This paper summarizes the determination of the fair market value of certain permanent life insurance policies for purposes of transferring, gifting or selling the policy from one individual or trust to another. Historically, life insurance companies offered two types of life insurance: Annual Renewable Term Insurance and Whole Life Insurance. Over time, new types of policies have evolved, such as Universal Life and Variable Life, which have been difficult to reconcile with the outdated Internal Revenue Service (“IRS”) guidelines for valuation. As a result, insurance companies are uncertain how to properly value certain policies, which has led to inconsistent valuations across life insurance companies. Accordingly, this paper focuses on alternative valuation methods of certain difficult to value life insurance policies, even after an IRS Form 712 has been issued.

Fair Market Value

The two Treasury Regulations (“Treas. Regs.”) applicable to valuing life insurance policies, Treas. Regs. §§ 20.2031-8 and 25.2512-6, were last amended in 1974. These Treas. Regs. are tailored to historically common policies, namely, Annual Renewable Term and Whole Life. An Annual Renewable Term policy has no reserves, thus the valuation is determined by looking to the “unearned premium1.” In order to determine the fair market value of a Whole Life policy (that has been in effect for several years with premiums remaining), insurance companies frequently use the interpolated terminal reserve value (hereinafter “ITR value”)2. Typically, the cash surrender value and the ITR value are very similar because the insurance company is aware of how much reserve is necessary each year based on the amount of future premiums to be received and the expected death benefit3.

In the 44 years since the IRS amended the Treas. Regs. regarding valuation of life insurance, new life insurance products have entered the market. For example, a Universal Life policy is a flexible premium policy, thus the terminal reserve value is not known until the end of the policy year. As a result, it is difficult to apply the Treas. Regs. currently used to determine the fair market value of these new types of policies4.

Furthermore, today there are several types of reserve values, including: tax reserve, statutory reserve, AG 38 reserve, and deficiency reserve. It is unclear which reserve an insurance company should use to calculate the fair market value of a policy. In addition, a few insurance companies use the cash surrender value, or the cash accumulation value, or the California Method (the average of the cash surrender value and the cash accumulation value), as the ITR value. The different options available for the reserve value has led to different methodologies for calculating the ITR value, which has resulted in different insurance companies arriving at vastly different fair market values for similarly situated policies.

IRS Form 712

Generally, in order to determine the fair market value of a life insurance policy, an owner will request an IRS Form 712 from the insurance company. The insurance company will then complete the form and certify that the information is “true and correct.” However, once an insurance company has developed a particular methodology (based on the type of reserve value calculation) for determining fair market value, the company is unlikely to change their methodology because they have an interest in ensuring equal treatment among policy holders who request an IRS Form 7125.

A dilemma occurs when the IRS Form 712 is returned with a value different than expected. If the owner chooses to use another value as the fair market value, it is recommended that the owner provides a full explanation regarding how the value was determined. This explanation is important in order to clarify that the transaction was actually a sale and not a gift, for example, in the event of a sale from an individual to his or her irrevocable grantor trust or from one grantor trust to another.

Consider the following example, which is based on a study by a life insurance company and cited from a Leimberg Services LISI Newsletter, for an insured who bought a combination of six policies each with a $5,000,000 face amount from three different companies6:

Carrier Policy Type Face Amount Cumulative Premium Cash Surrender Value Value Reported by Carrier Carrier Valuation Method
A GUL $5,000,000 $866,950 $0 $941,803 AG 38 Statutory Reserve without Deficiency
UL $5,000,000 $866,950 $285,011 $432,620 Statutory Reserve
B GUL $5,000,000 $982,500 $237,930 $237,930 Cash Surrender Value
UL $5,000,000 $982,500 $374,550 $374,550 Cash Surrender Value
C GUL $5,000,000 $912,500 $170,413 $512,389 AG 38 Statutory Reserve without Deficiency
UL $5,000,000 $912,500 $390,053 $474,053 California Method
Qualified Appraisal

Due to the lack of guidance from the IRS regarding the determination of fair market value of a certain policies, and the vast inconsistencies in methodologies amongst life insurance companies, an owner of a policy may argue that the fair market value is more accurately represented by a qualified appraisal that uses the “willing buyer, willing seller” standard. The “willing buyer, willing seller” approach is found in Treas. Regs. §§ 20.2031-1 and 25.2512. The Treas. Regs. provide that “[t]he value of the property is the price at which such property would change hands between a willing buyer and willing seller.” Therefore, a qualified appraisal using the “willing buyer, willing seller” approach is an alternative valuation method, which may be used to justify a lower sale price than the IRS Form 712 calculated.

Secondary Market Valuation (SMV)

Determining fair market value of a life insurance policy may no longer need to be a guessing game. The policy can be valued similarly to other pieces of property in the secondary market for life insurance. The secondary market for life insurance can produce an alternative value than the insurance carrier will provide. All types of policies can qualify, including term, if the policy fits the current purchase parameters.

A regulated and institutional framework has developed over the past decade to formalize the “willing buyer and willing seller” in a transparent platform. Policy owners and their advisors are no longer forced to rely on outdated rules for calculating fair market value. There is a proven methodology and process to determine a life insurance policy’s value based upon the current health of the insured and by analyzing the details of the life insurance contract and premium streams.

Revenue Ruling 59-60: A determination of fair market value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases.

  • In resolving such differences, he should maintain a reasonable attitude in recognition of the fact that valuation is not an exact science.
  • A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.

The methodology to estimate the fair market value of a client’s life insurance policy is outlined in a process known as the Secondary Market Valuation (SMV). This process employs standardized industry practices and analytics, which consist of a combination of analyzing the insurance contract, policy values, required capital outlay (premiums), database comparatives, and the life expectancy of the insured. The process is simple to follow and easy to integrate into an existing planning process. The insured and policy owner complete the appropriate forms and disclosures, and current information is obtained and reviewed to determine the potential value of the policy and the options that might exist.

Some of the common fact patterns for advisors and their clients participating in the Secondary Market are in situations such as:

  • Determining the fair market value of the contract
  • Transferring a policy from one entity to another
  • Completing a business valuation – including insurance or annuities
  • Valuing a Convertible Term Contract for a buy/sell or key-executive
  • Split Dollar rollouts
  • M&A or bankruptcy transactions
  • Exit-Planning recommendations

The process to evaluate a policy begins with contacting the insured and policy owner to sign the state regulated forms that provide the proper authorization to begin the valuation process. The following items and steps are required to build and facilitate the bidding process. The critical steps include a collection of the last five years of medical records, acquisition of independent life expectancy reports from licensed providers, review of database comparisons for reference, and engage the licensed buyers/capital markets to facilitate the bidding process.

The most attractive policies to institutional buyers are those that were issued standard or preferred and there has been a change health since issue. Ideal policies were issued by highly rated insurance carriers, with very low credit risk or volatility, and have a manageable carrying cost or future premium streams. This is important due to the illiquid nature of the asset itself. Buyers in the current market require returns similar to other alternative investments, as they are committed to a longer duration and have to maintain considerable capital commitments and reserves.

This life insurance asset and Secondary Market for Life Insurance is known globally as “Longevity Risk.” Top-rated insurance carriers performed better than banks during the Credit Crisis of 2008-2009 and both domestic and global funds became attracted to the non-correlated aspect of this asset class. It is not tied to the equity markets or other traditional markets. Sophisticated institutional buyers such as pension plans, reinsurers, private equity, municipalities, and others have realized that they could deploy large amounts of capital, while benefiting from an aging population, in short, an aged population has more predictable mortality. Many experts feel this investment strategy continue to attract global investors as it qualifies for a higher standard known as “socially responsible investing,” which is grounded by an approach that focuses on maximizing both financial return and social good.


Life insurance policy valuation remains a complicated topic fraught with antiquated Treas. Regs. and vast inconsistencies amongst life insurance companies. The result is no ascertainable standard for consistency in valuation methods. Therefore, a policy owner may, instead, wish to rely on a qualified appraisal that uses the “willing buyer, willing seller” standard to determine fair market value. The secondary market, for which there is no better example of “willing buyer, willing seller,” may provide a viable option for clients engaging in financial and/or estate planning transactions where determining the fair market value of a policy for tax reporting purposes is required. However, the secondary market is typically only available to policies that meet specific criteria, such as insureds who are over age 65. For younger insureds, or others for which the secondary market is not available, a qualified appraisal by an independent appraiser who specializes in life insurance valuation may be the better means for reporting purposes if the value reported by the carrier on Form 712 is not an appropriate representation of the policy’s fair market value.

IRS Required Statement: Pursuant to recently-promulgated U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly stated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

  1. The unearned premium is calculated by multiplying the premium already paid that year by a fraction. The numerator of which is the number of months from the current date until the next premium is due; the denominator of which is the total number of months the policy covers.
  2. The ITR value is calculated by subtracting the policy’s prior year reserve from the reserve at the end of the current policy year. Then, multiply the difference by a fraction. The numerator is the number of months of the current year the policy was in existence; the denominator is 12. Then, the product is added to the reserve of the previous year. Last, add this result to the unearned premium (unearned premium is calculated in footnote 1).
  3. Richard Harris, Transferring Life Insurance by Gift or Sale, Trust & Estates, (April 2011),
  4. Brody, Lawrence, et al., § 8.02 Current Issues Regarding the Valuation of Life Insurance Policies, NYU Review of Employee Benefits, (2012).
  5. Id.
  6. Source: LISI Estate Planning Newsletter 1638 (May 10, 2010),

A Charitable Remainder Trust (“CRT”) is usually created by a person (the “Grantor”) for his/her own benefit, and provides for an “income interest” to be paid to the Grantor for the remainder of his/her lifetime. Upon the death of the Grantor, the remaining assets in the CRT are distributed to a designated charity. The Grantor can reserve the right to change the charity at any time during the Grantor’s lifetime.

The “income interest” payable to the Grantor is either (i) a fixed dollar amount per year, or (ii) an amount based on a fixed percentage of the assets of the CRT as redetermined each year.

A CRT which provides for a fixed dollar amount is known as a Charitable Remainder Annuity Trust (“CRAT”). A CRAT has the advantage of a guaranteed payment, regardless of the actual rate of return realized on the investment of the trust assets. However, the Grantor will not benefit from any increase in value of the trust assets during the Grantor’s lifetime.

A CRT which provides for a payment based on a fixed percentage of the asset value is known as a Charitable Remainder Unitrust (“CRUT”). The assets of the CRUT are valued each year to determine the payments to be made to the Grantor for that year.

Under an alternate version of the CRUT, the payment to the Grantor will be the lesser of the net income or the fixed percentage amount. Such a CRUT can (and usually does) provide that if the payment to the Grantor for any year is less than the fixed percentage amount because the actual income is less, this undistributed amount will be paid to the Grantor in any later year if the actual net income of the trust for such later year is greater than the fixed percentage amount. This type of CRUT is known as a Net Income With Makeup CRUT (also called a “NIMCRUT”).

As a result of Regulations issued by the IRS, there is another alternative which is also available. This CRT is often referred to as a “FLIP Unitrust,” and starts out as a NIMCRUT (usually because the trust holds an asset which is to be sold and does not currently generate much, if any, income), then converts to a standard Unitrust at some future date or event (such as the sale of the asset).

Income Tax Consequences of a CRT

The following tax benefits are available for any CRT which qualifies under the provisions of the Internal Revenue Code. In order to qualify, one significant requirement is that the present value of the remainder interest (determined at the time the trust is created or when assets are added to the trust) must be at least 10% of the value of the CRT assets. In addition, the payment to the non-charitable beneficiary cannot be less than 5% nor more than 50% of the trust assets as determined each year (although a 50% distribution would almost always violate the 10% minimum charitable value rule anyway).

Income tax deduction. Upon the creation of a CRT, the Grantor is making a gift of a remainder interest to charity with respect to the assets transferred to the CRT. The Grantor is permitted to take a current income tax deduction equal to the present value of such remainder interest. The deduction is determined by valuation tables provided by the IRS, based on (i) the age of the Grantor when the CRT is created, and (ii) the discount interest rate currently allowedfor determining such values (this rate changes each month, but the Grantor is permitted to use the rate for the current month or either of the two months prior to the creation of the CRT).

As with all charitable income tax deductions, there may be a limit on the amount which can be claimed for a particular year, based on the total gross income of the Grantor for such year and the type of asset contributed. Usually, any amount which cannot be used in the year the CRT is created may be used (subject to the same annual limitations) in any of the next five taxable years.

CRT as a tax-exempt entity. A CRT is a tax-exempt entity for income tax purposes. Therefore, if a CRT sells an appreciated asset, there is no capital gain reportable by the CRT. In addition, the CRT is not taxed on any other type of income generated within the CRT. This is one of the most significant tax advantages of a CRT.

For example, if a person has an asset currently worth $1,000,000, and the person originally paid $100,000 to acquire the asset, the asset has appreciation of $900,000. If the person sells the asset, the person will have capital gain of $900,000 and, at a capital gain tax rate of 25% (federal and state), will pay $225,000 in income taxes, leaving only $775,000 to be reinvested. If the same person transfers the asset to a CRT and the Trustee of the CRT sells the asset, no capital gain is recognized, and the full $1,000,000 can be reinvested for the person’s benefit.

It is important that the appreciated asset not be “sold” prior to the date it is transferred to the CRT, with the Trustee of the CRT simply carrying out the terms of the sale. In order to realize the tax benefits described above, the Trustee of the CRT must be free to sell or retain the appreciated asset after it is transferred to the CRT by the Grantor.

Taxation of Distributions to Grantor. Although the transactions within a CRT are not subject to income tax, any distribution to the Grantor will be taxable to the extent it represents taxable income generated within the CRT. In determining the taxability of distributions to the Grantor, each distribution is characterized based on the following priority:

  • First, the distribution is treated as ordinary income (such as interest and dividends) to the extent the CRT has ordinary income for the current year, or undistributed ordinary income from prior years.
  • Second, the distribution is treated as capital gain to the extent the CRT has any capital gain for the current year, or undistributed capital gain from prior years.
  • Third, as other income (which includes any tax-exempt income such as municipal bond interest).
  • Fourth, as principal.

This priority system is important with respect to any capital gain which is not recognized by the CRT at the time an appreciated asset is sold. Such capital gain may later be recognized by the Grantor when subsequent distributions are made to the Grantor from the CRT. Even if the CRT invests the sale proceeds only in assets which generate tax-exempt interest income, the subsequent distributions to the Grantor each year will be taxable until all of the previously unused capital gain has been distributed. However, if the CRT has current income (other than tax-exempt income) which is equal to or greater than the annual distribution to the Grantor, the prior capital gain will not be recognized.

Estate Tax Consequences of CRT

Because the assets of the CRT pass to charity at the death of the Grantor, there will be no estate tax paid on the assets of the CRT at the Grantor’s death. Therefore, the estate tax benefit is the same as if the Grantor makes a bequest to charity in his/her Will (or Revocable Trust).

Tax Consequences if Another Beneficiary is Named

If anyone other than the Grantor or the Grantor’s spouse is the “income” beneficiary of the CRT, there can be gift and/or estate tax consequences upon the creation of the CRT (or upon the death of the Grantor, if the “income” interest continues for the other beneficiary). For example, if the CRT is originally created for the benefit of the Grantor’s children (or other family members), the Grantor is making a taxable gift at the time the CRT is created, basically equal to the present value of the payments to be made to the non-charitable beneficiaries during the existence of the CRT.

Impact on Family

Because the assets of the CRT will pass to charity upon the Grantor’s death, the assets will not be available for the benefit of the Grantor’s family. Because of this, a CRT is most beneficial to a Grantor who otherwise wants some or all of his/her estate to pass to charity at his/her death. However, even for a Grantor who desires his/her estate to pass to family members at death, a CRT may be a useful technique if the Grantor wants to benefit both family and charity. The CRT should probably not be considered by anyone who has no interest in providing a benefit to charity.

Remember that, if a CRT is created, the assets passing to the Grantor’s family are not being reduced by the full value of the asset transferred to the CRT, but only by the value which would pass to the family after the estate tax is imposed at the Grantor’s death.

Benefit of income tax deduction. The immediate income tax deduction available to the Grantor of a CRT may mean that the Grantor will have more assets at death to pass to family members (because the estate is not depleted by the income taxes which are saved).

Benefit of avoiding capital gain. Because the CRT avoids (or at least postpones) the capital gain tax on the sale of an appreciated asset, the entire proceeds from the sale will be reinvested for the Grantor’s benefit. Therefore, the annual distributions to the Grantor from a CRT are usually higher than the amounts which would otherwise be realized if the appreciated asset was simply sold, and the Grantor invested the proceeds reduced by the income tax on the capital gain. To the extent the Grantor does not consume this excess cash flow, the additional amount will increase the estate which will eventually pass to the Grantor’s family.

Using life insurance to replace value to family. The Grantor may acquire a life insurance policy which will provide a death benefit to the family equal to (or even greater than) what the family would have received at the Grantor’s death if the CRT was not created. The best way to acquire such a policy would be for (i) the family members to own the policy or (ii) the policy to be purchased through an irrevocable insurance trust (so that the policy proceeds would not themselves be subject to estate tax at the Grantor’s death).

The Grantor can pay for part or all of the insurance premiums with (i) the income tax savings caused by the creation of the CRT, and (ii) the increased cash flow available to the Grantor following the sale and reinvestment of an appreciated asset within the CRT.

Self-Dealing Rules

When creating a CRT, it is important to remember that most transactions between the CRT and “disqualified persons” are prohibited by federal tax law. A disqualified person is the Grantor of the CRT and the Grantor’s immediate family members (and entities owned by such persons). For example, a disqualified person would not be allowed to sell assets to or purchase assets from the CRT, and a disqualified person may not rent the assets of the CRT (such as eal property). Specifically, the Grantor of the CRT and any family member may not continue to live in any residential property held in the CRT, regardless of whether or not fair market rent is paid for the use of the property.


A Dynasty Trust is an irrevocable trust designed to allow its creator to pass wealth from generation to generation without the burden of transfer taxes, including estate tax and generation-skipping transfer (GST) tax.

  • A Dynasty Trust is designed to maximize a person’s gift and GST tax exemptions for as many generations as applicable state law permits1.
  • A Dynasty Trust may be drafted so that the assets of the trust should not be subject to creditor or divorce claims against a beneficiary.
  • A Dynasty Trust is designed to receive gifts2 from the grantor or to borrow funds from the grantor to make investments on behalf of the beneficiaries. The Trustee will use the trust assets for the benefit of the beneficiaries during their lifetimes.
  • A Dynasty Trust could contain special provisions that qualify it as a “grantor trust” for income tax purposes without causing its assets to be included in the grantor’s taxable estate at death.
  • As a result, although assets transferred to a Dynasty Trust, and all appreciation of those assets, will be removed from the grantor’s estate for estate tax purposes, the grantor will still be taxed on the income generated by the Dynasty Trust’s assets.
  • A Dynasty Trust Could Allow Successive Generations of Descendants to Access Wealth Without Transfer Taxes.
    • NOTE: The grantor should consider creating the trust under the laws of a state which has no limit on the length of time assets may remain in trust.
    • NOTE: Sufficient GST tax exemption must be allocated to the trust to ensure the assets are not subject to the GST tax.
  • Assets of the Dynasty Trust Appreciate Outside of the Taxable Estate.
    • NOTE: Appreciating assets are attractive candidates to be gifted to a Dynasty Trust. The assets transferred and all appreciation of those assets should pass free of transfer taxes.
    • In addition, the Trustee can use the Dynasty Trust and cash generated by the assets transferred to it (or funds lent to the Dynasty Trust by the grantor in the future) to make investments in new ventures for descendants or to purchase life insurance on the life of the grantor.
  • Income Tax Payments Should Not Constitute Gifts. As the “grantor” of the Dynasty Trust for income tax purposes, the grantor will pay the income taxes related to the income generated by the assets of the Dynasty Trust. The income tax payments:
    • Should not constitute gifts by the grantor for gift tax purposes; and
    • Should reduce the amount of wealth subject to estate taxes when the grantor dies.
  • Grantor Trust Status May Be “Turned Off.” A “Special Trustee” may be given the power to amend the Dynasty Trust so that the grantor is no longer taxed on the income from the assets of the Dynasty Trust.
    • NOTE: The Special Trustee provisions also provide flexibility to accommodate certain changes in the tax laws and family circumstances.
  • Risks of Using a Dynasty Trust:
    • A Dynasty Trust is an irrevocable trust the terms of which may not be amended by the grantor.
    • Gifts to a Dynasty Trust cannot be reacquired.

Generally, there are three ways to move assets into a Dynasty Trust: (i) Gift; (ii) Loan and/or (iii) Sale.

  • Gifts to a Dynasty Trust. A grantor may make a gift to a Dynasty Trust in an amount up to the grantor’s remaining lifetime gift tax exemption without paying any gift tax.3
    • In 2013, a grantor could gift up to $5,250,0004 to a Dynasty Trust without paying any gift tax.
    • Alternatively, a grantor could also make annual gifts to the trust using his or her annual gift tax exclusion (currently $14,000 per beneficiary of the Dynasty Trust).
  • Loans to a Dynasty Trust. A grantor may make loans to a Dynasty Trust.
    • Such loans could be used to fund life insurance premiums or could allow the trust to make investments in new ventures.
    • The IRS requires interest to be paid on these loans. For example, the June mid-term Applicable Federal Rate is 0.95% for a 9 year loan.
  • Sale to a Dynasty Trust. A grantor may sell assets to a Dynasty Trust in exchange for a promissory note.
    • Appreciation on the assets sold to the trust in excess of the interest rate payable on the note should escape transfer taxes.
    • The promissory note could be structured so as to provide flexibility to accommodate the actual financial performance of the assets transferred to the trust.
    • No capital gains should be due on the sale because the transaction is disregarded for income tax purposes.
  • Creating a Dynasty Trust and transferring assets to it involves complex financial, legal, tax, and other considerations. Please consult with tax and legal counsel before proceeding.
  • In addition, a Dynasty Trust is an irrevocable trust and therefore cannot be changed or revoked by the grantor after it is created.

For purposes of this example, we have made the following assumptions:

  • Husband and Wife and each 50 years old and have a net worth of approximately $20,000,000 and have one Child.
  • Husband and Wife each have a $5,250,000 gift tax exemption and $5,250,000 GST exemption.
  • Existing estate plan distributes assets outright to Child at the death of the surviving spouse.
  • The estate tax is 40%.

Do nothing, at the death of the surviving spouse the estate passes as follows:

  • $3,800,000 [20,000,000 – 10,500,000 = 9,500,000 * 40% = 3,800,000] to the IRS; and
  • $16,200,000 [20,000,000 – 9,800,000 = 16,200,000] to Child.
  • Child lives 30 more years with assets growing at 4%.
  • At Child’s death:
    • $18,917,215 [52,543,040 – 5,250,0005 = 47,293,040 * 40% = 18,917,215] of estate tax is due, leaving $33,625,825 [52,543,040 – 18,917,215 = 33,625,825] to grandchildren.
  • Total estate taxes paid: $22,717,215 [3,800,000 + 18,917,215 = 22,717,215]

Create a Dynasty Trust; Fund it with lifetime gift tax exemption; Buy second-to-die life insurance

  • Husband and Wife create a Dynasty Trust and make a $10,500,000 gift to the trust. GST exemption is allocated to 100% of the gift.
  • The Trustee of the Dynasty Trust purchases $5,000,000 of second-to-die life insurance with annual premiums of $27,000 and Husband and Wife live an additional 15 years.
  • At the death of the surviving spouse6, the estate passes as follows:
    • $3,800,000 [9,500,000 * 40% = 3,800,000] to the IRS;
    • $5,700,000 [9,500,000 – 3,800,000 = 5,700,000] to a non-GST trust for Child; and
    • $15,500,000 [10,500,000 – 405,000 + 5,000,000 = 15,095,000] in Dynasty Trust for Child.
  • Child lives 30 more years with assets growing at 4%.
  • At Child’s death:
    • Assets in the non-GST trust have grown to $18,487,366.
    • Child has a $5,250,000 exemption.
    • The non-GST trust triggers estate tax of $5,294,946, leaving $13,192,419 to grandchildren for the non-GST trust
    • However, $48,959,085 passes to grandchildren free from estate tax or GST tax in the Dynasty Trust.
    • This planning resulted in estate taxes savings of $13,622,270 and $28,525,681 additional assets being transferred to grandchildren.

Circular 230 Disclosure: In compliance with requirements imposed by the IRS pursuant to IRS Circular 230, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

  1. Under the laws of many states, the duration of trusts is limited so that the assets of the trust must be distributed from the trust within a period measured by a life or lives in being (alive at the creation of the trust) plus 21 years (typically 90 years). However, many states have enacted laws that eliminate or modify this rule and permit trusts that continue for very long periods, including trusts that may continue forever.
  2. For GST tax purposes, the grantor must apply his or her GST tax exemption to 100% of the gifts (both lifetime and annual exclusion).
  3. The grantor should ensure he or she allocates sufficient GST to cover 100% of the gift(s).
  4. Less any taxable gifts made during life.
  5. This ignores the inflationary adjustment to the estate tax exemption.
  6. For the purposes of this example we have the assets of Husband and Wife have not appreciated.

Proper risk management for business owners involves making sure that in the event of an untimely death and/or disability of an owner; arrangements are in place to protect the interests of surviving owners and the deceased owner’s heirs. An untimely death of an owner without proper buyout agreements and funding sources present unique planning challenges for both the heirs of the deceased owner and the business itself. These could include the following:

  • Who will purchase the business interest?
  • Are the surviving owners willing to share ownership with the deceased owner’s spouse and/or heirs?
  • Are the surviving spouse and/or children of the deceased owner comfortable being dependent on the surviving owners for their income?
  • What is a fair buyout price of the deceased owner’s interest?
  • When and how is the sale to be made?
  • What is the funding source of the buyout and what impact will it have on future cash flow/operations of the business?
  • How will the death of an owner impact the future revenue and/or credit quality of the business?
  • Are the unique skills and/or responsibilities of the deceased able to be fulfilled by the surviving owners? If not, how will the business be impacted by and fund the costs to find and hire a replacement?

These challenges can often be resolved, or prevented, with a properly drafted buy-sell agreement funded with a well-structured life insurance program.

A buy-sell agreement is a legal document obligating one party to buy and another to sell the interests of a business upon the occurrence of certain triggering events. The most common triggering events include death, disability and retirement but the agreement can also be structured to address divorce or bankruptcy of an owner. In the case of death, for example, it will assure that someone (i.e. the business itself, surviving owners a key employee, etc.) will be obligated to buy the interests of the deceased owner and the estate of the deceased owner will be obligated to sell his or her interests to the acquiring party. This type of planning can create certainty in otherwise tumultuous times.

The benefits of a properly drafted buy sell agreement upon death of an owner include:
  • Creates a market for closely held business interests, which may be difficult to dispose of by other means because, often times, no readily available market exists.
  • Provides for the orderly transfer of the deceased owner’s interest according to the terms of the agreement that are agreed upon by the respective parties when calmer heads exist.
  • Minimizes the risk that ownership interests could fall into the hands of inexperienced and/or unwilling outsiders.
  • Establishes a value for the business to ensure the surviving heirs of the decease receive the full fair market value and reduces the risk of a post-mortem valuation disputes.
  • Fixes the value of the business for estate tax purposes (assuming certain requirements are satisfied).
The benefits of a buy-sell agreement with permanent life insurance on the lives of each owner include:

Ensures the funding is available at the time it is needed (the event that creates the liability (at death) is also the event that triggers the funding (death benefit)).

Ensures the estate of the deceased a liquidity source to convert an illiquid asset to cash.

A cost effective way to fund the buy-out as the death benefit is typically far in excess of the premiums paid.

Helps hedge against “mortality risk” of an early death where the funds needed to buy out the deceased may not yet be available through traditional savings techniques.

Provides flexibility with tax-deferred policy cash values that can be accessed income tax free if circumstances change, (e.g. – disability, down payment on a lifetime buy out, supplemental retirement income or funding future business projects).

Additionally, coverage above and beyond the actual buyout price can be acquired to provide additional protection to the business to cover any additional costs resulting from the death of an owner, such as lost revenue and/or clientele, diminished credit standing, expenses related to hiring a replacement, etc. (i.e. – key man coverage).

Most common types of buy sell agreements:

Cross purchase: The agreement is between the owners themselves where each agrees to buy out the interests of the other. Life insurance is typically purchased by each owner on the life, or lives, of the other(s) to provide the necessary funding at death based on the value of each owner’s respective interests. The purchase price can be set in one of two ways: A fixed amount stated in the agreement or a formula by which a definite price can be established.

Entity purchase: The agreement is between the business itself and each respective owner individually where the business agrees to redeem, or repurchase, the interests of each owner. Life insurance is typically purchased by the business on the lives of each owner to provide the necessary funding at death based on the value of each owner’s respective interests. Similarly, the purchase price can be set in one of two ways: A fixed amount or a formula.

Benefits of a limited liability company (LLC) entity purchase arrangement with life insurance

Using a newly formed LLC to serve as the purchasing party in an entity purchase buy-sell arrangement can offer some unique planning opportunities.

One Policy per Owner with Cost Allocated Based on Ownership, Not Age/Health: Because an entity purchase agreement results in a one-way transaction between the LLC and the deceased owner’s estate, only one policy per owner is needed. The LLC will be the owner and beneficiary of a life insurance policy on the life of each owner. This simplifies the life insurance ownership structure particularly when there are more than two owners. For example, in a business with three owners, typically six policies would be purchased; however, in an LLC structure, only three policies would be required. Additionally, the LLC will pay the premiums with after tax earnings on which the members have paid taxes on in proportion to their ownership interest. This proportional allocation of taxes on the premiums can help equalize the cost of the life insurance between all owners based on their respective ownership interest which can be particularly attractive if the ages and/or health status of the owners vary dramatically resulting in varying amounts of premium expense per 1,000 of coverage.

Full Step Up in Basis for Surviving Owners: LLCs are “passthrough” entities regarding the taxation of its earnings. That is, all items of LLC income and loss pass through to the owners individually for tax purposes who then pay the taxes on the earnings regardless of whether distributed. All earnings of the LLC, then, increase the owner’s basis in the LLC and the character of taxation on those earnings flows through to the owners individually as well. Therefore, earnings from the receipt of life insurance proceeds should increase the basis in the LLC in proportion to a member’s ownership interest and the income tax free character of those proceeds should be maintained as they flow through for tax purposes.

Furthermore, due to the fact that special allocations can be made to the capital accounts inside the LLC (subject to certain requirements), a properly drafted operating agreement can allocate the earnings from receipt of life insurance proceeds following the death of an owner to the surviving owners’ capital accounts so that they can realize a full step up in basis on the value of interests redeemed from the deceased. The LLC will uses the life insurance proceeds to redeem the interests of the deceased owner whose heirs will also receive a step up in basis to the value of his or her interests at death under current transfer tax law (IRC Section 1014(a)).

Supplemental Retirement Income: LLCs also can enjoy favorable income tax treatment on the transfer of life insurance policy ownership from the entity to the insured owner. This transfer would simply reduce the owner’s capital account and, hence, his or her basis in the LLC, but there would be no deemed compensation to him or her and the LLC itself would not have to recognize gain in the policy. Once the transfer is complete, the owner could then take income tax-free withdrawals and loans from the policy to supplement retirement income. Note that a transfer to the insured would qualify as an exception to the transfer for values rules. Alternatively, the owner could leave ownership of the policy with the LLC which could take withdrawals and loans from the policy and, in turn, make tax-free distributions to the owner assuming his or her capital account is sufficient to characterize the distributions as reductions in basis.

This alternative approach could be appealing in situations involving large face amounts and/or where the insured’s personal net worth is large enough to result in an estate tax exposure. When an individual has incidents of ownership over a policy on his or her life, the death benefit proceeds are includible in his or her estate and subject to estate taxes, which could exacerbate the estate’s settlement costs. An LLC as the policy owner and beneficiary can exclude the death benefit proceeds from the estate of the deceased insured while still allowing for access to cash values as described above, assuming certain requirements are met. To do so, it is critical that the operating agreement is written accordingly so that the insured is not considered to have any incidents of ownership under IRC Section 2042 over the policy on his or her life that is owned by the LLC. In other words, the operating agreement must specifically prohibit the insured Members from voting on any matter relating to any life insurance policy owned by the LLC. For example, a special Manager can be appointed for the sole purpose of exercising any and all incidents of ownership with respect to the policy(ies).  his special Manager can be removed and replaced by majority vote of the Members if necessary.

Although the death benefit should be excluded from the deceased insured’s estate, the value of the deceased’s LLC interest, which appears to be based on his or her capital account in the LLC, is includible in the estate. See Private Letter Ruling 200747002 for additional information regarding the considerations associated with this technique.

Creditor Protection: Assets owned by the LLC are subject only the claims of the LLC’s creditors and not to personal creditors of the insureds. There may be additional creditor protection characteristics pertaining specifically to the life insurance policy itself based on the statutes of the state of issue.

IRS Required Statement: Pursuant to U.S. Treasury Department Regulations, we are required to advise you that, unless otherwise expressly stated, any federal tax advice contained in this communication, including attachments and enclosures, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any taxrelated matters addressed herein.