Estate Planning Chapter 11
Jack, age 40, $100k salary/year 30% tax bracket 20% remaining consumed by Jack Treasury Bond (riskless rate) = 6% Inflation = 2.5% How much life insurance should he buy?
(100,000 - .3(100,000) - .2(70,000)) / .06 - .025 56,000 / .035 $1,639,824
What is a buy sell agreement? What are the different types?
Agreement that agreement requires the estate of the business owner to sell the decedent's business interest to another entity or person, who is often a family member of close business associate Entity purchase (one life insurance policy per owner), cross purchase buy sell agreement (N(N-1) life insurance policies), wait and see buy sell argreement (often used for C corporations
Discuss a cross purchase buy sell agreement
An arrangement between individuals who agree to purchase the business interest of a deceased owner. It only involves the owners of the business. Each party purchases a policy on the life of the other(s). N = number of owners. -Number of policies = N(N-1) Preferred for tax planning: -Increase basis for surviving owners (no step up on the portion they originally owned, but step up on the new ownership stake they inherited) -No alternative minimum tax on life insurance death benefit -Does not trigger potential accumulated earnings tax.
To provide for liquidity of the estate, what can an ILIT trust do?
Can either purchase assets from the estate or authorize loans to the estate
What is the formula to determine how much life insurance someone needs?
Capitalized Income Approach: (Gross Income - Adjustments) / Riskless rate adjusted for inflation Adjustments mean subtracting off how much tax they will pay and how much of the remaining income after tax will be consumed by the individual
What is the definition of terminally ill?
Certified by a doctor to die from illness within two years
What is the definition of chronically ill?
Certified by doctor as being unable to perform at least two of the six activities of daily living (eating, toileting, transferring, bathing, dressing, continence)
In what ways can life insurance supplement retirement income?
Could surrender life insurance at retirement to supplement income If spouse is in retirement, could tak an annuity off the life insurance death benefit to supplement income
Talk about Second to die life insurance
Covers two parties (usually spouses) and pays only when second person dies Useful when one party is uninsurable Often used to pay estates tax at second spouse's death Usually owned by an ILIT Could be permanent or term coverage
Talk about term life insurance
Definite period of time Funds temporary income needs "pure" insurance protection Premium reflects the actuarial risk that the insured will die during the term of the contract. Useful for hedging against GRAT's, GRUT's and QPRT's that could result in estate tax inclusion
What is the gift tax treatment for a gift of life insurance to a charity?
Donor of policy gets income tax deduction equal to the lesser of the adjusted basis or FMV AGI Limitation - 50% if public charity / 30% if private
Generally speaking, are there income tax consequences for taking out a loan on a life insurance policy? Are there any exceptions?
Generally no income tax consequences, however, if you have an outstanding loan and the policy lapses, then there is ordinary income tax on the outstanding loan in excess of basis. Also, if it is a MEC (modified endowment contract). MEC was used as an investment rather than life insurance, so people would pay up premiums very fast (front end loaded premiums, policy fully funded before it is 7 years old). Thus, any loan taken from the policy cash value will be considered a taxable distribution while the death benefit is still income tax free
Discuss how an ILIT works, how it starts, what happens at death, etc
Grantor establishes ILIT and may donate a policy or may donate funds up to the annual exclusion to the trust. The ILIT will use these funds to purchase life insurance on the grantor. (In order for these annual contributions to qualify for the annual exclusion, the trust will need to utilize a Crummey Provision). Once the grantor dies, the life insurance proceeds within the trust can provide annual income to the surviving spouse. In addition, the trustee will often have the power to invade for the benefit of any beneficiary (HEMS). Remainder of trust assets are generally distributed to the children of the grantor after the death of the surviving spouse
Discuss wait and see buy sell agreements
Hybrid of entity and cross purchase buy-sell agreements. The business has the first option to purchase the interest of a deceased owner. Then surviving owners can purchase an interest in proportion to his/her ownership interest Any remaining interest is purchased by the business. Provides flexibility (simplicity of entity agreement and the tax advantages of the cross purchase) Advantageous for C-Corps (especially those with large amounts of retained earnings), tax features
Is there gift tax consequences if you change the beneficiary on the life insurance policy?
No
Discuss an ILIT
Irrevocable Life Insurance Trust Trust holds life insurance policy Utilizing the annual exclusion -Crummey provision Provision does not exceed the greater of $5,000 or 5%, the general power of appointment is ignored (five-and-five rule), p. 451, last paragraph. Avoid requiring the trust to pay proceeds to estate for taxes or administration expenses because it causes inclusion in the gross estate In order to provide liquidity: Allow trust to purchase assets of the estate Allow trust to loan money to the estate Not included in the gross estate of the insured if there is no incidence of ownership
Talk about the taxation of life insurance if there is a named beneficiary
It will avoid probate estate and generally will avoid income taxation
How does the insurance life cycle look?
Looks like a bell curve Typically when you start a family, you purchase term insurance or universal life. Then once your kids start to grow older, those term costs are increasing along with the risks of death so you start to consider whole life at that peak. Then there is the steady fall in the bell curve through retirement when your need for life insurance is critical
What are the possible settlement options for life insurance as well as their income tax situations?
Lump sum benefit, typically no income tax, although there will be tax on the earnings from the time of death until distribution (interest income accumulated from date of death until date of distribution) Annuity, income taxation on the interest portion of the annuity, exclusion ratio
Discuss a MEC
Modified endowment contract. MEC was used as an investment rather than life insurance, so people would pay up premiums very fast (front end loaded premiums, policy fully funded before it is 7 years old). Thus, any loan taken from the policy cash value will be considered a taxable distribution while the death benefit is still income tax free
Generally speaking, is there income tax on death proceeds from life insurance? Is there any exceptions to this?
No, however, the exception is if the policy is transferred for value, which is an exchange for valuable consideration, such as debt forgiveness. Chuck owes Marissa $50,000 Chuck owns a life insurance policy on ex wife CV of $20,000 and DB of $150,000. Marissa will forgive the debt if Chuck gives her the policy. Marissa's adjusted basis is $50,000 (amount of forgiven debt). If she cashes it now, she will take a $30,000 capital loss, but if she holds it until DB, then she will have a $100,000 capital gain
If you take out a loan on a life insurance policy, and then then insured dies, is there still the full death benefit payable to the beneficiary?
No, you add the outstanding loan balance and the accumulated interest due. Whatever that number is, that is the dollar for dollar reduction in the death benefit payable to the beneficiary
Which person has the title to a life insurance policy?
Owner
Who exercises control over the economic rights of a life insurance policy?
Owner
Talk about accelerated death benefits and the income tax treatment
Owner of policy must be chronically ill (can't preform two of the six activities of daily living) or terminally ill (will die from illness within two years) Viatical settlements are income tax free No income tax consequences even if there is a miraculous recovery
Talk about whole life insurance
Permanent insurance As long as premiums are paid, the insurer guarantees that the policy will remain in force. Funds permanent need (funeral, final expenses, final debts)
Talk about the differences between premium pay status and paid up policy when regarding the outright gift of a life insurance policy
Premium pay status is when premiums are still being paid. In the instance of an outright gift of a life insurance policy, then the gift tax value is the sum of the policy's interpolated terminal reserve (FMV?) plus unearned premiums. Paid up policy is when the premiums are no longer necessary to be paid. In this case the gift tax is the replacement cost of the policy.
There are two distinct purposes life insurance could be used for. Describe them and whether or not the insured should own them
Provide estate liquidity and benefits to heirs -Insured should NOT own For use during insured's life (possible reliance on cash value, etc.) -Insured should own (inclusion of death benefit)
Talk about universal life insurance
Term policy with a cash accumulation feature Premium is flexible May fund permanent income needs The insurer does not guarantee that the UL policy will remain in force as long as a certain premium is paid. Only as long as there is cash.
Talk about the federal estate tax treatment if you have a life insurance policy on someone else's life when you die
The FMV plus any unearned premiums are included in the gross estate of the owner decedent (IRS Section 2033)
Discuss an entity buy sell argreement
The business entity purchases the deceased owner's interest. Entity has separate legal existence from the owner's. Life insurance leaves cash holdings and other assets in tact. Permanent life insurance guarantees the coverage will be there no matter how long the owner lives or continues to be involved in the operation of the business. One policy purchased on the life of each owner and premiums are paid by the entity. Disadvantage, if the remaining owners want to sell, an entity buy-sell agreement will increase their taxable gain upon the sale of their interests. There is no step up in basis with an entity agreement.
If a policy is surrendered, what is the tax treatment?
The cash received less the basis is taxable
What is the gift tax treatment for a gift of premiums?
The gift is equal to the cash transferred. If it is transferred to a trust, you need a Crummey provision to qualify as present interest
What happens if you take out a loan on a life insurance policy and then there is a lapse in the policy?
The outstanding loan in excess of the basis will be taxed as ordinary income
If no beneficiary is listed on a life insurance policy, who or what does the life insurance payout default to?
The owner of the policy. If the owner is also the insured, then it passes to the owner's estate
Talk about policy dividends for life insurance policies
These policy dividends are a return on basis to the policy owner. Some individuals choose to leave these dividends on deposit with the insurer, and the insurer pays interest on these dividends. These interest on the dividends is taxable to the owner of the policy even if they aren't distributed on an annual basis
When a life insurance policy pays out dividends, how are they treated tax wise?
They are treated as a return on basis and overpayment of premiums
What are the objectives of life insurance?
To protect income stream for beneficiaries To fund education To provide liquidity at death To fund retirement income To create or sustain family wealth To fund buy/sell agreements using either cross purchase or entity purchase (redemption) agreement
Life insurance policies can be exchanged for another insurance policy, an endowment contract, or an annuity as a non taxable event. An annuity can also be exchanged for another annuity as a non taxable event. However, you CANNOT exchange from an annuity to a life insurance policy without it being a taxable event. Think of the crosstabs. Exchange from on top with life insurance and annuity. Exchange to down the side with life insurance and annuity. The top right box is the only one that results in a taxable event
True
Policies owned by the decedent on his own life that are assigned within 3 years are included in the decedent's gross estate. This is called the three year rule (IRS Section 2035)
True
How do you use life insurance to create or sustain family wealth specifically regarding a trust?
Trust corpus purchase life insurance policies on each of the beneficiaries At the death of each one, an infusion of capital is used to provide the income for the remaining and future beneficiaries.
Talk about variable universal life
Universal life with the ability of the owner to determine how to invest the cash accumulation Do no provide any guarantees Remain in force only as long as there is sufficient value to pay premium.
Talk about the gift tax consequences of life insurance
Well if you change the beneficiary, there is no gift tax consequences. However, if the owner and insured are different people, when the insured dies, a completed gift in the amount of the death benefit occurs between the owner and beneficiary (Unholy trinity (husband, wife, daughter scenario))