Chapter 11 - Life Insurance in Estate Planning

Question 1

Define Accelerated Death Benefit

Answer 1

A reduced payment of the death benefit of a life insurance policy paid to the insured during the insured’s lifetime in return for a surrender of the life insurance contract.

Question 2

Define Beneficiary

Answer 2

The person(s) entitled to receive the death benefit of a life insurance policy at the insured’s death. Also, the person(s) who hold(s) the beneficial title to a trust’s assets.

Question 3

Define Chronically Ill Individual

Answer 3

A person who has been certified by a licensed health care provider as being unable to perform, without assistance, at least two activities of daily living for at least 90 days, or a person with a similar level of disability.

Question 4

Define Crummy Provision

Answer 4

The explicit right a a trust beneficiary to withdrawal some or all of any contribution to a trust for a limited period of time after the contribution. A Crummy provision converts what otherwise would have been a gift of future interest to a gift of present interest, eligible for the annual exclusion.

Question 5

Define Five-and-Five Rule

Answer 5

The lapse of a general power of appointment, like the release of such a power, results in the transfer for gift tax purposes. This rule applies only to the extend of the value of the property subject to the lapsed powers exceeds the greater of $5,000 or 5 percent of the aggregate value of the assets out of which powers could have been satisfied.

Question 6

Define Incident Ownership of Life Insurance Policy

Answer 6

The ability to exercise any economic right in a life insurance policy.

Question 7

Define Insured

Answer 7

The person whose life is covered by the life insurance contract.

Question 8

Define Lapse

Answer 8

When a power or right ends because of time of circumstance.

Question 9

Define Lump-Sum Death Benefit

Answer 9

A single payment of a life insurance benefit to a beneficiary.

Question 10

Define Modified Endowment Contract

Answer 10

A life insurance policy that appears to function like an investment contract because the policy is paid up in just a few payments. MECs function life other life insurance policies except for the tax treatment of loans from the policy.

Question 11

Define Owner

Answer 11

The person who holds title to a life insurance contract. This person can exercise control over the economic rights of the policy like borrow cash value, pledge the policy for a loan, and increase or decrease the premium payments made on the policy.

Question 12

Define Paid-Up Policy

Answer 12

A life insurance policy where no more premium payments are necessary to keep the life insurance policy in force, or a life insurance policy that cannot accept additional premiums without causing the life insurance policy to become a modified endowment contract.

Question 13

Define Policy Dividends

Answer 13

Refunds or overcharged premiums to life insurance policy owners. The payments are treated as a return of the policy owner’s adjusted basis.

Question 14

Define Premium Pay Status

Answer 14

Premiums are currently being paid on the life insurance policy.

Question 15

Define Qualified Viatical Settlement Provider

Answer 15

A state licensed business that is regularly engaged in the business of buying life insurance policies for the policy owners.

Question 16

Define Section 1035 Exchange

Answer 16

A tax-free exchange of a life insurance contract for another life insurance contract, a modified endowment contract, or an annuity contract on the same insured.

Question 17

Define Settlement Options

Answer 17

The beneficiary’s available options when receiving the death benefit, usually either lump sum or annuity.

Question 18

Define Surrender Value

Answer 18

The cash value of the life insurance policy less a surrender charge which is governed by the policy of state law.

Question 19

Define Term Insurance Policy

Answer 19

A life insurance contract which states if the insured dies within the term of the contract, the insurance company will pay a stated benefit.

Question 20

Define Terminally Ill Individual

Answer 20

A person who has been certified by a licensed health care provider as having a condition or illness that can reasonably be expected to result in death within 24 months.

Question 21

Define Three-Year Rule

Answer 21

If an individual gratuitously transfers the ownership of a life insurance policy on his life within three years of his date of death, the death benefit of the policy is included in his federal gross estate.

Question 22

Define Transfer For Value

Answer 22

A transfer of an asset by means of a sale, exchange or any transfer which includes valuable consideration. If a life insurance policy is transferred for value, the death benefit in excess of the transferor’s adjusted basis will be subject to income tax, unless the transfer meets certain exceptions.

Question 23

Define Universal Life Insurance

Answer 23

A term insurance policy with a cash accumulation account attached to it.

Question 24

Define Variable Universal Life Insurance

Answer 24

A universal life insurance policy with investment options available for the cash accumulation account.

Question 25

Define Whole Life Insurance

Answer 25

A permanent insurance policy which guarantees that the policy will remain in force as long as the premium is paid. The policy has a cash account attached to it which grows tax deferred.

Question 26

What are common objectives that can be met using life insurance? 5

Answer 26

• Protecting the income stream of the client’s family
• Funding the children’s education
• Providing liquidity at a client’s death
• Providing a source of retirement income
• Creating or sustaining family wealth

Question 27

Generally why would an insured not want to own their policy? Why would they want to own their policy?

Answer 27

You would not want to own your policy if you were using the policy to:

• Provide estate liquidity
• Provide benefit to the heirs

You would want to own your policy if you were using the policy to:
-Use it for education or retirement (by using the cash value)

Question 28

How do you determine the amount of life insurance needed when you use the capitalized income approach?

Answer 28

(Gross income - Adjustments) / Riskless rate adjusted for inflation

Adjustments - ex. - % paid to taxes, % of income the decedent used personally
Riskless rate = (1 + treasury bills rate/ 1 + inflation rate) - 1

Question 29

What are the five basic types of life insurance?

Answer 29

• Term
• Universal life
• Variable Universal Life
• Whole Life
• Second-to-Die

Question 30

What are the three parties to a life insurance policy?

Answer 30

Owner
Insured
Beneficiary

Question 31

When would a death benefit in excess of the adjusted basis be subject to income tax? What is this called?

Answer 31

If the life insurance policy was transferred for valuable consideration.
The Transfer for Value Rule

Question 32

When does the transfer for value rule not apply? 5

Answer 32

When transfer of a policy is made to any of the following individuals:

• The insured
• A partner of the insured
• A partnership in which the insured is a partner
• A corporation in which the insured is a shareholder or officer
• A transferee who takes the transferor’s basis in the contract.

Question 33

When would an owner of a policy face an income tax consequence regarding a life insurance policy?

Answer 33

They surrendered the policy and the value is over their adjusted basis. The amount in excess is considered taxable income.

Question 34

How is the tax treatment of a policy dividend different than that of a cash dividend issued on a stock? What is the reasoning behind this difference?

Answer 34

The cash dividend would be fully subject to income tax while the policy dividend would not be.

A cash dividend represents a distribution of earnings and profits, things that would be taxed.
A policy dividend represents a return of the policy owner’s adjusted basis because it is usually a return of overpayment of premiums.

Question 35

What are the two reasons people usually take loans of cash value from their policy?

Answer 35

1 - they expect to repay them

2 - If the loan will not be repaid, the policy will remain in force until the death of the insured.

Question 36

What accounting method is used on traditional life insurance loans? MEC loans? What is the result of that difference?

Answer 36

• FIFO
• LIFO
• MEC loans are treated as taxable income

Question 37

What are the two tests in determining if a life insurance policy is a MEC?

Answer 37

• Corridor Test

- Premiums Paid Test

Question 38

When making exchanges from a life insurance policy or annuity to a life insurance policy to annuity, which combination of exchange results in a taxable event?

Answer 38

Exchanging an annuity for a life insurance policy

Question 39

Whena life insurance contract is exchanged under Section 1035, how is the owner’s adjusted basis in the new policy determined?

Answer 39

It will equal the adjusted basis in the old policy plus any consideration paid for the issuance of the new policy.

Question 40

When would basis be an used with life insurance policies? 2

Answer 40

1 - the policy is a MEC and the owner is taking a distribution or borrowing money from the policy, or
2 - the policy is surrendered before the death of the insured triggering income taxation on the policy gain.

Question 41

What are the other rules that apply to a Section 1035 exchange?

Answer 41

1 - Two individual life insurance policies cannot be exchanged for one joint life insurance policy insuring both lives
2 - Section 1035 does not apply to an exchange of life insurance if the insured is not a US citizen.

Question 42

What are the exceptions that make accelerated death benefits income tax free? What is the stipulation to that rule?

Answer 42

The amounts received under a life insurance contract of the life of an insured individually who is chronically or terminally ill may be excluded from gross income.

For persons that are chronically ill, however, the nontaxable portion is limited to the amounts incurred by the payee (that are not reimbursed by insurance) for qualified long-term care services provided for the insured.

Question 43

What are the six activities of daily living and when do they apply?

Answer 43

1. Eating
2. Toileting
3. Transferring
4. Bathing
5. Dressing
6. Continence

To persons to be certified as chronically ill in regards to Accelerated Death Benefits

Question 44

What is the primary difference between a viatical settlement and an accelerated death benefit?

Answer 44

Who will give you the money. Accelerated death benefits are paid by your life insurance company and viatical settlements are paid by private, third party companies.

Question 45

Why would taking an accelerated death benefit or viatical settlement be beneficial if the person did not need the money to pay for medical expenses?

Answer 45

If they were in the situation they were going to pay estate taxes and owned the policy then they could take the money before death and make qualified gifts to whom they wish to take that out of the gross estate.

Question 46

What are the common types of transfers of life insurance that may trigger gift tax liability? 4

Answer 46

• Changing the beneficiary on the life insurance policy
• Outright gift of a life insurance policy
• Gift of premiums
• Gifts of life insurance to charities

Question 47

For a policy in premium pay status, what is the value for gift tax purposes? For a paid-up policy?

Answer 47

• The sum of the policy’s interpolated terminal reserve plus any unearned premium.
• Replacement cost of the policy, which equals the present costs charged by the insurance company to issue a similar contract.

Question 48

What is the one exception to the valuation rules for gift of life insurance policies?

Answer 48

-If a physician has determined that the insured has a physical condition that is terminal, the value of the policy will be the death benefit, discounted for the predicted life expectancy of the insured.

Question 49

To generate a current income tax deduction, what must be done in regards to a life insurance policy that will benefit a charity?

Answer 49

The policy ownership must be transferred to the charity if the donor wishes to qualify the gift for the income tax charitable deduction.

Question 50

What is the AGI limitations in place when transferring a policy in regards to the value of the policy? What about when the charity owns the policy, what are the AGI limits that apply to the premium the donor continues to pay?

Answer 50

50% of AGI for public charities
30% of AGI for private charities

30% of AGI for public charities
20% of AGI for private charities.

Question 51

When does the three year look back apply? What small change (besides the time) would make this rule not apply?

Answer 51

• When the insured gifts a policy or incidents of ownership in a policy on his life within three years of his death.
• If the owner of the policy was not the insured and the owner of the policy gives the policy to another party, then the three year look back does not apply.

Question 52

What exceptions to the transfer-for-value rule are relevant when it comes to three year look backs?

Answer 52

A transfer to the:

• Partner of the insured
• A partnership in which the insured was a partner
• A corporation in which the insured is a shareholder or officer
• A transferee who takes the transferor’s basis

A sale of the life insurance policy from the insured to any of these individuals or entities will avoid both the transfer-for-value rule and the three-year rule.

Question 53

When does the IRC require the death benefit of a life insurance policy on the insured to be included in the insured’s gross estate?

Answer 53

1. The insured owns the policy at any time within the three year period before his death;
2. When the insured possess any incident of ownership over the policy at any time within the three year period before his death, and
3. When the proceeds of the policy are made available to the executor.

Question 54

What two provisions are commonly found in ILITs that allow the trust to provide the needed liquidity for the insured’s estate while, at the same time, preventing the policy death benefit from being subject to estate tax?

Answer 54

1. Giving the trustee of the ILIT the right to purchase assets from the estate of the insured; and
2. Giving the trustee of the ILIT trust the right to loan money to the estate of the insured.

Question 55

Why should an ILIT not require the trustee to purchase assets or make a loan to the estate and the decedent’s will should not require the estate to sell assets to the ILIT or borrow money from the trust? What is the reasoning?

Answer 55

The reason for this is that any requirement may be construed as the insured or his estate having an incident of ownership in such policy thus causing the proceeds to be included in the gross estate.