Insurance: Chapter 8 Flashcards
What is a buy-sell agreement?
It is an arrangement for the sale of the individual’s interest in a business due to death or disability. Agreement may be structured under a stock redemption (entity purchase) or a cross-purchase agreement. Both arrangements are typically funded by life insurance.
What is an example of a stock redemption agreement?
Frank and Howie of HF Inc. Basis is $1k each. Current FMV of HF Inc. is $1mil. Two $500k life insurance policies on the two owners lives.
Corporation agrees to purchase stockholder’s interest for $500k using life insurance.
Practicallity: Pracitcal with multiple owners.
LI owner and beneficiary: The corporation is the owner and beneficiary of the policies on lives of each shareholder.
Life premiums: non-deductible
Result when Howie dies: $500,000 income tax free to corporation, company buys the stock. Frank’s basis is $1,000 and Frank owns 100%
Rights of creditors: Life insurance can be attached
Result if Frank sells the company for $1mil: Gain is $999,000 ($1mil less his basis)
What is an example of a cross-purchase agreement?
Frank and Howie of HF Inc. Basis is $1k each. Current FMV of HF Inc. is $1mil. Two $500k life insurance policies on the two owners lives.
One stockholder agrees to purchase deceased stockholder’s interest for $500k using life insurance.
Practicality: cumbersome with multiple owners.
LI owner and beneficiary: LI is generally required by each shareholder on the lives of the other shareholders
Life premiums: non-deductible
Result when Howie dies: $500,000 income tax free to Frank, he buys the stock. Frank gets a step-up in basis on shares purchased with $500k and Frank now owns 100%
Rights of creditors: Life insurance cannot be attached
Result if Frank sells the company for $1mil: Gain is $499,000 ($1mil less Frank’s $1k basis plus shares purchased with $500k)
What are the benefits of a buy sell agreement?
- Guarantees a market for the business interest
- Provides liquidity for the payment of death taxes and other estate settlement costs of
the deceased owner. - Helps establish the estate tax value of the decedent’s business interest
- Enables the business to continue in the hands of the remaining owners
- Makes a business a better credit risk
What is a step-up in basis?
With the cross purchase method, the non-deceased person owns the policy, their interest gets a step-up in basis. The deceased estate gets a step-up in basis.
How does a disability buy-sell agreement differ from a life buy-sell agreement?
- Benefits to the deceased:
Disability - Capital gains above basis (he would realize a gain)
Life- Deceased’s family benefits - Benefits to deceased’s family:
Disability - None
Life- Step-up in basis (tax free)
What is the transfer of value exposure for a stock redemption buy-sell agreement?
Corporation buys deceased shares from their estate for previously agreed value. Deceased’s basis is stepped up but the buy-sell proceeds are included in their estate. Remaining owner now own’s 100% of company but their basis remains unchanged. They could then either leave the buy-sell policy in place or buy it from the company, but since they are the insured it will not cause a transfer for value problem.
What is the transfer of value exposure for a cross-purchase buy-sell agreement?
Remaining owner buys deceased shares from their estate for previously agreed value. Deceased’s basis is stepped up but the buy-sell proceeds are included in their estate. Remaining owner now own’s 100% of company and their new basis equals the buy-sell agreement value plus their original basis.
They could buy the policy the deceased owner owned on their life from the deceased’s estate, but since they are the insured it will not cause a transfer for value problem.
Why would an employer purchase key employee life insurance?
To protect them against economic loss from the death of a valued employee. The business should be the owner and beneficiary of the policy, premiums are non-deductible but the DB is received tax free.
What is a split dollar plan?
An arrangement under which an employer and an executive share costs and benefits of a life insurance policy. There are two methods the endorsement method and the collateral assignment method
What are the fundamentals of the endorsement method?
The employer owns the policy and pays the premium. The employee is not a shareholder. The employer’s share of the benefits is secured through owner of the policy. The cash value or premiums paid whichever is higher is refunded at death or surrender. The employee’s beneficiary gets the balance of the death benefit.
What are the fundamentals of the collateral assignment method?
The employee is the policy owner, they are a shareholder and they assign the policy. The employer lends the employee the corporations share of the annual premium and the loans amounts are secured by the assignment of the policy to the corporation. The corporation receives premiums paid at either death or surrender of the policy. The employee receives balance of cash value if surrender (charged with table 2001 insurance cost) or beneficiary receives balance of death benefits income tax free.
What is business overhead expense (BOE) insurance used for?
To cover costs of operating a business while the business owner is totally disabled. Actual expenses are reimbursed during time of disability usually up to 1 to 2 years but not inclusive of owners salary.
What about BOE premiums and proceeds for a sole proprietor?
IRS ruled that premiums paid on overhead expense disability policy are deductible as a business expense and that proceeds are taxable
What about BOE premiums and proceeds for a corporation?
They cannot deduct premiums but can exclude insurance benefits from its gross income
What is the general assumption for annuities on the exam?
That they are annuitized
What is an annuity?
A periodic payment from an account maintained by a life insurance company beginning at a specific or contingent date and continuing for a fixed period or for the duration of a designated life or lives
What ways may an annuity be classified?
By type: Immediate, Fixed and Variable (also indexed)
By period: Accumulation and annuitization
By payout method: life, period certain, joint with survivorship
What is a pure life annuity?
Annuity that provides periodic benefit payments as long as the annuitant lives, with the payments ceasing up their death
What are the advantages of a pure life immediate fixed annuity?
- Annuitant has a guaranteed stream of income no matter how long they live
- No residual values remains in the policy at the annuitants death that would be subject
to estate taxes - This annuity has the highest payout among all the settlement options
What are the disadvantages of a pure life immediate fixed annuity?
- Annuitant receives a fixed payment no inflation hedge
- Annuitant cannot commute the remaining value. Can’t change mind once health
changes - Annuitant may die before the return of the entire principal is realized
- Payout can lose most of its purchasing power in 30-40 years
What is a period certain annuity?
An annuity where a certain number of payments are guaranteed whether the annuitant lives or dies. They are either 5, 10, 15 and 20 year periods.
What is a refund annuity?
The contract promises up the death of the annuitant to pay the annuitant’s estate or to a designated beneficiary a lump sum that is the difference, if any, between the purchase price of the annuity and the sum of the monthly payments that had been distributed up to the annuitants death
What is a joint and survivor (not joint-life) annuity?
Annuity’s payout is computed based on two lives. Under the joint-and-last-survivor annuity, the insurance company promises to make payments until both annuitants die
What is a single premium deferred annuity (SPDA)?
Annuity is purchased with a single premium rather than periodic payments. Earning accumulate tax-deferred until distributed
What are the characteristics of a variable annuity?
Annuity may be variable during the accumulation period and variable or fixed during the payout period. Premiums are normally invested in sub accounts. Both an insurance and security license are required to see the annuity.
Who are variable annuities suitable for?
Clients with moderate to high risk tolerances.
*If the wording on the exam is attempt to cope with inflation or keep up with market conditions is used in a suitability question, variable annuity is usually the right choice
What is a qualified longevity annuity contract (QLAC)?
A deferred fixed annuity funded from an IRA or qualified retirement plan designed to keep the client/spouse from outliving their retirement savings. They provide a monthly stream of income later in life.
How are earnings in an annuity taxed?
They are not taxed until they are distributed to the contract holder
When the annuitant receives their deferred periodic or lump sum distribution, how is the taxable amount calculated and what is it called?
The exclusion ratio is the portion of the deferred payment that is taxable as ordinary income. The formula to calculate is listed below.
Monthly payment x Life expectancy in months = Expected Return
Investment/ Expected Return = Exclusion ratio
When can a loss deduction be claimed?
Only if the loss is incurred in connection with the taxpayer’s trade or business or from a transaction entered into for a profit.
What is the taxation on withdrawals of an annuity policy?
Contracts issued after 8/13/1982 are taxed as LIFO. A withdrawal is taxable interest to the extent the cash surrender value of the contract exceeds the investment. Contract owners under 59.5 years of age are charged a 10% withdrawal penalty
What if the annuity is held by a non-natural person how is the income taxed?
The income on the contract is treated as ordinary income received or accrued by the holder that year
