1 Fixing Common Problems with Life Insurance and Life Insurance Trusts Scott Gunderson James B. Hodge

2 Overview Estate Taxation of Life Insurance Policies –IRC 2042 Requires inclusion in the estate of decedent the amount receivable by the estate as insurance proceeds on the life of the decedent; and Requires inclusion in the estate of decedent the amount receivable by all beneficiaries as insurance proceeds on the life of the decedent if the decedent possessed at his or her death any “incidents of ownership” in the policy.

3 The 3-Year Rule IRC Section 2035 –Requires that the value of transfers of interests in property (in trust or otherwise) made within 3 years of decedent’s death be included in decedent’s estate if the property interest would have been included in the decedent’s gross estate under IRC Section(s) … 2042.

4 Exception to IRC 2035 The three year rule of IRC Section 2035 does not apply to transfers (in trust or otherwise) to any bona fide sale for an adequate and full consideration in money or money’s worth.

5 Policy Transfers Case 1: 65 year old male owns $2,000,000 insurance policy with his 3 adult children as beneficiaries He has been advised that for estate tax purposes he should not own the policy. What are his options?

6 Policy Transfers Option 1: Gift of existing insurance policy to children Issues: Gift Tax Loss of Control 3 Year Estate Inclusion from Date of Gift Children’s Creditors & Predators Child Predecease Parents

7 Policy Transfers Option 2: Transfer Existing Policy to Trust Issues: Gift Tax 3 Year Inclusion Loss of Control Fixed Creditor/Predator Issue Fixed Predeceased Child Issue

8 Policy Transfer Option 3: Sell Policy to a Grantor Trust Fixes Gift Tax Issue – no gift Fixes 3 Year Inclusion Issue – exception to 2035 and approved in Revenue Ruling

9 Policy Transfer Sale to Grantor Trust raises new issues: What is the value of the policy? Transfer for value

10 Policy Transfer Valuation (Treas.Reg (a)) For a policy that has been in place for “some time” and for which further premium payments are to be made, then: Value is the ITR at the date of transfer plus any unearned premium already paid Insurance Companies issue 712s

11 Policy Transfer Valuation –How is valuation affected as the client ages? –Is the real value of the policy the replacement cost? The death benefit? –How will the life settlement market affect valuation? –As this market matures – assume IRS will want to use “comparable sales” to determine policy value in these circumstances –What if client is ill, maybe terminally ill?

12 Policy Transfer Transfer for value (IRC 101(a)(2)) Income tax on policy proceeds if acquired for value If transferee trust is a grantor trust: exception to transfer for value rule applies under Rev.Rul

13 Policy Transfers Case 2 Same facts except policy is owned by an irrevocable life insurance trust (ILIT); client does not like terms of existing trust and wants to change the terms of the trust. Solution 1: Amend trust if possible under state law Solution 2: Petition court for reformation Solution 3: Create new trust and transfer policy to new trust.

14 Policy Transfers Create New Trust & Transfer Policy: Issues: –Gift Tax –Transfer for Value

15 Policy Transfer Solution: Sell to a grantor trust (Rev Rul ). If grantor trust to grantor trust transfer deemed not to be a transfer (Rev. Rul ) If non-grantor trust to grantor trust transfer then an exception to the transfer for value rule applies (Rev. Rul )

16 Cash or Note? On Sale of Policy to New Grantor Trust can the policy be sold for a note? –Potential Issues if Using a Note (No Rulings on Point) Does the Transfer for Value rule apply at death of Grantor if ILIT holds note, since it is no longer a Grantor Trust? If the note exceeds the ILIT’s basis in the policy, at Grantor’s death, potential gain recognition to the extent that the debt exceeds the trust’s basis. It’s possible that “negative basis” disappears once trust is entitled to insurance proceeds (date of death). Should probably use cash if possible for sale

17 New Policy Old policy Life settlement Surrender 1035 exchange Loan from Trust 1 to Trust 2

18 New Policy Advisor duty/liability to investigate new insurance Increased life expectancies; lower mortality cost; better guarantees available today if client is still insurable. May be able to obtain more insurance at same or lower cost, or same insurance at lower cost, even though client is older

19 Common ILIT Problems No Crummey notices sent –Does not result in estate inclusion of life insurance –Only limits the use of annual exclusion gifts to ILIT and erodes Lifetime exemption amount –Not required to be in writing –Actual notice is required –Affidavits from beneficiaries

20 Common ILIT Problems Payment of premium by insured –Not an issue so long as insured has no incidents of ownership over the policy –Either direct or indirect payments –Headrick v. Comm’r 93 TC 171 (1989), aff’d 918 F2d 1263 (6 th Cir. 1990)

21 Common ILIT Problems Client wants to have adult child purchase insurance rather than ILIT –No Estate Tax Inclusion Issues –No Gift Taxes (unless client is paying premium) –No Control Over Policy Proceeds –No Creditor/Predator Protection for Child –May Not be Used for Intended Purpose

22 Common ILIT Problems Trustee Issues –Uncooperative –No Successor Named –Trust Protector –Professional Fiduciaries

23 Summary Rev. Rul Approves Tax-Efficient Methods of Dealing with Bad ILITs New Insurance May Be Better than Keeping the Old Policy Insurance Belongs in a Trust Questions?