Three important issues that practitioners need to be aware of are coming to the fore: (1) fiduciary responsibility of trustees of irrevocable life insurance trusts (ILITs); (2) the increase in the income and capital gains tax rates coupled with the utility of private placement life insurance (PPLI) and private placement variable annuities (PPVA); and (3) the valuation of life insurance policies when transferred by gift, distribution or sale. Here’s an overview of these three areas.
Fiduciary Responsibility and ILITs
More and more attention is being paid to fiduciary responsibility. The Treasury is holding stockbrokers, insurance brokers and others, including trustees, to higher standards. At the 2014 Heckerling Institute on Estate Planning in Orlando, Fla., a panel discussing fiduciary responsibility of trustees of life insurance in trusts made a number of points.
A trustee should be able to or have available someone to answer the following in an annual review:
• What’s the carrier’s rating? Several organizations rate the claims-paying abilities of life insurance companies. The main rating agencies include AM Best, S&P and Moody’s. Ratings are an indication of the financial strength of the carrier. Having a policy with a well-rated carrier is important.
• How has the policy performed? When the policy was originally sold, the owner received an illustration projecting performance. Comparing how the policy has actually done versus that projection is important to predict what will happen in the future. For example, a policy that was originally projected to last until the insured’s age 100 may now only last until the insured’s age 85, unless some action is taken. This issue can arise if the policy projections were made at a time when interest rates were higher. If interest rates go down, the policies don’t perform as well.
• How is the policy priced? Is there a better product considering the insured’s insurability and money that can be transferred from the existing policy? (See the discussion of private placement products (PPPs) below.)
Life insurance involves risk sharing between the owner and the insurance company. The extent of that risk sharing varies by product.
Traditional whole life (WL) (without dividend term riders) transfers the majority of the risk to the insurance company. As long as premiums are paid, the guaranteed death benefit will also be paid. In exchange for the guarantees, a policy owner will pay more for the initial death benefit than in any other type of insurance. A WL illustration shows dividends going forward based on current assumptions (the expenses, mortality costs and earnings aren’t disclosed). If the owner is relying on dividends for some purpose (for example, paying future premiums), the owner bears the risk.
Universal life (UL) (or flexible premium life) shifts a lot of the risk to the owner. Any illustration is a projection. An illustration assumes that nothing will change for the rest of the insured’s life—not earnings credited, mortality costs or expenses. In a UL policy, the owner can change premium payments. The actual inner workings—the expenses, mortality costs and earnings—all can change. Even with a guaranteed death benefit UL policy, the actual timing of the premium payments can affect the guarantees. For example, if premiums are paid after the premium due date, then the guarantees may change. In UL, owners can take even more risk—they can elect to have the performance of the policy depend on the performance of an underlying asset chosen by the owner, an equity index or separate accounts in a variable policy.
While some life insurance trusts are drafted to exculpate the trustee from responsibility, the Heckerling panel considered it a bad practice. A grantor should want a trustee that has the knowledge and responsibility to oversee a life insurance portfolio or that can outsource it to a party that does. The Uniform Principal and Income Act has raised the bar for trustees. A number of companies assist in the administration of life insurance trusts, including reviewing the items above. Additionally, you should address the purpose of the insurance and the premium payer’s willingness to fund premiums. One way of assuring that the grantor’s desires are followed is to prepare an investment policy statement setting out the purpose of the insurance and the parameters as to the kinds of policies and companies to be used.
Planning and Tax Consequences
It’s also important to consider the intersection of planning and tax consequences—another hot topic at Heckerling. Income tax rates have gone up 13 percent. However, with the Medicare tax, the capital gains number has jumped almost 60 percent—from 15 percent to 23.8 percent. This jump has a strong effect on the net returns to be earned from net investment income. What’s especially noteworthy is that the new rate applies to complex trusts with net investment income (NII) of more than $12,150. In the end, it’s not what the investor earns but rather what the investor keeps that’s meaningful. Tax efficiency is increasingly relevant.
A question arises as to whether a fiduciary or money manager is doing his job if he doesn’t look into ways to make investments more tax efficient. That’s when PPPs should be considered. Can the fiduciary or money manager arrange to manage money in an insurance dedicated fund inside a PPP? By doing so and complying with other requirements, the fiduciary or money manager can take the investment out of the income tax environment. This goal can be accomplished with relatively little initial outlay. The cost of PPLI over time is less than 1 percent.
But, is that always the right thing to do? Do a feasibility study showing the net return of investing in the taxable environment, as opposed to the net return in a PPP taking into account all fees. Because only cash can fund policies, the investment must be liquidated. The income tax consequence of liquidating the investment has to be accounted for. For many investments, there aren’t embedded gains, so the result doesn’t affect the calculations as to whether it’s advantageous to use UL. The result can be significant. Even the 1.5 percent tax advantage of PPLI results in a huge difference over time. And, if the insured dies, the death benefit bump will also show a better return. I know of one case in which there was a 300-basis point per year benefit in using PPLI because there were no longer income taxes payable.
For transactions involving transferring a life insurance policy, there are different code sections, regulations, revenue proclamations and notices detailing how to value a life insurance policy.1 Each transaction type has a preferred or safe harbor method of valuation. That method isn’t prescriptive, however.
In Schwab, et al. v. Commissioner,2 the U.S. Court of Appeals for the Ninth Circuit came down on what I consider to be the side of reason. This case involved the value of policies going from a welfare benefit plan. The policies had no cash surrender value (CSV) but did have an accumulated value that was reduced by a surrender charge to come up with the CSV. The insureds argued that because there was no CSV, the values were zero. The Internal Revenue Service maintained that the surrender charge should be disregarded and came up with a valuation of $81,243. The Tax Court said otherwise.3
The single most important factor in a life insurance policy is the death benefit. The Tax Court got information about the policies and discovered that, on a guaranteed basis, the death benefit continued for a period of time for the two plaintiffs (Schwab 54 days, Kleinman 24 days). Using the mortality costs in the insurance policies, the court calculated a value of $2,666. The IRS appealed.
On appeal, the Ninth Circuit said that surrender charges may be among the considerations in ascertaining value, but not the only one. It used the term “fair market value,” which it said, “… appears in about 200 Sections of the Internal Revenue Code … and in about 900 sections of the supporting Treasury regulations.”4
Fair market value based on the facts and circumstances of each case is the real standard. Amen.
1. See Richard L. Harris, “Transferring Life Insurance by Gift or Sale,” Trusts & Estates (April 2011) at p. 37.
2. Schwab, et al. v. Commissioner, 136 T.C. No. 6 (9th Cir. Apr. 24, 2013).
3. Ibid., at 122.
4. See “Richard Harris on Schwab: Appeals Court Upholds Fair Market Value of Life Insurance Policies,” Steve Leimberg’s Estate Planning Newsletter Archived Message 2098 (May 14, 2013).