AAII Journal - April1998

Life Insurance Issues and the Proposed Tax Law Changes

By Peter Katt

TheClinton administration has proposed that certain tax laws affecting lifeinsurance, annuities, and estate planning be changed. This column alertsreaders to four of the proposed changes, and it discusses how you may wantto handle insurance, annuity, and estate planning issues while faced withthe uncertainty of whether or not these changes will be enacted.

Elimination of Crummy Rule

One change that would affect some life insurancepurchases is the proposed elimination of the so-called Crummey rule.

The Crummey rule is an estate-planning device.Gifts must be immediately available to the persons receiving them in orderto qualify for the annual gift tax exclusion of $10,000 per donor per doneeper year. When life insurance is purchased by an irrevocable trust, thecash gifts to the trust to pay life insurance premiums do not qualify forwhat is known as gifts of a present interest. Therefore, they do not qualifyfor the annual gift tax exclusion unless the trust notifies the trust beneficiariesthat they have the right to demand that these cash gifts be immediatelygiven to them. By having the right to take the cash gifts, a present interestis created and they qualify for the annual gift tax exclusion, even thoughthe beneficiaries do not actually take the cash gifts, which are used bythe trust to pay the life insurance premium. This is referred to as theCrummey rule, because of the 1968 tax court case, Crummey v. Commissioner,that established it. There are thousands of irrevocable life insurancetrusts that use the Crummey rule to reduce or eliminate gift taxes on giftsthat are used to pay premiums. As I understand it, the elimination of thisrule would be retroactive and would apply to any gifts to irrevocable trustsafter the law’s effective date.

Regarding this proposed law change, for existingirrevocable trusts there are two major alternatives. One is to continuemaking gifts to the irrevocable trust without being covered by the annualgift tax exclusion. Such non-annual exclusion gifts would reduce a taxpayer’sremaining estate and gift tax credits, which have a current equivalentvalue of $600,000, scheduled to increase to $1 million by 2006. Taxpayerswho have considerable wealth and would benefit from increasing their giftsanyway could make gifts directly to their children (and grandchildren ifappropriate) that would qualify for the annual gift tax exclusion as wellas make gifts to an irrevocable trust that would not qualify for the annualexclusion.

Another alternative, if allowed by the irrevocablelife insurance trust, is to gift the life insurance premium amount directlyto adult beneficiaries, who would then contribute the cash gifts to thetrust, which would in turn pay the premiums. This arrangement would qualifyfor the annual gift tax exclusion because the adult beneficiaries receivingsuch gifts would be under no obligation to contribute them to the irrevocabletrust and therefore a present interest would be created.

For those currently contemplating the purchaseof life insurance associated with estate planning, the irrevocable lifeinsurance trust could still be used, funded as noted in the previous paragraph.Alternatively, instead of using an irrevocable trust created by the familymatriarch and patriarch, their beneficiaries could execute a revocabletrust to own the life insurance policy(ies). The gifts for the premiumswould be made directly to adult children and grandchildren, which wouldqualify for the annual gift tax exclusion; the children or grandchildrenwould then contribute these gifts to the revocable trust for the paymentof the premiums. This latter technique, whereby the children own the lifeinsurance via a revocable trust, removes some of the privacy of such planningfor their parents. Parents who wish greater privacy may opt to continueto use the irrevocable trust even if the gifts to pay the premiums reducetheir estate and gift tax credits.

Corporate-Owned Life

Many corporations, especially banks, have purchasedindividual cash value life insurance policies on the lives of many employeesin order to fund certain employee benefits. The cash value build-up istax-deferred, and the death benefits are tax-free. Operating or capitalfunds that are needed by the business and that would otherwise come fromthe life insurance premium budget can be borrowed, with the interest paymentsof this debt a tax-deductible expense to the business. Because the Clintonadministration believes this is unfair tax arbitrage, it has proposed legislationthat will effectively limit its use by denying deductions for debt servicewhen the business also has purchased life insurance on non-owner employees.

Employers considering such a plan should waitto see if this change is enacted because it will impose a large tax penaltyon such business.

Exchanging Contracts

Under current law, (IRC Sec. 1035) life insuranceand annuity policyowners who exchange their contracts for certain otherinsurance policies can do so without incurring any taxable gain. Currentlaw does not distinguish between types of life insurance (whole, universalor variable life) or types of annuities (fixed or variable). However, theClinton administration has proposed to tax any gains on exchanges betweenwhole or universal life and variable life or variable annuities, and to tax any gains on exchanges between variable life and whole or universallife. As written, the proposed change in current law would allow for onelast tax-free exchange for policies already in existence before the proposednew law would apply.

The term exchange is a euphemism for theterm policy replacement, which occurs all too often and is frequentlyadverse to a policyowners’ best interests. A new law taxing certain policyreplacements might actually benefit unwary consumers if it reduces inappropriatepolicy replacements.

Reduced Cost Basis

Under current law, a policyowner calculates taxablegain on the surrender of a life insurance or annuity policy as the amountreceived in excess of his cost basis, usually defined as the cumulativepremiums paid. The proposed tax law change would reduce the cost basisfor life insurance by the cost of insurance and other policy expenses andfor annuities by a fixed 1.25% of the surrender value. Under the currentlaw, a life insurance policy with a 10th year surrender value of $195,000and a cost basis of $200,000 would not report any taxable gain if surrenderedbecause the surrender value is less than the cost basis. However, underthe proposed new law, if the cost of insurance and other policy expenseswere, say, $70,000, this would reduce the policyowner’s basis by $70,000to $130,000, creating a taxable gain of $65,000. This tax would similarlyimpact cash value withdrawals from life insurance.

The proposed change would also impact the surrenderof annuity policies as well as the partial withdrawal of cash values. However,it would not change the current taxation of annuities that pay monthlybenefits for the rest of the annuitant’s life, which will continue to usethe 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 treatmentfor consumers. Life insurance death benefits are still income tax-free,and annuities that pay monthly benefits for the life of the annuitant stillallow for the full prorated recovery of the investment in the annuity.Life insurance purchased for the dual purposes of protection and investmentwill still have tax-deferred accumulation of the cash values and recoveryof basis before taxation, even if the cost basis is reduced. And deferredannuities will continue to accumulate tax-deferred. It is my opinion thatthis proposed change is more of a nuisance than a catastrophe.

Conclusion

Proposed changes of obscure and complicated tax lawscan produce significant additional revenues for Washington, D.C., withoutthe general public even knowing it is happening. This allows elected officialsto increase their control over the wealth of a nation without having topay the political price of proposing major tax increases.

But for individuals, the bottom line is what youget to keep after taxes, and it is important for those who may be affectedto take the proposed changes into consideration when making long-term decisions.


Peter Katt, CFP, LIC, is sole proprietor ofKatt & Co., a fee-only life insurance adviser located in Kalamazoo,Michigan (616/372-3497). His book, "The Life Insurance Fiasco: How to AvoidIt," is available through the author.