As discussed at the May 2011 AALU annual meeting, the antiquated gift tax regulations create valuation ambiguities
At the May 2011 annual meeting of the Association of Advanced Life Underwriters (AALU), Mary Ann Mancini of Washington’s Bryan Cave LLC, Randy L. Zipse of Boston’s John Hancock Life Insurance and I spoke about the difficulties in valuing a life insurance policy. Antiquated gift tax regulations create ambiguity in valuing certain types of newer policies that are sold today.
The issue of a policy’s proper valuation can arise in different ways. For income tax purposes, a company may distribute a policy to an employee or a qualified retirement plan might distribute a policy to a participant. For gift tax purposes, advisors regularly recommend that an insured who owns a policy in his own name transfer the policy to a new irrevocable life insurance trust (ILIT) to remove the policy from the insured’s gross estate.
Different rules apply to valuations for income tax purposes. To calculate the charitable deduction of a policy donated to charity, the Tax Code says to use the lesser of fair market value (FMV) or the donor's cost basis. If the policy has been valued in the secondary (life settlement) market, the capital gain portion of the policy in excess of the greater of the donor’s basis or cash value may be deductible.
In certain limited situations, the Internal Revenue Service has provided more recent guidance concerning how to value a life insurance policy. In reaction to perceived abuses in undervaluing policies, the IRS issued Revenue Procedure 2005-25, which applies to qualified plan distributions (Internal Revenue Code Section 402), employer distributions to service providers (IRC Section 83) and distribution of permanent group term policies (IRC Section 79). Rev. Proc. 2005-25 provides a safe harbor, which is the greater of the interpolated terminal reserve (ITR) value or the “premiums plus earnings less reasonable charges” (known as the PERC) value.
Estate and Gift Tax
For estate and gift tax purposes, the Treasury regulations provide that FMV is determined by applying the “willing buyer-willing seller” rule. Before about 2000, there was no secondary market for the sale of life insurance policies. Even with the advent of this new market, it’s often limited to sales of policies by older, less healthy insureds; this market is generally unavailable to many insureds.
The estate and gift tax regulations indicate that the value of a policy is based on the cost of a hypothetical “comparable contract.” For newly issued policies, the value is the cost of the policy (that is, premiums paid). For one-time, single premium policies that are “paid up,” the value is the carrier’s current cost for an identical policy. For policies in force for some time on which additional premiums are due, the regulations say that the FMV of the policy can be “approximated” by using the ITR amount plus unearned premiums unless this method isn’t reasonably close to full value (for example, the insured is terminally ill).
ITR is at the heart of the current dilemma on how to value policies. Insurance carriers are required to reserve assets to meet future contractual obligations. Whenever a policy must be valued on other than its anniversary date, the reserve value must be “approximated” (that is, interpolated). This worked fine for whole life (WL) and annual renewable term (ART) policies. For a WL policy, the reserve value at the next anniversary date is known in advance, so the terminal reserve value can be “interpolated” to reflect a valuation before the next anniversary date. An ART policy is a one-year policy that matures before the next anniversary date, so there’s no reserve value. The value of an ART is the unearned premium for coverage until the next anniversary date.
How do we value variable universal life (VUL), universal life (UL), no-lapse guarantee (NLG) UL and multi-year level term policies? The future value of VUL, UL and NLG UL policies are tied to stock or bond markets, and their terminal reserve value at the next anniversary date isn’t known until that date. Carriers create reserves for level term policies, so their value is often greater than the remaining unearned premium.
Different Reserve Values
Further compounding the valuation conundrum is that carriers use different types of reserve value methods for a policy. Some carriers use the “tax reserve,” which is the reserve value reported on their corporate income tax return. Every carrier is required to file financial statements with their state regulators using the “statutory reserve” method. Carriers use the so-called “AG 38 reserve” method for policies with a secondary no-lapse guarantee (for example, NLG UL). The AG 38 reserve method is generally higher than the tax or statutory reserve due to the long-term death benefit guarantees. Sometimes carriers also use a minimum “deficiency reserve” in calculating the AG 38 reserve, which creates even larger reserve values.
IRS Form 712
When a policy is transferred for gift and estate tax purposes, the value of the policy must be reported to the IRS on either a Form 709 or Form 706. The instructions to these forms state that if the value of a life insurance policy is being reported, an IRS Form 712 (life insurance statement) should be attached to the return. The carrier prepares the Form 712 and has no discretion to use any method other than the ITR value.
The takeaway for advisors is to only request a Form 712 from a carrier if the policy value is required because of the need to file a Form 709 or Form 706. If, however, an insured currently owns a policy and plans to “sell” the policy to his ILIT (structured as a grantor trust) for full and adequate consideration (for example, using cash or a note), that transfer shouldn’t be a gift. In that situation, there should be no need for an advisor to request a Form 712 from the carrier. Instead, the advisor may be better off retaining in the file a letter from the carrier supporting the value. Conversely, even though an ILIT owns a life insurance policy on a decedent whose estate must file a Form 706 and there should be no estate tax due on the death benefit because the ILIT owns the policy, the instructions to Form 706 require that a Form 712 be attached with the estate tax return.
Best Practices Today
Advisors should start out by informally asking the carrier for a policy valuation. An advisor’s primary objective should be to avoid surprises to clients that can’t be undone. Before a Form 712 is issued, the advisor should ask the carrier to explain how it determined the policy value. The advisor should consider having a dialogue with the carrier’s advanced sales attorney or someone from the carrier’s actuary department who should have significant familiarity with policy valuation issues. Some carriers will provide multiple values for the same policy. Other carriers might adopt a rule of convenience and only provide the tax reserve value.
Some Hope for Tomorrow
The American Bar Association’s “Task Force on Policy Valuation” was created to ensure objectivity and uniformity across carriers while simplifying the valuation process and limiting actuarial discretion. Its initial view is that the current valuation rules for current assumption UL and VUL policies work reasonably well. The FMV of these policies is roughly their net cash value. However, the Task Force is currently considering preparing a White Paper recommending new safe harbor methods in valuing level term and NLG UL policies. Eventually, the Task Force will share its recommendations with the Treasury.