate excludes the proceeds from the insured's estate Reg. 25.2512-6 spells out rules for the valuation of certain life insurance policies for gift tax purposes #AICPApfp 20
Generally Value may be approximated by adding to the interpolated terminal reserve value a proportionate part of the last premium paid which is unearned at the time of the gift In no instance is the cash surrender value to be used #AICPApfp 21
Annual Exclusion In the case of a gift of a life insurance policy, whether the gift is of a present interest depends on whether the donee has a present unrestricted right to the policy, its value and its benefits Irrevocable assignments of life insurance directly to the beneficiary are gifts of present interests So too are premiums paid on the policies after assignment. However, any restrictions limiting the assignee's present right to the policy, its value or benefits under it, will result in the assignment being treated as a gift of a future interest #AICPApfp 22
Split Gifts Spouses may split their gifts and double the annual exclusion amount given to a donee #AICPApfp 23
Use of the Gift Tax Marital Deduction An individual may make gifts in unlimited amounts to his or her spouse free of gift tax #AICPApfp 24
Policy Loan to Reduce Amount of Gift If there are loans against a policy that are outstanding at the time of the gift of the policy, this reduces the value of the gift #AICPApfp 25
Considerations Affecting Gifts of Life Insurance The more difficult question for the insured may be whether or not he or she wants to give up the cash value in the policy and the low interest loans against the cash value that become attractive when interest rates increase One must decide who is to own the policy #AICPApfp 26
Gifts of Policies to Children The gift of a single premium life insurance policy to a child, especially a child under the age of 19 or 24, in view of the kiddie tax, may be an attractive savings vehicle The donor may transfer cash to adult children who, in turn, will apply for a policy on the donor's life #AICPApfp 27
Sale of Policy by a Terminally Ill Insured There are companies that are in the business of buying the life insurance policies of terminally ill insureds #AICPApfp 28
Taxation of Viatical Settlements A viatical settlement made to an individual considered terminally ill (under HIPAA, one who has a life expectancy of 24 months or less) is entirely tax free The policyholder must be individual (not a business) A viatical settlement made to an individual who is considered chronically ill receives a different tax treatment The proceeds must be used for those costs incurred for long-term care services that are not compensated by insurance #AICPApfp 29
Beneficiary Designations Making the proceeds payable to the estate or executor may be unwise because they then become includible in the probate estate and are fully subjected to such charges as executor's commissions and attorney's fees, and vulnerable to creditors The beneficiary or trustee could make the funds available to the estate either by lending cash or buying estate assets #AICPApfp 30
Beneficiary Designations Generally, the most common course for a married individual will be to name the spouse as the beneficiary, with the children named as contingent beneficiaries If the children are to be named as prime, or even contingent, beneficiaries, and some of them are minors, guardianships should be considered #AICPApfp 31
Life Insurance and the Estate Tax Life insurance proceeds payable to the insured's estate or executor are includible in the insured's gross estate for estate tax purposes The same is true if the proceeds are payable to a beneficiary other than the estate or executor if the insured at the time of death retained any incidents of ownership of the policy exercisable either alone or in conjunction with any other person #AICPApfp 32
Life Insurance and the Estate Tax To avoid inclusion of the policy proceeds in the gross estate, the insured must name a beneficiary other than the estate or executor and must transfer the policy and all incidents of ownership therein to one or more individual beneficiaries or to a trust more than three years before death #AICPApfp 33
Transfer of All Incidents of Ownership The term incidents of ownership includes The power to change the beneficiary To surrender or cancel the policy To assign it To revoke an assignment To pledge the policy for a loan Or to borrow against the cash surrender value #AICPApfp 34
Group-term policies The courts and the IRS have been reasonably understanding in addressing group term life insurance policies where employers or employees may change certain arrangements Basic changes are not treated as new transfers #AICPApfp 35
Powers Held by Grantor-Trustee A decedent will not be deemed to have incidents of ownership over an insurance policy on a decedent's life where the decedent's powers are held in a fiduciary capacity, and are not exercisable for the decedent's personal benefit, where the decedent did not transfer the policy or any consideration for purchasing or maintaining it to the trust from personal assets #AICPApfp 36
Powers Held by Grantor-Trustee A decedent will be deemed to have incidents of ownership over an insurance policy on the decedent's life where the decedent's powers are held in a fiduciary capacity and the decedent has transferred the policy or any of the consideration for purchasing and maintaining the policy to the trust #AICPApfp 37
Power of Substitution In Rev. Rul. 2011-28 The IRS concluded that the grantor s retention of the power, exercisable in a nonfiduciary capacity, to acquire an insurance policy held in trust by substituting other assets of equivalent value will not, by itself, cause the value of the insurance policy to be includible in the grantor s gross estate Provided that The trustee has a fiduciary duty and The substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries #AICPApfp 38
Corporate Ownership Incidents of ownership of the corporate-owned policy will be attributed to a sole or controlling shareholder One owning at the time of death stock possessing more than 50 percent of the total combined voting power To the extent that any part of the policy proceeds are not payable to or for the benefit of the corporation #AICPApfp 39
Community Property The decedent and his spouse were deemed to each own one-half of the policies #AICPApfp 40
Partners and Partnerships If a partnership owns and pays the premiums on a life insurance policy on a partner's life, and the proceeds are payable to the partnership, the proceeds are not includible in the insured partner's estate if the insured does not otherwise retain any incidents of ownership in the policy The incidents of ownership of a whole life insurance policy owned by the partnership on the life of a partner, the proceeds of which are not payable to the partnership, are deemed to be held by the insured partner in conjunction with the other partners, with the result that the proceeds are includible in the insured partner's gross estate #AICPApfp 41
Gifts within Three Years of Death A gift of an insurance policy made by the insured within three years of death results in the entire proceeds of the policy together with any gift tax paid thereon being included in the insured's gross estate Neither premiums paid by a decedent within three years of death on a life insurance policy assigned or transferred more than three years before death nor the proceeds of the policy are includible in the gross estate of a decedent #AICPApfp 42
Gifts within Three Years of Death The proceeds of a policy of insurance taken out on the life of a decedent within three years of death are not includible in the decedent's gross estate even if the decedent makes the premium payments, so long as the decedent does not possess incidents of ownership in the policy and the policy was never issued in the name of the decedent. #AICPApfp 43
Conversion Rights An employee had the right to convert an employer-provided group term life insurance policy into an individual policy The transfer was treated as a transfer within three years of death, rather than as the purchase of a new policy #AICPApfp 44
Renewable Term Insurance If a five-year renewable term policy were involved, for example, there would be three dangerous years and two safe years #AICPApfp 45
Sale of Policy Code Sec. 2035(d) excepts from the three-year rule any bona fide sale for an adequate and full consideration in money or money's worth. #AICPApfp 46
Death of Owner Who is Not the Insured Only the value of the unmatured policy is included in the policy owner's gross estate #AICPApfp 47
Life Insurance Trusts Personal Financial Planning Planning Section Section #AICPApfp
The Revocable Trust The trust property is includible in the settlor's gross estate The principal reasons for the use of a revocable life insurance trust are It avoids probate and the attending expense and publicity; and On the death of the settlor, the trust becomes irrevocable #AICPApfp 49
Policy Owned by Spouse of Decedent There is a completed gift on the death of the insured #AICPApfp 50
The Irrevocable Trust The settlor is taxable on the trust income if it may be applied, without the approval or consent of any adverse party, to the payment of premiums on policies of insurance on the life of the settlor or the settlor s spouse #AICPApfp 51
Transfers within Three Years of Death If the life insurance policy is transferred by the insured within three years of his death The proceeds of the policy would be includible in the insured's gross estate A well -drafted insurance trust should contain an escape hatch providing that, if the grantor of the trust should die within three years of the transfer of the insurance policies to the trust, the policy proceeds should be paid outright to the grantor's spouse or to a separate trust that will qualify for marital deduction treatment #AICPApfp 52
Procurement of Policy by Trustee The proceeds of an insurance policy purchased by a trustee within three years of a decedent's death were not includible in his gross estate #AICPApfp 53
Other Considerations in Creating an Irrevocable Life Insurance Trust Can the grantor of a life insurance trust provide that the grantor's spouse will be a beneficiary only if she is married to him at his death, without subjecting the trust assets to inclusion in his gross estate? The answer is yes Will the exchange by life insurance trustees of a life insurance policy for a new policy within three years of the insured's death cause inclusion in the insured's estate if the new policy is received within three years of death? IRS Letter Ruling 8819001 answered that question in the negative #AICPApfp 54
Use of Trust in Lieu of Marital Deduction An irrevocable life insurance trust may be used by married couples to eliminate federal estate tax of the insurance proceeds not only on the death of the insured But also on the death of the surviving spouse #AICPApfp 55
Use in Connection with Charitable Remainder Trust An irrevocable life insurance trust may be used as a complement to a charitable remainder trust to allow a grantor to satisfy his charitable instincts without reducing the amount of property passing to other family members #AICPApfp 56
The Annual Exclusion and Crummey Powers Personal Financial Planning Planning Section Section #AICPApfp
Generally If the interest of the beneficiaries in a life insurance trust is contingent on surviving the insured, it has been held that the gift is of a future interest The present payment of premiums on such policy will also be regarded as gifts of future interests #AICPApfp 58
Crummey Powers The Crummey power gives the trust beneficiary the right to withdraw contributions to the trust, which right is deemed a present interest As a way of avoiding having to send out the annual notices, many practitioners have the beneficiaries sign waivers of their right to notices The beneficiary should be given a reasonable period of time within which to exercise the right of withdrawal Crummey powers should generally be limited annually to not more than $5,000 or 5 percent of the value of the trust corpus #AICPApfp 59
Income Tax Aspects of Crummey Powers Under Code Sec. 678, a trust beneficiary may be treated as the owner, for income tax purposes, of that portion of a trust as to which he or she has a right to demand distribution #AICPApfp 60
Transfers of Life Insurance to Charity Personal Financial Planning Planning Section Section #AICPApfp
Income Tax Consequences Charitable contributions of life insurance policies on the donor s life are subject to the same rules of deductibility governing charitable contributions of other types of property Premiums paid by the donor, after having transferred the policy to the charity, are deductible as charitable contributions Gifts made by individuals who are terminally ill must be valued using a mortality factor that reflects the individual s actual life expectancy #AICPApfp 62
Estate Tax Consequences If the insured dies within three years of the policy s transfer, the proceeds will be includible in the insured s gross estate The proceeds will be includible in the insured s gross estate under IRC Section 2042 if the insured, at the time of his or her death, possessed any incidents of ownership in the policy #AICPApfp 63
Insurable Interest The charity should never be the applicant for the policy, nor should the donor apply for the policy in the charity s name #AICPApfp 64
Split-Dollar Life Insurance Split-dollar life insurance is a cash value life insurance policy that is often used to cover the lives of key executives of a company The individual and the company may share the cost of the policy and the benefits and proceeds The two basic types of split-dollar life insurance plans are the endorsement method and the collateral assignment method Under the endorsement method, the employer owns the policy and endorses the death benefits to the employee #AICPApfp 65
Split-Dollar Life Insurance The employer pays most or all of the premiums The employee pays the cost of the equivalent term insurance Under the collateral assignment method, the employee owns the policy and the employer may pay all or most of the premiums The employee assigns a security interest in the policy to the employer in an amount that equals the premiums paid by the employer #AICPApfp 66
Split-Dollar Life Insurance The tax consequences of an equity split-dollar life insurance arrangement depend on its classification under one of two alternative regimes 1) The economic benefit regime or 2) The loan regime The economic benefit regime applies when the employer is the owner of the policy The economic benefit is taxable to the employee as compensation #AICPApfp 67
Split-Dollar Life Insurance Under the loan regime, the employee owns the policy and the employer pays the premiums The employer is deemed to loan the premium payments to the employee The imputed interest on a below-market loan to an employee under a split-dollar arrangement is usually taxable compensation to the employee #AICPApfp 68
Mistakes and Problems to Avoid in Life Insurance Planning Avoid a three-party insurance situation Avoid purchasing a policy, then transferring it to an irrevocable trust Avoid naming minors or immature persons as policy beneficiaries The desired life insurance coverage has a premium larger than the annual gift tax exclusion #AICPApfp 69
Mistakes and Problems to Avoid in Life Insurance Planning The taxpayer owns a single premium policy on herself The policy is now worth more than the premiums paid and the insured wants to borrow money and pledge the policy as collateral and she wants to exchange the policy Taxpayers own a business and have an insured cross-purchase buy/sell agreement Taxpayer has a policy with a significant cash surrender value on which there has been borrowing Taxpayer wants to make a tax-deferred exchange of the policy and cancel a policy loan Has the client updated life insurance beneficiary designations after divorces or deaths? #AICPApfp 70
Questions? Personal Financial Planning Planning Section Section #AICPApfp
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