> Cory Chmelka, CFP, is a managing partner with Capstone Wealth Management in New York, NY.
ABSTRACT
CPAs and estate planning attorneys are often asked to review individuals’ life insurance portfolios. In the event they act as trustees, this evaluation is required by the Uniform Prudent Investor Act (UPIA). The UPIA, adopted by many states in 1994, was intended to replace the “prudent man” rule, moving trustees from the safety of principal and administrative functions to regular management and monitoring of all trust assets. Assuming a client is healthy, the first response for many insurance professionals would be to transfer the policy’s cash surrender value into a new policy using the provisions in IRC section 1035(a). A section 1035 exchange may provide a higher death benefit and cash surrender values than the original policy, but even if it does improve upon the old policy, it may not be the optimal solution. Clients who are very conservative, dislike leverage, and are concerned about interest rates probably would prefer a section 1035 exchange. FULL TEXT
Is a Section 1035(a) Exchange the Only Option?
CPAs and estate planning attorneys are often asked to review individuals’ life insurance portfolios. In the event they act as trustees, this evaluation is required by the Uniform Prudent Investor Act (UPIA). The UPIA, adopted by many states in 1994, was intended to replace the “prudent man” rule, moving trustees from the safety of principal and administrative functions to regular management and monitoring of all trust assets. As an asset of the trust, the death benefit of life insurance policies may represent a significant percentage of the trust assets being managed by the trustee for the benefit of the stated beneficiaries.
Changing Needs
During the policy auditing process, it is not uncommon to find that several different types of life insurance policies are owned by an individual, each one with a different premium, face amount, cash value, and mortality charge. As a result, the auditing process can be complicated. In most cases, a CPA and attorney will contact a seasoned life insurance professional to provide direction to determine whether the policies continue to address the client’s original objectives, or if changes should be made to enhance the efficient use of these assets. Life insurance professionals, as a first step, should ask the CPA, attorney, or client to identify the future purpose of the life insurance policy within the estate plan. For example, a policy purchased 10 years ago might have had as its primary purpose the accumulation of cash reserves to indemnify a surviving spouse’s income or liquidity needs. Over time, however, the original objective may have changed. As a result, the life insurance policy that was purchased may not meet the current objectives appropriately. Even if the original need remains the same, restructuring the existing insurance might be beneficial because newer policies are issued with updated mortality tables (lower insurance costs) that may solve the need more efficiently.
Assuming a client is healthy, the first response for many insurance professionals would be to transfer the policy’s cash surrender value into a new policy using the provisions in IRC section 1035(a). Similar to a section 1031 tax-free exchange, section 1035 allows the basis of the existing policy to be transferred into a new policy, resulting in the continued tax deferral on any gain in the policy. Section 1031 was first introduced into the tax code in the mid-1950s. Commonly used in real estate, it allows the taxpayer to defer the tax recognition on certain types of “like kind” property if the purchase of a similar type of property is made within a certain time period. The purpose of IRC section 1035, which also dates to the 1950s (H.R. Rep. No. 1337, 83rd Cong., 2d Sess. 81 [1954]), is to defer the tax on the exchange of life insurance policies on the same life. A section 1035 exchange may provide a higher death benefit and cash surrender values than the original policy, but even if it does improve upon the old policy, it may not be the optimal solution. A review of a recent estate planning case brought to the author by a CPA in New York City will illustrate why.
Case Study
A 62-year-old female client’s grantor trust owned a $55 million permanent life insurance policy. The cash surrender value of this policy was $11,782,833 with an annual premium of $1,358,550. The tax basis of the policy was $13,585,500, so there was not an income tax liability. The policy was purchased by the trustee of an irrevocable trust 10 years ago, and had five more premiums due, based on current assumptions. The client’s net worth was $80 million, and her goal was to use the death benefit to pay estate tax.
As with most owners of life insurance policies, this individual didn’t realize that, if she died tomorrow, the trust would only receive the $55 million death benefit and not the $11,782,833 cash surrender value. One could argue that the $11,782,833 cash surrender value was a “dead” asset, because the cash surrender value adjusts (reduces, in this case) the net at risk for the issuing life insurance carrier.
The first option for the insured in this case would be to keep her current policy. The projected death benefit at age 85 would be $60 million.
The second option, assuming the client gets approved for new coverage, would be to transfer the cash surrender values into a new policy using section 1035, with a death benefit of equal value (or $60 million). The net premium cash flow will be the same as the original policy, assuming five more $1,358,550 premium payments based on current assumptions. If the insured died tomorrow, her trust would net $60 million. The projected death benefit at age 85 would also be $60 million.
A third option, which many advisors fail to recognize, is to surrender the policy for its cash value inside the trust. The surrender value would be reclassified as an investment and create a new asset for the client that could be invested in bonds, stocks, or whatever else the trust allows. At the same time, the trust would purchase a new $50 million policy with a returnof-premium rider that grows the death benefit in an amount equal to each premium payment. To fund the new policy, the client’s trust could borrow $4,127,000 from a third-party lender. Assume that the interest rate on the promissory note is 5%, or $206,350 per year; the trust would then make interest payments to the lender going forward from gifts from the grantor or withdrawals from the assets currently being invested within the trust. The interest on the loan would not be deductible (IRC section 264[a]). In addition, Revenue Ruling 2009-13 does not apply, because the client did not have a gain in the contract. The trust had already paid 10 premiums of $1,358,550 ($13,585,500 basis) and the surrender value was $11,782,833. Had there been a gain in the contract, meaning the surrender value was greater that premiums paid, the gain would have been ordinary income.
In the event the client died tomorrow, she would be ahead by $2,934,233 ($62,934,233 total trust value) compared to a section 1035 exchange to a new policy ($50,000,000 death benefit + $4,127,000 return of premium rider + $11,782,833 cash value + $1,358,550 premium paid to trust – $4,127,000 lender repayment – $206,350 in interest).
Assume, however, that the trust were to earn 5% on the investments from the surrendered value of the original policy as a result of the financing solution. If the insured dies in 23 years, at age 85 (two years beyond her life expectancy), she would be ahead by $23,809,736 ($83,809,736 total trust value) as compared to the section 1035 exchange to a new contract. If she were to die at 95, she would be ahead by $5,539,420 ($63,539,420 total trust value).
What happens if the future is a period of high inflation? If the cash surrender value is invested conservatively, some if not most of the money will be in very short-term bonds. As those bonds come due, the bonds paying higher interest would be bought, offsetting the increased cost of borrowing. Second, the client could pay off the loan. In year 10, the loan balance would be $4,127,000 and the surrendered cash value would have grown to $26,863,787 (assuming a rate of 5%). Even if it earns zero, the account would be worth $16,718,433.
Examining the Options
The purpose of this case study is not to recommend a specific course of action for anyone in a similar situation, but rather to introduce a third option to consider as part of the analysis to determine what is best for the beneficiaries. When, then, is an IRC section 1035 exchange still the best option? Clients who are very conservative, dislike leverage, and are concerned about interest rates probably would prefer a section 1035 exchange.
The surrender and finance option is actually not a complex solution, and it doesn’t require future investments with unrealistic rates of returns to be attractive. In fact, a trust could earn 0% until the client is 84 (22 years) on the surrendered cash value and still leave more money than the alternatives. It also clearly demonstrates that there may be other more flexible and economic options for existing life insurance policies than simply moving cash value from an old insurance contract to a new policy via a section 1035 exchange. This doesn’t mean that section 1035 exchanges are of no value; however, it does mean that a thorough analysis is essential in order to find the right solution. SIDEBAR
There may be other more flexible and economic options for existing life insurance policies than simply moving cash value from an old insurance contract to a new policy via a section 1035 exchange.
GRAPHIC: Photographs
LOAD-DATE: July 22, 2010
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