Special Handling

1. Income Tax-Transfer For Value
If a life insurance policy is transferred from one person/entity to another in return for something of value, then the death benefit may become taxable as income. Of all the traps we have encountered, this is probably the most disastrous. Everyone expects life insurance to be free of income tax. Clients will look to the advisor if something goes wrong here. Two important examples occur in practice:

Father owns a $5 million whole life policy on his life.
He has paid $500,000 in premiums since he bought the policy. The policy now has a cash value of $800,000. He wants to transfer ownership to his daughter to remove it from his estate, assuming he lives three years after the gift. A financial planner advises him to take out a $700,000 loan from the policy before the gift to minimize the gift. (The value of the gift is the policy's reserve value plus any unearned premium minus the loan.) He follows the planner's advice. What are the results of this transaction? Yes, the gift has been reduced, but income tax is owed now and later. When he gives a policy encumbered by a loan to his daughter, he must recognize income equal to the amount of debt relief less his cost basis in the policy, i.e., $700,000 minus $500,000 = $200,000 of ordinary income (not capital gain.) He has shifted the debt to his daughter and that is a taxable event. In addition, he has transferred a policy and received something of value, namely debt relief. This constitutes a transfer for value and the death benefit, minus cost basis, will be taxable as income to his daughter.

What can you do if you encounter such a situation? If you catch it in the same calendar year you may be able to reverse it without cost. If you catch it later, you can reverse it (a transfer back to the insured father is exempt from transfer for value) but it may be a taxable gift. What should have been done? The income tax problems can be avoided if the loan is equal to or less than the father's basis ($500,000 in our example.) Alternatively, the loan may make the policy costly to maintain and it may be worth using part of the lifetime gift exemption when transferring the policy.

Jeff and Harry are 50% shareholders in a C corporation. They have a buy-sell agreement funded by life insurance, and the policies are owned by the corporation (redemption agreement). Their accountant has advised them that the death benefit on redemption will trigger the alternative minimum tax (AMT) and they should change to a cross-purchase arrangement: transfer the policy on Jeff's life to Harry and vice versa. Result? Transfer for value. Why? What is the value received by the corporation? The corporation will be relieved of two obligations-premium payments and stock redemption at death. What should be done to avoid transfer for value? Create a partnership between Jeff and Harry for a legitimate business purpose, e.g., to own and manage business real estate; then transfer the policies to the partnership. A partnership is not subject to AMT and is also exempt from the transfer for value rule. Transfers to the insured, a partner of the insured, a partnership in which the insured is a partner, a corporation in which the insured is an officer or shareholder and a trust which is a grantor trust with respect to the insured, are all exempt from transfer for value. Note that a transfer to a co-shareholder is NOT one of those exceptions.

2. Income Tax-Policy Loans
We saw in the first example how dangerous a policy loan can be, and they often cause problems.

Example: a client has a $4 million whole life policy, with a cash value of $300,000 and an annual premium of $60,000. He decides to stop paying premiums, and the policy has an "automatic premium loan" (APL) provision. Policy loans each year pay the premiums. Some years later, after a series of dividend reductions, the policy runs out of cash. A total of $600,000 in premiums has been paid. He receives a notice from the insurer that the policy will lapse in October 2007. His reaction: "No problem, I do not want this policy any longer." In January 2008, he gets a 1099 from the insurer. Why? His outstanding loan on the policy has grown to $740,000 because the insurance company charged 8% annually on the loan and interest was accrued. He has to recognize ordinary income equal to the loan minus his basis, i.e., $740,000 minus $600,000 = $140,000. This is just like cancellation of debt income. What should have been done? 1. Avoid policy loans in general; 2. Review a client's policy portfolio regularly and alert the client to emerging problems, like interest accruing at 8%; 3. Evaluate the policy's performance and see if it should be replaced by a more efficient policy.

Another example: a client has a $4 million whole life policy inside a retirement plan. The policy's cash value is growing at about 5% each year. The client wants better investment performance, and is also the trustee of this plan sponsored by his family business. He borrows $500,000 from the policy and reinvests in a mutual fund in the plan. The insurance company charges 6% on the policy loan and the $500,000 invested in the mutual fund earns 10% in 2007. This is an example of unrelated business income, or debt-financed income in a retirement plan. The net income, 10% earnings minus 6% interest expense, which is 4% of $500,000, i.e., $20,000, is income that must be reported by the retirement plan, even though the plan is a tax-exempt entity. The message is: no loans against insurance policies held by a retirement plan.

3. Income Tax-Modified Endowment Contracts (MECs)
An MEC is a life insurance policy that has been "over-funded" in the first seven years of the policy. The over-funding exceeds the usual premium required to maintain the policy but does not exceed the limit required to keep the basic tax benefits of a life insurance policy. So MECs have the following characteristics:

The policy is rapidly funded in one or a few years and, based on current nonguaranteed projections, no more premiums will be required for the life of the policy.
The policy retains the tax benefits of tax-deferred cash value growth and an income-tax-free death benefit.
The policy loses the tax benefit of income-tax-free loans and withdrawals. Any distribution from the policy will be taxed to the extent of any investment gain in the policy. For example, Joe invests $1 million, a single payment in 2007, to buy a $3.5 million universal life policy. Five years later, the policy's cash value is $1.5 million and Joe withdraws $300,000. The policy has a built-in gain of $500,000 (cash value minus premium paid.) All of Joe's $300,000 distribution is treated as taxable ordinary income. Distributions are taxed as gain first, and then return of principal (LIFO-last in first out).

If the policy is pledged as collateral for a loan, the pledge is also treated as a taxable distribution, to the extent of any gain in the policy.
Any distribution from a life insurance policy in the two-year period BEFORE it becomes an MEC is also treated as a taxable MEC distribution, i.e., it is treated as made in anticipation of becoming an MEC. For example, Bob borrows $60,000 from a whole life policy in 2007. In 2008 the policy's death benefit is reduced, causing it to become an MEC. The 2007 distribution is taxed like an MEC distribution.
Another MEC trap: Ray buys a $6 million second-to-die whole policy with a single premium payment of $700,000 in 1990. Based on the 1990 dividend scale, no more premiums are required to fund the policy. In 2005, an in-force illustration shows reduced dividends and new premium requirements. Ray does not want to make additional payments, and the policy APL provision is triggered. A loan is made to fund the premium. That loan, to the extent of any gain, triggers taxable income. Try explaining that to the client!
Message: watch MEC's carefully, and review clients' policies continuously.

4. Income Tax-1035 Exchanges
Life insurance policy exchanges occur frequently, especially with the introduction of efficiently priced guaranteed universal life policies. Policies can be exchanged under the umbrella of Section 1035 of the Internal Revenue Code, and any built-in gain is NOT taxed.

Example: Harry wants to replace an old universal life (UL) policy with a guaranteed UL policy. The old policy has a cash value of $1 million and a tax basis of $600,000. If he cancelled the old policy and transferred the cash to the new policy, he would have to recognize $400,000 of ordinary income. On the other hand, if he assigns the policy's cash value to the issuer of the new UL policy, then the gain is not recognized.
Recommendation: carefully handle the paper work of any 1035 exchange to preserve the tax benefit; never allow money from the old policy to flow through the client. All cash value in the old policy goes from one insurer to the other.
Another trap: You cannot exchange an individual life policy with a second-to-die policy because 1035 tax-free treatment requires the same insured on both sides of the transaction. One exception: if one of the spouses covered by a second-to-die policy dies, then that policy CAN be exchanged with a policy on the life of the surviving spouse.

5. Income Tax-Corporate-Owned Life Insurance (COLI)
COLI policies are now subject to special rules under Code section 101(j). Remember that these rules may apply to buy-sell and split dollar policies, as well as other COLI plans. The rules you must know and adhere to:

Only policies issued after August 17, 2006, are affected.
To qualify for the income-tax-free treatment of the death benefit, the insured person must be an employee in the 12-month period before death, the insured person must be a highly compensated employee or director at the time of policy issue, the beneficiary of the policy is a family member/trust, or the insurance is used to purchase an interest in the business from a family member.
Before the policy is issued, the employee must be notified in writing of the purchase and must consent to the purchase.

6. Income Tax-Value Of A Life Insurance Policy Distributed By A Retirement Plan
Before 2005, life insurance policies distributed from a retirement plan were valued at their cash surrender value. In some cases, the cash surrender value was artificially low and the IRS responded with a new ruling to properly value such policies (Revenue Procedure 2005-25.) The IRS safe harbor value is the greater of the reserve value or adjusted PERC value (premiums plus earnings minus reasonable charges). The good news is that we now have some certainty in valuing policies sold by retirement plans and the value, even under the new IRS rules, may offer a discount of 25% to 30% below cumulative premiums paid. Remember that valuation abuse in this area may jeopardize the qualification of the plan and, in turn, cause adverse tax results for ALL plan participants.

7. Income Tax-Charitable Gifts Of Life Insurance
Some important rules and pitfalls in this area to be aware of:

When a life insurance policy is given to charity, the income tax deduction is the LESSER of the policy's cost basis or fair market value.
If the donor retains any incidents of ownership of the policy, such as the power to change the beneficiary or borrow against the policy, then the charitable income tax deduction for the gift is lost.
If the gift exceeds $5,000, then a qualified appraisal of the policy and Form 8283 are required.
If the donor gives the policy to a public charity and continues to make premium payments, then he gets continued income tax deductions for the premium payments-BUT the limit on the amount of the deduction depends on the manner of premium payment. If the donor pays the insurance company directly ("for the use of the charity"), then the limit is 30% of adjusted gross income (AGI). If the donor gives the money to the charity and the charity, at its discretion, pays the insurance company, then the limit is 50% of AGI.
Charitable split dollar plans were eliminated in 1999 by Code Section 170(f)(10)(F).
If a client wants to donate a newly issued policy to a charity, check state law to make sure the charity has an insurable interest.

8. Gift Tax And Income Tax-Beneficiary Designation
Avoid the "Goodman rule:" a husband buys a policy on his life, names his wife as owner of the policy and his child as the beneficiary. Result: when husband dies, the death benefit is treated as a taxable gift from the mother to child.
Good general rule: avoid the "unholy" trio-the insured person, owner of policy and beneficiary are three different people. Example: A shareholder buys a policy on his life, names C corporation family business as owner and his son as beneficiary. When he dies, the death benefit is treated as a distribution from the corporation to the son, possible compensation or dividend income.

9. Estate Tax-Life insurance Trust
It is a good practice to review a client's insurance trust, especially with respect to the payment of estate taxes with life insurance proceeds. Actually, the trust should NEVER stipulate that the insurance proceeds must be used to pay estate taxes, even though that may have been the whole purpose of buying the insurance. If the trust has such language, then the life insurance will be included in the insured's estate for federal estate tax purposes, because it is relieving the estate of one of its obligations.
Rather, the insurance trust should give the trustee the power to lend money to the estate at his or her discretion, or buy assets from the estate.
What happens if you discover a trust with faulty language after the fact? There are possible solutions: (a) Sell the policy to a new grantor trust with the "right" language-a grantor trust is exempt from the transfer for value rule, (b) Sell the policy to a trust, which is a partner of the insured in a family partnership. A partner of the insured is also exempt from the transfer for value rule, and (c) Appoint the policy from the existing trust to a new trust in those states which permit it (Alabama, Delaware, New York and Tennessee).

10. Estate Tax-Private Split Dollar
Private split dollar is a premium financing strategy designed to avoid gift taxes on large premiums. Economic benefit split dollar reduces the gift from the entire premium to a small fraction. In most cases the split dollar arrangement contemplates some kind of exit plan, which may be funded with gifts or a grantor-retained annuity trust (see Private Wealth, June/July 2007, "Show Me The Money"). In private split dollar, the insured person may enter into the split dollar agreement with an insurance trust. It is essential to prevent the insured from having any incident of ownership in the policy. Otherwise we defeat the estate plan and the insurance is includable in the insured's estate. The IRS has issued a number of favorable rulings over the years (recently PLR 200728015.) However, the most useful ruling in providing a road map to avoiding incidents of ownership is PLR 9511046 (this ruling deals with a corporate split dollar agreement, but the same principles apply to private split dollar.) Here are the guidelines:

The donor (insured) has no rights to any of the economic benefits of the policy (e.g., borrowing against the cash value) other than to be repaid his investment when the agreement terminates.
The donor is required to make premium payments less any amount paid by the trust, but CANNOT demand that the trust pay any portion of the premium. Such a demand could be construed as access to the policy's cash value if the trust has no assets other than the cash value.
Only the trustee can surrender the policy or terminate the agreement. Again, we want to prevent the donor from having indirect access to the policy's cash value.

Conclusion
We must be vigilant and proactive to protect the powerful tax benefits of life insurance when doing estate planning for our clients. A valuable proactive strategy is the "life insurance checkup," no different in concept from our annual medical checkup. Look for early symptoms and signs, and prevent serious disease. The checkup is a systematic review of all the client's policies when we are first engaged, and then regularly every year or two. We look at owner and beneficiary designations, policy performance, outstanding loans and financial ratings of the carriers, and keep in mind the key tax rules (transfer for value, MEC, 1035, etc.) as we review the policies.