VAL

Question 1

What problems may arise when a sole proprietor or sole corporate owner dies? 4

Answer 1

• Survivor Income - How will an income be continued to surviving family members?
• Debts - Will there be sufficient funds to pay the sole proprietor’s personal and business debts?-Estate Settlement Costs - Will the executor or administrator have sufficient cash to pay estate taxes and other estate administrative costs required to settle the estate.
• Business Disposition - How can the value of the business interest best be preserved for the heirs?

Question 2

With planning, what can an insured buy-sell plan accomplish for a sole-proprietorship or sole owned corporation? 6

Answer 2

• A market for the sale of the sole proprietorship is created.
• The price at which the sole proprietorship will sell and the purchaser will buy the business is agreed upon in advance.
• The full purchase price is available exactly when needed at the sole proprietor’s death.
• The business is sold promptly and for its full market value, avoiding the losses associated with a forced liquidation.
• The value of the business may be fixed for federal estate tax purposes.
• Cash is available to settle the estate promptly and efficiently.

Question 3

What are the four methods a buy-sell plan be funded?

Answer 3

• Cash - save up what is needed in full.
• Installment Method - Price could be paid in installments after the death.
• Loan Method - If possible the purchase price could be borrowed.
• Insured Method - Only life insurance can guarantee that the cash needed is available, assuming valuation done accurately.

Question 4

When a key employee dies why might that cause a company to suffer financial loss? 5

Answer 4

• Reduction in Earnings
• Disruption of Management
• Replacement Costs
• Credit Problems
• Confidence Problems

Question 5

How could life insurance help prevent financial loss resulting from a death of a key employee? 6

Answer 5

• Indemnify your business for the permanent loss of the key employee’s skills and experience.
• Replace lost profits.
• Locate, hire and train a replacement.
• Provide a financial reserve during the adjustment period following the key employee’s death.
• Fund the purchase of a deceased shareholder’s ownership interest in the business.
• Provide benefits to the deceased employee’s family.

Question 6

What is the objective of business protection planning?

Answer 6

To assist in evaluating the impact that the death of disability of an owner or key employee could have on your business, and to help provide the funds that will be needed to protect your business from adverse financial consequences that car arise when an owner or key employee dies or becomes disabled.

Question 7

What issues can arise for the business around a deceased business owners heirs?

Answer 7

The heirs:

• Can become active in the business, even though they may be unqualified.
• They may even become owners of a controlling interest and be able to dictate corporate policy.
• They can remain inactive but look to the business for income, or
• They can sell their stock…to anyone with the purchase price.

Question 8

When an heir inherits a business ownership stake, what problems could arise for the heir? 3

Answer 8

• Need for income - They may need income, which can only come in the form of dividends from the corporation. Will this need for income conflict with the surviving shareholder’s salary expectations and desire to reinvest in the business?
• Estate liquidity - Will there be sufficient liquidity in the estate to pay taxes and other administrative costs without selling some portion of the stock, which may make up the majority of the estate?
• Market - Will there be a ready market for closely-held stock?

Question 9

How could the issues of an heir inheriting a share of a deceased’s business find a solution using life insurance?

Answer 9

Let the corporation and its shareholders enter into a binding stock redemption buy-sell plan that is funded with life insurance, the corporation will have the cash to purchase a deceased shareholder’s interest for a previously agreed-upon price that is fair to the heirs.

Question 10

What could an insured stock redemption buy-sell plan accomplish? 6

Answer 10

• The surviving shareholders avoid business problems associated with active or inactive heirs, while heirs receive cash instead of generally poor investment potential of closely held-stock.
• The corporation is committed to buy and the deceased shareholder’s estate is committed to sell the business interest for a price that is agreed upon in advance.
• The funds to complete the sale are available exactly when needed at a shareholder’s death.
• The value of the business interest may be fixed for federal estate tax purposes.
• The deceased shareholder’s heirs are guaranteed a full and fair cash price for the business.
• Cash becomes available to settle the deceased shareholder’s estate promptly and to replace family income.

Question 11

If not prepared for, what happens to a partnership when one partner dies? Why is this an issue?

Answer 11

-The partnership no longer exists-The surviving partners have no authority for the partnership, except for purposes of winding up its business affairs.

Question 12

When a partner dies and there is no plan do dispose of the business interest, what are the only two options available to the survivors?

Answer 12

• Reorganization

- Liquidation

Question 13

What is a Business Split-Dollar Life Insurance Plan?

Answer 13

Not an insurance policy, but when used by a business, is an arrangement that allocates life insurance policy benefits, and in some cases, premium costs between an employer and a valued employee.

Question 14

What are the two types of Split-Dollar Life Insurance Plans?

Answer 14

• Equity Split-Dollar Plan

- Non-Equity Split-Dollar Plan

Question 15

What is an Equity Split-Dollar Plan?

Answer 15

In this arrangement, the employee receives an interest in the policy’s cash value (equity) that is disproportionate to the employee’s share of the premiums payments, while the employer pays more of the premium. Typically, the party paying less (the employee) also receives the benefit of current life insurance protection.

Question 16

What is a Non-Equity Split-Dollar Plan?

Answer 16

In this arrangement, the employer typically provides the employee with current life insurance protection, but the employee has no interest in the policy’s cash value.

Question 17

Name the two regimes which determine how a split-dollar life insurance plan will be taxed.

Answer 17

• Economic Benefit Regime (Endorsement Split-Dollar Plan)

- Loan Regime (Collateral Assignment Split-Dollar Plan)

Question 18

Describe the Economic Benefit Regime (Endorsement Split-Dollar Plan)

Answer 18

The employer owns the life insurance contract, advances the money to pay premiums and provides economic benefits to the employee by allowing the employee to name a beneficiary for the policy’s death benefit by means of an endorsement to the life insurance contract.The employee is then taxed on the value of the economic benefits received in each taxable year.The endorsement method allows the policy’s cash value to be carried as a business asset and borrowed for business purposes (withdrawals and loans will reduce the policy’s death benefit and cash value available for use).

Question 19

Describe the Loan Regime (Collateral Assignment Split-Dollar Plan)

Answer 19

The employee owns the life insurance contract, names a personal beneficiary and assigns the policy as collateral to the employer, in return for the employer’s premiums payments. At the employee’s death, the employer receives a portion of the death benefit (usually equal to the total premiums it has paid) and the employee’s beneficiary receives the balance. If the policy is surrendered, the employer receives back the total premiums it has paid, up to the policy’s cash surrender value, and the employee receives any remaining cash surrender value.The payments of premiums by the employer for a life insurance contract owned by the employee is treated as a series of loans to the employee. Unless the employee pays the employer market-rate interest on the loans, the employee is taxed each year on the difference between market-rate interest and the actual interest paid, if any.Since the employer’s premium contributions are considered loans to the employee, federal and state laws should be checked to determine if there are any restrictions on corporate loans to employees, shareholders, officers, etc, before implementing a collateral assignment split-dollar plan. In addition, publicly-held corporations are strongly encouraged to consult their securities counsel on the potential impact of the Sarbanes-Oxley Act of 2002 on collateral assignment split dollar plans.

Question 20

What are the various Premium Sharing Variations on a split-dollar plan? 5

Answer 20

• Employer Pay All Split-Dollar
• Level Outlay Split-Dollar
• Economic Benefit Split-Dollar (Endorsement Plan Only)-Bonus Split-Dollar (Endorsement Plan Only)
• Bonus Split-Dollar (Collateral Assignment Plan Only)

Question 21

What are the features of a Split-Dollar Life Plan to the employer? 4

Answer 21

• The employer can select which employees will be covered by the plan and for what amounts.
• A business split-dollar life insurance plan requires no IRS approval.
• The employer can ultimately recover its premium outlays.
• A business split-dollar life insurance plan may help retain its valuable employees, since the benefit will be lost if the employee terminates employment.

Question 22

What are the features of a Split-Dollar Life Plan to the employee? 5

Answer 22

• The employee receives valuable life insurance protection at reduced or no out-of-pocket cost.
• Personal funds that might otherwise be spent on life insurance become available for other purposes.
• The employee’s personal beneficiary generally receives the death proceeds free of income tax.
• It may be possible to arrange the split-dollar life insurance plan so that death proceeds are not subject to tax.
• A split-dollar life insurance plan may be cost effective way for a shareholder-employee of a closely-held corporation to shift a portion of the cost of the owner’s personal life insurance to the corporation, if the corporation is in a lower tax bracket than the shareholder-employee.

Question 23

What is an Executive Bonus Plan?

Answer 23

A way to provide personal life insurance to selected key employees using fully-deductible business dollars that provides them with the benefit of life insurance coverage that only lasts while they are employed with the company.

Question 24

What are the two variations on Executive Bonus Plans?

Answer 24

• Standard Executive Bonus Plan

- Double Executive Bonus Plan

Question 25

What is the Standard Executive Bonus Plan?

Answer 25

The business pays the tax-deductible premiums for the life insurance policy and reports them as bonus to the selected key employee. The key employee then must pay the income tax due on this additional taxable income.

Question 26

What is the Double Executive Bonus Plan?

Answer 26

The business increases the tax-deductible bonus to cover both the premiums and the income tax due on the total bonus, meaning that the selected key employee has no additional out-of-pocket cost for this valuable employer-provided fringe benefit.

Question 27

What are the 6 steps of setting up an insured buy-sell agreement for a sole-proprietorship?

Answer 27

1. The sole proprietor and purchaser enter into a buy-sell agreement in which the sole
   proprietor agrees to sell and the purchaser agrees to buy the business for an agreed-upon
   price.
2. The purchaser buys sufficient insurance on the sole proprietor’s life to purchase the
   business and pays the premiums.
3. The life insurance policy on the sole proprietor’s life is owned by the purchaser, who is also
   named as the beneficiary.
4. At the sole proprietor’s death, the life insurance death benefit is received free of income
   tax by the purchaser, who is policy owner and beneficiary.
5. The purchaser uses the proceeds of the life insurance policy to buy the business interest
   from the sole proprietor’s estate for the purchase price agreed upon in the buy-sell
   agreement.
6. After settling the estate, the executor or administrator distributes the balance of the estate
   to the sole proprietor’s heirs.

Question 28

What are the tax implications of an insured buy-sell plan? 5

Answer 28

• Premium payments are not deductible
• Proceeds received by the purchaser at the business owner’s death are not subject to federal income tax.
• If sole proprietor holds no incidents of ownership, the death benefit will not be included in his estate.
• If purchase price established in the buy-sell agreement is arms length and realistically represents the value of the company, that price may set the value of the business for estate tax purposes.
• The transfer of a business owner’s business interest in exchange for the death benefit proceeds is treated as the sale of a capital basis. If the purchase price equals fair market value than there will be no gain for federal income tax purposes.

Question 29

What problems may arise upon the death a partner in a partnership? 6

Answer 29

Both the surviving partners and the deceased partner’s heirs must consent to a reorganization of the partnership. This consent may be dependent on the ability of all parties to overcome problems
such as:
-Estate Settlement Costs - Will there be sufficient liquidity in the deceased partner’s estate to
pay estate taxes and the other estate administrative costs required to settle the estate without liquidating the partnership?
-Heirs as Active Partners - Is one or more of the heirs qualified and willing to assume an active role in managing the business? Do the surviving partners
want to be in business with the deceased partner’s family?
-Heirs as Inactive Partners - Will the surviving partners be willing and able to support the deceased partner’s family, as well as their own? Will the interests
of the surviving partners and the heirs in running the business be compatible?
-Sell to Outsiders - Will the surviving partners want to work with outsiders selected by the deceased partner’s family?
-Sell to Heirs - Will the heirs be both willing and able to buy the business? Will the surviving partners be willing and able to start another business from scratch?
-Buy from Heirs - Will the heirs be willing to sell? Will the heirs and the surviving partners be able to agree on a price? How will the surviving partners fund the purchase?

Question 30

With planning, what can an insured cross purchase buy-sell plan accomplish for a partnership? 6

Answer 30

-Both a forced liquidation and an undesirable reorganization are prevented.
-The surviving partners are committed to buy and the deceased partner’s estate is
committed to sell the partnership interest for a price that is agreed upon in advance.
-The funds to complete the sale are available exactly when needed at a partner’s death.
-The value of the partnership interest may be fixed for federal estate tax purposes.
-The deceased partner’s heirs are guaranteed a full and fair cash price for the business.
-Cash becomes available to settle the deceased partner’s estate promptly and to replace
family income.

Question 31

What are the steps in setting up an insured cross-purchase plan for a partnership? 5

Answer 31

1. The partners enter into a cross purchase buy-sell agreement under which they agree to buy a deceased partner’s interest and the deceased partner’s executor is directed to sell that interest to the surviving partner(s) for an agreed-upon price. The partnership itself is
   not part of the agreement.
2. Each partner owns, is the beneficiary of and pays the nondeductible premiums for life insurance on the other partner(s) in an amount approximately equal to that partner’s share of the purchase price.
3. At a partner’s death, each surviving partner receives the income tax-free death benefit from the life insurance policy owned on the deceased partner.
4. The surviving partner then uses the proceeds of the life insurance to buy the partnership interest from the deceased partner’s estate for the purchase price agreed-upon in the buy-sell agreement.
5. After settling the estate, the executor distributes the balance of the estate to the deceased partner’s heirs.

Question 32

With planning, what can an insured entity purchase buy-sell plan or an insured cross purchase buy-sell plan accomplish for a partnership?

Answer 32

• Both a forced liquidation and an undesirable reorganization are prevented.
• The partnership is committed to buy and the deceased partner’s estate is committed to sell the partnership interest for a price that is agreed upon in advance.
• The funds to complete the sale are available exactly when needed at a partner’s death.
• The value of the partnership interest may be fixed for federal estate tax purposes.
• The deceased partner’s heirs are guaranteed a full and fair cash price for the business.
• Cash becomes available to settle the deceased partner’s estate promptly and to replace family income.

Question 33

What are the steps in setting up an insured entity purchase plan for a partnership? 5

Answer 33

1. The partnership and its owners enter into en entity purchase buy-sell agreement under which the partnership agrees to buy a deceased partner’s interest and the deceased partner’s executor is directed to sell that interest to the partnership for an agreed-upon price.
2. The partnership owns, is the beneficiary of and pays the nondeductible premiums for life insurance on each partner’s life in an amount approximately equal to each partner’s share of the purchase price.
3. At a partner’s death, the partnership receives the income tax-free death benefit from the life insurance policy it owns on the deceased partner.
4. The partnership uses the proceeds of the life insurance to buy the partnership interest from the deceased partner’s estate for the purchase price agreed-upon in the buy-sell agreement.
5. After settling the estate, the executor distributes the balance of the estate to the deceased partner’s heirs.

Question 34

What are the steps in setting up an insured cross purchase buy-sell plan for a partnership?

Answer 34

1. The partners enter into a cross purchase buy-sell agreement under which they agree to buy a deceased partner’s interest and the deceased partner’s executor is directed to sell that interest to the surviving partner(s) for an agreed-upon price. The partnership itself is not part of the agreement.
2. Each partner owns, is the beneficiary of and pays the nondeductible premiums for life insurance on the other partner(s) in an amount approximately equal to that partner’s share of the purchase price.
3. At a partner’s death, each surviving partner receives the income tax-free death benefit from the life insurance policy owned on the deceased partner.
4. The surviving partner(s) then use the proceeds of the life insurance to buy the partnership interest from the deceased partner’s estate for the purchase price agreed-upon in the buy sell agreement.
5. After settling the estate, the executor distributes the balance of the estate to the deceased partner’s heirs.

Question 35

With planning, what can a corporate insured cross purchase buy-sell plan accomplish? 6

Answer 35

• The surviving shareholders avoid the business problems associated with active or inactive heirs, while the heirs receive cash instead of the generally poor investment potential of closely-held stock.
• The surviving shareholders are committed to buy and the deceased shareholder’s estate is committed to sell the business interest for a price that is agreed upon in advance.
• The funds to complete the sale are available exactly when needed at a shareholder’s death.
• The value of the business interest may be fixed for federal estate tax purposes.
• The deceased shareholder’s heirs are guaranteed a full and fair cash price for the business.
• Cash becomes available to settle the deceased shareholder’s estate promptly and to replace family income.

Question 36

What are the steps in setting up a corporate insured cross-purchase buy-sell plan?

Answer 36

1. The shareholders enter into a cross purchase buy-sell agreement under which they agree to buy a deceased shareholder’s stock and the deceased shareholder’s executor is directed to sell that stock to the surviving shareholder(s) for an agreed-upon price. The corporation itself is not part of the agreement.
2. Each shareholder owns, is the beneficiary of and pays the nondeductible premiums for life insurance on the other shareholder(s) in an amount equal to that shareholder’s portion of the purchase price.
3. At a shareholder’s death, each surviving shareholder receives the income-tax-free death benefit from the life insurance policy owned on the deceased shareholder.
4. The surviving shareholder(s) then use the proceeds of the life insurance to buy the stock from the deceased shareholder’s estate for the purchase price agreed upon in the buy-sell agreement.
5. After settling the estate, the executor distributes the balance of the estate to the deceased shareholder’s heirs.

Question 37

With planning, what can a corporate insured stock redemption buy-sell plan accomplish?

Answer 37

-The surviving shareholders avoid the business problems associated with active or inactive
heirs, while the heirs receive cash instead of the generally poor investment potential of
closely-held stock.
-The corporation is committed to buy and the deceased shareholder’s estate is committed
to sell the business interest for a price that is agreed upon in advance.
-The funds to complete the sale are available exactly when needed at a shareholder’s
death.
-The value of the business interest may be fixed for federal estate tax purposes.
-The deceased shareholder’s heirs are guaranteed a full and fair cash price for the
business.
-Cash becomes available to settle the deceased shareholder’s estate promptly and to
replace family income.

Question 38

What are the steps in setting up a corporate insured stock redemption buy-sell plan?

Answer 38

1. The corporation and its owners enter into a stock redemption buy-sell agreement under which the corporation agrees to buy a deceased shareholder’s stock and the deceased shareholder’s executor is directed to sell that stock to the corporation for an agreed-upon price.
2. The corporation owns, is the beneficiary of and pays the nondeductible premiums for insurance on each shareholder’s life in an amount approximately equal to each shareholder’s interest in the business
3. At a shareholder’s death, the corporation receives the income-tax-free death benefit from the life insurance policy it owns on the deceased shareholder.
4. The corporation uses the proceeds of the life insurance to buy the stock from the deceased
   shareholder’s estate for the purchase price agreed upon in the buy-sell agreement.
5. After settling the estate, the executor distributes the balance of the estate to the deceased shareholder’s heirs.

Question 39

What are the steps in setting up an insured buy-sell plan for sole corporate owners?

Answer 39

1. The sole corporate owner and purchaser enter into a buy-sell agreement in which the sole owner agrees to sell and the purchaser agrees to buy the corporation for an agreed-upon price.
2. The purchaser buys sufficient insurance on the sole owner’s life to purchase the business and pays the premiums.
3. The life insurance policy on the sole owner’s life is owned by the purchaser, who is also named as the beneficiary.
4. At the sole corporate owner’s death, the life insurance death benefit is received free of income tax by the purchaser, who is policy owner and beneficiary.
5. The purchaser uses the proceeds of the life insurance policy to buy the corporation from the sole owner’s estate for the purchase price agreed upon in the buy-sell agreement.
6. After settling the estate, the executor or administrator distributes the balance of the estate to the sole owner’s heirs, according to the terms of the sole owner’s will.

Question 40

What are the steps in setting up key employee indemnification insurance plan?

Answer 40

1. Your business establishes the value of the key employee’s contribution to the business.
2. After satisfying the notice and consent requirements for employer-owned life insurance contracts, your business purchases insurance in that amount on the key employee’s life and pays the nondeductible premiums.
3. The life insurance policy is owned by your business, which is also named as the beneficiary.
4. While the premium payments for key employee indemnification insurance are not tax deductible, the death benefit is received by the business free of regular income tax at the key employee’s death, assuming the requirements for employer-owned life insurance
   contracts are satisfied. However, while policy proceeds are not subject to the regular corporate income tax, corporations that are subject to the alternative minimum tax (AMT) may incur a tax liability, both on annual cash value increases and on the death benefit.

Question 41

What problems can arise when a key employee terminates employment?

Answer 41

• Reduction in earnings
• Disruption of management
• Replacement costs
• Credit problems
• Confidence problems
• competition

Question 42

With an executive bonus plan, your business pays a bonus to selected key employees in the
form of tax-deductible life insurance premiums. In addition to providing key employees with
personal life insurance protection paid for with tax-deductible business dollars, an executive bonus
plan can offer what advantages?

Answer 42

• The business can select which employees will be covered by the plan and for what amounts. An executive bonus plan can be used to motivate and retain the key employees of sole proprietorships, partnership and corporations, as well as to benefit shareholder-employees of a closely-held corporation.
• If they wish, shareholder-employees of a closely-held corporation can install an executive bonus plan for themselves only, excluding all other individuals.
• An executive bonus plan is simple to implement and administer, requiring no IRS approval.
• The business can deduct the executive bonus plan life insurance premiums it pays as a business expense under Section 162 of the IRC
• While covered employees must report the bonus as ordinary income, they owned their policies and can use any dividends or cash values to offset taxes due on the premium payment.
• At retirement, policy cash values are available to supplement other sources of retirement income.
• Generally, death benefits are received free of income tax by the key employee’s personal beneficiary and may be structured to avoid estate taxation.

Question 43

What are the steps in setting up an executive bonus plan?

Answer 43

1. The business agrees to pay the tax-deductible premiums for life insurance policies applied
   for by selected key employees.
2. Each of the selected key employees owns the policy on his or her life and names a personal beneficiary for the death benefit. While alive, the key employee controls the policy’s cash value and is entitled to any policy dividends paid.
3. The cost to the key employee is the income tax due on the premiums paid by the business as a bonus.
4. At the key employee’s death, his or her personal beneficiary receives the death benefit free of income tax

Question 44

What is an Employer Pay All Split-Dollar plan?

Answer 44

The employer pays the entire premium. Depending on policy ownership, the employee either reports as income the value of the economic benefits received (economic benefit tax regime), or the difference between market-rate interest and the actual interest paid by the employee, if any
(loan tax regime).

Question 45

What is an Level Outlay Split-Dollar plan?

Answer 45

The employee’s premium contribution is a level amount for a specified period of time, with the employer paying the balance of the premium.

Question 46

What is an Economic Benefit Split-Dollar (Endorsement Plan Only) plan?

Answer 46

The employee pays the portion of the premium equal to that year’s reportable economic benefit and the employer pays the balance. This approach eliminates the employee’s out-of-pocket cost for the tax on the economic benefit.

Question 47

What is a Bonus Split-Dollar (Endorsement Plan Only) plan?

Answer 47

The employer bonuses the annual economic benefit to the employee. The employee then uses the bonus to pay the portion of the premium equal to that year’s reportable economic benefit and the employer pays the balance of the premium. Assuming overall compensation is reasonable, the employer can deduct the bonused amount, which the employee must include in income.
Another alternative is for the employer to bonus both the economic benefit and the tax on the bonus, resulting in no out-of-pocket cost to the employee.

Question 48

What is a Bonus Split-Dollar (Collateral Assignment Plan Only) plan?

Answer 48

The employer bonuses to the employee an amount equal to the employee’s tax liability on the market-rate interest imputed to the outstanding premium “loans.” The employee then uses the bonus to pay his/her tax liability. Assuming overall compensation is reasonable, the employer can deduct the bonused amount, which the employee must include in income. Another alternative is for the employer to bonus both the tax liability on the imputed interest and the tax on the bonus, resulting in no out-of-pocket cost to the employee, assuming the employer is paying the full premium.

Question 49

What does it take to set up a business split-dollar life insurance plan?

Answer 49

1. The business enters into a split-dollar agreement with each selected employee. The agreement spells out the rights and responsibilities of each party.
2. Based on the premium sharing arrangement, the business and employee each contribute a portion of the premium payments.
3. The ownership and beneficiary arrangements of the life insurance policy are determined by selection of the collateral assignment or endorsement method.
4. The employee may have to pay income tax on the economic benefit received (economic benefit tax regime) or on imputed interest on the employer’s premium “loans” (loan tax regime).
5. At the employee’s death, the business is usually entitled to receive from the death benefit the total of the premiums it has paid, with the employee’s beneficiary receiving the balance of the death benefit, generally on an income-tax-free basis. In an endorsement split-dollar plan, the employee must have either paid for the cost of the current life insurance protection or taken the value of the current life insurance protection into account as an economic benefit in order for his/her beneficiary to receive death proceeds free of income tax. Otherwise, the death proceeds are considered payable from the business to the employee’s beneficiary and are taxable as income to the beneficiary.
6. If the policy is surrendered prior to the employee’s death, the business is usually entitled to receive from the cash surrender value the total of the premiums it has paid, and the employee receives the balance, if any

Question 50

Do annuity death benefits receive favorable estate tax treatment?

Answer 50

No. While the growth of annuities receives favorable tax-deferred treatment, there is no comparable special treatment afforded to annuity death benefits.

When an individual dies, the property owned by the decedent, including annuities, forms the gross estate, which is then subject to estate taxation. The estate taxation of annuity death proceeds generally falls under one of these IRC Sections:

Sec. 2033 – Property in which the decedent had an interest
Sec. 2039 – Annuities

Question 51

For a single life annuity, what is the valuation date for federal estate tax purposes?

Answer 51

Valued as of the date of the decedent’s death, even if the alternate valuation date is elected.

Question 52

For joint and survivor annuities, what is the valuation date for federal estate tax purposes?

Answer 52

1. If the alternate valuation date is elected (the date six months after the decedent’s death), IRC Sec. 2032 still requires that the survivor’s annuity be valued as of the date of the decedent’s death, “with adjustment for any difference in its value as of the later date not due to mere lapse of time.”
2. This means that if the value of the survivor’s annuity declines for a reason other than the mere passage of time, a lower valuation may be used if the alternate valuation date was elected.

Question 53

How are deferred annuity death benefits valued for federal estate tax purposes?

Answer 53

In the event of death before the annuity starting date, deferred annuity contracts usually provide for the return of the greater of the cash value or premiums paid, which is then the value of the annuity includable in the decedent’s gross estate.

Question 54

How are straight life annuities valued for federal estate tax purposes?

Answer 54

Since annuity payments end at the annuitant’s death, there is no value to include in the decedent’s gross estate.

Question 55

How are refund or period certain single life annuities valued for federal estate tax purposes?

Answer 55

1. Lump sum payment – The lump sum payment itself (usually equal to the commuted value of the remaining payments guaranteed under the annuity) is the value of the annuity includable in the decedent’s gross estate.
2. Payments continue – If payments are to continue to the beneficiary to the end of the guarantee period, the value of the annuity included in the decedent’s gross estate is the present value of the remaining payments based on the interest rate in the annuity contract.

Question 56

How are refund beneficiary of an annuity on the life of another single life annuities valued for federal estate tax purposes?

Answer 56

1. If the decedent was the refund beneficiary of an annuity he/she had purchased for someone else, the value of the refund may be includable in the purchaser’s estate as a transfer intended to take effect at death, if the value of the refund exceeds 5% of the value of the annuity immediately before the purchaser’s death
2. If, however, the donee- annuitant has the power to surrender the annuity contract or change the beneficiary, it appears that these powers of appointment would preclude the above as a transfer intended to take effect at death

Question 57

How are joint and survivor annuities valued for federal estate tax purposes.

Answer 57

A. The value of the survivor’s annuity is includable in the deceased annuitant’s gross estate in proportion to the decedent’s contribution to the annuity purchase price
B. The value of the survivor’s annuity for estate tax purposes is equal to the amount the same insurance company would charge the survivor for a single life annuity as of the date of the first annuitant’s death
1. If it can be proven that the survivor’s life expectancy is below average (e.g., the survivor has a terminal illness), it may be possible to base the value of the survivor’s annuity on the survivor’s actual life expectancy
C. If the executor elects the alternate valuation date to value estate assets (the date six months after the decedent’s death), the survivor’s annuity is still valued as of the deceased annuitant’s date of death unless:
1. The surviving annuitant dies within six months of the deceased annuitant’s death, in which case a lower valuation may be available by subtracting the cost of a single life annuity as of the date of the survivor’s death from the cost of a single life annuity as of the first annuitant’s date of death

Question 58

What is an annuity?

Answer 58

An annuity is a contract that provides for the systematic liquidation of principal and interest, either (a) for a fixed period of time or (b) over the life of the annuitant or annuitants.

From a tax perspective, the term annuity applies to all arrangements that systematically liquidate a principal sum of money through periodic payments made over a stated period of time, including life. This means that the annuity tax rules apply not only to commercial annuity contracts purchased from insurance companies, but also to periodic payments received from matured endowment contracts and life insurance cash surrender values.

Question 59

What are the six basic ways annuities can be classified?

Answer 59

I. Annuity purchase method (single premium or periodic premiums)
II. When annuity payments begin (immediate or deferred)
III. Growth of annuity principal (fixed or variable)
IV. Number of lives covered (single or joint)
V. Annuity payout method (life, life with guaranteed minimum or temporary)
VI. Annuity payout units (fixed or variable)

Question 60

What are the characteristics of an annuity classified by the purchase method?

Answer 60

A. An annuity is a contract that systematically liquidates a principal sum and interest.
B. The principal sum can be delivered to the insurance company in two ways:
1. Single premium; or
2. Periodic premiums, which can be:
a. Level; or
b. Fixed.

Question 61

What are the characteristics of an annuity classified by when annuity payments begin?

Answer 61

A. Payments from an annuity contract can begin:

1. Immediately (known as an immediate annuity).
   a. Requires a single premium payment.
2. At a specified future time (known as a deferred annuity).
   a. Can be purchased with a single premium or with periodic premiums.

Question 62

What are the characteristics of an annuity classified by the growth of annuity principal (deferred annuities only)?

Answer 62

A. Deferred annuities have an accumulation period during which the single or periodic premium payments earn interest.
B. There are two ways in which interest can be credited to a deferred annuity:
1. Fixed annuity – A stated fixed rate of interest is credited on the annuity principal. Most fixed annuities pay a current fixed interest rate (e.g., 8%) that is guaranteed to never fall below a stated minimum (e.g., 4%).
2. Variable annuity – The contract owner selects from various investment subaccounts (e.g., stock, bond, money market) and, in return for assuming greater risk, may enjoy a higher return than that earned by fixed annuities.
a. The value of a deferred variable annuity is expressed in accumulation units.
b. The value of an accumulation unit, which changes daily, depends on the performance of the underlying investments selected by the contract owner.

Question 63

What are the characteristics of an annuity classified by the number of lives covered?

Answer 63

A. An annuity contract can cover one or two or more lives:

1. Single life annuity – Annuity benefits are paid only for as long as a single annuitant is alive.
2. Joint and survivor annuity – Annuity benefits are paid for as long as either of two or more designated annuitants is alive. This is a popular annuity alternative for husbands and wives. A joint and survivor annuity can pay the full benefit until the death of the surviving annuity (joint and 100% annuity), or it can reduce at the first annuitant’s death to two-thirds (joint and 66-2/3% annuity) or one-half (joint and 50% annuity) of the initial benefit.
3. Joint annuity – Pays annuity benefits only for as long as both designated annuitants are alive; benefits cease at the first annuitant’s death.

Question 64

What are the characteristics of an annuity classified by

Answer 64

A. The systematic payments from an annuity can be for:

1. Life – A straight life annuity pays benefits for as long as the annuitant is alive; benefits stop at the annuitant’s death.
2. Life with a minimum guarantee – If the owner of a straight life annuity dies after receiving just a few payments, most of his/her investment is lost. As a result, life annuities that offer a minimum guaranteed return are available:
   a. Period certain annuities pay benefits for as long as the annuitant is alive, but if the annuitant dies before receiving a guaranteed number of payments (e.g., 120 monthly payments), the remaining payments are made to a designated beneficiary. If the annuitant outlives the “certain period,” payments cease at the annuitant’s death.
   b. Refund annuities guarantee that all or a portion of the annuity purchase price will be returned, either to the annuitant if he/she lives or to a designated beneficiary if the annuitant dies before receiving the refund guarantee amount.
   c. Joint and survivor annuities pay benefits for as long as one of two or more designated annuitants are alive.
3. Temporary – Unlike life annuities, temporary annuities do not guarantee a lifetime income. Instead, a specified number of payments is made to the annuitant or his/her beneficiary (fixed period temporary annuity), ceasing at the end of the specified period of time, or a specified level payment amount is paid until the funds available are exhausted (fixed amount temporary annuity).

Question 65

What are the characteristics of an annuity classified by annuity payout units?

Answer 65

A. Annuity payments made to an annuitant can be fixed or variable in amount.

1. Fixed payments – The value of the annuity is converted into a stream of level periodic payments, using annuity rates that take into consideration the annuitant’s age, sex, an interest assumption and any period certain, refund or survivor features.
2. Variable payments – The value of the annuity is converted into annuity units. While the number of annuity units remains fixed, the value of the annuity unit fluctuates based on the performance of the underlying investment account. As the value of the annuity unit increases and decreases, so does the annuity benefit paid.

Question 66

Do variable annuities have different requirements than fixed annuities?

Answer 66

The significant difference between fixed and variable annuities arises from the way the insurance company invests annuity premiums.

Fixed annuity premiums, like traditional cash value life insurance premiums, are placed in the company’s general account, where they are invested in relatively safe instruments, such as bonds and mortgages.

Variable annuity premiums, however, must be deposited in a separate account (i.e., separate from the company’s general account), where they are then invested in securities, such as common stocks. The buyers of variable annuities may then select among a variety of investment sub-accounts that usually include money market and bond funds, in addition to an array of stock- based funds, for the investment of their annuity premiums.

In order to be treated as an annuity and receive the favorable annuity tax treatment described in this section of TaxFAQs, however, the underlying investments must not only be part of a “segregated asset account” maintained by the insurance company for variable contracts, but that separate account must also be adequately diversified in accordance with regulations prescribed by the IRS

Question 67

What impact does a divorce have upon the taxation of a transfer of annuity contract?

Answer 67

The transfer of an annuity contract after July 18, 1984 pursuant to a Qualified Domestic Relations Order (QDRO) is a tax-free transfer.

Question 68

What impact does a divorce have upon the taxation of annuity payments?

Answer 68

A. The taxation of annuity payments received under a decree of divorce or separation (or a written separation agreement) depends on the date the annuity was transferred.
B. Transfer date on or before July 18, 1984:
1. The entire amount of each annuity payment is taxable to the receiving spouse.
2. There is no provision for an exclusion ratio.
C. Transfer date after July 18, 1984:
1. Annuity payments are taxed under the usual annuity rules, with the receiving spouse using the transferring spouse’s investment in the contract to determine an exclusion ratio.

Question 69

What is considered an annuity payment?

Answer 69

All amounts received from an annuity contract, as well as the taxation of living proceeds received from life insurance and endowment contracts (those amounts generally received while the insured is still alive). IRC Sec. 72 has different rules for:

Annuity payments – All periodic payments (installment payments as well as payments for life) resulting from the liquidation of a principal sum, whether from an immediate or deferred annuity or from the application of life insurance cash surrender values or matured endowment proceeds to an optional settlement option

Amounts not received as an annuity – Any amount received from an annuity, endowment or life insurance contract that is not received as an annuity, such as policy dividends, withdrawals, partial surrenders and annuity death benefits

Interest payments only – Any payments consisting of interest only (i.e., not part of the systematic liquidation of a principal sum) are fully included in gross income in the year payable

Question 70

What is the tax treatment of any dividends or excess interest credited to annuity payments?

Answer 70

Some annuity arrangements are participating in nature. A specified minimum annuity payment, based on a guaranteed annuity rate, is guaranteed to be paid for life or for the installment period selected. The actual annuity payment, however, is based on a higher, current annuity rate or current interest rate that reflects the company’s current experience, and which may change from year to year. In no event will the annuity payment received by the annuitant fall below the minimum payment guaranteed by the contract.

The expected return in the exclusion ratio is calculated based on the guaranteed annuity payment . As a result, any amounts paid in excess of the guaranteed annuity payment are fully taxable to the annuitant as dividends in the year received.

In the case of a fixed amount installment annuity, any payments made beyond the payment period originally guaranteed are due to excess interest and, as a result, are fully taxable as received.

Question 71

What are the income tax consequences if an annuitant dies before fully recovering his/her investment in the contract for a straight life annuity?

Answer 71

1. If the annuitant dies before fully recovering his/her investment in the contract, an amount equal to the unrecovered investment in the contract may be deducted on the individual’s final income tax return

Question 72

What are the income tax consequences if an annuitant dies before fully recovering his/her investment in the contract for a refund or period certain guarantee?

Answer 72

1. If the beneficiary of a refund or period-certain annuity will not fully recover the annuitant’s unrecovered investment in the contract, the beneficiary may deduct any unrecovered amount.
2. The beneficiary’s deduction is limited to unrecovered investment in the contract in excess of the annuitant’s and the beneficiary’s excludable amounts.

Question 73

When does the gift of any annuity occur and what are the income tax consequences? (Issued post 4/22/87)

Answer 73

A. Prior to the annuity starting date
1. The donor is treated as having received an “amount not received as an annuity” equal to the amount by which the cash surrender value at the time of the gift exceeds the investment in the contract
2. This means that the donor realizes taxable income in the year of the gift equal to any gain on the contract allocated to investment in the contract made after August 13, 1982.
3. The requirement that the donor include any gain in income does not apply to transfers between spouses or former spouses incident to a divorce.
B. After the annuity starting date
1. Annuity payments received by the donee are taxed under the annuity rules. The donee can include in his/her investment in the contract the amount of any gain that was included in the donor’s income as a result of the transfer.

Question 74

How is the seller of an annuity contract taxed?

Answer 74

A. Any gain realized by the seller is taxed as ordinary income, and not as a capital gain.
B. If sold before the annuity starting date:
1. Taxable gain is determined in the same way as if the contract had been surrendered, with sale price being substituted for cash surrender value– gain is equal to the excess of the sale price over premiums paid by the seller less any excludable amounts previously received.
2. If the cost basis of the annuity contract exceeds the sale price, the seller realizes an ordinary loss.
C. If sold after the annuity starting date:
1. The total excludable portion of annuity payments already received by the seller must be taken into account in determining the seller’s taxable gain.
2. This means that the seller’s cost basis must be reduced by the total amount of annuity payments that have been received by the seller and excluded from income.
3. However, the seller’s cost basis cannot be reduced below zero, meaning that the taxable gain cannot be more than the sale price.
a. This could otherwise happen if, for example, the annuitant had outlived his/her life expectancy before the sale and was excluding amounts in excess of his/her investment in the contract.
4. If the cost basis of the annuity contract exceeds the sale price, the seller realizes an ordinary loss.

Question 75

How is the buyer of a preexisting annuity contract taxed?

Answer 75

A. If purchased before the annuity starting date
1. The buyer is taxed in the same way as the original owner of the contract would have been taxed except:
2. The buyer’s cost basis in the contract is equal to:
a. consideration paid for the contract; plus
b. any premiums paid after the purchase; minus
c. any excludable dividends received by the buyer and any unrepaid excludable loans received after the purchase.
B. If purchased after the annuity starting date
1. A new exclusion ratio must be calculated based on:
a.the buyer’s cost basis (consideration paid for the contract); and
b.the buyer’s expected return, using an annuity starting date equal to the beginning of the first period for which the buyer receives an annuity payment.

Question 76

How is a beneficiary taxed if the annuitant dies before receiving the full amount guaranteed by a refund or period certain life annuity when a single sum payment is to be made to the beneficiary?

Answer 76

A. Refund guarantee: The beneficiary is paid a single sum equal to the present value of the refund guarantee not received by the annuitant prior to his/her death (e.g., an annuitant with a guaranteed refund of the purchase price dies after receiving payments equal to $60,000 of the annuity’s $75,000 purchase price; the beneficiary receives the present value of the remaining $15,000).
B. Commuted value – At the annuitant’s death, the beneficiary is paid a single sum equal to the present value of the remaining payments due in a certain period or installment annuity (e.g., an annuitant with a 120 month certain annuity dies after receiving 80 monthly payments; the beneficiary receives the present value of the remaining 40 payments in a single sum).
C. Taxation if the single sum is taken by the beneficiary in cash:
1. The beneficiary will have no taxable income unless the single sum, when added to the amounts excludable by the annuitant, exceeds the annuitant’s investment in the contract.
2. Any excess received by the beneficiary above the annuitant’s investment in the contract, reduced by amounts previously excludable by the annuitant, is fully taxable.
D. Taxation if single sum is applied under an annuity option
1. If the beneficiary elects to apply the single sum under an annuity option, the annuity payments will be taxed under the annuity rules.
2. A new exclusion ratio for the beneficiary must be calculated, using a new annuity starting date and the portion of the investment in the contract unrecovered at the annuitant’s death as the beneficiary’s investment in the contract for exclusion ratio purposes
E. Unrecovered investment in the contract
1. If the annuity starting date was after July 1, 1986 and the beneficiary will not fully recover the annuitant’s investment in the contract (taking into account any amounts excludable by the annuitant), the beneficiary may deduct any unrecovered investment in the contract.
2. If the annuity starting date was before July 2, 1986, the beneficiary cannot deduct any unrecovered investment in the contract.

Question 77

How is a beneficiary taxed if the annuitant dies before receiving the full amount guaranteed by a refund or period certain life annuity when installment payments are to be made beneficiary?

Answer 77

A. If the beneficiary continues to receive the remaining installments due under the refund or period certain life annuity guarantee, the beneficiary will have no taxable income until the total amount received by the beneficiary, when added to excludable amounts already received by the annuitant, exceeds the investment in the contract. Thereafter, all installments received by the beneficiary are fully taxable.
B. Unrecovered investment in the contract
1. If the annuity starting date was after July 1, 1986 and the beneficiary will not fully recover the annuitant’s investment in the contract (taking into account any amounts excludable by the annuitant), the beneficiary may deduct any unrecovered investment in the contract.
2. If the annuity starting date was before July 2, 1986, the beneficiary cannot deduct any unrecovered investment in the contract.

Question 78

What are the annuity distribution requirements for when the annuitant dies before receiving the full amount guaranteed by a refund or period certain life annuity?

Answer 78

In order to be treated as an annuity and taxed under the IRC Sec. 72 annuity rules, the contract must provide that if the owner of an annuity dies on or after the annuity starting date and before the entire interest in the contract has been distributed, the remaining interest in the contract must be distributed at least as rapidly as under the distribution method in effect prior to the owner’s death.

Question 79

How are deferred annuities owned by individuals taxed during the accumulation period?

Answer 79

The income taxation of annuity contracts is governed by IRC Sec. 72, which provides for annuity income to be taxed when it is actually or constructively received.

Since the income credited to a deferred annuity contract is deemed not constructively received, it is not currently taxable. This means that the tax on annuity income credited to a deferred annuity contract during the accumulation period is deferred until actually received in the future.

Question 80

How are deferred annuities owned by corporations and other “non-natural persons” taxed during the accumulation period? What are the exceptions?

Answer 80

Income on contributions made after February 28, 1986 to a deferred annuity owned by a corporation or other “non-natural person” is treated as ordinary income and taxed to the “non-natural person” in the year it is credited to the contract.

I. Determining taxable ordinary income
A. Taxable ordinary income is defined as the excess of:
1. the sum of the net surrender value of the contract at the end of the taxable year plus all amounts distributed under the contract during the taxable year and any prior taxable year, over:
2. the total net premiums paid (total premiums paid under the contract for all years reduced by any policy dividends) plus any amounts includable in gross income for prior tax years.

II. Exceptions
A. Their are several exceptions that allow for tax-deferred treatment of annuity contracts owned by “non-natural persons.”
B. The exceptions include:
1. An annuity contract acquired by the estate of a decedent by reason of the decedent’s death.
2. An annuity contract held under a qualified pension, profit sharing or stock bonus plan, as a Section 403(b) tax-sheltered annuity or as an IRA.
3. An annuity contract that is a qualified funding asset (an annuity contract purchased and held to fund periodic payments for damage awards), without regard to whether there is a qualified assignment.
4. A deferred annuity contract purchased by an employer at the termination of a qualified pension, profit sharing or stock bonus plan or tax-sheltered annuity program and held by the employer until all amounts under the contract are distributed to the employee for whom such contract was purchased or to the employee’s beneficiary.
5. Immediate annuities, defined as an annuity purchased with a single premium or annuity consideration with an annuity starting date that is no later than one year from the date of purchase and which provides for a series of substantially equal periodic payments to be made at least annually during the annuity period.

Question 81

How are loans, withdrawals and partial surrenders taxed during the accumulation period?

Answer 81

The taxation of annuities is governed by IRC Sec. 72, which divides amounts received into two types: (1) amounts received as an annuity and (2) amounts not received as annuities. Different tax rules apply to each type of payment. Amounts received as an annuity are taxed under the annuity rule. Amounts not received as annuities either are fully taxable to the extent there is gain in the contract, or are taxed under the cost recovery rule, depending on when the contract is issued. Loans, withdrawals and partial surrenders fall into this second type of payment.

A. Loans, withdrawals and partial surrenders are taxed as income to the extent that the cash value of the annuity before the distribution exceeds the investment in the contract.
B. The value of any part of an annuity that is pledged or collaterally assigned is treated as a loan and taxed as described above.
C. In addition, such distributions made before the annuitant’s age 59-1/2 may be subject to a 10% penalty tax on the amount of the distribution included in income.
D. Beginning on October 22, 1988, all annuity contracts issued by the same company to the same annuitant in any calendar year are treated as one annuity contract for purposes of determining the taxable amount of any distribution.

Question 82

What are the general rules for taxing an annuity?

Answer 82

I. Annuity rules
A. The basic rule for taxing annuity payments provides for the return of the annuitant’s investment in the contract in equal tax-free amounts over the projected annuity payment period. The balance of each payment is then taxable as received.
B. At the annuity starting date, an “exclusion ratio” is calculated to determine the portion of each annuity payment that can be excluded from income. The balance of each annuity payment must then be included in gross income for the year received.
1. The annuity starting date is the first day of the first period for which an annuity is received from the contract.
C. If the annuity starting date is after December 31, 1986, the annuitant cannot recover more than his/her investment in the contract on a tax-free basis. Once the equal tax- free amounts received equal the investment in the contract, each annuity payment thereafter is fully includable in gross income.
1. If the annuitant dies before recovering his/her full investment in the contract, however, a deduction for the unrecovered amount is allowed for the annuitant’s final tax year.
2. For annuity starting dates before January 1, 1987, the exclusion allowance continues to apply, even after the total tax-free amounts received exceeds the annuitant’s investment in the contract.

Question 83

How do you calculate the exclusion ratio for an annuity?

Answer 83

A. Definition
1. The exclusion ratio is a percentage or fraction that results from dividing the annuitant’s investment in the contract by the expected return from the contract.

Investment in the Contract
——————————- = Exclusion Ratio
Expected Return

  2. The annuity payment is then multiplied by the exclusion ratio, resulting in the portion of each annuity payment that is received tax-free. 

Annuity Payment
X Exclusion Ratio
———————
Tax-Free Portion of Annuity Payment

  3. Finally, the tax-free portion is subtracted from the annuity payment to arrive at the portion of each annuity payment that must be included in gross income. 

Annuity Payment
-Tax-Free Portion
———————
Taxable Portion of Annuity Payment

Question 84

For an annuity, how do you determine the investment in the contract?

Answer 84

1. Generally speaking, investment in the contract is equal to the total premiums or other consideration paid for the contract, reduced by amounts previously received under the contract to the extent they were excludable from income.
2. Investment in the contract is equal to total premiums paid or, if the contract was purchased from a previous owner, to the consideration paid for the contract plus total premiums paid after the purchase, reduced by the following amounts:
   a. Any extra premiums paid for supplementary benefits (e.g., the waiver of premium benefit) (Rev. Rul. 55-349, 1955-1 CB 232).
   b. Any policy dividends and unrepaid policy loans received before the annuity starting date to the extent they were excludable from gross income.
   c. Any other amounts received under the contract before the annuity starting date and excluded from income (Reg. Sec. 1.72-6).
3. Investment in the contract must be increased by any policy loan received under the contract and includable in gross income [IRC Sec. 72(e)(4)] (See FAQ14/B/5).
4. Reduction for refund or period-certain guarantee
   a. If the annuity is a life annuity that has a refund or period-certain guarantee, the investment in the contract must be reduced by the value of this guarantee

Question 85

For an annuity, how do you determine the expected return?

Answer 85

1. Generally speaking, expected return is just that – the total amount the annuitant can expect to receive from the contract.
2. Installment (fixed period or fixed amount) annuity payments:
   a. Expected return is equal to the sum of the guaranteed payments.
3. Fixed life annuity payments:
   a. Expected return is calculated by multiplying the total of one year’s guaranteed annuity payments by a life expectancy factor taken from the appropriate IRS annuity table.
   b. If investment in the contract includes a post-June 30, 1986 contribution, unisex Annuity Tables V - VIII are used, depending on the type of annuity.
   c. If investment in the contract does not include a post-June 30, 1986 contribution, gender-based Annuity Tables I - IV are used, although an irrevocable election to use the unisex tables can be made.
4. Variable annuity payments: Since expected return is unknown for a variable annuity, the exclusion ratio uses a different formula.

Question 86

How is the exclusion ratio calculated for a variable annuity?

Answer 86

Go here and figure it out your damn self:

http://vsa.fsonline.com/vsa/taxinfo/faq14b18.html

Question 87

How is the death benefit taxed if the annuitant dies before the annuity starting date?

Answer 87

I. Taxation of annuity death benefit
A. Since this death benefit does not qualify as life insurance proceeds, any gain is taxed to the beneficiary as ordinary income in the year of death.
B. Taxable gain at the annuitant’s death is equal to:

Death benefit
\+	All dividends and any other amounts that were excluded from income
-	Total gross premiums paid
----------------------------
Taxable gain to beneficiary

C. Exceptions:

  1. The beneficiary is taxed on any gain in the year of death unless within 60 days of the annuitant's death, he/she elects to apply the death benefit to a life income or installment settlement option [IRC Sec. 72(h)]. In this event, the beneficiary is taxed under the regular annuity rules, with a portion of each annuity payment representing a tax-free return of the deceased annuitant's investment in the contract and the balance of each payment included in the beneficiary's gross income.
  2. Variable annuities acquired before October 21, 1979: If the annuitant dies before the annuity starting date, the contract receives a step-up in cost basis to its value on the date of the deceased annuitant's death (or the alternate valuation date if elected). If the new stepped-up cost basis equals the death benefit received by the beneficiary, the beneficiary will have no income tax to pay.
     a. If a pre-October 21, 1979 variable annuity contract is exchanged for a new variable annuity contract after that date, however, the beneficiary will not receive the step-up in basis and the appreciation in the annuity's value will not escape taxation 

II. Annuity distribution requirements
A. Contracts issued after January 18, 1985 only
1. In order to be treated as an annuity and taxed under the IRC Sec. 72 annuity rules, the contract must provide that if the owner of an annuity dies before the annuity starting date, the entire interest in the contract must be distributed within five years after the owner’s death.
2. Annuitization by a designated beneficiary within one year after the owner’s death is allowed.
3. If the surviving spouse is the designated beneficiary, the surviving spouse is treated as the owner of the contract in regard to distribution requirements.

Question 88

What is the exception regarding personally-owned annuity contracts about the rule that premiums for an annuity contract generally aren’t tax deductible?

Answer 88

A. Premiums that an individual pays to purchase an annuity contract are a personal expense and are not tax deductible.
1. The result is the same regardless of whether the premiums are paid by the annuitant or by someone else, such as a spouse.

Question 89

What is the exception regarding charitable deduction for annuity premiums about the rule that premiums for an annuity contract generally aren’t tax deductible?

Answer 89

A. While premiums paid for personally- owned annuities are not tax deductible, a charitable deduction may be available for premiums paid to an annuity that is irrevocably payable to a charitable organization.

1. A charitable organization or trustee of an irrevocable charitable trust must own the policy.
2. The deduction is subject to the limits on deductions for gifts to charities:
   a. Cash payments “to charity” in the amount of the premiums will qualify for a current deduction of up to 50% of the donor’s adjusted gross income, with a five-year carryover.
   b. The deduction for premiums paid directly to the insurer “for the use of charity” may be limited to 30% of the donor’s adjusted gross income, with a five-year carryover

Question 90

What is the exception regarding employer-paid annuity premiums about the rule that premiums for an annuity contract generally aren’t tax deductible?

Answer 90

A. Employer-owned annuities:
1. If the business owns the annuity contract, premiums are not deductible as a business expense.
2. Furthermore, a deferred annuity owned by a “non-natural person” does not receive tax-deferred treatment of annuity income during the accumulation period.
B. Employee-owned annuities:
1. If an employee’s rights to the annuity contract are nonforfeitable at the time the employer pays the premiums, the premiums are deductible by the employer.
a. The premiums are considered a bonus to the employee, who must report them as ordinary income.
b. The employer can deduct the bonus payments as an ordinary business expense, assuming that the bonus, when combined with the employee’s other compensation, is considered reasonable.

Question 91

What is the exception regarding qualified plan and IRA annuity premiums about the rule that premiums for an annuity contract generally aren’t tax deductible?

Answer 91

A. Premiums paid for annuities under a qualified pension or profit-sharing plan are deductible as provided in IRC Sec. 401(a).
B. Premiums paid to purchase an individual retirement annuity (IRA) may be deductible, subject to the requirements of IRC Sec. 219.
C. Premiums paid to purchase a tax- sheltered annuity subject to the requirements of IRC 403(b) are not included in the employee’s taxable income.

Question 92

What is a split annuity?

Answer 92

A combination of a fixed interest single premium immediate annuity and a fixed interest single premium deferred annuity.

Question 93

Who would a fixed interest annuity best be suited for?

Answer 93

 Prefer to rely on fixed rates of return
 Focus on preservation of assets
 Want protection from market volatility
 Prefer to delegate investment decisions and risks to the insurance company
 Understand that a fixed rate of return may not provide a good hedge against inflation

Question 94

Who would a variable annuity best be suited for?

Answer 94

 Prefer to invest in equities
 Want to make their own investment decisions
 Understand that assets can decline in value
 Are willing to assume the risk of loss of principal in exchange for the possibility of greater asset growth and a stronger hedge against inflation

Question 95

Who would indexed annuities best be suited for?

Answer 95

 Are adverse to risk
 Understand that a rate of return linked to stock market performance provides the potential for higher returns than fixed interest investments, together with the risk of losing money if the issuing company does not guarantee 100% of the principal and no index-linked interest is credited, or if the indexed annuity is surrendered while a surrender charge is in
effect
 Prefer to delegate investment decisions to others
 Want less market risk than with a variable annuity

Question 96

What are the advantages of an annuity?

Answer 96

 Earnings on your annuity premiums are tax deferred so long as they remain in the annuity. When compared to an investment whose earnings are taxed each year, tax deferral offers the potential for accumulating significantly higher amounts of money over time.
 An annuity can be used to provide a steady source of retirement income that you cannot outlive.
 Unlike an IRA or employer-sponsored retirement plan, there are no annual contribution limits to an annuity…you can contribute as much as you want.
 Subject to the terms of the contract, there is no required date by which you must begin receiving annuity income payments, providing you with the flexibility to defer payments until you need the income.
 If you die while your annuity still has value, the annuity death benefit passes directly to your beneficiary without probate.
 In most states, an annuity is free from the claims of a creditor.

Question 97

What are the disadvantages of an annuity?

Answer 97

 Premiums for a non-qualified annuity are not tax deductible, meaning that they are made with after-tax dollars.
 While you can surrender or make withdrawals from a deferred annuity before you begin receiving income payments, the surrender or withdrawal may be subject to a charge if made within a stated number of years after the annuity is initially purchased.
 If made prior to age 59-1/2, a surrender or withdrawal will be subject to a 10% federal penalty tax unless one of the exceptions to this tax is met.
 When received, investment gains are subject to ordinary income tax rates and not the lower capital gains tax rate.
 Once annuity income payments begin, annuity contracts vary in regard to whether the payment amount can be changed and/or whether amounts can be withdrawn from the contract. Ask your licensed financial adviser to explain whether the contract you are considering allows for annuity payments to be increased or decreased and whether withdrawals are available.

Question 98

What are the tax implications of an unfunded irrevocable life insurance trust during the grantor’s lifetime?

Answer 98

None

Question 99

What are the tax implications of a funded irrevocable life insurance trust during the grantor’s lifetime?

Answer 99

Income tax liability is shifted from the grantor to the trust or trust beneficiaries, who may be in a lower tax bracket, unless the trust is treated as a grantor trust.

Question 100

What are the tax implications of an grantor irrevocable life insurance trust during the grantor’s lifetime?

Answer 100

Any trust income, losses, deductions or credits realized by the trust must be reported by the grantor if any of the following conditions exist:

a. The grantor or grantor’s spouse retains a reversionary interest that exceeds 5% of the value of the trust;
b. The grantor or grantor’s spouse retains the power to control the beneficial enjoyment of the trust income or principal;
c. The grantor and/or trustee can revoke the trust;
d. The grantor or grantor’s spouse retains certain administrative powers; or
e. Trust income is or, in the discretion of the grantor or a non-adverse party, may be:
(1) distributed to the grantor or grantor’s spouse;
(2) held or accumulated for future distribution to the grantor or grantor’s spouse;
(3) used to pay premiums on a policy insuring the life of the grantor or grantor’s spouse; or
(4) used to discharge a legal obligation of the grantor or grantor’s spouse

Question 101

What are the tax implications of using trust income to pay insurance premiums insuring the grantor’s (or spouses) life?

Answer 101

It is considered taxable income to the grantor unless the policy is irrevocably payable to a charity.

Question 102

What are the tax implications of an irrevocable life insurance trust at the grantor’s death?

Answer 102

1. Policy proceeds – Free of income tax to the trust and to the trust beneficiaries when distributed.
   a. Any earnings or proceeds retained by the trust, however, are taxed in the same manner as any other trust income.
   b. If the policy was transferred for value to the trust, however, the proceeds may not be fully exempt from income tax.

Question 103

Can life insurance proceeds received by an irrevocable life insurance trust be used to provide estate liquidity without causing the proceeds to be included in the insured/grantor’s gross estate for estate taxation purposes?

Answer 103

Possibly. The includability of proceeds received by an irrevocable life insurance trust will depend on the trustee’s powers and how the proceeds are used to provide estate liquidity:

• If the trustee is required to use proceeds to discharge estate obligations, the amount of such proceeds is included in the insured’s gross estate, whether or not actually used for such purposes.
• If the trustee has a discretionary power to use proceeds to discharge estate obligations, and the trust is for the benefit of named individuals (i.e., not for the benefit of the estate), only the amount of any proceeds actually used for such purposes is included in the insured’s gross estate.

Still another option is to give the trustee a discretionary power to loan funds to the estate or to purchase assets from the estate. Assuming that the power is discretionary and not required, the proceeds should not be included in the insured’s gross estate

Question 104

What is the recommended way to transfer ownership of a life insurance policy to an irrevocable life insurance trust?

Answer 104

A primary objective of an irrevocable life insurance trust is to avoid federal estate taxes, as well as state death taxes, on life insurance proceeds, both at the insured’s death and, later, at a surviving spouse’s death.

An irrevocable trust becomes an irrevocable life insurance trust when:

1. the grantor makes an absolute assignment of one or more life insurance policies to the trust; or
2. the trustee uses trust funds to purchase new life insurance on the grantor’s life.

A problem can arise with the first method, however, if the insured dies within three years of transferring the policy to the trust. In this event, IRC Sec. 2035(d) requires that the proceeds be included in the grantor/insured’s gross estate. Since this result cancels out a primary advantage of an irrevocable trust, the second method should be considered, assuming the grantor is still insurable.

The best way to avoid the “within three years of death” problem is for the insured to never own the policy. Using contributions to the trust made by the grantor, the trustee should apply for the life insurance policy, own all incidents of ownership from inception, pay the premiums from trust funds and be named the beneficiary. It is important that the trustee act independently in the purchase of the life insurance and not at the direction of the grantor. For example, the trust document should permit the trustee to purchase life insurance and pay premiums, but not require it. Finally, the grantor’s involvement should be limited to signing the application as “insured” and verifying information on the application.

Question 105

Does the gift of life insurance to an irrevocable trust qualify for the annual gift tax exclusion?

Answer 105

I. Use of the annual gift tax exclusion
A. If the annual exclusion is available, then up to $10,000 of the value of the gift (as indexed for inflation; $14,000 in 2014) is shielded from gift tax ($20,000 if a split-gift by a married couple; as indexed for inflation; $28,000 in 2014). If there is more than one trust beneficiary, an annual exclusion can be applied to each beneficiary.
B. Availability for use with gifts to an irrevocable life insurance trust:
1. The annual exclusion is available only for gifts of a present interest.
2. A gift of a future interest does not qualify for the annual exclusion.
3. To avoid the future interest rule, the trust beneficiary must generally have the right to borrow against or surrender the policy, which by definition is almost always contrary to the objective of an irrevocable life insurance trust. This means that:
4. Absent a special trust provision (i.e., the “Crummey power”) that creates a present interest in one or more trust beneficiaries, the gifts of life insurance policies or premiums to an irrevocable life insurance trust do not qualify for the annual exclusion.
II. The Crummey power
A. A gift of a life insurance policy in trust, however, is designed by its nature to delay the beneficiary’s control and enjoyment of the policy, making it a gift of a future interest that does not qualify for the annual exclusion.
B. Use of a special trust provision called the “Crummey power,” however, makes it possible to secure the annual exclusion for life insurance gifts in trust.
1. The Crummey power is named for the case from which it derived.
C. By giving a trust beneficiary the noncumulative annual power to withdraw a specified amount from the trust, the Crummey power creates a gift of a present interest (while the trust beneficiary may not currently enjoy the gift, he/she has the legal right to do so).
D. A Crummey power that meets the following requirements will qualify both the gift of a life insurance policy and the gift of policy premiums for the annual exclusion:
1. The trust beneficiary must be given an absolute, noncumulative right to withdraw a specified amount from the trust each year.
2. The beneficiary must be given proper and timely notification of his/her withdrawal rights.
3. While the demand period to exercise the withdrawal right can be limited, the beneficiary must have a reasonable opportunity to actually exercise his/her right to withdraw.
a. A 30-day demand period each year is generally considered the minimum acceptable period.
E. With the Crummey power, each time a contribution is made to the trust, the trust beneficiary then has a temporary right to demand a withdrawal from the trust. Assuming the demand right is not exercised, the trustee can then use the funds contributed to pay premiums. If the demand is made, the trustee must deliver the funds to the trust beneficiary.
1. Since the trust beneficiary normally understands the purpose of the trust and the fact that a withdrawal may cause the grantor to discontinue future transfers to the trust, the beneficiary generally allows the withdrawal right to lapse.
G. The five-and-five rule
1. The Crummey power is a general power of appointment.
2. If a trust beneficiary fails to exercise his/her right to withdraw and there are other trust beneficiaries, the beneficiary is treated as having made a taxable gift to the other trust beneficiaries.
a. Any such gifts are gifts of a future interest and ineligible for the annual exclusion.
3. However, the lapse of a power of appointment that does not exceed the greater of $5,000 or 5% of the aggregate value of trust assets at the time of lapse is considered a release of such power, which does not result in a taxable gift.
4. This means that the lapse of a Crummey power is a taxable gift to other trust beneficiaries only to the extent that the amount the trust beneficiary could have withdrawn exceeds the $5,000/5% threshold.
5. It is for this reason that many irrevocable life insurance trusts with the Crummey power limit the beneficiary’s right of withdrawal to the greater of $5,000 or 5% of the value of trust assets at the time the power lapsed.

Question 106

If income from a funded irrevocable life insurance trust is used to pay premiums, what are the income tax results?

Answer 106

Any trust income used to pay premiums on a policy insuring the grantor’s life (or the life of the grantor’s spouse) are taxable income to the grantor, unless the policy is irrevocably payable to a charity. The result is the same whether the grantor transfers the policy to the trust or the trustee applies for the insurance. Furthermore:

If trust income may be used to pay premiums without the consent of an adverse party, it is taxed to the grantor to the extent that trust income may be used for this purpose, even if it is not actually used to pay premiums.

If the trustee is empowered to purchase insurance on the grantor’s life, but no policies are in existence, no trust income is taxed to the grantor.

Question 107

If money from funded irrevocable life insurance trust is to be used to pay premium, what can the grantor do to avoid being taxed on the trust income?

Answer 107

• The trust document should prohibit use of trust income to pay premiums; and
• The grantor should make sufficient cash contributions to the trust with which to pay premiums.

Question 108

Can the grantor/insured be the trustee of an irrevocable life insurance trust?

Answer 108

While it is technically possible, in reality naming the grantor/insured as trustee can cause potential estate tax problems. The safer course of action is to name someone other than the grantor/insured as trustee.

If the grantor/insured is named trustee and the IRS can successfully argue that, as trustee, the insured retained an incident of ownership, the proceeds are includable in the insured’s gross estate.

In a Revenue Ruling, the IRS spelled out the circumstances under which the insured as trustee will not be deemed to possess incidents of ownership:

1. the insured’s powers over the trust cannot be exercised for his/her personal benefit;
2. the insured did not transfer either the policy or the premiums to the trust; and
3. the trust powers held by the insured were not part of a prearranged plan in which the insured participated.

Since it would be impossible for a grantor/insured to meet all of the above conditions, the IRS could claim that a grantor/insured named as trustee held incidents of ownership at his/her death, causing the proceeds to be included in the insured’s gross estate.

Question 109

What is the definition of what is considered life insurance for estate tax purposes?

Answer 109

A. For estate tax purposes, the definition of life insurance is a broad one that includes life insurance of every description.
B. A contract meets the definition of life insurance if an insurer must pay a specified death benefit to a beneficiary at the insured’s death.
1. There must be an element of risk present in order for the proceeds of the contract to be classified as life insurance at the insured’s death.
2. If the terminal reserve value of the contract equals or exceeds the face amount at the insured’s death, the rules that apply to the estate taxation of annuities are applicable

Question 110

Besides the death proceeds of a life insurance contract, what else is considered life insurance for estate tax purposes?

Answer 110

1. accidental death benefits (regardless of whether payable from a life insurance or a health insurance policy);
2. paid-up additional insurance;
3. proceeds paid from a policy rider at the insured’s death;
4. group insurance proceeds;
5. death benefits paid by a fraternal society’s lodge system; and
6. death benefit payable under “no-fault” automobile liability insurance

Question 111

When would payments made at an individual’s death not be considered life insurance for estate taxation purposes?

Answer 111

1. If payments are conditional or have an effect on other legal liabilities or rights connected with an individual’s death, the payments are not considered life insurance for estate taxation purposes.
   a. This situation arises most frequently in connection with air travel and automobile policies.
2. Just because a payment is not classified as life insurance does not mean that it will not be subject to inclusion in the deceased’s gross estate. It just means that it will not be included based on the estate taxation provisions dealing with life insurance.

Question 112

Does life insurance receive favorable estate tax treatment?

Answer 112

While life insurance receives favorable income tax treatment, there is no comparable special treatment afforded to the estate taxation of life insurance.

When an individual dies, the property owned by the decedent, including life insurance, forms the gross estate, which is then subject to estate taxation. In the case of life insurance, “ownership” is rather broadly interpreted. For example, if the decedent held just a single “incident of ownership” (e.g., the right to change the beneficiary) within three years of death, the value of the life insurance asset is included in the decedent’s gross estate. In addition, the value included depends on whether the decedent was the insured or the owner of a policy insuring someone else.

Question 113

In general, when are life insurance proceeds included in a decedent’s gross estate?

Answer 113

I. Decedent was the insured
A. The death proceeds of life insurance are included in a deceased insured’s gross estate when:
1. the proceeds are payable to or for the benefit of the insured’s estate;
2. the insured held one or more incidents of ownership in the policy at the time of death;
3. the insured made a gift of the policy within three years of death; or
4. the insured retained certain lifetime rights, such as:
a. the right to enjoy certain rights to the policy;
b. under certain conditions, the right to have the policy revert back to the decedent or his/her estate; or
c. the right to alter, amend, revoke or terminate the policy.
II. Decedent owned a life insurance policy on the life of another
A. If the owner of the policy is someone other than the insured and the owner dies before the insured, the value of the policy will be included in the deceased owner’s estate.
1. The value included generally is the interpolated terminal reserve value of the policy, plus accrued dividends and any unearned premium.
III. Decedent was the beneficiary of a life insurance policy
A. If the beneficiary dies before the insured:
1. If the beneficiary is simply the beneficiary of a life insurance policy and dies before the insured, there are no proceeds to include in the deceased beneficiary’s estate.
B. If the beneficiary dies after the insured:
1. Lump sum death benefit – If the decedent had previously received a lump sum death benefit, any of those proceeds remaining at the decedent’s death generally will be included in the deceased beneficiary’s gross estate.
2. Proceeds payable under a settlement option – This is a very complex area. If a primary beneficiary is receiving death proceeds paid in installments under a settlement option, the commuted value of any remaining installments due generally is included in the deceased beneficiary’s gross estate if:
a. the commuted value is paid to the deceased beneficiary’s estate; or
b. the beneficiary had a general power of appointment over the proceeds, such as the right to revoke the contingent beneficiary designation or an unrestricted right to withdraw principal.
c. Absent either of the above conditions, the transfer of any remaining installments from the primary beneficiary to the contingent beneficiary at the primary beneficiary’s death generally is considered a transfer from the insured. The commuted value of the remaining installments is not included in the deceased primary beneficiary’s estate.

Question 114

Are life insurance proceeds payable to or for the benefit of an insured’s estate included in his/her gross estate?

Answer 114

Yes. Even if the insured held no incidents of ownership in the policy, if the proceeds are payable to the estate or used for the benefit of the estate, those proceeds are included in the insured’s gross estate.

I. Proceeds payable to the estate
A. If the insured’s estate is the beneficiary of life insurance proceeds, those proceeds must be included in the insured’s gross estate for estate taxation purposes.
1. Generally, the amount that must be included is the death benefit, minus any outstanding loan and plus any accrued dividends and interest and any unearned premium as of the date of death.
B. It makes no difference who applied for the policy, owned the policy or paid the premiums; the proceeds are includable if they are paid to the insured’s estate.
C. Community property – If the proceeds are community property, one-half of the proceeds paid to the insured’s estate will be included in the insured’s gross estate for estate taxation purposes.
II. Proceeds paid for the benefit of the estate
A. If the insured held no incidents of ownership and the beneficiary is other than his/her estate, all or a portion of the proceeds can still be included in the insured’s gross estate if the beneficiary is legally obligated to pay the debts, taxes or other expenses of the insured’s estate.
B. Legally binding obligation
1. If the beneficiary has a legally binding obligation to pay the debts, taxes and other expenses of the estate, the amount of proceeds required for payment in full of these expenses is includable in the insured’s gross estate, even if the proceeds are not actually used for this purpose.
2. On the other hand, if a beneficiary not under a legally binding obligation loans the proceeds to the estate or uses the proceeds to buy assets from the estate, the proceeds should not be included in the insured’s gross estate, assuming that the insured held no incidents of ownership.
C. Collateral assignments
1. The proceeds of a policy purchased as collateral security for a creditor are considered payable for the benefit of the estate and will be included in the insured’s gross estate to the extent that the creditor has the right to collect the loan from the proceeds.
2. The outstanding loan due at the insured’s death is deductible in determining the taxable estate, even though paid from the proceeds.
D. Irrevocable trusts
1. If life insurance proceeds are paid to an irrevocable trust and the trustee is under a legally binding obligation to pay the debts, taxes and other expenses of the estate, the proceeds required for payment in full of these expenses is includable in the insured’s gross estate, even if the proceeds are not actually used for this purpose.
2. If the trustee has the power to use the proceeds to pay the debts, taxes and other expenses of the estate, but is not legally required to do so, then only the amount of any proceeds actually so used will be included in the insured’s gross estate.
3. If the trustee is not under a legally binding obligation, but has the authority to loan the proceeds to the estate or use the proceeds to buy assets from the estate, the proceeds should not be included in the insured’s gross estate, assuming that the insured held no incidents of ownership.
E. Beneficiary barred from collecting proceeds
1. If the beneficiary is barred by state law from collecting the policy proceeds (for example, some states bar a beneficiary who murders the insured and is convicted of a felony in the offense from collecting the proceeds), state law may then mandate that the policy proceeds are diverted to the other heirs of the insured’s estate.
2. In this event, the proceeds are treated for federal estate tax purposes as though they were first paid to the insured’s estate and then paid out to the other heirs. As a result, the proceeds would be included in the insured’s gross estate for federal estate taxation purposes.

Question 115

Are life insurance proceeds payable to a beneficiary other than the insured’s estate included in the insured’s gross estate for estate taxation purposes?

Answer 115

The answer to this question depends on the facts of the situation:

If the insured held no incidents of ownership within three years of death: NO

If the insured held no incidents of ownership within three years of death, but the beneficiary is legally obligated to pay the debts, taxes and other expenses of the insured’s estate: YES

If the insured held one or more incidents of ownership at the time of death: YES

If the insured transferred the policy within three years of death: YES

Question 116

How is Incident of Ownership Defined?

Answer 116

A. An incident of ownership is the right of the insured to one or more benefits from the life insurance policy.
B. The incidents of ownership that will cause life insurance proceeds to be included in the insured’s gross estate include the right to (Reg. Sec. 20.2042-1(c)(2)):
1. cancel or surrender the policy;
2. change the beneficiary;
3. change a beneficiary’s share of the proceeds;
4. obtain a policy loan, including a policy loan to pay premiums;
5. assign the policy;
6. revoke an assignment;
7. pledge the policy for a loan; and
8. require the insured’s consent before a change of beneficiary (Rev. Rul. 75-50, 1975-1 CB 301) or policy assignment.
C. The insured need not possess all of the incidents of ownership for the policy proceeds to be included in his/her estate. Possession of just one incident of ownership is enough to trigger inclusion of the proceeds.
D. The legal right to exercise one or more incidents of ownership is sufficient to trigger inclusion, even if the insured is physically incapable of exercising the ownership rights.
E. Incidents of ownership retained over only part of the proceeds will still cause the entire proceeds to be included in the insured’s gross estate

Question 117

Is the right to receive policy dividends an incident of ownership?

Answer 117

No; however, the right to surrender dividend accumulations or paid-up additions would be considered an incident of ownership.

Question 118

Is the right to alter the time and manner of payment of the proceeds to a beneficiary an incident of ownership?

Answer 118

Yes, in all states except Pennsylvania, Delaware, New Jersey and the Virgin Islands

Question 119

If the right to select a settlement option an incident of ownership?

Answer 119

Yes, in all states except Pennsylvania, Delaware, New Jersey and the Virgin Islands

Question 120

If ownership rights can be exercised only in conjunction with another party, does the insured still hold an incident of ownership?

Answer 120

Yes

Question 121

Is the right to change the beneficiary of a policy held in trust an incident of ownership?

Answer 121

Yes

Question 122

Is the right to change the terms of a trust which holds a policy, either alone or in conjunction with another, an incident of ownership?

Answer 122

Yes, even though the insured holds no rights under the policy.

Question 123

If an insured/grantor has the power to remove a trustee and appoint another, is this an incident of ownership?

Answer 123

1. If an insured/grantor cannot appoint him/herself as trustee, this would not be a reservation of the trustee’s power and, as a result, would not be an incident of ownership.
2. If, however, there is a reservation of the trustee’s powers (e.g., the insured/grantor can appoint him/herself as trustee), both the courts and the IRS agree that the insured/grantor retains incidents of ownership.

Question 124

What if the insured did not intend to retain an incident of ownership, but a mistake was made by the agent or insurance company? Are the proceeds includable in the insured’s gross estate?

Answer 124

Generally no, but the issue may have to be determined by state law, which can require considerable time and legal expense to resolve.

Question 125

Is the right to convert term insurance to permanent insurance an incident of ownership?

Answer 125

Yes.

Question 126

If the insured has the right to consent to the designation of a beneficiary who does not have an insurable interest in the insured’s life, is this an incident of ownership?

Answer 126

Yes

Question 127

What if the insured’s employer owns a policy on the insured’s life, but the insured has the right to name and change the policy’s beneficiary? Is this an incident of ownership?

Answer 127

1. Yes.
2. However, an employee who has the right to designate the beneficiary for employer-paid death benefits does not possess an incident of ownership in any life insurance funding purchased by the employer, assuming that the employer is the sole owner and beneficiary of any such life insurance purchased to fund the benefit.

Question 128

Is the right to purchase a life insurance policy from its owner an incident of ownership?

Answer 128

1. Generally yes, although the IRS and the Tax Court have reached different conclusions on similar fact situations.
2. The safest way to eliminate potential incident of ownership problems is to make the insured’s right to purchase the policy contingent on the occurrence of a prior event of “independent significance.” If, for example, an insured employee has the right to purchase a policy on his/her life only in the event of disability or other termination of employment, that event is of independent significance and should eliminate any incident of ownership problem.

Question 129

If the insured holds incidents of ownership only as a trustee or other fiduciary, will the proceeds be included in the insured’s estate?

Answer 129

1. The IRS and various courts have taken different positions on this issue and the “strictness” with which Rev. Rul. 84-179 is applied.
2. In Rev. Rul. 84-179, 1984-2 CB 195, the IRS position is that powers the insured holds as a trustee or other fiduciary will not cause the policy proceeds to be included in the insured’s gross estate if:
   a. the insured could not exercise the powers for his/her personal benefit or for the benefit of his/her estate;
   b. the insured did not transfer to the trust the policy or any of the consideration to pay premiums from personal assets; and
   c. the powers were not transferred to the insured as part of a prearranged plan that involved the insured’s participation.

Question 130

How can an insured remove all incidents of ownership for new life insurance?

Answer 130

A. Having a third party be the original applicant for and owner of a life insurance policy means the insured has no incidents of ownership.
1. Even with a third party applicant/owner, proceeds cannot be payable to or for the benefit of the insured’s estate and escape inclusion in the insured’s gross estate for estate taxation purposes.

Question 131

How can an insured remove all incidents of ownership for existing life insurance?

Answer 131

A.The insured can remove existing life insurance from his/her estate by making an absolute assignment of all ownership rights in the policy, assuming that:

1. all incidents of ownership are absolutely assigned;
2. the insured lives for more than three years after the assignment; and
3. the assignee is not legally obligated to use the insurance proceeds for the benefit of the insured’s estate

Question 132

If an insured holds incidents of ownership in a life insurance policy owned as entirely as community property, what are the estate tax results?

Answer 132

A. In general, life insurance owned as community property is considered as being owned 50% by the husband and 50% by the wife, regardless of who is listed on the application as policy owner. This means that each spouse holds incidents of ownership over only one-half of the policy.
B. If the insured spouse dies first, only one-half of the proceeds are included in the insured’s gross estate, regardless of who the beneficiary is.
1. This holds true even if the full proceeds are payable to the insured spouse’s estate.
C. If the non-insured spouse dies first, one-half of the value of the unmatured policy is included in the non-insured’s gross estate.
1. If the insured spouse then receives ownership of the policy under the deceased non-insured spouse’s will, the full proceeds will be included in the insured spouse’s estate at his/her death.
D. While life insurance acquired after marriage in a community property state is generally presumed to be community property, it is possible through clear and convincing evidence for the spouses to establish that they intended to hold the policy in some form of ownership other than community property.
1. Even if one spouse is clearly designated the policy owner, to the extent that premiums are paid from community funds, the insurance proceeds are likely to be community property as well.

Question 133

If an insured holds incidents of ownership in a life insurance policy owned as community property, what are the estate tax results if the premiums are paid with both community and separate funds?

Answer 133

A. Life insurance is most commonly paid partially with community and partially with separate funds when:
1. the policy was purchased prior to marriage; or
2. the policy was purchased before the married couple moved to a community property state.
B. In these cases, the estate tax treatment of the insurance proceeds is determined by state law.
C. Premium tracing rule (California and Washington)
1. The insurance proceeds are part community and part separate in proportion to the premiums paid with community and separate funds.
2. At the insured’s death, the portion of the proceeds deemed paid for by the insured’s separate property plus one-half of the portion of the proceeds deemed paid for by community funds would be included in the insured’s gross estate.
D. Inception of title doctrine (Texas, Louisiana, Arizona and New Mexico)
1. Life insurance originally purchased as separate property remains separate property, even though community funds were used to pay some of the premiums.
a. The surviving spouse is entitled to be reimbursed for one-half of the community funds used to pay premiums.
b. The amount of the proceeds included in the insured’s gross estate would equal the total proceeds less one-half of the premiums paid with community funds.
2. Life insurance originally purchased as community property remains community property and is taxed as described in (previous card).

Question 134

What is a reversionary interest?

Answer 134

A. If an insured has made a gift of a policy, but there are certain “strings” attached to the gift that could cause the policy or its proceeds to come back to the insured or his/her estate, the insured has a “reversionary interest” in the policy.
B. Under certain circumstances, a reversionary interest is considered an incident of ownership that would cause the insurance proceeds to be included in the insured’s gross estate for federal estate taxation purposes.

Question 135

How does a reversionary interest impact the estate taxation of life insurance proceeds?

Answer 135

A. If the insured has a reversionary interest in a life insurance policy and that reversionary interest exceeds 5% of the actuarial value of the policy immediately before the insured’s death, the insurance proceeds are includable in the deceased insured’s gross estate.
1. The value of a reversionary interest is determined by use of IRS tables.
B. In valuing a reversionary interest, interests held by others must be taken into account in determining the value of the reversionary interest.
1. Example: If immediately before the insured’s death someone else had an unrestricted right to obtain the policy’s cash surrender value, the value of any reversionary interest held by the insured would be zero and the proceeds would not be included in the insured’s gross estate.
C. A reversionary interest must be a retained right arising by express terms of the policy or by some other instrument or by operation of law.
1. The mere possibility of a policy reverting back to the insured by will from the donee’s estate or through intestacy of the donee is not considered a reversionary interest, nor is exercising a surviving spouse’s statutory right of election.
2. If the decedent’s spouse was the owner and beneficiary of a policy on the decedent’s life and the policy provided that the decedent could direct the payment of proceeds by will if the spouse died first, there is not a reversionary interest.

Question 136

How does attribution of ownership impact the estate taxation of life insurance proceeds for a partnership?

Answer 136

A. If a partnership owns a life insurance policy on the life of one of its partners and the proceeds are payable other than to or for the benefit of the partnership, the insured partner holds an incident of ownership in the policy and the proceeds will be included in the insured partner’s gross estate.
1. No minimum partnership interest is required for this result to occur.
B. However, so long as the insurance proceeds are payable to the partnership or for the benefit of the partnership (e.g., to its creditors), the insured partner does not hold an incident of ownership and proceeds will not be includable.
C. The ability of a partnership to surrender or cancel a group term life insurance master contract is not attributable to the partners. This means that a partner can successfully transfer all incidents of ownership in group life insurance and avoid having the proceeds included in the partner’s gross estate, assuming that the partner lives for more than three years after the transfer.

Question 137

How does attribution of ownership impact on the estate taxation of life insurance proceeds for a corporation?

Answer 137

A. If a corporation owns a life insurance policy on the life of a sole or controlling (owns more than 50% of the total combined voting power of the corporation) shareholder and the proceeds are payable other than to or for the benefit of the corporation, the insured sole or controlling shareholder holds an incident of ownership in the policy and the proceeds will be included in the insured’s gross estate.
B. However, so long as the insurance proceeds are payable to the corporation or to a third party for a valid business purpose, such as paying corporate debt, the insured sole or controlling shareholder does not hold an incident of ownership and proceeds will not be includable.
1. In this case, proceeds payable to the corporation, along with other corporate assets, will be a factor in valuing the sole or controlling shareholder’s stock for estate tax purposes.
C. The ability of a corporation to surrender or cancel a group term life insurance master contract is not attributable to the shareholders, including sole or controlling shareholders. This means that a shareholder can successfully transfer all incidents of ownership in group life insurance and avoid having the proceeds included in the shareholder’s gross estate, assuming that the shareholder lives for more than three years after the transfer.
D. Key employee insurance – So long as the policy was owned by and payable to or for the benefit of the corporation, the proceeds are not included in the insured’s gross estate, assuming that the insured key employee held no incidents of ownership.
E. Section 303 stock redemption – There should be no attribution of ownership problem so long as insurance proceeds are paid to the corporation.
F. Split dollar insurance – In order to avoid inclusion of the proceeds in the insured employee’s estate, care must be taken in properly arranging third party, collateral assignment split dollar agreements for sole or controlling shareholders.
G. Buy-sell agreements – So long as insurance purchased to fund a buy-sell agreement is not payable to the insured’s estate and the insured holds no incidents of ownership in the policy, the proceeds are not included in the insured’s gross estate.

Question 138

How are life insurance proceeds valued on the estate tax return at the insured’s death?

Answer 138

A. Insured held an incident of ownership in the policy.
1. The full proceeds receivable at the insured’s death are included on the estate tax return.
2. The value of the proceeds on the insured’s date of death is used even if the executor elects the alternate valuation date.
B. Insured held a reversionary interest in the policy.
1. If the value of the reversionary interest exceeds 5% of the actuarial value of the policy immediately before the insured’s death, the full proceeds receivable at the insured’s death are included on the estate tax return.

Question 139

How are life insurance proceeds valued on the estate tax return at a third party owner-beneficiary’s death?

Answer 139

A. If the owner of the policy is someone other than the insured and the owner dies before the insured, the value of the policy will be included in the deceased owner’s estate.
1. The value included generally is the interpolated terminal reserve value of the policy, plus accrued dividends and any unearned premium.
B. Impact of the alternate valuation date
1. If the executor elects to use the alternate valuation date to value assets in the estate and the insured dies within six months of the third party owner’s death, the full proceeds receivable as a result of the insured’s death must be included in the deceased third party owner’s gross estate.
C. Impact of a common disaster.
1. If the Uniform Simultaneous Death Act applies, the presumption is that the insured survived the beneficiary. As a result, the policy’s interpolated terminal reserve value, plus accrued dividends and any unearned premium, are included in the deceased third party owner’s gross estate.
2. If, however, a “reverse simultaneous death clause” is inserted in the policy, the presumption is that the beneficiary survived the owner and the full proceeds payable at the insured’s death will be included in the deceased third party owner’s gross estate.

Question 140

How are life insurance proceeds valued on the estate tax return at a beneficiary’s death?

Answer 140

If the beneficiary is simply the beneficiary of a life insurance policy (i.e., holds no incidents of ownership in the policy) and dies before the insured, there is no value to include in the deceased beneficiary’s estate.

Question 141

How can an ILIT be funded? 2

Answer 141

• By transferring ownership of an existing policy to the trust, or
• By purchasing a new life insurance policy

Question 142

What is the potential issue with funding an ILIT by transferring over an existing policy?

Answer 142

While an existing life insurance policy can be transferred to an irrevocable life insurance trust, there are “strings attached.” If the gift of an existing life insurance policy is made within three years of the grantor/insured’s death, the value of the life insurance proceeds are brought back into the estate for federal estate tax purposes.

Question 143

What would be a benefit of funding an ILIT by purchasing a new policy?

Answer 143

Assuming the grantor is insurable, it may be preferable to
make cash gifts to the trust, which then purchases a new insurance policy on the grantor’s life. Since the grantor/insured never held any “incidents of ownership” in the new policy, the insurance proceeds should not be included in the taxable estate, even if death occurs within three years of the insurance purchase by the trust.

Question 144

What does a Crummey withdrawal power do for a trust?

Answer 144

Gives the trust beneficiary a noncumulative, annual right to demand withdrawal from the trust. For the demand right to be legitimate, the trustee must provide the beneficiary with notice of annual trust contributions and provide an adequate amount of time, such as 30 days, for the demand right to be exercised. If the demand right is exercised, the trustee must deliver the funds to the beneficiary. If the demand right is not exercised, the annual gift is then available for the trustee to use for premium payment purposes. Since the beneficiary stands to ultimately benefit from the trust and since a demand withdrawal from the trust may affect the grantor’s decision as to future gifts to the trust, beneficiaries generally understand that making a demand withdrawal is not in their best interest.

Question 145

What are the mechanics of an ILIT?

Answer 145

1. The grantor makes an annual gift to the irrevocable life insurance trust sufficient to pay the premiums on the life insurance policy owned by the trust.
2. The trustee provides a notice to the trust beneficiary(ies) of the annual trust contributions
   subject to withdrawal, qualifying the gift for the annual gift tax exclusion.
3. Assuming the trust beneficiary(ies) do not exercise their withdrawal right, the trustee then uses the gift to pay the life insurance premiums.
4. When the grantor/insured dies, the life insurance death benefit passes income and estate tax free to the trust.
5. If needed for estate liquidity purposes, the trustee can loan money to the estate or purchase assets from the estate.
6. Finally, the trust assets are distributed to the trust beneficiary(ies) according to the terms of the trust document.

Question 146

What are some uses of an ILIT?

Answer 146

 If your estate is likely to face a federal estate tax liability, an irrevocable life insurance trust can replace funds used to pay the estate tax, without the death proceeds also being subject to the estate tax.
 If your heirs are likely to need additional estate liquidity after your death, such as to continue a family business, an irrevocable life insurance trust can provide that liquidity, again without the insurance proceeds being subject to the federal estate tax.
 If you want to control how death proceeds are distributed, you can do so through the provisions included in an irrevocable life insurance trust.
 If you have children from a prior marriage, but want your current spouse to be the primary beneficiary of your estate, naming your children the beneficiaries of an irrevocable life insurance trust can provide them with a distribution at your death, rather than at your surviving spouse’s later death.
 If you want to leave your loved ones a substantial life insurance estate, an irrevocable life insurance trust can be used to pass the full value of life insurance proceeds to your heirs estate tax free.
 If you want to make a substantial bequest to a charity, either during your lifetime or at your death, an irrevocable life insurance trust can play a wealth replacement role, with the proceeds from the trust replacing for your heirs the value of assets given to charity.

Question 147

What are the potential drawbacks of an ILIT?

Answer 147

 Since the trust is irrevocable, you relinquish control of the life insurance policy and annual gifts made to the trust. In addition, once the trust document is executed, you cannot change the terms or terminate the trust.
 If the trust contains the Crummey withdrawal provision in order to qualify the gifts to the trust for the annual gift tax exclusion, a beneficiary may exercise his or her right to demand a withdrawal.
 There is some expense involved. In addition to possible trustee fees, you should consult with an attorney experienced in estate planning in order to avoid unforeseen tax and distribution consequences.