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of policies have evolved, such as Universal Life and Variable Life, which have been difficult to reconcile with the outdated Internal Revenue Service (“IRS”) guidelines for valuation.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:

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), trustsandestates.com.
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), www.leimbergservices.com

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.

DYNASTY TRUST

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.

BRIEF DESCRIPTION OF A DYNASTY TRUST

• A Dynasty Trust is designed to maximize a person’s gift and GST tax exemptions for as many generations as applicable state law permits^1.
• 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.

POTENTIAL BENEFITS OF A DYNASTY TRUST

• 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.

FUNDING A DYNASTY TRUST

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.

PLANNING CONSIDERATIONS

• 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.

EXAMPLE – USING LIFE INSURANCE TO LEVERAGE A GRANTOR’S GST TAX EXEMPTION

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.