The taxation of life insurance policies – part 1

Many clients come into my office and indicate that they have life insurance coverage and that they were told by their insurance agent that they would be protected from all taxes by the life insurance death benefit. They are also told that they can access the cash value of their life insurance policies on an income tax free basis during their life for retirement, or other purposes (paying for children’s college expenses, medical needs, etc.). While all of these statements are generally correct, I often meet with people who have misunderstood their life insurance agent or who really do not understand the different ways that a life insurance policy can be subject to taxation. My goal in this multiple part series of posts is to identify some of the common misconceptions regarding the taxation of life insurance and educate you on what you should look for when you are reviewing your own planning to identify potential problems that need to be fixed.

Initially, we must deal with the income and estate taxation of the death benefit of the life insurance policy. Under section 101(a) of the Internal Revenue Code (26 USC §101(a)), the general rule is that, “gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.” Based on this statute, the death benefit of life insurance is generally exempt from income taxation. We will see some situations in future posts where this may even be incorrect, but the general rule is that there are no income taxes payable due to the receipt of a death benefit under a life insurance policy.

Unfortunately for many people they do not understand that just because the proceeds are not subject to income taxation, this does not mean that they are not subject to some other tax that is set forth in the internal revenue code. If the owner of the policy is the insured under the policy and they continue to have the power to change the beneficiary of the policy throughout their lifetime, then the death benefit will still be income tax free when it pays out, but under section 2042 of the Internal Revenue Code the proceeds of the life insurance policy will be subject to estate taxes. This means that while income tax will be avoided, estate taxes will not.

To illustrate this, an example may be of some help. Let’s say a single individual has a 1.0 million estate and has a life insurance policy of 5.0 million dollars on him or herself. Let’s also say that this insured has one child who is the beneficiary of the life insurance policy. When this person dies, the death benefit of the insurance (the 5.0 million) is paid to the child who receives the death benefit income tax free. However, since the insured owned the policy and had the ability to change the beneficiary through his or her lifetime (what the Internal Revenue Code refers to as the “incidents of ownership”), that death benefit will be added to the decedent’s other property and be subject to estate taxes. Based on that, the gross estate for estate tax purposes will be 6.0 million. By doing a rough calculation of the estate taxes payable in 2009 on such an estate, we would take the 6.0 million, reduce it by the individual’s estate tax exemption (currently 3.5 million) and then take the net result (2.5 million) and multiply that by the highest marginal estate tax rate of 45%. This would mean that while the child received 5.0 million income tax free, 1.125 million would have to be paid for the taxes on the estate based on the inclusion of the death benefit in the taxable estate (and would be due within nine months of the date of death of the insured). This is a rough estimate which could change with other planning or variables, but it shows the initial issue that the owner of a life insurance policy should not always be the insured. In the next post we will look at some ways to deal with life insurance policies that are owned outright in your own name and some other planning techniques that can both keep the death benefit income tax free but also estate tax free. If you have any questions about this or anything else on this blog, do not hesitate to contact me at mziebold@ferruzzo.com.

Upcoming Asset Protection Society Meetings

Many people have asked for the schedule for the next few APS meetings. Here are the dates, speakers and topics for the next three meetings. If you are interested in attending any of these meetings, feel free to contact me at mziebold@ferruzzo.com to RSVP.

Tuesday, November 24, at 7:00 PM – Todd Rustman will be presenting on principally protected investment vehicles for your clients with some time spent on current premium financed life insurance programs.

Tuesday, January 19, at 7:00 PM – Jason Forsyth of FFG Valuations will be presenting on valuation topics (exact topic TBD), but will at least go over the changes in valuations due to any changes that occur in the legislation that passes throughout the end of 2009.

Tuesday, March 16, at 7:00 PM – Hilary Schneider of ESOP Corporate Resources is going to be presenting on planning with ESOPs (Employee Stock Ownership Plan) for income tax planning, asset protection, and a wide range of other applications.

Next Asset Protection Society Meeting

We have scheduled the next Orange County Asset Protection Society Meeting for Tuesday, November 24, at 7:00 PM in our office located at 3737 Birch, Suite 400, Newport Beach, CA 92660. Todd Rustman of GR Capital Asset Management (www.gr-cam.com) will be speaking on principally protected investment options for your clients and include a discussion on some of the current options involving premium financed life insurance. If you are looking for investment options for your clients who have suddenly become much more risk adverse in this economy, you will not want to miss this discussion. Non financial advisors will also be in attendance to discuss the asset protection characteristics of these planning structures and how to ensure that your client is as protected as he or she can be. Please RSVP by emailing me if you would like to attend and if you have any other questions do not hesitate to contact me to discuss. Any advisor, client, or other people may attend by RSVP'ing with me at mziebold@ferruzzo.com.

The Next Business Killers Presentation

We had a wonderful turnout for the first Business Killers presentation and will be doing another one on November 12 from noon to 1:30. This presentation covers important topics for business owners that I regularly see in my practice. Some of these topics are buy/sell agreements, key person insurance, valuations of businesses, business succession planning, and many others. If you are interested in learning more, then you can read about the presentation here: ( http://www.businesskillers.com ). If I can answer any questions about these topics or if you would like to attend this presentation, feel free to email me at mziebold@ferruzzo.com. The next upcoming presentation will be held on Wednesday, September 30from noon to 1:30.

Next Asset Protection Society Meeting

A reminder that the next meeting of the Asset Protection society in Orange County will be on Tuesday, September 22 at 7:00 PM. We have had an overwhelming response to this event and we have had to change the location of the event due to that response. We currently have over forty certified public accountants, financial advisors, insurance agents, attorneys and other advisors who will be attending this event. If you are interested in attending, we do have a few more spots open so contact me to RSVP.

The speaker will be David Shaver of Ferruzzo and Ferruzzo, LLP. David Shaver's bio can be found here: ( http://www.ferruzzo.com/staff/dshaver.asp ). David is the partner in the firm that handles all of our trust, estate, and fiduciary litigation and he will be speaking to the CPA's, Financial advisors, and any other advisor who regularly works with trustees and others who are in fiduciary roles such as these about common mistakes that people in these positions make that generate liability not only for the trust, estate, or other entity, but also for the person individually and possibly for the other advisors.

If you advise fiduciaries, trustees, executors, administrators, conservators, guardians, or anyone else who has these increased duties, then you will not want to miss this presentation. Individuals who are acting in these capacities for family members may also want to attend as there will be a time for questions and answers on what they should and should not be doing in these roles. If you are interested in attending, please feel free to contact me at mziebold@ferruzzo.com to RSVP for this event. IF YOU DO NOT KNOW OF THE NEW LOCATION OF THIS EVENT, CONTACT ME FOR THE NEW ADDRESS.

Premium Financed Life Insurance Programs

A client recently asked me about his options for paying for life insurance. His agent told him that he should not own the policy as the death benefit would be included in his taxable estate, so he should have his children purchase the life insurance on his life and be the beneficiaries of the policy. His concern was over the method to transfer enough to the children to pay for the premiums without gift taxes. I told him that gift taxes in that context would be a concern but from an asset protection perspective he probably would not want the children to own the policy outright. If the death benefit paid out directly to them, then they would be open to lawsuits, transmuting the separate property gift to community property (and leaving it open to divorces), etc.

The conversation then turned to using an Irrevocable Life Insurance Trust (ILIT) but the same concerns arose regarding the gift tax consequences of funding the trust with enough assets to pay for the premiums on the life insurance. With the withdrawal notices that most estate planners draft into ILITs, the annual gift tax exclusion gifts can be used to place a certain level of assets into the trust, but otherwise (especially if a client has a small amount of heirs or beneficiaries) the gifts will be taxable or use up some of their lifetime gift tax exemption amount (currently 1.0 Million per person). We then had a discussion on premium financed life insurance and the client both enjoyed the idea and decided to move forward with implementing this strategy.

Premium Financed Life Insurance is a planning strategy that uses third party financing to pay for the premiums. Usually the Life Insurance Policy is used as the primary collateral and the lender will credit a portion of the cash value of the policy against the overall collateral requirement. Any shortfall in the collateral position must be made up by someone, either the trustee of the trust or the insured or a beneficiary. By borrowing the premiums, the Trustee can enter into a variety of strategies to fund the insurance policy, such as:

1) Using Equity Indexed Universal Life policies to attempt to grow the cash value faster than the loan.

2) Having the insured gift an amount of funds to the trust on an annual basis to cover the interest payments on the loan.

3) Do one of the above and enter into other advanced estate planning such as a rolling GRAT (Grantor Retained Annuity Trust) strategy to place other assets inside of the trust on a tax efficient basis.

4) One of the other various programs that are out in the marketplace today.

Some of the important issues to keep your eye on with regard to premium financed life insurance strategies is the management of the third party loan (ensuring that the LIBOR or other interest rate is kept as low as possible throughout the term of the loan), the growth of the policy (if using a cash value strategy), and the requirements to either pay interest or to manage those interest payments during the lifetime of the loan.

I have reviewed many of the premium financed life insurance programs that are out in the marketplace and have an opinion on the best strategies from the legal perspective (as I am not insurance licensed and do not share in any of the commissions paid on any of these insurance products). If it has ever been suggested that you enter into a premium financed life insurance program and it did not make sense to you or there was something about the program that you did not like, then you may have been told about some of the inferior programs that are out in the marketplace. I advise many clients about the proper use of life insurance in their comprehensive estate plans for the payment of taxes, replacement of income of a deceased spouse, for charitable gifting after death, or for other reasons. All of these can be met with a premium financed life insurance program if the plan makes sense for you and your situation. If you have questions about this or would like to talk further about what planning options are available for you, do not hesitate to contact me at mziebold@ferruzzo.com or 949-608-6900.

Business Killers Presentation

For those of you who are business owners, you will not want to miss these upcoming presentations. I will be speaking at several upcoming events that will highlight many of the issues that face business owners in regard to current and future planning. The presentation is named "Business Killers" as it deals with several topics that I see in my practice quite often that are very important but often neglected such as buy/sell agreements, key person insurance, valuations of businesses, business succession planning, and many others. If you are interested in learning more, then you can read about the presentation here: ( http://www.businesskillers.com ). If I can answer any questions about these topics or if you would like to attend this presentation, feel free to email me at mziebold@ferruzzo.com. The next upcoming presentation will be held on Wednesday, September 30, from noon to 1:30.