Life Insurance Review Issues. Factors That Cause Life Insurance Policies to Be Reviewed 2.

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Life Insurance Review Issues Slide 2 Factors That Cause Life Insurance Policies to Be Reviewed 2 Slide 3 A Decline in ratings of the in-force insurance carrier. A Comdex review of the in-force carrier. The Comdex gives the average percentile ranking of this company in relation to all other companies that have been rated by the rating services. The Comdex is the percentage of companies that are rated lower than this company. Keep in mind that where a promise of future performance is sold for present dollars, they buyer is at the sellers mercy. A review of the impact of declining interest rates or dividend scales on the non-guaranteed assumptions of the in-force policy. A review of policy risk. Is most, if not all of the risk with the insurance company through contractual guarantees OR has it been transferred to the policyholder through dividend projections and non guaranteed pricing? 3 Slide 4 Factors That Cause Life Insurance Policies to Be Reviewed (continued) Has the insurance company changed its operating structure through a conversion from a mutual company to a publicly traded company? Has the in-force dividend scale declined suggesting a move away from policy holder focus to stockholder interest? Your job of helping people get the most insurance for their money contains a second responsibility which is making sure that the insurance product is of a high quality and reliability. A review of policy provisions is to confirm that they are clear and fair; in regulation for solvency or its equivalent and to see that the promise can be performed when it comes due. In regulation, the relationship between the insurer and policyholder is to see that the promise is indeed performed fairly and that the buyers reasonable expectations as to what was bought are not too rudely disappointed. 4 Slide 5 Guarantees are only as good as the guarantor. A thorough evaluation of the carrier should be paramount to selection of contracts promising long term guarantees. Review the rules of your state on trustee duties and responsibilities. 5 Factors That Cause Life Insurance Policies to Be Reviewed (continued) Slide 6 General Rules Of A Trustees Duty To Sell Investments That Are No Longer Prudent Investments 6 Slide 7 General rule is a trustee must review investments on a regular basis and dispose of investments that are no longer prudent within a reasonable time- this applies to life insurance policies. A trustee who violates this duty can be held personally liable for any loss to the investment. This rule applies to investment management both inter vivos and testamentary (during and after lifetime). Fifty states with different statutes and/or case law interpretation of a trustees duties under specific fact situations. 7 Slide 8 General Rules Of A Trustees Duty To Sell Investments That Are No Longer Prudent Investments (continued) In most states, the trust document trumps state law unless trust provisions are clearly illegal or against public policy. The majority of states have statues that read It is the duty of the trustee to exercise prudence in determining whether to retain investments made by the settler. Professional responsibility is to review the investment to determine if the trustee is acting in a prudent manner. The courts have ruled a trustee is not justified in retaining investments if it becomes imprudent to do so, even if directed by the settlor. The trustees duty is to apply to the court for permission to sell or exchange the contract. 8 Slide 9 Selected Issues In 1035 Exchanges 9 Slide 10 The ability to defer gain in a life insurance, annuity or endowment contract through a section 1035 exchange can be of significant benefit to a policyholder. As the above discussion indicates, however, it is important that the exchange be effected correctly, and that all potential tax implications are fully considered. Failure to do so may not only result in a loss of the deferral, but the loss of a client as well. Section 1035 exchanges are an integral part of the life insurance business. Unfortunately, these exchanges can have unexpected results and their income and estate tax implications are not always fully understood. This information will review a variety of exchange transactions. It will explain the known tax ramifications of these transactions, and point out those instances in which the results are not entirely clear. As most of you are aware, the law is often uncertain, making the business of selling life insurance difficult at times. Nevertheless, the attempt here is to provide you with guidance to help you avoid some of the pitfalls posed by section 1035 exchange. 10 Slide 11 Exchanges in Life Insurance Contracts 11 Slide 12 Exchanges in Life Insurance Contracts Contract with an Outstanding Premium Loan Modified Endowment Contracts Grandfathered loan limits Business Exchange rider Change of ownership in a policy exchange Exchange for a Life-Two policy Exchange into an existing contract Section 1035(a) of the Internal Revenue Code provides that no gain or loss will be recognized on the exchange of a life insurance contract for another life insurance contract, for an annuity contract or for an endowment contract. As the following will indicate, certain conditions will apply; and the transaction may have other implications that should be understood: 12 Slide 13 Exchanges in Life Insurance Contracts (continued) A) Exchange of a policy with an outstanding loan In order for an exchange to be tax-free, it must be of a like kind, meaning that no money or other property (I.e., no boot) can be received in addition to the contract. The receipt of the boot will cause the gain in the contract to be recognized to the extent of the sum of money and the fair market value of the property received. Sec. 1031(b). If the boot received exceeds the gain in the contract, the entire gain will be recognized; if the boot is less than the gain in the contract, gain recognition will be limited to the amount of the boot. Both also includes the amount of any liability of which the transferor is relieved as a result of the exchange. Sec. 1031(d). A policy loan is treated as a liability for this purpose. Thus, The exchange of a life insurance contract with an outstanding loan can result in the receipt of boot and make an otherwise tax-free exchange taxable. The Internal Revenue Service has, however, taken the position that if the new contract is encumbered by an equivalent liability, no gain or loss will result. See, e.g., PLR 880658. Although a taxable event may be avoided if the new contract is issued with an equivalent loan, few insurers will do so; meaning many 1035 exchanges of contracts with the outstanding loans will result in the recognition of gain. Policies with Outstanding Loans 13 Slide 14 Exchanges in Life Insurance Contracts (continued) B) Exchange of the policy following a partial surrender Since the exchange of a contract with an outstanding loan will result in the recognition of gain (assuming there is gain in the contract) a seemingly logical tactic might be to first eliminate the loan by effecting a partial surrender of the contract, and the then effect the exchange of the now unencumbered policy. A partial surrender is not a taxable event unless the loan paid off with the surrender proceeds the contract holders basis in the contract. Sec. 72(e)(5). The Internal Revenue Service has taken the position, however, that this is the equivalent of the exchange of the contract with an outstanding loan. In PLR 9141035 the Service invoked the step transaction doctrine to collapse the repayment of the loan and the subsequent 1035 exchange into a single transaction and ruled that the contract holder was taxable on the amount of the gain to the extent of the loan. Policies with Outstanding Loans (continued) 14 Slide 15 Exchanges in Life Insurance Contracts (continued) Modified Endowment Contracts B) Exchange of a pre-June 21, 1988 single premium life insurance contract A single premium life insurance contact issued prior to June 21, 1988 is not treated as a modified endowment contract. If such a contract is exchanged later for a new single premium life insurance contract, will it lose its grandfathered status and be treated as a MEC? Although the law is not entirely clear, most insurers do not treat the new contact as modified contract to 7-pay premium testing. In calculating the seven pay limit on the new contract, the formula takes into account the cash value of the existing contract, but do not treat it as a premium payment. The new contract will therefore have a very low or perhaps zero seven-pay limit, but will not be a MEC. This often means, however, that if any additional premiums are paid into the new contract, it will become a MEC. A) Exchange of a Modified Endowment Contract The Internal Revenue Service Code provides that if a modified endowment contract (MEC) is exchanged for a new contract, the new contract will be a modified endowment contract. SEC 7702 (a)(2). Thus, it is not possible to purge a MEC of its MEC Status by exchanging it for a new contract. 15 Slide 16 Modified Endowment Contracts (continued) C) Policy loan limits- Exchange of a pre-June 21, 1986 Business-owned contact Prior to the enactment of the Tax Reform Act of 1986 there was no limitation on the amount of policy loan interest a business could claim as an income tax deduction. The Act added section 264 (a)(4) to the Code, which limited the deduction of policy loan interest, with respect to one or more policies on the life of any officer, employee or individual financially interested in the business, to the interest paid or accrued on an aggregate $50,000 of indebtedness. The Small Business Job Protection Act of 1996 amended section 264(a)(4) and added section 264(d), which placed further restrictions on the deductibility of policy loan interest paid or accrued after October 15, 1995. Contracts purchased prior to June 21, 1986 were grandfathered under the 1986 Act, and were in large measure spared by the 1996 changes. Thus, in the case of these pre-June 21, 1986 policies, interest paid or accrued on an unlimited amount of policy borrowing continues to be deductible, albeit subject to an interest rate cap imposed by the 1996 Act. If however, a pre-June 21, 1986 contract is exchanged for a new contract, will its grandfathered status be lost? The legislative history of section 264 (a)(4) indicates that a contracts grandfathered status will be lost if it is exchanged for a contract of a different insurer. Although this implies that grandfathered status will be retained by a contract that is exchanged for a contract of the same insurer, the legislative history is actually ambiguous on this point. It suggests that changes to a pre-June 21, 1986 contract, other then minor administrative changes may cause the contract to be treated as purchased after June 20, 1986. In light of the uncertainty, if the deductibility of interest is a significant consideration, a business intending to exchange a grandfathered contract should consult with their tax advisors prior to the exchange. It should also be kept in mind that any loan outstanding at the time of the exchange will, as described above, be treated as boot, if it is repaid or eliminated in the process of the exchange. Exchanges in Life Insurance Contracts (continued) Slide 17 Business Exchange Rider A) Exchange of a contract under a Business Exchange Rider Business-owned insurance contracts often carry a rider that allows the insured to be replaced with another employee of the business. The fact that these are called business exchange riders has led some to believe that this exchange if insureds would constitute a section 1035 exchange. Section 1035 requires that the contracts exchanged relate to the same insured, i.e.. That the insured under both contracts be the same. Since an exchange under a business exchange rider, by its very nature, involves a change of insureds, such an exchange does not qualify as tax-free under section 1035. The IRS made this explicitly clear in Revenue Ruling 90-109, 1990-2 C.B 191, which held that such exchanges are treated as surrenders for income tax purposes. Thus, the exercise of a business exchange rider will result in the recognition of gain by the business that owns the contract, as though it had been surrendered. 17 Slide 18 B) Exchange of a contract in conjunction with a change of ownership Very often, in a business or estate planning context, the exchange of a contract will be accompanies by a simultaneous change of ownership to another person, or to entity, such as a trust. Although an insurer may process the exchange as a single transaction, for tax purposes this constitutes two separate transactions; a transfer of ownership and a 1035 exchange. Although the exchange itself will be non-taxable (assuming no boot is received) the transfer of ownership will have income and/or gift tax implications. If the contract is owned by a business and is transferred to the insured employee, the employee will be subject to income tax on the value of the contract. If the business transfers the contract to a member of the insured's family, or to an irrevocable trust created by the employee, the change of ownership will likely be treated as a constructive transfer to the insured, followed by a constructive transfer to him or her, and the constructive transfer by the insured will be treated as a gift to the transferee. The direct transfer of the policy by the business, to a family member of the insured or to a trust, may also raise a potential transfer for value, issue. The transfer for value rule comes into play whenever there is a transfer, for a valuable consideration, of a right to receive proceeds of a life insurance policy. A transfer made in connection with employment, i.e., in exchange for services rendered, would be for a valuable consideration. If a transfer for value occurs, and if no exception to the rule is applicable, the death proceeds in excess of the transferees basis in the contract will be subject to income tax. The exceptions to the rule are: (1) A transfer to the corporation in which the insured is an officer or a shareholder; and (2) A transfer in which the basis of the transferee is determined in whole or in part by reference to the basis of the transferor. Sec. 101 (a)(2). Exchanges in Life Insurance Contracts (continued) Business Exchange Rider (continued) Slide 19 B) Exchange of a contract in conjunction with a change of ownership (continued) In the event a contact is transferred by a business directly to an employees irrevocable trust, it would be difficult for the IRS to argue, on the one hand, that the contract was constructively transferred to the insured and then to the trust, and, on the other hand, that the death proceeds should also be subject to income tax under the transfer for value rule. The two positions would appear to be mutually exclusive...

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