This year’s Heckerling Institute on Estate Planning featured a special session “That Life Insurance Policy May Be Worth More (Or Less) Than You Think!” with panelists Donald O. Jansen, Mary Ann Mancini and Lawrence Brody.
Overview
Brody opened the panel with an overview of different types of life insurance policies to give a primer on products that clients may already own, such as whole life, universal “flexible premium” life, equity-indexed and variable universal life insurance policies. He emphasized the different risks associated with these products – particularly investment risks, carriers’ credit risks and cost of insurance risk. To minimize these risks, Brody advised that clients annually request multiple illustrations from carriers to reflect best- and worst-case scenarios with varying projected rates of return and costs of insurance. He also recommended having clients pay more into policies than necessary to mitigate potential falling rates of return.
Value for Income Tax Purposes
After the overview, Jansen continued the presentation with a focus on valuing life insurance policies for income taxation purposes. Unlike most assets, life insurance policies aren’t evaluated by a willing-buyer, willing-seller standard. Instead, the Internal Revenue Service generally takes the position that policies use the same valuation rules for income tax purposes as gift tax purposes (that is,use the interpolated terminal reserve value (ITR) plus unused premiums) (Revenue Ruling 59-195). Carriers can provide a policy’s ITR on Form 712s; however, be aware that there many accuracy related arguments against using these values for reporting purposes. Carriers may even issue multiple Form 712s with different ITR values and then leave it up to the owner to determine which value they should use.
Though ITR is the general standard, this rule rarely applies for income tax reporting, and it’s more likely that one of the many exceptions will be appropriate:
- For charitable deductions, one should use the lesser of the fair market value (FMV) of the policy and the owner’s basis in the policy. The FMV is generally determined by an appraisal using ITR. (See Treasury Regulations Section 1.170A-13(c)(1)(i), which requires a qualified appraisal of any policy with a potential value in excess of $5,000). The owner’s basis is their “investment in the contract,” which amounts to the premiums paid and any other consideration (such as the price resulting from the purchase of the policy), less any dividends paid and withdrawals (IRC Section 72). Note there may be a 50% or 30% deduction limits under IRC Sections 170(b)(1) (A) and (B).
- For other policy sales and dispositions with regard to qualified and non-qualified retirement plans, welfare trusts, transfers for services rendered and group term insurance with a permanent benefit, the value is the appraised FMV of the policy - with a safe harbor of the greater of: (1) the sum of ITR and any unearned premiums plus a pro-rata portion of a reasonable estimate of dividends expected to be paid for that policy year, or (2) the product of the PERC (premiums, earnings and reasonable charges) and the Average Surrender Factor (Revenue Procedure 2005-25, Internal Revenue Code Sections 402, 83, 79 and 170(e)(1)(A) and (5)(c)).
Value for Gift Tax Purposes
Mancini finished the presentation discussing the valuation of life insurance policies for gift tax purposes. Like income tax, gifts of life insurance policies aren’t evaluated by a willing-buyer, willing-seller standard, as there typically aren’t any “comparable” deals to consider, and the insured’s health isn’t known on the date of a gift. Instead, various gifts of a life insurance policy from the owner to a third party are dictated as follows:
- For new policies, the value for gift tax purposes is the premiums paid into the policy
(that is, the cost of the contract) (Treas. Regs. Section 25.2512-6, Example 1).
- For policies with no further premiums due (including single-premium policies), the value for gift tax purposes is the policy’s replacement cost, which is the amount the carrier would charge for a single premium contract of the same amount on the life of a person of the age of the insured (Treas. Regs. Section 25.2512-6, Example 3).
- For policies which still have premiums due and have been in force “for some time,” the value may be approximated by the policy’s ITR combined with prepaid premiums (Treas. Regs. Section 25.2512-6). Unfortunately, the regulation doesn’t define the length necessary for “in force for some time,” though three years seems to satisfy this requirement (Rev. Rul. 79-429). Mancini specifically brought attention to the regulation’s use of the word “may,” which indicates the ITR is a permissive, not required valuation method, thus allowing clients to still use a separate method to value the policy. The IRS has challenged this appraisal position in a recently filed Tax Court case, asserting (despite direct language to the contrary), the ITR value must be used to value gifted policies (M. Joseph Dematteo v. CIR, Dck. No. 3634-21).
- For group-term policies, the value is the remainder of the economic benefit for the year of the gift provided to the employee/insured, as provided in Rev. Rul. 84-147, under group term Table 1 (Rev. Rul. 76-490).
Additionally - making this arena even more complex – Treas. Regs. Section 25.2512-6(a) provides a general exception to all of the above rules that if, due to the “unusual nature” of the contract, the applicable formula doesn’t reasonably approximate the policy’s “full value,” then such formula shouldn’t be used. Unfortunately, the IRS didn’t define either “unusual nature” or “full value,” and there doesn’t seem to be any indication as to what method should be used instead if this paragraph were deemed to apply.
There are, of course, many other scenarios in which one may need to determine the value of a life insurance policy (other gifts, sales, swapping assets in and out of trust, transfers for value rules, etc.), which the panel didn’t have time to cover. The lesson from the panelists seems to be this: the world of valuing life insurance policies for income and gift tax purposes is complicated. Policy values are governed more by exceptions than general rules, and it’s easy to get lost in the nuances. Don’t simply rely on ITR to report any transfers of life insurance policies; it’s worth a call to the professionals to ensure your clients are reporting income and gift tax values as accurately as possible.
Katie Coeyman is a tax and estate planning attorney at Schechter Partners