Advanced Underwriting Consultants

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.