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INSURANCE & RISK MANAGEMENT

What Planners Need to Know about Life Insurance in an Uncertain Estate Planning Environment by Steve Parrish, JD, CLU, ChFC, RHU

I’m teaching a law school course on federal estate and gift taxation this semester. Considering the results of the presidential and congressional elections, I’m surprised that I even have enough enrollees for the class. Perhaps the students know something we as estate planners don’t about the fate of the federal transfer tax system. In preparing my class syllabus, I reviewed several articles on the use of life insurance in estate planning. Two problems with these articles caught my eye. First, much of the literature concerns what the insurance professional needs to know: estate and gift tax traps, owner and beneficiary designations, will and trust considerations, and so on. The writers assume the reader understands life insurance products and simply needs to know how to apply these products in the estate planning process. But this is not the case with my students, and it is often not the case with other professionals involved in estate planning. Second, some of the articles are playing old tapes on life insurance design and its use in estate plans. For example, many authors present only two flavors of life insurance—“term” and “permanent”—and they focus exclusively on the policy’s death benefit. Many limit the product’s use even further by assuming the life insurance policy will automatically be placed in an irrevocable life insurance trust (ILIT). Just as estate planning has changed significantly

ABSTRACT Much of the traditional literature concerning the use of life insurance in estate planning focuses on what insurance professionals need to know about the product’s application in planning: estate and gift tax concerns, owner and beneficiary designations, will and trust coordination, and so on. A different set of issues arises for estate planners who are not well versed in life insurance and who need to know more about the product itself: where it can help, tax minefields to avoid, and how to leverage the concept in planning. In light of the uncertain planning environment created by the recent federal elections, the need for estate planners to understand life insurance is even more acute.

Vol. 71, No. 2 | pp. 43-46 This issue of the Journal went to press in February 2017. Copyright © 2017, Society of Financial Service Professionals. All rights reserved.

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | MARCH 2017 43


2. Modern Life Insurance Policies Are Designed to Address Multiple Life Events

in the last few years, so too has the world of life insurance. And with the uncertain times facing estate planners because of the recent election, it is all the more important to understand this flexible and liquid product. In this spirit, I offer six key life insurance considerations for estate planners.

Traditionally, life insurance was a euphemism for “death benefits.” Life policies focused on mortality, generally ignoring morbidity, longevity, and other life events. A change began this century, accelerating when a favorable tax provision became effective in 2009.1 Now life insurance policies address far more than the pure mortality risk. They are capable of insuring perils such as chronic illness, critical illness, commitment to a long-term care facility, retirement income, and more. As long as these policies conform with the relevant provisions of the Internal Revenue Code (IRC), particularly IRC Secs. 72, 101, and 7702B, the life insurance policy chassis is available to cover numerous nonmortality-based risks. Because modern policies can address multiple risks, they have become more useful in estate planning. Not only do they provide the requisite death benefit, but they can also assist in premortem morbidity planning. For example, a policy may provide the liquidity needed to defray the financial costs associated with a long-term care event. To the extent such a lifetime need has been addressed, the client has more latitude in designing and funding dispositive provisions for death.

1. Life Insurance Has More Uses in Estate Planning than Simply as a Lump-Sum Death Benefit to Pay Taxes Life products in an ILIT continue to be an effective strategy for using tax-free death benefits to defray the costs of estate taxes and other debts. But they can be so much more. For example, life insurance is an important source of predictable liquidity for illiquid estates. Consider these three liquidity strategies: • Life insurance can fulfill specific bequests, facilitating estate equalization between children who are involved in the family business and those who aren’t. • In required minimum distribution (RMD) planning with IRAs, a life insurance policy can provide a specific, tax-free inheritance to a beneficiary, unfettered by the rise and fall of the grantor’s IRA investment account. The RMD is instead used to pay the life insurance premium. • Life insurance offers the liquidity and flexibility needed to assure the continuation of a family business. For example, death proceeds can provide cash to a) pay a stay bonus to a nervous nonfamily key employee, b) make a loan to a potential buyer, and c) generate spousal income while the business continues. When a policy has cash value, that account becomes an equity source for other planning. For instance, it can be used as collateral for a loan. Or, it can generate tax-free income as a bridge until other income sources, such as Social Security, become available. Further, as the secondary market for life insurance policies expands, a policy can potentially be sold for cash.

3. Life Insurance Taxation Is Known and Predictable Because life insurance has long enjoyed a tax-favored status in the United States, its uses in planning have been well tested. There are known tax landmines that planners can avoid and safe harbors that are clearly defined. Three particularly common tax issues with life insurance in estate planning stand out; these issues have solutions when handled properly. • IRC Sec. 2042 provides that life insurance proceeds will be included in the taxable estate if the decedent had “incidents of ownership” in the policy during lifetime. To avoid estate inclusion, the taxpayer cannot have controlled the policy



mains, however, that life insurance products typically cost less per thousand of coverage than they have in the past, and they are available to more individuals.

either directly or as a trustee. This is why large life insurance policies are so often placed in an independently managed ILIT. • An insured’s death triggers a significant increase in a life insurance policy’s value—i.e., the death benefit becomes payable. To avoid having a policy’s death benefit included in the taxable estate, taxpayers would understandably want to gift the policy whenever death appears imminent. To counter this, IRC Sec. 2035 provides that transfers of a policy made within 3 years of the decedent’s death will result in the death benefit being included in transferor’s estate. In order to avoid this negative outcome, planners will often have an established ILIT serve as applicant and owner of the policy. Because the insured is neither the applicant nor owner of the policy, no transfer of the policy occurs, and IRC Sec. 2035 is avoided. • The donor’s payment of life insurance premiums on his or her life is not considered a present interest gift for tax purposes. This deprives the donor of the $14,000 per donee annual gift tax exclusion. To convert life insurance premium payments into present interest gifts, planners use the time-tested concept of Crummey gifts.2 This nearly 50-yearold process serves as an estate planning road map for significant gift tax savings.

5. Life Insurance Is a Common Element in Sophisticated Estate Planning The possibility of tax reform places a target on the entire U.S. transfer tax system. Still, there may be offsetting revenue raisers associated with any repeal. For example, while the estate tax may disappear, saving wealthy individuals millions in taxes, the deathtime step-up in income tax basis benefit could also disappear, ushering in millions in new income taxes on beneficiaries. We simply don’t know yet. We do know, however, that life insurance has a long history as a planning tool for larger, more sophisticated estates. It has been used in private split-dollar transactions, generational split-dollar, dynasty trust leveraging, charitable remainder trusts, grantor retained annuity trusts, and a variety of other arcane but still tax-saving concepts. While it’s understandable to be looking down the road toward potential tax changes, estate planners are well advised to not lose sight of the tax-saving opportunities that currently exist. It may be wise planning to lock in the flexibility and liquidity of life insurance coverage while we await the possible changes to come.

4. Never Assume Uninsurability

6. Work with a Specialist

Even though estate planning often focuses on older individuals, age alone does not determine insurability. Life insurers have become increasingly adept at analyzing mortality risks, and they’ve found new ways to cater to older, affluent applicants. From predictive analytics with single lives to joint life pricing for couples, insurers have found new ways to make offers on individuals who, in the past, would have been declined for coverage. Further, due to improved mortality, there has been a general decline in the cost of life insurance products over the last 20 years. In our persistent low-interest-rate environment, we may be seeing the end of this pricing trend. The fact re-

We are in a world where robo-advice and online legal documents are gaining legitimacy. To save cost and time in planning, clients are attracted to various tech solutions, hoping to cut out the middleman. We know, however, that these tools have their limits. Estate planners should apply the same caution to their own planning practices. We may scoff when a client asks, “How different can one last will and testament be from another?” yet then be guilty of the same oversimplification when dealing with life insurance policies. Life insurance planning is a highly specialized discipline, requiring knowledge of, among other things, risk analysis, finance, and tax law. Estate



planners should work with Chartered Life Underwriters and other specialists who can sort through the labyrinthine world of life insurance underwriting, products, premium structures, ownership, beneficiary designations, and servicing. Bottom line: Life insurance should not just be bought and put away.

beneficiaries. It offers flexibility and tax advantages. And that’s what planners need to know about life insurance in an uncertain estate planning environment. ■ Steve Parrish, JD, CLU, ChFC, RHU, is an adjunct law professor and consultant. He can be reached at stephen.parrish@ drake.edu.

Conclusion

(1) The 2006 Pension Protection Act [29 U.S.C.§1001 92006)] provided several income tax provisions related to living benefits associated with life insurance. Most of these provisions became effective in 2009. (2) Crummey v. Commissioner of Internal Revenue, 397 F.2d 82 (1968). This case established the principle that a donee can be offered cash for a period of time, and if the offer is not exercised, the cash’s use as a premium payment will be treated as a present interest gift.

Whenever tax reform is threatened, both clients and advisors tend to go into stalling mode. They want to avoid decisions that could be wiped out later with the stroke of the president’s pen. Life insurance may be an effective estate planning tool during these ambiguous times. It provides the needed liquidity for estates and

The Kenneth Black, Jr.,

Journal Author Award Program The Foundation for Financial Service Professionals funds a program that recognizes the top three articles published in each volume (six issues within the same calendar year) of the Journal of Financial Service Professionals. Honoraria of $1,500, $1,000, and $500 will be awarded to the authors of the winning entries for first, second, and third place, respectively. The program is open to all authors published in the six issues of any calendar year. Articles will be judged by a panel independent of the Journal’s editorial and business staffs utilizing criteria stressing originality of research, clarity, timeliness, and appropriateness for the Journal’s readership. Manuscripts should be from 2,000-8,000 words in length. All submissions must be original work, not previously published elsewhere. For a copy of the guidelines for submission of articles to the Journal, call 610-499-1180 or visit www.SocietyofFSP.org.

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