Advanced Underwriting Consultants

Ask the Experts – July 20, 2015

Question:  If my client receives Social Security survivor benefits from her deceased spouse and then gets re-married, is she still eligible for the survivor benefits?

Answer:  It depends.

If your client re-marries before age 60, she cannot receive survivor benefits as a surviving spouse while married. If, however, remarriage occurs after age 60, the client will continue to qualify for benefits on her deceased spouse’s Social Security record.

If the client re-marries after 60 and stays married long enough to become eligible for spousal benefits, she may be eligible for three types of benefits: one based on the deceased spouse’s record, another based on the new spouse’s record and the third based on her own record. While she may be eligible for three different types of benefits, the Social Security Administration will generally pay ONLY whichever benefit is the highest.

Your client may be able to collect a certain type of benefit now and then switch to a higher benefit later.

Ask the Experts – October 24, 2014

Question:  My client’s CPA believes that the death benefit from a modified endowment contract is income taxable.  Is the CPA correct?

Answer:  No.

The authority for this answer requires stitching together a few different parts of the Internal Revenue Code.

Section 101(a) says that the death benefit of a life insurance policy is generally income tax free.

(a)   Proceeds of life insurance contracts payable by reason of death

(1)   General rule

Except as otherwise provided in paragraph (2), subsection (d),subsection (f), and subsection (j), gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.

Section 7702 defines life insurance, and sets out the kinds of guideline premium tests that must be met for a contract to qualify.  MEC life policies must (and do) meet the tests in Section 7702.

Section 7702A explains how the separate seven-pay test works.  Contracts that fail to meet the 7702A seven-pay test are MECs—but they are also still life insurance, because they meet the tests in Section 7702.

Finally Section 72(e)(10) explains that MECs are taxed differently from “normal” life policies for the purpose of lifetime distributions.  Nothing in Sections 7702A, 101 or 72 says that MECs are taxed differently from normal life policies with regard to the death proceeds.  Therefore, the death proceeds of a MEC life policy are income tax free.

There are lots of third party sources online that confirm the same conclusion.  Here’s a link to one:

http://www.investopedia.com/terms/m/modified-endowment-contract.asp

Ask the Experts – July 14, 2014

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: If my client is going through bankruptcy and receives a life insurance death benefit from on his father’s life during the proceeding, will the death benefits be protected from creditors?

Answer: It depends on the state. In bankruptcy, the debtor is able to exclude certain assets from his bankruptcy estate (referred to as exemptions). While the bankruptcy code sets forth the federal bankruptcy exemptions, Congress has given the states the choice to create their own exemptions that the state can either require residents to use, or allow residents to use (with the option to instead choose the federal exemptions).

Currently, every state has created its own set of asset protection laws, and 19 states and the District of Columbia have given their residents a choice between the state exemptions and the federal exemptions.

The federal government doesn’t protect the death benefits a debtor receives as a beneficiary unless the debtor is a dependent of the insured, and then they are protected only to the extent necessary for support of the debtor.

For example, consider the recent bankruptcy case In re Sizemore (12/5/13), where a debtor going through bankruptcy received $100,000 from her ex-husband’s life insurance policy. Being a resident of Kentucky, the debtor had the choice of using either federal or state exemptions. The debtor sought to exempt the entire amount under the federal bankruptcy protections, but the bankruptcy court held that life insurance proceeds were part of the bankruptcy estate. Therefore, the life insurance proceeds could not be excluded from the debtor’s bankruptcy estate.

Also consider In re White (5/16/14), a bankruptcy case using Alabama state exemptions. Under Alabama’s bankruptcy exemption laws, death benefits of a life insurance policy are exempted from the estate if the beneficiary is the person who effected the policy in the first place.

In White, a married couple were going through divorce. The wife, who was the insured on a $50,000 life policy, died, and her husband was the beneficiary. The husband claimed that the proceeds from the policy on his wife’s life were protected from his creditors under Alabama exemption laws. He argued that he was the one who effected the policy because (1) she obtained the life insurance through his employer, and (2) he paid the premiums.

The bankruptcy court, however, ruled that because the wife was the owner of the policy, she was the one who effected the policy. Therefore, the death benefits were not protected under Alabama’s exemption laws.

A client going through bankruptcy should check with a local bankruptcy attorney to fully understand his state’s exemption laws that may apply.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – May 28

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: I have a client who received $100,000 as the beneficiary of his deceased wife’s life insurance policy. My client and his wife were in bankruptcy at the time of her death. Will the death benefit be protected from both of their creditors?

Answer: It depends on the state law and other facts surrounding their situation.

For example, consider the recent Alabama bankruptcy case, In re White, in which a married couple was in Chapter 13 bankruptcy when the wife died. Prior to filing a petition for bankruptcy relief, the debtors purchased a $50,000 life insurance policy on the life of the wife through the husband’s employer. The wife was the insured and policy owner, while her husband was designated as the sole beneficiary.

The wife died and the husband received $50,000. Ordinarily, money received during a bankruptcy plan would go to the bankruptcy estate and the trustee would dictate where that money was allocated. However, the husband asserted that the funds were exempt from the bankruptcy estate because of the following state asset protection statute:

(b) If a policy of insurance . . . is effected by any person on the life of another in favor of the person effecting the same . . . the latter shall be entitled to the proceeds and avails of the policy as against the creditors, personal representatives, trustees in bankruptcy and receivers in state and federal courts of the person insured. If the person effecting such insurance . . . is the wife of the insured, she shall also be entitled to the proceeds and avails of the policy as against her own creditors, personal representatives, trustees in bankruptcy, and receivers in state and federal courts.

Alabama Code Section 27-14-29(b). The statute is rife with legalese, but here’s a translation: if the husband effects a life insurance contract on his wife’s life and names himself as the beneficiary, then the death benefit is exempt from both of their bankruptcy estates.

The husband argued that he “effected” the policy because it was purchased through his employment and paid for with payroll deductions. The bankruptcy trustee disagreed, claiming that the $50,000 death benefit should go to the bankruptcy estate—not to whomever the debtor-husband wants.

The bankruptcy court agreed with the trustee, reasoning that although the wife purchased the policy through her husband’s employment, and, although it was funded with payroll deductions, the policy was owned by the wife, and it was therefore not effected by the husband. Therefore, this particular Alabama creditor exemption did not apply to the husband, and the $50,000 death benefit was not protected from his creditors. (Note that it was protected from his wife’s creditors, but since they were jointly in bankruptcy, that made no difference.)

The White case reinforces the idea that a policy’s death benefit, when paid to a beneficiary going through a bankruptcy, might also be lost to creditors. The court’s decision hinged on its interpretation of the Alabama state law bankruptcy exemption and the ownership of the life policy on the deceased wife’s life. It probably never occurred to the husband in this case that policy ownership might make a difference as to whether he might be able to keep the death benefit later on. Even though state bankruptcy exemptions provided some protection for life insurance proceeds, the specific circumstances of this case didn’t extend those protections to the surviving husband.

Finally, the decision serves as a reminder (again) to life insurance professionals to

  • Review the ownership and beneficiary designations of all their clients’ life insurance and financial products on a regular basis.
  • Consider naming a spendthrift trust as beneficiary instead of the individual directly to protect beneficiaries who might have future financial difficulties.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – April 14

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client owns a life insurance contract where he is the insured and his daughters are the beneficiaries. Can he make a Section 1035 exchange so that an ILIT becomes the owner of the policy? If so, does the three-year rule that would bring the full death benefit back into his estate still apply?

Answer: Section 1035 requires consistent ownership before and after the exchange for it to be tax-free. Since an ILIT is a legally distinct entity, the ownership change would generally disqualify it for Section 1035 treatment, and it would simply be a surrender of the old policy followed by the purchase of a new policy in the name of the ILIT.

It could be argued that if the ILIT is a grantor trust, the grantor/original policy owner is still the constructive owner of the life insurance policy; therefore Section 1035 would apply. However, if this analysis is true, Section 1035 would apply, but the individual would not avoid the rule bringing the death benefit back into his estate if he dies within three years from the transfer.

As you can see, the bottom line is that an individual cannot make a Section 1035 exchange into an ILIT and avoid the three-year rule. If he wants to get the life insurance policy inside an ILIT, he would either have to (1) take the risk of the full death benefit being brought back into his estate if he dies within three years, or (2) surrender the policy for its cash value, pay income taxes on any gain, transfer money to the ILIT, and have the ILIT purchase a policy on his own life.

If he chooses the latter, he faces gift taxes on the transfer of money to the ILIT if such transfers are more than the $14,000 exclusion amount in 2014. He also faces potential problems with the policy being considered a modified endowment contract (MEC). Both options have risks or costs, and so it’s up to the client to decide which option suits him best.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.  

Ask the Experts – April 11

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client transferred his life insurance policy to an ILIT to avoid having the death benefit included in his gross estate. I’ve heard that if he dies within three years from the transfer, the death benefit will be brought back into his estate. Is this correct? Does the fact that he paid a gift tax based on the cash value affect the amount he would owe for estate tax purposes?

Answer: Yes, under Section 2035, the entire death benefit will be included in your client’s gross estate if he dies within three years from the date of the transfer to the ILIT. However, the fact that your client paid a gift tax (or used a portion of his unified credit to pay the tax) would lower the amount he owes for estate taxes.

For example, let’s say your client has given away enough money that he’s already used up his $5.34 million lifetime exclusion amount (as of 2014). Also suppose he owns a life insurance policy with a cash value of $600,000 and a death benefit of $1 million. If he transfers the policy to his ILIT in 2014, he will incur a $240,000 (40% of $600,000) gift tax in 2014. If he survives for three more years, the entire $1 million death benefit will be excluded from his gross estate.

On the other hand, let’s say he dies within three years from the transfer. Section 2035 brings the full value of the death benefit back into his gross estate, and ordinarily the $1 million death benefit would incur a $400,000 estate tax (40% of $1 million); however, your client would get credit for the $240,000 gift tax he has already paid, resulting in an estate tax of $160,000 ($400,000 less $240,000).

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.