Disposition of Life Insurance Policies

By Robert E. Bertucelli and Michael N. Balsamo

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In the case of financial distress, one might assume that paying a life insurance premium is a lower priority than other, more pressing financial demands. However, failure to pay premiums could have a detrimental effect on the policy and result in policy lapse or termination. Likewise, termination of employment or retirement could produce the same result for employer-provided policies.

Despite the prevalence of life insurance policies, the tax consequences of the disposition of these commonly held assets is not very well known. The disposition of any kind of life insurance policy can have significant tax repercussions.

Any proposed transfer of an existing life insurance policy should take into account the “transfer for value” rules under IRC section 101(a)(2). Failure to address these rules could cause the policy proceeds to be taxable when received as a result of the death of the insured. It is a tax generally to be avoided.

Lapse in Policy

The life insurance policy is a contract between the insurance company and the policy owner that calls for the provision of life insurance coverage if the required policy premiums are timely paid. If the premiums are not timely paid, the insurance company, depending upon the type of underlying policy, may either borrow against the cash surrender value or make withdrawals from the investment fund to pay the premiums or, in the case of regular term insurance, allow the policy to lapse. If the policy has cash surrender value available and an automatic policy loan provision is present, the premiums and any accrued loan interest will be “borrowed” from the cash surrender value until it is exhausted and then the policy will lapse. Similar provisions would apply to universal or variable universal life policies where the investment fund would provide the same financial support as the cash surrender value in a whole-life policy.

If the insurance policy lapses due to nonpayment of the premiums or the exhaustion of the cash surrender value or investment fund, the policy owner does not have a deductible loss for any remaining basis in the lapsed policy. According to London Shoe Co., Inc. v. Comm’r, 35-2 USTC para. 9664, CA-2, the “unrecovered basis” is treated as part of the cost of the insurance protection while the policy was in effect.

Cash Surrender Value

If a policy is not a straight term policy, it will generally have some cash surrender value. If the owner of the policy surrenders it, the insurance company will pay the cash surrender value or remaining investment fund in accordance with the policy terms after withholding any policy loans that may exist at the time of surrender. Under Treasury Regulations section 1.72-11(d)(11), if the amount received by the owner (inclusive of any outstanding loan balance) is greater than the basis in the policy, the owner will recognize income in the amount of the difference. This income will be treated as ordinary income, even under the expansive definition of “capital asset,” because the surrender of the policy is not deemed to be a “sale or exchange” as required under IRC section 1201 (Bodine, 39-1 USTC para. 9450, CA-3). Likewise, in accordance with TAM 200452033, the income that was recognized was due to the “accretions to the value of a capital asset properly attributable to ordinary income.”

If the proceeds are less than the policy’s basis, the difference will not produce any tax benefit to the owner under the “additional insurance cost” concept mentioned above (London Shoe Co., Inc. v. Comm’r).

Sale

An insurance policy is an asset that is generally transferable by the owner. According to Reingold (BTA Memo Dec. 11, 868-B), if the policy were to be sold to a third party, the sale or exchange requirements of IRC section 1202 would presumably be met and the transfer might qualify for capital gain treatment. Several cases and rulings, however, have concluded that the gain recognized on the sale of a life insurance policy was ordinary income under the “accretion to the value of a capital asset” concept (Estate of Gertrude H. Crocker, 37 TC 605). If, however, the policy were sold and the price paid for the policy was not determined by the cash surrender value but rather by other criteria, such as the insured’s age and medical condition, would the gain on the sale of the policy be treated in the same manner? This transaction has become common in recent years, as companies have entered the market of purchasing insurance policies from older taxpayers. A transfer of this nature could presumably be treated as a capital gain transaction because the value of the policy is determined by the face amount of the policy and not “the accretions to the value of a capital asset properly attributable to ordinary income” (TAM 200452033).

One exception to this rule exists for payments received by a terminally ill taxpayer under a transfer or assignment of the policy to a viatical settlement provider [IRC section 101(g)(2)]. Assuming that the “transfer for value” rules of IRC section 101(a)(2) don’t apply, if a taxpayer qualifies as terminally ill—that is, a taxpayer produces a doctor’s certificate indicating that he is reasonably expected to die from his disease or physical condition within 24 months—then any payments received from the company will be considered received as a result of the death of the insured and therefore will generally be tax-free.

Exchange of an Insurance Policy

The IRC allows taxpayers to exchange insurance policies without adverse tax consequences in a manner similar to the like-kind exchange rules for business or investment properties under IRC section 1031. Under IRC section 1035, the exchange of an insurance policy for another insurance policy, or the exchange of an annuity for another annuity, will be tax-free as long as the taxpayer does not receive any other property in the exchange. Even the exchange of an insurance policy for an endowment policy or an annuity contract will qualify for this favorable tax treatment.

Because of the increased popularity of survivorship insurance, it should be noted that an owner cannot exchange a single-life insurance policy for a survivorship policy. Nevertheless, the IRS has permitted an exchange of a second-to-die policy where the first insured has already died for a single-life policy insuring the life of the remaining policy owner (PLR 9330040). If the policy being surrendered has an outstanding loan at the time of the exchange, there will be no adverse tax effect as long as there remains at least the same level of indebtedness on the new policy received in the exchange (PLR 8816015). This result is similar to what would result from a like-kind exchange under IRC section 1031. This exchange potential does provide flexibility to a taxpayer who may have experienced adverse results with a particular insurance or annuity company, or who wishes to exchange an illiquid insurance policy for a current stream of income under an annuity arrangement.

Gifts

As with any other unrestricted asset, the owner of an insurance policy can make a gratuitous transfer of the policy to another taxpayer. It is common in estate planning to find life insurance policies being transferred to trusts, particularly irrevocable life insurance trusts (ILIT), or to other family members. One obvious reason for this type of gift is to exclude the proceeds from the original policy owner’s taxable estate while preserving the tax-free nature of the policy proceeds upon death. Thus, if a policy on the life of a husband is owned by the husband but with his wife as the beneficiary, the policy will be includible in the husband’s taxable estate under IRC section 2042, but would be part of the marital deduction. If the ownership of the policy were to be transferred to his wife, the policy proceeds would not be includible in the husband’s estate if he predeceased his wife. The transfer of the policy would not trigger a gift tax, regardless of the value of the policy, as a result of the unlimited marital deduction. However, the estate tax exclusion from the husband’s estate would apply only if the transfer had occurred more than three years prior to the death of the transferor [IRC section 2035(a)]. The ability to remove this insurance from the husband’s estate would not seem like a valuable estate planning tool because of the unlimited marital deduction, but this apparent “no-cost” technique could actually result in substantial savings, including administration costs, creditor claims, and, in particular situations, litigation.

Transfers of policies to an ILIT could bring new planning opportunities for families by excluding the policy proceeds from the estates of both spouses. This would allow for the transfer of wealth to children or grandchildren while maintaining a valuable source of liquidity for the estate. The ILIT could buy assets from the estate at the date-of-death value, keeping those assets within the family while injecting cash into the estate for the payment of expenses or taxes. The transfer of the policy to the trust would cause a gift tax return to be filed if the value of the policy was in excess of any annual exclusion available to this transfer. The value of the policy would depend upon the type of policy transferred and could vary from a low value for a straight term policy to a much higher value for a whole-life or universal life policy. The annual exclusion for the transfer, currently at $12,000 per year per donee, would depend on the qualification of the transfer as one of a present interest after considering any available Crummey provisions (IRS Revenue Ruling 81-7, 1981-1, C.B. 474).

For the policy to be removed from the transferor’s estate, the transferor must relinquish all “incidents of ownership” in the policy [IRC section 2042 (2)]. If the policy transferor retained any of the common rights under the policy, such as the right to change the beneficiary or to borrow against the cash surrender value of the policy, it would be treated as if the policy had not been transferred for estate tax purposes. Upon the death of the insured, the full amount of the policy proceeds would be includible in the gross estate of the transferor. This is a significant increase from the gift tax value that, for a whole-life policy, is the policy’s “interpolated terminal reserve” plus any unearned portion of the last premium (TD 6680, 1963-2 CB 417).

If the policy transferor were to continue to fund the premiums after the transfer, as is common when the policy is transferred to an ILIT, the subsequent premiums paid by the transferor would be treated as gifts subject to tax, but could reduce the taxable estate. These annual premium payments could escape gift taxation, depending on the amount of the premiums and their qualification under the Crummey provisions.

Charitable Contributions

If taxpayers have excess insurance coverage, they might consider donating an insurance policy to a charitable organization. Assuming that the transfer includes all of the incidents of ownership associated with the policy, a taxpayer would produce a charitable contribution deduction on the transaction. The value of the policy for income and gift tax purposes is governed by the provisions of Revenue Ruling 59-195, which holds that for purposes of valuing a policy that has been in effect for a long period of time, and where premiums must still be paid on the policy, the correct valuation method is to take the interpolated terminal reserve of the policy and add to it the unearned portion of the last premium payment. The only exception under this ruling is for a contract that is so unusual that this method does not approximate replacement value of the contract.

Once the value of the policy is determined, the amount of the charitable contribution must be addressed. In normal transactions, an asset that qualifies as a capital asset held by the contributing taxpayer for at least one year may be contributed to a charity with the fair market value of the asset determining the deduction. For life insurance policies, however, because the sale of such a policy would generally produce ordinary income, the amount of the contribution would be limited to the policy’s basis unless the policy’s fair market value was lower. Thus, any unrealized appreciation in the cash surrender value will not usually affect the amount of the charitable contribution.

If the owner of an insurance policy continues to make the premium payments after the ownership has been transferred to the charity, the payments should qualify as a charitable contribution [Hunton v. Comm’r., 1 T.C. 821 (1943)]. In addition, state law may include restrictions on the ownership of such insurance by a charitable organization. If this type of restriction exists, the charitable contribution deduction may not be available.

Opportunities, but Pitfalls

There are many planning opportunities involving life insurance policies, but also a number of tax pitfalls. CPAs must have a firm grasp of the issues surrounding life insurance so that planning is maintained at the highest quality.

Robert E. Bertucelli, CPA, CFP, CLU, is a professor of accounting and taxation at the C.W. Post Campus of Long Island University, Brookville, N.Y. He has served as a member of the NYSSCPA’s board of directors and as an executive board member and committee chair for its Suffolk Chapter. Michael N. Balsamo, Esq., JD, LLM, is an adjunct professor of law at the State University of New York, Old Westbury, N.Y., and an attorney in Garden City, N.Y.

©2009 The New York State Society of CPAs. Legal Notices