The
Effect of the Secondary Market in Life Insurance on Estate Planning
by Jon J.
Gallo, J.D.
The
development of a secondary market in life insurance contracts is giving me
insomnia. If my guess is right, the secondary market is going to have a
profound and uncertain effect on the income, estate and gift tax planning
involving the sale or other transfer of many life insurance contracts. Since
misery loves company, I want to use my first column in the Journal of
Financial Planning to share my insomnia with you.
The secondary
market has turned life insurance policies into financial instruments that can
be purchased and sold. When sufficiently large groups of policies are bundled,
they become predictable financial instruments with acceptable levels of risk
and predictable cash flows for costs and returns. In 1990 there were perhaps
six companies in the secondary market that had purchased about 500 policies
with a face value of between $40 and $50 million. Today, the Federal Trade
Commission estimates that $500 million in life insurance policies is viaticated
annually. CNA’s Viaticus division advertises that it has underwritten more than
$6 billion in policies since it entered the secondary market.
The growth of
the secondary market has raised numerous fascinating and troubling questions.
Some have already been resolved by statute. Others remain open and only time,
Congress and the Internal Revenue Service will supply the answers. For the
estate and financial planner, the can of worms created by the secondary market
is truly mind boggling. Several observations and questions follow. As the
perceptive reader will note, it is far easier to pose questions than to provide
answers.
The Problem of
‘Unnecessary’ or ‘Uneconomic’ Insurance
Estate
planners have traditionally viewed life insurance policies as a means of
providing liquidity to pay estate taxes or funding for buy/sell agreements.
With that perspective in mind, it was not uncommon for the estate planner to
agree with the client who suggests that policies be allowed to lapse or be
surrendered for their cash values, once the coverage was no longer necessary or
the premiums became uneconomic. How many of us have clients whose life insurance
trusts own thinly funded universal life policies that they are thinking about
dropping? What is the liability of the trustee of an insurance trust who allows
a thinly funded policy to lapse if the policy had a value in the after market?
And what is our liability for failing to tell the trustee and the insured about
the after-market?
Valuing Insurance for Gift
Tax Purposes
If our client
wishes to transfer an insurance policy by gift, can we continue to rely on the
Treasury regulations to determine value for gift tax purposes? The Treasury
regulations tell us that the transfer of all ownership rights in a life
insurance policy is a taxable gift measured by the replacement value of the
policy. And the regulations give us guidelines to "approximate" the
value of an insurance policy for gift tax purposes by "adding to the
interpolated terminal reserve at the date of the gift the proportionate part of
the gross premium last paid before the date of the gift which covers the period
extending beyond that date" [Treas. Reg. 25.2512-6(a)].
But the
secondary market didn’t exist when these regulations were adopted in 1958. The
only place where the regulations give us any guidance about the effect of the
secondary market is by inference. They tell us that the valuation rules
described above are not to be used if "because of the unusual nature of
the contract," doing so does not result in a value that is
"reasonably close to the full value" of the policy [Treas. Reg.
25.2512-6(a)]. The courts have relied on this exception to tell us that if the
insured is uninsurable at the time of the transfer, the fair market value of
the policy may be substantially higher than the amount computed pursuant to the
regulations. For example, in Pritchard v. Comm’r [4 TC 204 (1944)], the
Tax Court held that where death was imminent and the insured was uninsurable,
the cash surrender value "would be only helpful as a criterion of the
minimum value to be placed on the policies.…" [Id. at 208].
In situations
where death is imminent, the present value of the death benefit has often been
computed using the Section 7520 tables, which determine the discount rate by
reference to the federal midterm rate in effect under Section 1274 for the
month in which the valuation date falls. The present value of the death benefit
determined in this manner may be greater or less than the value that would be
placed on the policy in a viatical settlement. If so, it is arguable that the
value determined by reference to a viatical settlement should control.
Whenever a
policy is transferred for estate or financial planning purposes, it is
imperative to determine whether an after-market exists for that policy.
Consider a typical scenario. You meet with a new client, age 75. The client is
in good health and owns a $5 million policy on her life. In an effort to remove
the policy on her gross estate, you recommend that she transfer the policy to a
newly created irrevocable life insurance trust. If the policy is transferred by
gift, the existence of an after-market is likely to increase substantially the
amount of the taxable gift. If the policy is sold to a grantor trust or other
purchaser exempt from the transfer-for-value rule in order to avoid the three
year rule of Section 2035, a sale for less than the after- market value will
have a gift component, which will make the three-year rule applicable to the
transfer. Prudence suggests that, in either situation, the parties solicit
statements of interest from several viatical providers. If no provider is
interested in acquiring the policy, the file should reflect this lack of
interest and the policy can be valued using the rules of Treas. Reg.
25.2512-6(a). If there is an after-market for the policy, the after-market
value would apparently trump the traditional insurance valuation rules and make
the willing buyer/willing seller test of Treas. Reg. 25.2512-1 applicable for
determining value.
Valuing Insurance for
Charitable Deduction Purposes
On the
positive side, if an insurance policy donated to charity would qualify for a viatical
settlement or for sale in the after market, should not the donor claim an
income or gift tax charitable deduction based on the willing buyer/willing
seller test rather than the lower value of the policy determined under Treas.
Reg. 25.2512-6(a)?
There is an
ancient Chinese malediction: "May you live in interesting times." The
developing secondary market is clearly producing interesting times for those of
us who must advise clients concerning the retention, sale or transfer of life
insurance policies.
Acknowledgment:
The author wishes to thank Neil Alexander, CLU, ChFC, of Alexander Capital
Consulting in Los Angeles, California, for his invaluable assistance.
Jon Gallo, J.D., is a tax partner at the Los Angeles law firm of
Greenberg Glusker Fields Claman & Machtinger LLP, where he specializes in
high net worth estate planning. He can be reached at (310) 201-7460, jgallo@ggfcm.com,
or 1900 Avenue of the Stars, Suite 2100, Los Angeles, CA 90067-4590.
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