As a result of the Act, there may be a decrease in death benefit-oriented life insurance policies purchased to provide liquidity to pay federal estate taxes. Similarly, some policy owners may question the value of retaining an existing policy that was originally purchased to pay estate taxes. This makes sense, as the exemptions are now doubled, even if it is only temporarily. Of course, nobody knows what the laws will be in the future, many states still have a state estate/inheritance tax, and many decedents have numerous post-mortem non-tax obligations, such as satisfying debts or equalizing bequests.
At Apexium, we envision an uptick of life settlements (described herein) and outright surrenders of existing life insurance policies as a result of the Act, especially where the policy owner no longer needs the death benefit. A so-called “Policy Audit” may uncover an opportunity to reconfigure or repurpose an existing life insurance policy. Much like we recommend reviewing your estate plan and homeowner’s insurance every 3-5 years, Apexium also suggests a detailed periodic review of all life insurance contracts. If a policy is owned by a trust, a Policy Audit is especially prudent to ensure that the trustee is properly discharging his/her/its fiduciary duty. Regardless of policy ownership, an audit is recommended for any or all of the following reasons:
- Determine if the policy ia performing as anticipated
- Determine if the policy matures at a certain age of the insured, or can it run until death (many older policies terminate at age 95 or 100)
- Determine if the policy is running off outdated mortality tables (i.e., is the owner paying a higher than necessary mortality charge)
- Run hypothetical illustrations to explore different options and scenarios
- Identify the initial need or reason for the policy
- Identify any current need or reason for the policy
- Determine if the existing policy is best suited for the current needs of the policy owner
- To make any adjustments to the policy
- To surrender the policy
- To sell the policy on the secondary market in a life settlement
- To undertake a tax-free 1035 exchange of the policy to a new policy better suited for the owner (“Better” might mean a policy with more death benefit for the same premium, stronger guarantees, and/or extended maturity [where the death benefit lasts until death])
- Identify and perhaps exercise any policy riders
- For a term policy, note any conversion date limitations or restrictions
- Review the ratings of the carrier
A life settlement is when a life insurance policy owner decides to sell their policy to a third-party rather than surrender it to the issuing carrier. The surrender of a life insurance policy is essentially a sale back to carrier for the contract’s cash surrender value. In a life settlement, the policy owner can sell the policy to an investor, typically a private equity or hedge fund, for a sum greater than the cash surrender value. When the insured dies the investor, now the new policy owner, receives the death proceeds. The investor has to pay income tax on the death proceeds to the extent it has a gain. This is because the investor paid for the policy, which makes the transaction a so-called transfer-for-value. When an insured dies and the policy-owner/beneficiary acquired the policy in a transfer for value, the “normal” rule of income tax-free death benefit does not apply.
Congress may have anticipated a potential uptick in life settlements because the Act added provisions that limit the applicability of exceptions to the so-called transfer-for value rule (IRC 101(a)(2) and impose reporting requirements on a taxpayer that acquires a life insurance policy in a typical life settlement transaction. If a life insurance policy is sold, the buyer and seller now have to report the transaction to the IRS. The reporting requirements include the personal identification of the parties, the payment amount, the seller’s basis and the death benefit. Recently, however, the IRS stated it will delay its enforcement of the above referenced reporting requirements and will apparently issue regulations to clarify some of the Act’s ambiguities.
Before undertaking a policy surrender or settlement, consider the pros and cons. Moreover, there may be other options. There are several factors the policy owner should research and consider, including, but not limited to, the health of the insured, the tax consequences, the loss of insurability, the prudence of a partial surrender and/or policy loan, and whether the policy makes sense as a component of the owner’s investment portfolio.
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Apexium is not a law firm, does not draft legal documents and does not render legal advice.