OWNERSHIP OF LIFE INSURANCE BY A THIRD PARTY

By Russell J. Rolnick, CPA, CFP, Hudson Valley Financial Group

Selecting an appropriate third-party owner of life insurance requires an analysis of both tax and nontax factors. Generally, the third-party comparison is between the insured's adult children and ownership by an irrevocable trust, usually established by the insured.

Tax Considerations

For Federal estate tax purposes, there is virtually no difference between ownership of life insurance by the insured's children individually and ownership by an irrevocable trust. Death proceeds of life insurance are includable in the gross estate only if--

1. the proceeds are receivable by the executor of the insured/decedent,

2. the insured had any incidents of ownership in the policy at the time of death, or

3. such incidents of ownership were transferred by gift within three years of the date of death (IRC Secs. 2035 and 2042).

If the insurance is owned by a third party from the inception of the coverage, no portion of the death proceeds is includable in the gross estate.

Because the Federal estate tax is due nine months after the date of death, life insurance is generally viewed as being the vehicle of choice to fund liquidity needs without having to liquidate assets at firesale prices. Both types of third-party ownership of life insurance solve the estate liquidity problem without subjecting the death proceeds to estate tax or eroding the estate assets.

Traditional life contracts insuring only one life are frequently appropriate to fund such needs as survivor income, educational needs, and final expenses. Where a married couple defers the imposition of estate tax until the second spouse's death through the combined use of the unified credit and the unlimited marital deduction, so called "second-to-die" or "survivorship" insurance, which pays the death benefit after both insureds have died, is generally the recommended type of coverage.

Gift taxes must be considered when there is ownership by a third-party. Generally, the consequences can be very similar. Irrevocable trusts designed to own life insurance usually contain Crummey powers, which allow the beneficiaries to withdraw some or all of the property transferred to the trust by gift each year. Transfers to these Crummey trusts qualify as gifts of a present interest, eligible for tax-free treatment under the annual $10,000 gift-tax exclusion ($20,000 if the gift is given jointly with the spouse). After the Crummey withdrawal period ends or all beneficiaries decline to exercise their withdrawal privileges (whichever occurs first), the trustee uses the money to pay the policy premium.

Instead of using a life insurance trust, the parents could make separate gifts to each adult child, which would also fall within the annual exclusion. The children, in turn, would then make their checks out to the insurance company for the entire annual premium. If only one adult child owns the insurance contract, payment of the premium by the parent directly to the insurance carrier should also qualify as a gift of a present interest. If more than one adult child owns the policy, however, the premium cannot be paid from the parent to the insurance company directly, and characterized as a present interest for gift taxes, since no one owner has the present ability to exercise incidents of ownership or reach policy values when acting alone.

The transfer of ownership from either an insured or an adult child to a trust can also have adverse consequences if not transferred properly. The transfer might not occur before the insureds die. IRS might claim that the owner was only the agent for the insureds before the transfer. Was the owner making a gift to his brothers and sisters when making a transfer? A new policy with the initial ownership in the manner planned is the safest answer.

Nontax Considerations

Many nontax issues must be considered when selecting between adult children and an irrevocable trust as the third-party owner of life insurance. Arguably, these considerations are more important than the tax consequences.

When there are multiple owners of a policy, insurance carriers typically require all joint owners of the policy to act together. This can make the exercise of even the most basic ownership rights cumbersome. If the joint owners are inattentive or live in different parts of the country, exercising these rights can be very difficult. Furthermore, if the owners disagree, or one or more owners become incompetent or incapacitated, then exercising rights in the policy may become impossible. A remedy that many insurance carriers will accept is for one of the siblings to have power of attorney to act on behalf of all the siblings.

Another problem associated with joint ownership of the life insurance is ownership title. Without specific language to the contrary, an insurance company may treat multiple owners of a policy as "joint tenants with right of survivorship." As such, each owner has an equal undivided interest in the entire contract. If one owner predeceases the insureds, the
survivors will own 100% of the policy. This results in removing one branch of the insureds family from a share in the death proceeds.

The problem is potentially solved by designating multiple owners as "tenants in common." In theory, this ownership arrangement gives an equal, divisible, and alienable interest in the life insurance policy. Insurance carriers may nevertheless require the signatures of all owners to exercise policy rights.

However, ownership as tenants in common also raises many problems. First, although this form of property right is frequently used in the context of real estate, it is untested in ownership of life insurance, with the result that survivor's rights are uncertain. Second, upon the death of a tenant in common, the deceased tenant's heir succeeds to his interest in the policy. An heir could be a surviving spouse, with the result that an in-law will possess ownership rights in a valuable asset originally purchased to facilitate the transfer of property along family lines.

One solution to the problems associated with multiple owners of a single insurance contract is to issue a separate policy to each adult child covering a proportionate amount of the desired coverage. Although this might increase the overall premium paid due to rate banding and fees, it may facilitate payment of premiums directly to the insurance company.

However, the drawback to this type of ownership is that the adult child could tap the cash value built up in the policy and possibly destroy planning and policy benefits. The purpose of the policy could be defeated. In addition, there are the problems associated with divorce.

The establishment of an irrevocable trust to own life insurance eliminates
the need for multiple owners. It also facilitates the payment of premiums without the potential problem of an owner not paying the premium. Trust ownership also negates the borrowing of cash value or surrendering or lapsing of the policy for such cash value thereby eliminating coverage.

Lapsing is disastrous if the insureds subsequently become uninsurable.

The same issue potentially applies to the policy proceeds. Once the death benefit is received by the owner/beneficiaries, nothing prevents their using the money for personal purposes and squandering the money before the due date for payment of the estate tax.

The preservation of the policy is accomplished more easily when insurance is owned by an irrevocable trust because the trustees are fiduciaries and are required by law to act in the interests of the trust beneficiaries. The fiduciary trustee must also exercise full due diligence in the choice of the insurer. Because of potential liability in the event of nonperformance or failure of an insurer, the trustee would be well advised to choose only those insurers earning the highest ratings by at least three of the major rating agencies.

Potential problems of trust ownership include possible gift taxes upon transfer of a policy into the trust. Also, unless the policy was never owned by the insureds, funding of the policy must begin at least three years before the second spouse's death to avoid death benefit inclusion in the estate.

Individual ownership of an insurance policy is simple in some ways and incurs no additional expense. If the insured parents believe that their children will act in a prudent manner so that policy values will be available for their intended purpose, there may be no reason to incur the expense for attorneys, trustees, and other advisors that establishing a trust entails.

To establish an irrevocable trust, the insureds must retain a qualified attorney to draft a document specifically tailored to their individual needs and circumstances. When the trust is funded with the policy death benefit, trustee's fees, investment advisory fees, and other administrative expenses may be necessary. On the other hand, the rationale for establishing an irrevocable trust is to provide for the management and ultimate distribution of the life insurance proceeds and other assets in an orderly and prudent manner. Accordingly, the cost and complexity of the trust must be kept in perspective. In light of the gift tax, nontax, and other issues frequently raised by joint ownership of the policy, a trust may be well worth its costs. *

GIFTS WHICH REVERT TO THE ESTATE AND THE THREE-YEAR RULE

By Mitchell Sorkin, Smallberg Sorkin & Company

Personal financial and estate tax planners often recommend lifetime gifts to reduce eventual estate taxes. Individuals whose estates exceed $600,000 can benefit by making lifetime gifts, because there is no Federal estate tax under this amount by operation of the unified credit.

Lifetime gifts are usually made for the following reasons:

1. To transfer assets that will appreciate in value.

2. To reduce the value of the estate by the gift taxes paid instead of paying non-
deductible estate taxes upon demise.

3. To start the 36-month clock and retain assets in the family when there is a potential Medicaid need.

When making taxable gifts in excess of the unified credit deduction, the planner should make the donor aware of the possible reversions to the estate and of the three-year rule, under IRC Secs. 2035 through 2038. Gifts which revert to the estate include the proceeds of life insurance policies if the policy was gifted within three years of death.

IRC Sec. 2035 also requires that gift taxes paid within three years of death must be added back to the estate. This reduces the estate tax savings since the estate is not reduced by the gift taxes previously paid.

Any appreciation or income generated from the excluded gift, however, will not be included in the decedent's estate. For Federal estate tax purposes, usually only the Federal gift tax paid within three years is added to the taxable estate. Since the gift tax addback under IRC Sec. 2035 is an adjustment to arrive at the taxable estate, instead of the gross estate, there is no increase in the state estate tax credit. New York State has a similar provision relating to the NYS gift taxes paid.

Under the Federal and New York State unified estate and gift provisions any gift taxes paid previously will be allowed as a credit against the estate tax liability.

Gift Splitting

There have been two private letter rulings relating to how IRC Sec. 2035 (c) works in gift-giving scenarios.

In TAM 9128009, a husband made gifts which were split with his wife: He paid all the gift taxes from his funds. When the husband died within three years, the estate wanted to indirectly attribute one half of the gift tax to his wife's gift and exclude it from the estate. The IRS ruled that since the husband was primarily responsible for the gift taxes, he was primarily liable for the tax despite the joint and several tax liability.

In addition, the marital deduction could not be claimed because the gift tax was paid to the IRS and not to the surviving spouse.

In PLR 9214027, the donor spouse did not pay the gift taxes. The consenting wife agreed to pay. The ruling addressed the question of whether all portions of the gift taxes paid would be included in the husband's estate, if he died within three years of the gift. The IRS ruled that the gift taxes would not be included in the husband's estate.

When a husband and wife make taxable gifts, it is advisable to have the healthier spouse pay the tax, to avoid its reversion. *

Editor:Milton Miller, CPA,Consultant

Contributing Editors:Andrew B. Blackman, CFP, CPA/PFS, Shapiro & Lobel LLP

David Kahn, CPA/PFS, Goldstein Golub Kessler & Co., P.C.

AUGUST 1995 / THE CPA JOURNAL