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Journal of Financial Planning - April 1998 Insurance products could be in for some significant changes if the Clinton administration gets its way. Our insurance expert looks at four proposed changes. Insurance Planning in the Face of Uncertain Tax Law Changesby Peter Katt, CFP, LIC The Clinton administration has proposed that certain tax laws affecting life insurance, annuities and estate planning be changed. This column will explain four of the eight proposed changes; discuss how to possibly handle insurance, annuity and estate planning issues while faced with the uncertainty of whether these changes will be enacted; and generally alert readers so they may express their opinions about these proposed tax law changes to elected officials on a timely basis. Eliminate 'Crummey' Rule Gifts must be available immediately to the persons receiving them in order to qualify for the annual gift tax exclusion of $10,000 per donor per donee per year (now indexed). When life insurance is purchased by an irrevocable trust, the cash gifts to the trust to pay life insurance premiums do not qualify for what is known as gifts of a present interest; therefore, they do not qualify for the annual gift-tax exclusion unless the trust notifies the trust beneficiaries that they have the right to demand these cash gifts immediately. By having the right to take the cash gifts, a present interest is created and the gifts qualify for the annual gift-tax exclusion, even though the beneficiaries do not actually take the cash gifts, which are used by the trust to pay the life insurance premium. There are thousands of irrevocable life insurance trusts that use the Crummey rule to reduce or eliminate taxes on gifts used to pay premiums. As I understand it, the elimination of this rule would be retroactive and would apply to any gifts to irrevocable trusts after the law's effective date. Regarding this proposed law change, for existing irrevocable trusts there are two major alternatives. One is to continue making gifts to the irrevocable trust without being covered by the annual gift tax exclusion. Such non-annual exclusion gifts would reduce a taxpayer's remaining estate- and gift-tax credits, which have an equivalent value of $625,000 in 1998 and are scheduled to increase to $1 million by 2006. For taxpayers who have considerable wealth and would benefit from increasing their gifts anyway, they could make gifts directly to their children (and grandchildren, if appropriate), which would qualify for the annual gift tax exclusion, as well as gifts to an irrevocable trust, which would not qualify for the annual exclusion. Another alternative, if the irrevocable life insurance trust is allowed, is to gift the life insurance premium amount directly to adult beneficiaries, who would then contribute the cash gifts to the trust, which would then pay the premiums. This arrangement would qualify for the annual gift-tax exclusion because the adult beneficiaries receiving such gifts would be under no obligation to contribute them to the irrevocable trust; therefore, a present interest is created. For those currently contemplating the purchase of life insurance associated with estate planning, the irrevocable life insurance trust still could be used, funded as noted in the previous paragraph. Furthermore, instead of using an irrevocable trust created by the family matriarch and patriarch, their beneficiaries could execute a revocable trust to own the life insurance policy(ies). The gifts for the premiums would be made directly to adult children and grandchildren, which would qualify for the annual gift tax exclusion, and they would contribute these gifts to the revocable trust for the payment of the premiums. This latter technique, whereby the children own the life insurance via a revocable trust, removes some of the privacy of such planning for their parents. Parents who wish greater privacy may opt to continue to use the irrevocable trust, even if the gifts to pay the premiums reduce their estate- and gift-tax credits. Modify Corporate-Owned Life Insurance (COLI) Rules Many corporations, especially banks, have purchased individual cash value life insurance policies on the lives of many employees in order to fund certain employee benefits. The cash value build-up is tax-deferred and the death benefits are tax-free. Operating or capital funds needed by the business, which would otherwise come from the life-insurance-premium budget, can be borrowed, with the interest payments of this debt as a tax-deductible expense to the business. Apparently, the Clinton administration believes this is unfair tax arbitrage, and they have proposed legislation that will effectively limit its use by denying deductions for debt service when the business also has purchased life insurance on non-owner employees. Employers considering such a plan probably should wait to see if this tax law change is enacted because it will impose a significant tax penalty on such business. Tax Certain Exchanges of Insurance Contracts Under current law (Internal Revenue Code Section 1035), life insurance and annuity policy owners who exchange their contracts for certain other insurance policies can do so without incurring any taxable gain. Current law does not distinguish between types of life insurance (whole, universal or variable life) or types of annuities (fixed or variable). However, the Clinton administration has proposed to tax any gains on exchanges between whole or universal life, and variable life or variable annuities. It also has proposed taxing any gains on exchanges between variable life and whole or universal life. As written, the proposed change in current law would allow for one last tax-free exchange for policies already in existence before the proposed new law would apply. The term exchange is a euphemism for the term policy replacement, which occurs all too often and is frequently adverse to a policyowner's best interests. A new law taxing certain policy replacements might actually benefit unwary consumers if it reduces inappropriate policy replacements. Reduce 'Investment in the Contract' for Mortality and Expense Charges Under current law, a policy owner calculates taxable gain on the surrender of a life insurance or annuity policy as the amount received in excess of the policy owner's cost basis, usually defined as the cumulative premiums paid. The proposed tax law change would reduce cost basis for life insurance by the cost of insurance and other policy expenses, and by a fixed 1.25 percent of the surrender value for annuities. Under the current law, a life insurance policy with a tenth-year surrender value of $195,000 and a cost basis of $200,000 would not report any taxable gain if surrendered because the surrender value is less than the cost basis. However, under the proposed new law, if the cost of insurance and other policy expenses were, say, $70,000, this would reduce the policy owner's basis by $70,000 to $130,000, creating a taxable gain of $65,000. This tax would similarly affect cash value withdrawals from life insurance. The proposed change also would affect the surrender of annuity policies, as well as the partial withdrawal of cash values. However, it would not change the current taxation of annuities that pay monthly benefits based for the annuitant's life, which will continue to use the full investment in the annuity as its cost basis. Regardless of whether this new law is enacted, life insurance and annuities will continue to provide favorable tax treatment for consumers. Life insurance death benefits are still income-tax-free, and annuities that pay monthly benefits for the life of the annuitant still allow for the full, prorated recovery of the investment in the annuity. Life insurance purchased for the dual purposes of protection and as an investment still will have tax-deferred accumulation of the cash values and recovery of basis before taxation, even if the cost basis is reduced. And deferred annuities will continue to accumulate tax-deferred, as well. It is my opinion that this proposed change is more of a nuisance than a catastrophe. It should not affect decisions about the purchase of cash value life insurance and deferred annuities while this proposed change is being considered. Conclusion Proposed changes of obscure and complicated tax laws can produce significant additional revenues for Washington, D.C., without the public even knowing it is happening. This allows elected officials to increase their control over the wealth of a nation without having to pay the political price of proposing tax increases that would be obvious to a nation of sitcom watchers. Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, April 1998.
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