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Estate Planning Section Sample Discussion Thread

QUESTION:
91 yr old mother owns single premium life policy on son with son's wife as beneficiary. $150,000 was originally put into the policy. Total loans equal $480,000. Current Cash value equals $71,000. If policy is cashed in, I'm assuming tax on $480K+$71K minus $150K basis or tax on over $400,000. Is this correct? Second, if mother dies, does son become owner? If so, who owes tax if the policy were to "implode?" Finally, if son dies, I'm guessing we have gift situation. How is that treated? Thanks for your help

John R. Vollmer, CLU®, ChFC®

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RESPONSES:

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John,
Is the policy a MEC? If so, then wouldn't the taxes have been paid on the gain as it was received, even if it was a loan.

Thomas Royer

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Right as far as income tax is concerned. Mother can will or give policy to anyone during life or at death. Generally cash value becomes the taxable amount and new owner assumes her basis. Income tax consequence is the same to recipient as to her. Gift from Grandmother to son's wife of the entire benefit if son predeceases mother.

Time to think of ILITs!

Vivienne Gilbert

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If policy is a MEC, then taxes have been paid, but I'm guessing policy is not a MEC judging from cash value/premium ratio. It is not if it was purchased before June 21, 1988. John is correct on tax calculation, 401,000 taxable. If mother dies son does not necesarily become owner unless:

1. he is named as contingent owner in policy
2. he is sole beneficiary of mother's estate
3. he is legatee of policy via mother's will.

In any event, tax will be owed by whomever is owner of policy at implosion.

If son dies, mother has made gift to son's spouse under Goodman doctrine in Goodman v. Commissioner, 156 F.2d 218 (2d Cir. 1946), affg. 4 T.C. 191 (1944). Gift will be equal to proceeds of policy paid to daughter-in-law.

Chuck Hinners

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This is a very timely and important topic. The situation that John describes exists in lots of policies that are in-force today. I've seen two similar cases this quarter. Many of us will likely run into these in the immediate future.

Millions of dollars of single premium policies were purchased in the 80's prior to the imposition of the MEC definition. They were sold on the concept that income could be provided through policy loans that were not currently taxable. The policies were sold mostly to seniors. If the senior was not insurable, it was common practice to "borrow" the life of a child in order to write the contract. Consequently, there are lots of policies out there that are owned by parents on the lives of their children (the parents are now in their 70's and 80's and the children are in their 50's and 60's). Many have maximum policy loans and are at risk of lapsing. Of course, lapse triggers a huge income tax problem.

Some of the marketing materials at that time explicitly stated that life insurance cash values, owned by the decedent on the life of another, get a step up in basis. If this is true, this would be a solution in many of these cases. In John's situation, the income tax problem would go away at the death of the 91 year old policy owner.

What do you think? Does the cash value of a policy owned on the life of another get a stepped up basis in the decedent's estate?

Johnny Thorne
The Thorne Corporation
Columbia, SC 29206

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Vivienne --
I am pretty sure that the usual rule is no step-up in basis on a policy, since the income tax aspects of the policy generally are governed by IRC Section 72. Is there an exception wher the policy owner is different from the insured?

Bill DuBois JD CLU
Dallas TX

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Vivienne.Gilbert@chase.com wrote: Yes it does, if mother predeceases son.

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RE: Value of mom's interest in life insurance policy on life of son, upon mom's deaath:
"Estate Tax Value: The estate tax value of third party owned unmatured policies includable in the estate of someone other than the insured is generally the replacement cost of the policy. Replacement cost is ascertained using the same rules governing valuation of policies for gift tax purposes (the date of death is substituted for the date of the gift in valuing the policy). In most cases, this approximates the sum of (a) the cash surrender value of the policy (technically, the interpolated terminal reserve of the policy is the amount includable and in early policy years this can significantly exceed the cash surrender value) plus (b) the unearned premium (any premium the insured paid but that was not earned by the insurer as of the date of the policyowner's death)." - Leimberg et al., Tools and Techniques of Life Insurance Planning, Appendix A.

"2) If a person makes a gift of a previously purchased policy, and the policy is single-premium or paid-up, its gift value is the single premium which the company would charge currently for a comparable contract of equal face value on the life of a person who is insured's age at the time of the gift. Treas. Reg. §25.2512-6(a), Example 3. A 1978 ruling concerned a single premium life policy in force for 20 years, where the replacement cost of a single premium life policy of the same face value on the same insured was substantially less than the cash surrender value of the existing policy. The Service ruled that the replacement contract would not be "comparable" and that in the absence of information pertaining to a "comparable contract" the value of the policy would be determined by reference to the interpolated terminal reserve value (see (3) below). Rev. Rul. 78-137, 1978-1 CB 280." (Tax Facts 2003, Vol 1, Q.643)

As to the LOAN OUTSTANDING on the policy,

"(3) If the gift is of a policy on which further premiums are payable, the value is established by adding the "interpolated terminal reserve" (the reserve adjusted to the date of the gift) and the value of the unearned portion of the last premium. Treas. Reg. §25.2512-6(a), Example 4.

Example. A gift is made four months after the last premium due date of an ordinary life insurance policy issued nine years and four months prior to the gift thereof by the insured, who was 35 years of age at date of issue. The gross annual premium is $2,811. The computation is as follows:

Terminal reserve at end of tenth year $14,601.00

Terminal reserve at end of ninth year 12,965.00

Increase $ 1,636.00

One-third of such increase (the gift having been made four months following the last preceding premium due date) is $ 545.33

Terminal reserve at end of ninth year 12,965.00

Interpolated terminal reserve at date of gift $13,510.33

Two-thirds of gross premium ($2,811) 1,874.00

Value of gift $15,384.33

The amount of a policy loan outstanding at time of gift would be subtracted. IRS Form 712, Part II."

Now, that Example 3 concerns a policy on which further premiums are payable - not, as in the instant case, a Single Premium policy. But the same rule applies, in the case of Single Premium policies. On IRS Form 712 (the form supplied by insurer, stating the value of the policy for gift or estate tax purposes), the "net total of policy (for gift or estate tax purposes)" is the TOTAL COST (IRS Form 712, Part II, line 59a) PLUS ADJUSTMENT ON ACCOUNT OF DIVIDENDS TO CREDIT OF POLICY (line 59b), LESS OUTSTANDING INDEBTEDNESS AGAINST POLICY (line 59d).

- John Olsen