Journal of Financial Planning - April 1997

What are the areas of tax certainty when it relates to life insurance? How can you identify exaggerated claims?

Tax Issues Associated with Life Insurance

by Peter Katt, CFP, LIC

While April brings to mind spring showers and young love, it is also the month of maximum tax awareness, an appropriate time for me to briefly review the tax implications associated with life insurance. Subsequent columns will deal with some of these issues in more detail.

There are three major tax issues to be considered when purchasing financial assets.

Tax-deductible or nondeductible contributions, purchase costs or premiums
Tax consequences associated with the investment's or cash value's build-up
Tax status of benefits received

Too often, financial asset marketers and purchasers focus primarily on presumed tax advantages that can cloud their judgment as to the overall merits of a financial asset purchase.

Cash value insurance has four legitimate tax benefits.

Policy cash values grow tax deferred.
Cash value withdrawals are not included in income until they exceed cumulative premiums paid (non-modified endowment contract [MEC] policies).
Cash value withdrawals are not subject to penalty taxes if done before age 59 1/2. (Tax benefits two and three are in contrast to annuities, which require withdrawals to be treated as taxable income on an interest-first basis and impose a penalty tax on withdrawals before age 59 1/2).
The death benefits are not subject to income taxes.

The certainty of these tax benefits associated with cash value life insurance is well established; however, some life insurance marketers make exaggerated tax-benefit claims in order to sell their products. This column will identify those areas of tax certainty and offer a partial list of schemes that may be tomorrow's nightmare for consumers and possible lawsuits for marketers.

Legitimate Designs, Good Results

These four tax benefits make the use of cash value life insurance for the dual purpose of providing needed family death benefit protection and tax-deferred accumulation very worthwhile. This is especially true if the client has the cash flow to superfund his or her policy to emphasize the tax-deferred cash build-up rate-of-return (ROR). I calculate that a low-load universal life policy purchased by a 40-year old male with a $500,000 increasing death benefit, maximum non-MEC premiums of $15,980 and a projected interest crediting rate of 6.4% will have a ROR (premiums to cash value) of 5.3% after 10 years, 5.9% after 15 years, and 6.2% after 20 years. (Full-load policies, everything else being equal, don't do nearly as well, producing 3.5% in 10 years, 4.5% in 15 years, and 5.0% in 20 years.) Low-load policies offer a very competitive fixed-income ROR, considering that it is tax-deferred with access to a good deal of the cash value tax-free. Using cash value insurance as an adjunct for education funding or to supplement retirement income is a reasonable alternative for clients who otherwise need the death benefits. (Note: Clients who wish to invest in equity or equity combination funds can do so with variable universal life.)

Many life insurance marketers sell policies intended to offer consumers large zero-interest loans as a way to have access to all the cash values tax-free. Some words of caution: This is a loophole Congress did not intend and could very well close, probably retroactively if history is any guide. Furthermore, don't take too seriously illustrations showing policy performance culminating in many years of policy loans. All cash value policies have to be monitored and managed because important factors that affect policy performance will constantly change. This is especially true for policies purchased to provide retirement income, since they have many more moving parts. I insist that my clients make their decision about purchasing a superfunded policy for the dual purpose of providing needed death benefits and asset accumulation based on the assumption that tax-free, zero-interest loans will not be available. If the client still sees as a good plan the less-attractive scenario of tax-free withdrawals up to cost basis, followed by taxable withdrawals, then we will be pleasantly surprised if the better scenario comes true.

Life insurance used to transfer wealth (inter-generation transfers) also has a distinct tax advantage over investing in annuities or mutual funds. The death benefits are entirely income tax-free, as well as estate tax-free, if set up properly. A wealth transfer life insurance design that features purchasing the minimum initial-level death benefits (relative to the premium pattern) that are projected to rise dramatically over time will maximize the wealth transfer ROR.

Legitimate Designs, Questionable Results

Although some split-dollar designs remain legitimate, they have very limited positive results because the difference between corporate and personal marginal tax rates has substantially narrowed since split-dollar's arrival in the 1960's. For split-dollar to be worthwhile, the corporate tax has to be much lower than the insured's tax rate. That's because life insurance premiums are an after-tax expense and paying premiums from a lower tax bracket therefore is positive. For example, if the corporate tax rate is 35% while the insured's personal marginal tax rate is 70%, the corporation will have to earn $35% while the insured's personal marginal tax rate is 70%, the corporation will have to earn $15, 385 to pay a $10,000 premium, whereas the insure has to earn $33,333. But if the corporate rate is 30% while the insured rate is 39%, the corporation has to earn $14,286 while the insured has to earn $16,393, a difference not large enough to justify the complications and adverse characteristics of split-dollar. Nevertheless, split-dollar has remained a popular sales gimmick.

Purchasing life insurance within a qualified plan is also a legitimate design concept with very limited positive results because the tax-deductible premium advantage is more than offset by the following factors:

The insured includes the cost of protection in income.
If the insured dies while the policy is in the plan, the cash value portion of the policy minus the insured's basis is taxable, which isn't the case if the life insurance were outside the plan. (For example, the net-death value of a $500,000 policy purchased at age 35 with death at age 60 within a qualified plan is about $460,000, while it would be $500,000 outside the plan.)
Proceeds upon death are included in the insured's estate.
At retirement, the policy must either be surrendered within the plan or take as a plan distribution; the policy cannot be rolled into an IRA.

Questionable Designs

There are two split-dollar designs that have been targeted by the Internal Revenue Service (IRS) for close scrutiny. One design is the majority shareholder split-dollar, a design in which the majority shareholder of a corporation has an irrevocable trust owning a policy collaterally assigned to his corporation. The IRS will treat the insured's control of the corporation as incidence of ownership in the irrevocable trust owned policy and include its proceeds in the insured's estate (Rev. Rule 82-145). Many insurance companies and lawyers believe that a collateral assignment with limited corporate rights ma be a safe haven, a claim I continue to be wary of. Even if majority shareholder split-dollars have a safe haven, it would have very limited use in my practice because of the previously mentioned narrowing of corporate and personal tax rates and the fact that the amount of premiums due back to the corporation will be included in the insured's estate as a corporate asset; defeating, in part, the purpose of having the life insurance outside the estate.

The other split-dollar design that the IRS recently signaled it will attack is equity split-dollar. This is an arrangement in which the insured's corporation pays the premium under a split-dollar collateral assignment, while the insured's family gets the death proceeds, less the collateral assignment amount. The insured also receives the benefit of the cash value build-up in excess of the corporation's contributions. It is this cash value build-up in excess of the contributions that the IRS has signaled it will tax on a current basis (TAM 9604001) bringing into question the future of equity split-dollar as a nonqualified employee benefit. (It also appears that this problem may apply to majority shareholder split-dollar because the cash value build-up in excess of corporate contributions might currently be taxable to the irrevocable trust or the grantor).

Very Questionable Designs

A few life insurance marketers and salesmen continue to search for life insurance's equivalent of the holy grail - tax-deductible premiums. About four times a year, I am retained by a client to review one of these plans that promises such tax nirvana. One common design is typically referred to as leveraged life insurance and is sold primarily to physicians and dentists who own their own small professional corporations. The essential ingredient is the creation of what I see as a phony loan between the corporation and the insurance company up to $50,000. No money is exchanged, only bookkeeping entries. This so-called policy loan carries a high loan rate, say, 15 percent. The interest cost, which I believe in reality substitutes for a major portion of the premium, is therefore claimed to be tax-deductible. Frequently, this leveraged plan also includes a split-dollar component. One of the popular versions of leveraged life insurance was shot down in late 1995 when the tax court (Young vs. Commissioner, TC Memo 1995-379) ruled against leveraged life insurance by not only denying the tax deduction, but by ruling that the amount thought to be deductible was a dividend to the shareholder insured. The ink wasn't dry on Young vs. Commissioner, when I saw another version of leveraged life insurance being marketed.

Another design promising tax-deductible premiums I recently reviewed was a group permanent plan in which the permanent premium was included in the employee's income less the amount of the employee's contributions. This plan was being presented in a 25-page report with dazzling detail, including an opinion letter written by a tax attorney. The apparent trick to this scheme is the salesman's claim that the employee's contributions are coming from previously taxed savings, creating the illusion that this constitutes a net tax-deduction , when in fact such employee contributions either are coming from fully-taxed current earnings, or fully-taxed current earnings will be replacing previously taxed savings that will be used to pay the employee's permanent group term premiums.

Claimed tax-deductible premium life insurance designs can be presented in such a complicated manner that to thoroughly evaluate them would cost more in fees than a client is willing to pay, so I have found a neat way to challenge these plans at little cost to my client. After offering a preliminary opinion, I insist that my client's salesperson fund a thorough review of the proposed plan by an experienced tax attorney and myself with our fees - probably around $5000 - being paid up front. So far, no salesperson has taken us up on our offer and clients have therefore walked away from these proposals.

Conclusion

There is a saying used in the investment and life insurance worlds that "pigs get fat and hogs get slaughtered." Life insurance has significant legitimate tax advantages, but apparently, these aren't enough to satisfy the hogs.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, April 1997.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).