Journal of Financial Planning - November 2000

Our columnist catches readers up on springing cash value schemes, under-priced long-term care insurance and lapse traps.

Disguised Tax Avoidance Is Still Tax Avoidance

by Peter Katt, CFP, LIC

Starting with this column, I will periodically update readers about issues or ideas previously raised and to briefly present issues or ideas that don't warrant an entire column.

My September 1999 column , New Versions of Old Tricks: Springing Cash Values, described two schemes being sold that induced physicians (primarily) to avoid taxes by using variations of an old trick known as springing cash values. A scheme sold to many doctors in New Jersey used (or should I say abused) a VEBA (Voluntary Employee Benefits Association) that promised to provide owner/employee physicians with (1) tax-deductible contributions, (2) pre-retirement term life insurance, (3) tax-free retirement income and (4) post-retirement paid-up life insurance. The doctors were given a single-page schedule of costs and benefits that were presented with certainty, having no caveats.

An explanation of how the plan actually worked was not provided and the doctors didn't ask for it because (1) the Medical Society of New Jersey had endorsed the plan and the agents selling it were authorized representatives of MSNJ, (2) the doctors were given a handful of impressive-looking legal opinion letters from several law firms attesting to its legitimacy and (3) the promoters claimed that the IRS had repeatedly approved this plan.

The actual design of this retirement/insurance plan had two stages. The first stage insured the doctors with what the promoters claimed was term insurance owned by the VEBA. As such, the promoters claimed the contributions were tax-deductible. The premium cost was some ten times higher than normal. After four or five years, this so-called term insurance would be converted to permanent insurance now owned by the doctors personally. Magically, the permanent policy's cash values would begin to soar without the payment of any premiums. The soaring cash values were the funding source for the tax-free retirement income and the paid-up life insurance.

What the doctors didn't know is that the promoters had told the Internal Revenue Service (IRS) that the VEBA had death-only benefits, contradicting what the doctors had been promised: tax-free retirement income and paid-up life insurance. It didn't take long before the IRS noticed that the so-called term premiums were excessive and issued the doctors tax deficiency notices. The promoters of this plan, with the cooperation of their tax attorney, strongly recommended that the doctors fight this injustice being imposed on them by the IRS. The doctors, still believing in these magicians, paid significant legal fees to fight the IRS in Tax Court.

In Neonatology Associates et al. v. Commissioner (www.ustaxcourt.gov), issued July 31, 2000, Judge Laro handed these doctors a stunning defeat, ruling that the VEBA contributions in excess of true term costs were not tax-deductible and the doctors must pick up, as dividend income, a like amount. Add in the interest and penalties, and these doctors' out-of-pocket costs as a result of this scam may be higher than the actual contributions! They now know they have been victimized. I am working with several legal teams representing some of these doctors to obtain the benefits they were promised and recover their losses.

I am frequently asked to review retirement income plans having convoluted designs that promise tax-deductible contributions and tax-free benefits. I no longer take much time trying to figure them out. Instead, I tell the client to demand from the promoters an IRS Private Letter Ruling that complies in every respect with the mechanics of the plan being sold. If they are unwilling to obtain such a letter, I recommend that the client tell the promoters to spread their pixie dust elsewhere.

Long-Term Care Insurance

My December 1998 column, Live Long and Prosper?, discussed long-term care (LTC) insurance. One of the points raised was pricing variability. I contended that LTC pricing that isn't guaranteed would very likely rise primarily because competitive pressures had enticed most companies to price it to sell without really understanding the underlying factors that contribute to its cost. I especially pointed out that human behavior would be greatly influenced simply by people now having LTC insurance. Maladies that older folks have put up with for years would become triggering events for filing LTC insurance claims and this would substantially increase claims-that is, some LTC insureds will certainly feel that they deserve benefits for all the premiums they have paid.

Several weeks after this column was published, I received a call from an actuary who recently had worked for a company selling competitively priced LTC insurance. One of his assignments was to assist in the pricing and design of an LTC policy. He confirmed that my concerns about LTC pricing were totally accurate because there is minimal LTC claims experience to draw on; therefore, studies on the subject are flawed because they can't take into account the impact being insured for LTC will have on claims.

During 1999 it became evident that many LTC policies were terribly underpriced as renewal rates soared, causing a good number of lawsuits, attempts by California to legislate rate caps, and special attention from the National Association of Insurance Commissioners for creating price stability standards with model regulations.

An issue that hasn't received the attention it deserves is the absence of any LTC policy value in the event it lapses. Several actuaries I talked with confirm that LTC policy pricing uses lapse support. This means that the profits from policy lapses are considered in overall pricing (profits in the sense that reserves have been accumulated for the payment of possible claims in the future, but policy lapses eliminate the future liability). Receiving no value from a lapsed LTC policy, perhaps after paying many years of premiums, is not fair, and companies profiting from policy lapses could be a slippery slope if unethical companies were to shrewdly enhance their policy lapse rates by causing nonguaranteed elements of their policies to become uncompetitive, thereby chasing away policyowners. LTC policy designs should allow for a build-up in LTC policy values, either in the form of a cash value or reduced paid-up LTC benefits in the event a policy lapses.

Unlike life insurance, whose one-time triggering event is certain, an LTC policy may pay benefits for a long period of time based on criteria that are somewhat subjective. This, combined with significant premium pricing uncertainty, means the choice of LTC company should be based on its record for fair policyowner treatment (in life insurance, since LTC insurance hasn't been around enough to have a track record) and not selecting companies based on the best price. With this in mind, I offer my clients the option of purchasing the most expensive LTC policy available from a particular company with unquestioned integrity because of probable excellent claims payment experience and because there is less likelihood that shocking premium increases will occur (even the possibility of premium decreases). I also offer my clients the option of selecting from all the other competitively priced LTC policies with the caveats expressed here.

I recommend that financial advisors wishing to sell or advise about LTC insurance act in the most humble manner possible. Regardless of the apparent confidence exhibited by the companies selling LTC insurance, there is a lot they don't yet understand about it because they simply have very little claims experience with this new generation of policies.

Life Insurance Lapse Trap

In August of this year I received a call from financial columnist Jane Bryant Quinn about a distraught reader, Mrs. Howard, who recently had been notified via a 1099 form from her insurance company that she must include $47,000 in her income. This shocking fact, Mrs. Howard quickly discovered, was due to the inadvertent lapse of her permanent life insurance policy due to a zero cash value balance. The zero balance was the result of Mrs. Howard having taken a cash loan some years ago, then taking loans for the payment of premiums and further loans for compounding loan interest payments. The policy lapse transaction resulted in the inclusion of $47,000 in Mrs. Howard's income and a zero cash balance from which to pay taxes of some $16,000. This is referred to as phantom income.

Mrs. Howard was livid because the agent had encouraged her to take the large cash loan and never indicated anything was amiss with her continuing to take loans to pay premiums. And while the insurance company did send her notices encouraging her to repay the loan because of the positive effects it would have on the policy, no one cautioned or even mentioned the possibility that the policy could collapse under the weight of the loans and cause her to pay substantial taxes. Mrs. Howard was further infuriated because two attorneys she contacted after receiving her 1099 had no idea such a situation could occur, convincing her that she was the victim of some awful conspiracy.

Mrs. Howard hoped that her ignorance of the tax law and the failure of those in possession of such knowledge to properly inform her of the looming danger might let her off the hook with the IRS or provide grounds to sue the agent and insurance company. As to the former, the IRS doesn't allow unfamiliarity with the law to avoid taxes due. As to the latter, I advised her that such a suit would be a waste of time and more expense.

I contacted the insurance company for Ms. Quinn to obtain a schedule of the minimum costs to reinstate the policy and keep it going so Mrs. Howard could avoid being charged with this taxable income. This year's cost is $3,700, with subsequent annual costs ranging from $1,500 to $2,500 annually and dropping death benefits. I compared the $16,000 current tax bill with the present value for the minimum policy costs and determined that in ten years the two figures would be equal. However, delaying the policy's lapse only causes the amount of taxable income to increase. The current taxable income of $47,000 is nearly half what it increases to in ten years when it is $95,000.

One additional factor I considered was the health of the insured. If the insured were in poor health, continuing the policy would be the prudent thing to do because, if death occurred, not only is the beneficiary entitled to the proceeds, but the proceeds are income tax-free. In this case, the insured (Mrs. Howard's ex-husband!) is in excellent health, so there is little probability he will die while the policy is being sustained with minimum premiums. Unfortunately, Mrs. Howard is retired and has just enough income for her routine needs with no cushion for this totally unexpected disaster.

Of course, the insurance company considers its actions to be beyond reproach. They are just following the law and they sent out the notices asking for loan repayment to better enhance the value of the policy. However, the insurance company did fail this and other policyowners by not early, often and explicitly warning Mrs. Howard of the consequences if her policy lapsed.

A common human failing is to forget we don't all possess the same information. Just because insurance companies know that a policy can lapse due to loans causing a zero cash balance with phantom income, Mrs. Howard did not know, nor did several attorneys she contacted after the fact. Ms. Quinn (who published a column about this in September) and I both hope that Mrs. Howard's plight will serve as a rescue beacon to others who are blindly headed for the same disaster. Mrs. Howard doesn't have any spare resources to pay this $16,000 and she may have to sell her condominium or furnishings.

I am asking readers who wish to make donations to Mrs. Howard for the payment of her unexpected tax bill to send them payable to Stokes, McMillan et al. Trust Account addressed to Stokes, McMillan et al., Two South Biscayne Blvd., #3750 Miami, Florida 33131. Be sure to note on the envelope that it is a donation for Mrs. Howard. I will start it off with a donation of $200. Thank you for your consideration. If excess funds are collected, they will be sent back, but not on a pro rata basis. I want to thank estate planning attorney Paul Stokes, senior partner with Stokes, McMillan, et al. for agreeing to handle donations on a pro bono basis.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, November 2000.

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