Outline: The Top Life Insurance Planning Mistakes - And How to Avoid Them Presented by Linas Sudzius and Steve Leimberg January 28, 2014 at 11:00 am EST Here are some of the potentially disastrous situations that can generate huge and unexpected tax or other adverse consequences and simple solutions to protect and grow your practice:
1. The Three Corner Policy: The Goodman Problem • Created when the owner, beneficiary and insured under a life policy are all different • Entire Proceeds Treated As GIFT BY Owner At Insured’s Death OR • In Corporate Context IRS Treats As Taxable Dividend Or Compensation Make the beneficiary the same as the third-party owner
2. Surrender of Policy Subject to Loan (Phantom Income) • Policy About to Lapse And Subject to Large Loan • Sale or Other Disposition Of Policy Is Taxable Event • Policy Loan Added to Amount Actually Received Is Used To Compute T.P.’s Gain • The Result? Ordinary taxable income when the client may have no extra funds to pay the tax Monitor policy performance when subject to loan, or consider loan repayment
3. Section 1035 Exchange: Client Exchanges Policy w/Loan For Policy with Lessor or No Loan • Amount of Loan “forgiven” Treated as taxable “Boot” • Taxable Boot is Taxed Gain-first Exchange a policy subject to a loan for a new policy subject to a loan in the same amount, or repay the loan prior to exchange
4. Loans/Withdrawals From MEC (Or Use of MEC as Collateral for 3 rd Party Loan) • Distributions from MEC Subject to Same Rules As Distributions from Deferred Annuities • Makes loans against or collaterally assigning MEC life policies dangerous • 3rd Party Loans Secured by C.V. of MEC Considered DISTRIBUTIONS! •
10% Penalty Tax Imposed on Such Loans or Withdrawals If Client Under 59 ½ Do not borrow against or use a MEC as collateral unless the tax results have been considered.
5. Policy Loan In Excess of Basis Followed by Transfer Subject to Loan • Gift of Policy is Subject to Loan • If Loan Greater Than Basis, Transfer Treated as SALE, Loan Proceeds Considered “Amount Realized”
This is a Transfer for Value! Death Proceeds Subject to Tax as Ordinary Income Unless Transfer was to Exempt Party or to Grantor Trust If U.L Prior to Gift, Make Tax-Free Withdrawal Up to Investment In Contract to Repay Loan
6. Surrender Policy for C.V. Before Checking Life Settlement Possibilities • Advice to surrender That Might Be Sold Profitably on Life Settlement Market May subjects advisor to potential lawsuit Don’t surrender a permanent life policy on an older client for its cash surrender without considering alternatives
Consider Life Settlements for Older (70 +) Clients With Large Policies Whose Health Declined significantly Since Policy Purchase
7. Calculating Amount and Character of Gain of Policy Sale in Settlement Market • Gain on Cancellation or Surrender of Policy is Taxable as Ordinary Income • Policy SOLD In Life Settlement Qualifies For Partial Capital Gain Treatment ”Regular” Gain is Considered Ordinary Income
Any Excess is Capital Gain! The Basis is Reduced by Value Of Insurance Protection
Transfer of Policy to 3rd Party (e.g. ILIT) Without First Obtaining Gift Tax Value
8. • •
Transfer of Policy Or Interest in Policy For ANY Valuable Consideration
What IS Policy’s Value? Is it… ITR Plus Unearned Premium? Cash or Accumulation Value? C.S.V.? or PERC? Many Carriers Now Report Range of Values On Theory That F.M.V. is a “Legal Issue” To Be Determined by Counsel for Policy Owner
9. Transfer of Policy or Interest in Policy Without First Ruling Out Transfer for Value Trap (or Checking Qualification for Safe Harbor Exception)
Proceeds of Policy Transferred for Value Are Taxable as Ordinary Income (Except for Amount Paid by Transferee and Premiums Paid by Transferee) Cash payment for policy NOT Needed to Trigger Trap!
• • •
Quid Pro Quo (Reciprocity) – ENOUGH! For ANY Lifetime Transfer, Confirm Transaction Falls Within Safe Harbor! Transfers to the Insured, a Partner of the Insured, a Partnership that includes the Insured or to a Corporation in which the Insured is an Officer or Shareholder are Exempt from this Problem.
10. Loan Regime Split-Dollar Treated as Term Loan (Especially Gift Term Loans) Must Determine: (1) Which Federal Rate to Use and (2) Is Loan Demand, Term, or Hybrid?
Demand Loan: Interest Rate Based on Short Term AFR and Treated as Received on Annual Basis Hybrid Loan: Interest Rate Based on Term of Loan and Interest Treated as Received on Annual Basis Gift Loan: Interest Rate Fixed - All Imputed Interest Over Entire Term Discounted to P.V. and Treated as Up-Front Gift
11. Related Party Premium Financing May Violate Final Regs Loan with Interest Paid or Accrued at AFR Considered “Split-Dollar”
Triggers Special Compliance Problems
12. Termination of Pre-Final Reg Private Split-Dollar Without Considering Risk Equity on Termination May Be a Taxable Transfer
Notice 2002-8: On Termination During Insured’s Life, Equity May Be Treated as a Gift By Donor to Owner
The consequences of making these mistakes can be catastrophic to the client’s plans and the professional agent’s credibility. Click here to download the Webinar and/or listen to the audio versions.