When the Life Insurance Gift Becomes a Beautiful Gesture
October 28, 2015 by Louis S. Shuntich, J.D., LL.M.
The French phrase “beau geste,” or beautiful gesture, was the basis for P.C. Wren’s 1924 novel Beau Geste about the decent thing to do. It also describes the opportunity presented to those who have life insurance that they no longer want and may want to give to others in greater need.
The extent of that opportunity is demonstrated in a 2008 survey by the Life Insurance Settlement Association, which showed that Americans age 65 and older give up around $112 billion in life insurance benefits each year by surrendering their policies or letting them lapse. This may be due to a number of reasons, including that the insured:
» Owns a policy purchased for them when they were a child, but it is no longer needed.
» Bought the policy in connection with a business that no longer exists.
» Has retired and no longer needs to insure income.
» Purchased a policy with a beneficiary who has predeceased them.
» Purchased a policy as a source of supplemental retirement income that is no longer needed.
» Has other life insurance policies and is now overinsured.
» Is subject to changes in tax law making the policy’s original purpose obsolete.
GIFTING THE POLICY
While the insured might consider giving the policy to a charity, a more likely recipient would be an adult child with a family of their own and a need for cash to buy a home or to pay college tuition. Certainly, the insured could simply name the child as a beneficiary and let them wait to receive the death benefit. But if the policy has a substantial cash value, it could be used to meet the child’s current need for funds.
One of those needs might be for the child to use the gifted policy’s cash value to acquire coverage on their own life. To accomplish that, the child could surrender the gifted policy and use the cash value to buy a new policy, or they might do an exchange with an insurer for a new policy on their life. If the child took the exchange route, the transaction would not qualify as a tax-free exchange under the Internal Revenue Code, since the insured under the old and the new policies would not be the same. This means that if there were any gain in the old contract, it would result in taxable income to the child. Similarly, if the child simply surrendered the old contract for its cash value, they would have to recognize taxable income if there were gains in the old contract.
AVOIDING THE ESTATE TAX
A point worth noting when considering whether to keep or gift a policy is that by retaining ownership of the policy, the insured will cause the death proceeds to be included in their gross estate. This means that if the insured’s gross estate, including the death proceeds, exceeds the federal estate tax applicable exclusion ($5.43 million in 2015), it could generate an estate tax liability. However, when the policy is gifted to the child or to a trust for the child’s benefit, the estate tax would be avoided providing that the insured lives for more than three years after the gift was made.
GIFT TO AN IRREVOCABLE LIFE INSURANCE TRUST
That raises the question of why the insured might consider making the gift of the policy to a trust instead of directly to the child. The answer is that a trust would give the insured greater certainty as to how the funds would be used. This might be important if the child is not good at handling money and the insured knows someone who can act as a trustee to apply the policy’s cash values or death proceeds wisely on the child’s behalf.
THE GIFT TAX
When making a gift to the child or to a trust for the child’s benefit, the insured must consider gift tax exposure. The extent of that exposure depends on the fair market value (FMV) of the policy at the time of the gift, according to U.S. Treasury Department regulations. For newly issued policies, the FMV is the cost of the policy. In the case of single-premium or paid-up contracts, the FMV is the single premium that the issuing company would charge for a comparable contract. Finally, for premium-paying policies, the FMV is the interpolated terminal reserve plus unearned premiums. In any case, ask the issuing company for an Internal Revenue Service Form 712, on which the company will report the gift value.
The good news is that, in making a gift of the policy, the insured may offset the amount of the gift with their gift tax annual exclusion of $14,000 in 2015 ($28,000 if they are married and elect to split the gift with their spouse). Further, to the extent that the amount of the gift exceeds the insured’s annual exclusion, it will be offset by the insured’s gift tax applicable exclusion of $5.43 million in 2015.
TRANSFER FOR VALUE
One word of caution in making a gift of a policy is to be careful if the policy is subject to a loan. If the loan exceeds the donor’s basis (premiums paid), the transfer will result in taxable income to the donor. Further, if the donee keeps the policy until the donor dies, the death proceeds will be subject to the transfer for value rule. That would make the death proceeds subject to income tax to the extent that they exceed the donee’s basis in the contract. To avoid this problem, if there is a loan on the policy, the donor should pay down the loan so that it is less than premiums paid before making the gift to the donee.
WEALTH REPLACEMENT TRUST
Another possible use for a surplus policy would be to fund a wealth replacement trust. This would be the case where the insured has made or wants to make a substantial gift to charity but is concerned that the gift would leave family members feeling deprived of their inheritance. To deal with that problem, the insured could set up an irrevocable life insurance trust and transfer the policy to the trust. That way, when the insured dies, the trustee can collect the death proceeds and use them for the benefit of the family according to the terms of the trust.
TERMINATING A CROSS-PURCHASE BUY-AND-SELL
Life insurance that is acquired to fund a cross-purchase buy-and-sell agreement may also be a candidate for transfer upon termination of that agreement for reasons such as the termination of the business or its sale to an outsider. In such cases, the policy likely will be transferred to the insured for use as personal coverage. Of course, the ownership of the policy by the insured will cause the death proceeds to be included in the insured’s gross estate for federal estate tax purposes. As previously noted, however, that problem may be avoided by having the insured transfer the policy to a family member or a trust providing that they live for more than three years after the transfer. In any case, the transfer for value rule will not be a problem because the transfer is to the insured and that is one of the exceptions to the application of the rule.
TRANSFERRING A CORPORATE POLICY
There are a couple of situations in which a company might want to transfer a corporate-owned policy to the insured. Here are some examples.
A company may acquire a key person policy and want to transfer it to the insured at retirement. This could be a reward for service to the company and may be useful to the insured as a supplemental retirement benefit if it involves a cash value policy.
A corporation may purchase a policy on a shareholder to fund an entity purchase buy-and-sell agreement and then be sold to an outsider, making the buy-and-sell funding unnecessary.
In either of these situations, the policy might be useful to the insured for family financial security or for estate planning purposes. The good news is that, while the distribution of the policy may be taxable income to the insured to the extent of the policy’s fair market value, the death benefit will not be subject to the transfer for value rule because the transfer is to the insured.
MAKING A CLEAN BREAK
As a part of the process of helping your client see the advantages of transferring their policy, you should make sure to explain that only the new owner:
- Will receive any correspondence from the insurer about the policy.
- Can request any policy changes.
- Will receive any funds as a benefit under the contract.
The meaning of the French phrase “beau geste” carries with it the notion that the gesture, while beautiful, is accompanied by unwelcome or futile consequences. Certainly, that kind of result appears in Wren’s novel, but it is unlikely to occur with your client’s gift of their policy. Moreover, the meaning of the gift will be enhanced by your client living to see the benefits of their generosity, which makes the gesture all the more beautiful.
Originally Posted at InsuranceNewsNet Magazine on October 2015 by Louis S. Shuntich, J.D., LL.M..
Categories: Industry Articles
