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PERSONAL INCOME TAX PLANNING

James F. Ivers III

What Was the Situation Before?

Insurance companies and policyowners faced a dilemma regarding the income tax treatment of long-term care insurance. Although there was existing authority to indicate that such insurance should be treated as health insurance under the income tax laws, the IRS refused to rule on the issue and the answer was uncertain. Were premiums deductible? Were benefits taxable?

What Is the Nature of the Change?

Long-term care insurance contracts issued after 1996 will generally be treated as health insurance under the income tax laws. There are special rules limiting tax-favored benefits, deductibility of premiums, applications of coverage in employer plans, and various policy features. There is the usual myriad of definitions and qualifications. Many of the rules apply more to policy design than to placement in the field. The following planning tips may be helpful to the financial services professional who is involved with placing long-term care coverage.

Exclusion for Benefits. Perhaps the most welcome part of this area of the 1996 tax legislation is the income tax exclusion for benefits payable under qualified long-term care policies. "Pure" indemnity-type contracts are eligible for an unlimited exclusion for benefits. Contracts providing per diem benefits are eligible for an exclusion of up to $175 per day, or a greater amount if actual expenses exceed $175 per day.

The exclusion basically eliminates the dilemma previously facing insurance companies as to whether (or how) to issue a Form 1099 when benefits are paid from a long-term care policy. The law provides certainty for payers who are required to file information returns for long-term care benefits paid to individuals.

Deductibility of Premiums. Long-term care premiums are now treated as deductible medical expenses under IRC Sec. 213(d). However, the law imposes special dollar limits for deductibility of long-term care premiums, ranging from $200 to $2,500 per year per covered individual, based on age. Remember that clients still generally face the 7.5 percent of adjusted gross income "floor" with respect to the deductibility of these premiums. Unless income is low or total medical expenses are high, all or a part of the deduction for the premiums is likely to be lost "under the floor." If the client is self-employed, however, a different situation occurs (see below). The special limitations on deductibility of premiums are shown in the following table.

Notice that there is a substantial increase in deductible premium between age 60 and 61. Also, because the dollar limits apply per covered individual, a married couple filing a joint return could buy two policies (thus covering each spouse), and the limits would apply separately to each policy. Finally, long-term care expenses are added to other deductible medical expenses for purposes of applying the 7.5 percent "floor" for deductibility of medical expenses. Medical expenses paid for the care of the taxpayer, his or her spouse, or dependents (without regard to the gross income test under the dependency exemption rules) are eligible for deductibility under Sec. 213.

Exchanges Involving Long-Term Care Contracts. The law provides that until January 1, 1998, long-term care contracts may be exchanged without causing a taxable event. This is essentially the equivalent of a Sec. 1035 exchange. A special rule allows a 60-day grace period for reinvesting any proceeds received upon cancellation of an old contract. This provision has limited applicability since most long-term care policies have no cash value and therefore no untaxed gain.

Effective Date Provisions. Generally the new rules apply to contracts issued after December 31, 1996. However, any contract that met the long-term care requirements of the state in which the contract was "sitused" at the time of issuance will be eligible for treatment under the new law. What does "state in which the contract was sitused" mean? The most likely meaning is the state in which the contract was placed (sold). Most existing contracts should be grandfathered under this provision.

Cafeteria Plans. A disappointing aspect of the new law is that long-term care benefits cannot be used in a cafeteria plan arrangement. With respect to employer-provided insurance coverage, stand-alone coverage only will be possible. Employees will not be able to choose between long-term care insurance and other benefits. For income tax purposes, however, no nondiscrimination rules apply to insured long-term care plans, since they are treated the same way as health plans.

Flexible Spending Accounts (FSAs). Long-term care benefits cannot be provided through a flexible spending account. This means that any portion of long-term care insurance premiums paid by employees will be subject to the 7.5 percent floor for deductibility, rather than payable on a before-tax basis by means of an FSA.

How Does This Change Affect Your Clients?

Long-term care insurance will now be perceived as a "legitimate" product because of the governmental imprimatur of tax-favored treatment. It always was, of course, a legitimate product. But now more people will perceive it that way, and that is good. Long-term care insurance will also serve as a vehicle to introduce many new clients to the products and services offered by versatile financial planning professionals.

What Should Be Done?

The correlation of the tax treatment of long-term care insurance and the "above-the-line" deduction for health insurance premiums of self-employed taxpayers should also be considered.

Under 1996 legislation, the partial "above-the-line" deduction for health insurance premiums of a self-employed taxpayer will be increased. For 1996 that deduction is 30 percent of such premiums paid. The allowable percentage will be increased as shown in the following table:

An "above-the-line" deduction is one taken from gross income in determining adjusted gross income, rather than one taken as an itemized deduction. Most medical expenses are deducted as itemized or "below-the-line" deductions subject to the 7.5 percent floor.

Note that long-term care insurance premiums are eligible for the "above-the-line" deduction for self-employed taxpayers!

Implications for Taxpayers with Self-Employment Income. A self-employed taxpayer for purposes of the above-the-line deduction includes a sole proprietor, a partner in a partnership, and a more-than-2 percent shareholder in an S corporation. Unlike employer-provided medical expense insurance, long-term care insurance premiums are typically paid substantially or in full from the covered individual’s own funds, even under an employer-sponsored plan. Since FSAs cannot be used to fund such premiums, "employees" are facing the 7.5 percent "floor" for any premiums they pay, inside or outside a group plan, because the deduction for premiums is taken as an itemized deduction on Schedule A of Form 1040. But self-employed taxpayers can use the above-the-line deduction, which places them in a significantly better position to pay for long-term care insurance. Presumably anyone who files a Schedule C with Form 1040 can claim the above-the-line deduction, including "statutory employees" and part-time sole proprietors (moonlighters).

Example: Chuck Hughes, aged 62, is retired from full-time employment, and he has begun distributions from his retirement plan. He supplements his income with a small consulting practice currently earning $22,000 annually. Chuck purchases a long-term care policy with an annual premium of $1,950. In 1997 he can deduct 40  percent of the premium above the line, or $780. By 2006 he will be able to deduct 80 percent of the premium as long as he continues to earn income from self-employment.

Can individuals who are already covered by subsidized medical insurance plans and who also buy long-term care coverage with their own funds claim the above-the-line deduction? Consider the restriction on the use of the above-the-line deduction under IRC Sec. 162 (l)(2)(B):

Other coverage: Paragraph (1) shall not apply to any taxpayer for any calendar month for which the taxpayer is eligible to participate in any subsidized health plan maintained by any employer of the taxpayer or of the spouse of the taxpayer.

Does this provision disallow the above-the-line deduction for taxpayers who have medical insurance at their full-time job, but who file a Schedule C with Form 1040 and buy their own long-term care policy? This was not the original intent of the provision. It was meant to prevent self-employed taxpayers who had access to subsidized medical insurance from using the above-the-line deduction for their share of the premium payments. However, Sec. 162(l)(2)(B) could be interpreted to mean that taxpayers who are covered by subsidized medical insurance provided by their employers will not be able to claim the above-the-line deduction for personally paid long-term care policies, even though they have self-employment income.

Where Can I Find Out More?

• HS 321 Income Taxation. The American College.
• Stephan R. Leimberg, James F. Ivers III, Martin J. Satinsky, Eric Johnson, and John J. McFadden. Federal Income Tax Law, 1997 ed. RIA Group, New York.
• IRC Sec. 7702B.
• IRC Sec. 213(a), 213(d).
• IRC Sec. 162(e).

What Was the Situation Before?

In 1992 the IRS issued proposed regulations regarding the treatment of certain accelerated death benefits under a life insurance contract. In those regulations, accelerated death benefits paid under a life insurance contract were treated for income tax purposes as amounts paid by reason of the death of the insured, and therefore excludible from gross income under IRC Sec. 101(a)(1), if certain requirements were met. The most important requirement was that the insured be "terminally ill" in order for accelerated benefits to qualify for the income tax exclusion. An insured was considered to be "terminally ill" if he or she had an illness which was reasonably expected to result in death within 12 months of the payment of the benefit. No provision for payments made by viatical settlement providers was included in these proposed regulations. Prior to the issuance of these regulations, there was no income tax exclusion available for accelerated benefits paid under a life insurance policy.

What Is the Nature of the Change?

The Health Reform Act of 1996 added Sec. 101(g) to the Internal Revenue Code, codifying the exclusion for certain accelerated death benefits. This statutory change is effective beginning in 1997 and overrides the previous proposed regulations. The new exclusion follows the philosophy of the 1992 regulations but is different in certain important respects.

Amounts received under a life insurance contract covering the life of an insured who is either terminally or chronically ill will now be excludible if certain requirements are met. Amounts may qualify for the exclusion if paid by either the insurance company that issued the policy or by a licensed viatical settlement provider. However, the exclusion does not apply if the amounts are paid to a taxpayer other than the insured if the insured is a director, officer, or employee of the taxpayer or has a financial interest in a business conducted by the taxpayer.

A viatical settlement provider is defined as one regularly engaged in the business of purchasing life insurance contracts insuring terminally or chronically ill individuals. The provider must be licensed in the state in which the insured resides. If that state has no licensing requirement for viatical providers, certain requirements of the Model Regulations and/or the Viatical Settlement Model Act of the NAIC must be met by the provider.

A terminally ill individual is one who has been certified by a physician as having an illness or condition that can be expected to result in death within 24 months of the date the certification is given.

Example: Alvin is seriously ill. His personal physician believes that he has less than 2 years to live and certifies in writing that his illness can be expected to result in death within 2 years. Alvin owns a life insurance policy on his life, which he assigns to a licensed viatical settlement provider in exchange for a discounted percentage of the death benefit under the policy. Alvin may exclude the full amount he receives for the policy, regardless of his basis in the policy.

A chronically ill individual is one who is unable to perform at least two activities of daily living for at least 90 days. Activities of daily living include eating, toileting, transferring, bathing, dressing, and continence. Individuals suffering from severe cognitive impairment, such as Alzheimer’s and related disorders, are also considered to be chronically ill.

There are additional requirements for the exclusion if the insured is chronically ill rather than terminally ill. In such cases, the benefit must be paid under a rider or provision of the life insurance policy that qualifies as a long-term care insurance contract within the meaning of IRC Sec. 7702B (as discussed in "long-term care"). Therefore a life policy without such a provision or rider can pay excludible accelerated benefits only to a terminally ill insured. This rule prevents pure life insurance contracts from being used as long-term care policies with excludible benefits.

The term chronically ill has the same meaning as that term has for purposes of the new income tax rules applicable to long-term care insurance contracts (except that the term does not include a terminally ill individual). In addition, the rules and limitations applicable to excludible benefits paid from qualified long-term care contracts also generally apply for purposes of the accelerated benefits exclusion.

How Does This Change Affect Your Clients?

It’s important to understand how the new provision covering accelerated benefits differs from the previous regulations. The statute provides an exclusion for benefits paid to chronically ill individuals, and the regulations did not. Therefore persons insured under a life policy with a long-term care rider are in essentially the same income tax position regarding benefits paid in the event of chronic illness as are covered individuals under a separate long-term care policy.

The statute also allows an exclusion for benefits paid by viatical settlement providers, which the regulations did not.

With regard to benefits payable to a terminally ill insured, the statute provides that a physician must certify that the insured can reasonably be expected to die within 24 months. Under the regulations the period of time was 12 months.

The requirement for a physician’s certification raises a couple of questions regarding the exclusion. First, can the physician making the certification be any physician? Apparently the answer is yes. There is no requirement that the physician be independent or be representing any particular party to the transaction. Second, what happens if the physician makes the certification and then the insured lives beyond the 24-month period? The answer is that the law does not address this situation. Therefore it must be presumed that the actual death or survival of the insured after the required certification is immaterial for purposes of the income tax exclusion.

Another question involves the coordination of the exclusion for benefits paid to a chronically ill insured with the income tax rules for long-term care contracts under IRC Sec. 7702B. If benefits paid under a long-term care rider to a life contract are excludible as qualified long-term care payments under that code section, why is an exclusion for benefits paid to chronically ill insureds under IRC Sec. 101 (certain death benefits) also necessary? Do the two provisions taken together constitute statutory surplusage? The answer is no. There are a couple of situations where the Sec. 101 exclusion will apply to chronically ill individuals even though all the requirements of Sec. 7702B are not met. First, Sec. 7702(B) applies only to insurance benefits paid by the insurance company, while Sec. 101(g) also applies to payments made by viatical settlement providers. However, practically speaking, a chronically ill individual with a normal life expectancy will probably not be involved in a viatical settlement. Second, certain policies that combine long-term care and life coverage without a complete segregation of the premium may qualify for the accelerated benefits exclusion for payments to chronically ill individuals under Sec. 101(g) even though such policies may not meet all the requirements of a qualified long-term care policy under Sec. 7702B.

What Should Be Done?

Financial services professionals involved in the placement of life insurance policies that provide for the payment of accelerated benefits must inform their clients of the income tax rules that apply in the event of payment of such benefits. Contracts offering such benefits may be desirable for individuals who are concerned about the cost of a protracted terminal illness, as well as for clients who would like to combine life and long-term care coverage. Generally it will be the responsibility of the insurance company to design contracts that properly qualify for the desired income tax benefits.

Where Can I Find Out More?

• HS 321 Income Taxation. The American College.
• IRC Sec. 101(g).
• IRC Sec. 818(g).
• IRC Sec. 7702B.
• Aaron G. Chambers and Frederic J. Gelfond. "Provisions for the Journey: Accelerated Death Benefits and Viatical Settlements for the Terminally or Chronically Ill," The Insurance Tax Review, February 1997, vol. 12, no. 2.
• Prop. Regs. Secs. 1.101-8, 1.7702-0, 1.7702-2.

What Was the Situation Before?

There was no provision in the income tax law that provided a tax benefit specifically to adoptive parents.

What Is the Nature of the Change?

Beginning in 1997, a tax credit of up to $5,000 per eligible child for qualified adoption expenses will be available to taxpayers who pay such expenses (IRC Sec. 23). A credit of up to $6,000 is available for expenses paid with respect to a child with special needs. The limit on the credit applies to total overall expenses for each child. The credit is phased out for taxpayers with adjusted gross income in excess of specified levels. For tax years in which an adoption becomes final, the taxpayer is allowed to claim the credit for expenses paid during that year. For years in which qualified expenses are paid, but in which the adoption does not become final, the taxpayer must claim the credit for the tax year following the year in which the expenses are paid. Expenses for a foreign adoption qualify for the credit only if the adoption becomes final and may be claimed only in that year.

There is a 5-year carryover period available for taxpayers whose allowable adoption credit exceeds their tax liability for the year the credit is first allowable.

The credit is currently scheduled to be available only for expenses paid until December 31, 2001. After that date the credit will be available only for expenses paid for the adoption of a child with special needs.

How Does This Change Affect Your Clients?

It is important for clients considering adoption or in the process of adoption to understand what expenses qualify for the credit and how the income limitation is applied. Qualified adoption expenses include legal fees, court costs, and other related fees and costs that have the principal purpose of a legal adoption of an eligible child or a child with special needs by the taxpayer. However, costs associated with the adoption of a child of the taxpayer’s spouse are not qualified expenses. Costs for surrogate parenting arrangements are also not qualified expenses. In the case of foreign adoptions only, the adoption must actually be completed in order for the expenses to be eligible for the credit.

An eligible child for purposes of the credit is a person under the age of 18 or one who is physically or mentally incapable of self-care. A child with special needs is defined as a citizen or resident of the United States who is determined by state authorities to be unable to be placed for adoption without adoption assistance. There must be a determination by the state that the child should not be returned to his or her biological parents, and that there is a specific factor or condition that makes the child unable to be placed without adoption assistance.

The allowable amount of the adoption credit is phased out for taxpayers whose adjusted gross income for the year exceeds $75,000. For such taxpayers, the allowable credit is fully phased out when adjusted gross income (AGI) reaches $115,000. Adjusted gross income for this purpose is determined by including the calculation of taxable social security benefits, deductible IRA contributions, and allowable passive activity losses. The foreign earned income exclusion is not taken into account. To determine the amount phased out, the fraction resulting from dividing the amount of the taxpayer’s adjusted gross income in excess of $75,000 by $40,000 is multiplied by the allowable amount of the credit ($5,000 or $6,000).

Example: Jim and Denise Oliver pay $16,000 in legal fees, court costs, and other fees in 1997 to adopt     Michael, a 2-year-old U.S. citizen. The adoption is completed in 1997. Michael is not a special needs child.   The Olivers’ adjusted gross income for 1997 is $100,000. The maximum allowable credit for their cexpenses is $5,000. This $5,000 amount must be reduced by a fraction equal to $25,000 (the amount of AGI in excess of $75,000) divided by $40,000, or 5/8. Therefore, the amount of the allowable credit that is "phased out" is $3,125 ($5,000 x 5/8). The allowable credit is $1,875 ($5,000 – $3,125). The tax credit may be claimed in 1997 because the adoption is completed in that year.

In planning for the adoption credit, it is important to know that there is also an income tax exclusion available for amounts paid by a taxpayer’s employer for qualified adoption expenses on behalf of the taxpayer/employee. Such amounts must be furnished under a nondiscriminatory adoption assistance program. The rules defining and limiting this exclusion for adoption assistance payments are very similar to the rules just described for application of the adoption credit. For example, the dollar amounts of the available exclusion are the same as the dollar amounts of the credit. Any amounts excluded from gross income under such a program are not eligible to be treated as qualified expenses for purposes of the adoption credit.

What Should Be Done?

The adoption credit is the largest of any allowable tax credit for an expense of a personal nature that this writer can recall in the history of the income tax law. For that reason alone, it is significant. In addition, the credit reflects a congressional awareness of family values in a context that has not been so strongly recognized in the past. Since the first $5,000 spent to adopt a child will, in essence, be free for the majority of families, many fortunate children and their adoptive parents should benefit.

Planners should make sure that clients remember two things about the adoption credit. First, it is a per child, not a per year, credit. This means that the credit can be claimed up to the maximum amount only once for each child. However, it also means that the credit can be claimed again for the adoption of another child. Second, families have only until the end of the year 2001 to pay expenses eligible for the credit (except in the case of special needs children). Whether that date will be extended is unknown at this time.

With regard to tax benefits associated with adopted children, it should also be mentioned that the IRS will now allow adoptive parents to claim a dependency exemption or child care credit with respect to an adopted child before the adoption becomes final. Parents cannot obtain a social security number (SSN) for the child until the adoption becomes final, and that number is normally required to claim these tax benefits. However, since many adoptive parents have custody of the child before the adoption becomes final, the IRS is relaxing the general rule. Parents should write "U.S. adoption pending" in the exemption section of Form 1040 in place of the child’s SSN and attach documentation of custody. For foreign adoptions, the procedure is somewhat different. An individual taxpayer identification number (ITIN) should be obtained for the child by filing Form W-7. That number can be used until the SSN is obtained. Alternatively, parents can file amended returns when an SSN is obtained.

Where Can I Find Out More?

• HS 321 Income Taxation. The American College.
• IRC Sec. 23.
• IRC Sec. 137.
• IRS Press Release IR-97-6.

What Was the Situation Before?

Many life underwriters had been faced with the issue of whether the favorable income tax treatment of IRC Sec. 1035 could be applied to life insurance policy replacements involving joint life policies. Could a single life policy be exchanged under Sec. 1035 for a policy insuring more than one life? Could two single life policies be exchanged for a joint life policy insuring the same two lives? Could a joint life policy be exchanged for one or more single life policies? Such questions arose in many cases and for a substantial period of time were left unanswered by the IRS.

What Is the Nature of the Change?

Through the issuance of a series of private letter rulings, the IRS has addressed these issues in the context of second-to-die policies. Unfortunately, for the most part their answers are not favorable to life underwriters and their clients who are attempting to legitimately achieve the most appropriate life insurance configurations. Let’s take a look at the answers given by the IRS to some of these questions.

Question 1: Can a second-to-die policy be exchanged for a single life policy under Sec. 1035 where one of the insureds under the joint life policy has died and the new single life policy covers the life of the surviving insured?

Answer: The IRS says yes. This is the one situation in this whole area where the IRS has taken a position favorable to taxpayers. (See PLR 9330040, PLR 9248013.)

Example 1: Sam and Ginny, a married couple, owned a second-to-die life insurance policy. Sam passed away last year. This year Ginny exchanged the policy for a new single-life policy insuring her life. The IRS says that this exchange qualifies under Sec. 1035.

Question 2: Can a single life policy be exchanged under Sec. 1035 for a second-to-die policy covering the life of the insured under the old policy plus the life of a new, additional insured person?

Answer: The IRS says no. (See PLR 9542037.) Such an exchange would involve the addition of a new insured person to the insurance arrangement. The Service says that this violates the "same insured" requirement of the Treasury regulations under Sec. 1035. Rev. Rul. 90-109, 1990-2 C.B. 191, is cited to support this conclusion. That ruling involved a policy that offered an option of substituting the insured person with another insured. In other words, the policy feature addressed under Rev. Rul. 90-109 involved a change of the insured person (person A) to another newly insured person (person B). Such a substitution is a clear violation of the "same insured" requirement, so the exercise of such an option clearly would not qualify as a Sec. 1035 exchange but rather is treated as a taxable surrender of the policy under Rev. Rul. 90-109.

In PLR 9542037 this same rationale was applied to the addition of a new insured in a single life to second-to-die exchange, and the Service concluded that such an exchange does not qualify under Sec. 1035. Since such an exchange involves the addition of a newly insured person, that conclusion is sensible.

Example 2: Louise owns a life insurance policy covering her life. She exchanges the policy for a new policy insuring both her life and the life of her husband, Don. The IRS says that this exchange does not qualify under Sec. 1035.

Question 3: Can two single life policies insuring the lives of A and B be exchanged under Sec. 1035 for a second-to-die policy insuring the lives of both A and B?

Answer: The IRS says no. This issue was also addressed in PLR 9542037. It doesn’t matter whether the policies are owned jointly by the spouses, by one spouse individually, or by a trust. Such an exchange, according to the IRS, will be taxable under the authority of Rev. Rul. 90-109, discussed above.

Example 3: Rose owns a life insurance policy covering her life. Her husband, Tony, also owns a policy on his life. Rose and Tony exchange these single life policies for one second-to-die policy insuring both their lives. The IRS says that this exchange does not qualify under Sec. 1035.

This question was the one most frequently considered and wondered about before PLR 9542037 was released. Where an exchange involves the addition or subtraction of one or more insureds, a fairly clear violation of the "same insured" requirement under Sec. 1035 occurs. However, the scenario under question 3 does not involve the addition or subtraction of any insured person. It simply combines two life policies into one that covers the same lives. By denying Sec. 1035 treatment to such exchanges, the IRS seems to be saying that each policy involved in a Sec. 1035 exchange must insure the same, and only the same, life or lives as every other policy involved in the exchange. In other words, the IRS sees the "same insured" requirement as applying separately to each policy involved in an exchange rather than to the overall effect of the exchange. Curiously, the IRS cited Rev. Rul. 90-109 to support this position, even though that ruling is not on point regarding this question at all. It is, in fact, largely irrelevant from an analytical standpoint.

Commentators have, for the most part, meekly accepted this result as "logical" or "correct." But, in this writer’s opinion, it is neither. How does such an exchange violate either the letter or the spirit of Sec. 1035 or its accompanying regulations? The purpose for enactment of Sec. 1035 was to allow individuals to modify their insurance arrangements to better suit their needs without the imposition of a taxable event. Sec. 1035 treatment was intended to apply in situations where the life insurance investment is being continued without a change in the life or lives being insured.

The IRS has never denied Sec. 1035 treatment to an exchange merely because there was a different number of policies on one end of the exchange than on the other end. (See PLR 9708016, PLR 9644016, and PLR 6212194820A.) Furthermore, the Service has never denied Sec. 1035 treatment on the basis of differences in policy design or economic attributes among the contracts involved in the exchange.

In one ruling, the IRS approved the exchange of individual policies under Sec. 1035 for interests in a group life policy. (See PLR 9017062.) Naturally, the group policy covered the lives of many other individuals not involved in the approved exchange. The group policy also did not previously cover the life of the individual involved in the exchange. It could be argued that the interest in the group policy was simply viewed as a separate contract for Sec. 1035 purposes by the IRS. However, a group contract is a single contract for most legal and underwriting purposes.

What, then, was the Service’s logical analysis in PLR 9542037 for disallowing 1035 treatment for an exchange of two single life policies for one policy covering the same two insureds? There was, in fact, no logic. There was no explanation. There was no indication that the author of the ruling even understood the issue.

Ah, well, that’s enough venting. Thank you, kind reader, for your patience.

How Does This Change Affect Your Clients?

The effect of PLR 9542037 is, of course, a negative one, particularly with regard to question 3 just discussed. Exchanges disapproved by the ruling will not be processed by most insurance companies. Unfortunately (although understandably), insurance companies do not want to process varieties of policy exchanges that have been the subject of an unfavorable ruling from the IRS. Although the private letter ruling applies only to the taxpayer to whom it is issued and cannot be cited as authority, it does cast a pall over industry practices in this case. Many legal issues involving the income taxation of life insurance and annuities have no clear authority on point other than private letter rulings. In such cases, the industry follows the rulings. Such is the situation here.

What Should Be Done?

With regard to question 3 discussed above (exchange of policy insuring A and policy covering B for a second-to-die policy covering A and B), a judicial challenge of the IRS position might produce a favorable result. This would require the following steps: the processing of such an exchange under Sec. 1035 by an insurance company, then an IRS audit of an affected taxpayer, then a court action. Absent a willingness to go that route (making your client famous), taxpayers and insurers will simply have to "grin and bear it."

A related question that some life underwriters are still unsure about involves the application of PLR 9542037 to exchanges involving first-to-die, rather than second-to-die policies. There is a school of thought that holds that first-to-die policies should receive more favorable treatment than second-to-die policies in exchanges like the one in question 3. Since a first-to-die policy pays a death benefit on the first insured’s death (which a second-to-die does not), and since a first-to-die policy generally allows the remaining insured to continue coverage in some way after the first death, therefore (the argument goes) there is no violation of the same insured requirement where two single life policies are exchanged for a first-to-die policy covering the same two lives. The second-to-die policy does not qualify in such exchanges, it is argued, because it is really only one life that is insured in a second-to-die policy, since only one death benefit will be paid. This approach suggests that it is the subtraction, not the addition, of an insured in exchanges for second-to-die policies that violates Sec. 1035 principles.

Well, what about that? As the saying goes, the argument "proves too much." There is absolutely no indication in PLR 9542037 that it makes any difference to the IRS whether a first-to-die or second-to-die policy is received in such exchanges. The difference in mortality assumptions or, for that matter, any comparison of economic differences in any of the policies being examined was never a factor in the ruling. As previously stated, the Service never even got that far. They simply cited Rev. Rul. 90-109, which involved a completely different type of situation, and let it go at that.

In conclusion, there is nothing to indicate that the Service would approve an exchange of two single life policies for a first-to-die policy any more than for a second-to-die policy. There is also no indication that the result would be different if the exchange was reversed; that is, if a first- or second-to-die policy were surrendered in exchange for two single life policies. In this writer’s opinion, any of these transactions should qualify under Sec. 1035. However, the Service has thrown a wet blanket, it seems, over all these planning possibilities. The entire situation is uncalled for, unfortunate, and unsettling.

Where Can I Find Out More?

• PLR 9708016.
• PLR 9644016.
• PLR 9542037.
• PLR 9330040.
• PLR 9248013.
• Rev. Rul. 90-109, 1990-2 C.B. 191.
• PLR 9017062.
• PLR 6212194820A.

What Was the Situation Before?

When a trust or other entity is considered for annuity ownership, the first income tax problem that must be confronted is the "non-natural person" rule of IRC Sec. 72(u). If this rule applies, the annuity will not be treated as an annuity for income tax purposes, and the income on the contract will be taxed as ordinary income to the contract owner each year. In most cases, this tax result will result in the loss of the appropriateness of the annuity as a wealth building vehicle.

The non-natural person rule does not apply to annuities acquired by the estate of a decedent by reason of the decedent’s death, to annuities held by qualified plans, or to immediate annuities.

More importantly, however, if an entity holds the annuity as "an agent for a natural person," the non-natural person rule will not apply. In what kinds of situations will the "agent for a natural person" exception to the "non-natural person" rule apply? This question has often been asked since the enactment of IRC Sec. 72(u). Recently several private letter rulings have been issued that help bring the picture into focus.

What Is the Nature of the Change?

The IRS has recognized the "agent for a natural person" (agency) exception in two types of situations that are distinct but related: single beneficiary trusts and certain grantor trusts.

Single Beneficiary Trusts. The IRS has approved the application of the agency exception in rulings involving single beneficiary trusts. First, let’s examine PLR 9204010 and PLR 9204014. These two rulings are companion pieces issued under essentially the same ruling request. Annuity contracts were to be issued to trustee owners. There were age restrictions in the trusts on the beneficiary’s unfettered access to the trust property. The IRS observed that "although trustee is the contract owner of the annuity contract, its ownership interest is nominal . . . " The Service concluded in both rulings that since the sole beneficiary of the trust was the beneficial owner of the annuity, the tax-deferred status of the annuity was preserved.

In PLR 9639057, a financial institution proposed to maintain trusts to hold annuity contracts for the benefit of its customers. The trusts in question were single beneficiary trusts that were essentially under the customer’s complete control. The IRS also approved this arrangement under the agency exception to the non-natural person rule.

The trusts in question in these rulings were not grantor trusts for income tax purposes. (See below.)

It follows that where a trust has only one beneficiary and that beneficiary is a natural person, the agency exception to the non-natural person rule should apply, and the placement of an annuity will not cause income tax problems.

Grantor Trusts. In PLR 9120024, trusts were funded with annuities under a funeral trust arrangement. The trust model in question was treated as a grantor trust for income tax purposes because the grantors maintained reversionary interests in portions of the trust property that exceeded 5 percent of their value under IRC Sec. 673(a). The IRS concluded that the trust was an agent for a natural person because the trust was taxed as a grantor trust under IRC Sec. 673(a).

PLR 9316018 involved a trust established by an employee for the purposes of receiving bonuses from an employer. The employee had the right to decide whether to receive the bonuses personally or have them deposited into the trust. Also, the employee had the unilateral right to withdraw the trust’s current income and/or any bonuses paid into the trust within 30 days of their contribution. However, except for those specified withdrawal rights, the employer had the right to approve any withdrawals from the trust prior to the employee’s termination of employment. The employer’s creditors had no interest or rights in the trust. The trust was a grantor trust under IRC Sec. 677 because the trust property could be distributed to the grantor (the employee) without the approval of an adverse party under IRC Sec. 677. The IRS concluded that the trust was an agent for a natural person, because the trust was a grantor trust under IRC Sec. 677.

How Does This Change Affect Your Clients?

We have examined the rulings that apply the agency exception to the non-natural person rule to grantor trusts and single beneficiary trusts. Now let’s examine a few other related questions regarding the agency exception.

Question 1: Would any trust that is treated as a grantor trust under IRC Sec. 671-678 qualify for the "agent for a natural person" exception to the non-natural person rule under the logic in the existing rulings?

Answer: Sorry, but we don’t know. Although the IRS has not denied the exception to any grantor trust in any private ruling, it has specifically approved the exception using a grantor trust analysis only in the rulings just discussed. Trusts that are grantor trusts, for example, under the "power to control beneficial enjoyment" rules of IRC Sec. 674 or the "administrative powers" provisions of IRC Sec. 675 have not been the subject of rulings involving the ownership of annuities. It is very possible, however, that not all grantor trusts would be treated as involving the type of agency relationship with the grantor that was found in the rulings cited. Also, the grantor trust rulings involved grantor trusts that, for all practical purposes, were also single beneficiary trusts. If a grantor trust had more than one beneficiary whose beneficial interests were subject to discretionary powers, the required agency relationship between the trust and a natural person might not be present in the eyes of the IRS.

Question 2: Could an annuity be placed in a trust that would not violate the non-natural person rule, and at the same time also avoid federal estate tax inclusion of the annuity in the estate of the individual who pays the premium?

Answer: Probably, if the right type of trust were used. This technique has been referred to as the irrevocable annuity trust, or IRAT. Its practical suitability, however, is probably limited to certain specific situations.

For example, suppose a father and mother wanted to purchase a deferred annuity contract for the benefit of a son but did not want the annuity to be included in their own estates or the son to have control over the disposition of the contract. The contract could be placed in a single beneficiary trust with an independent trustee delaying the son’s control over the property until age 40. If the parents wanted to pay the annuity premiums, they would either have to make a taxable gift to the trust or limit the premiums to $20,000 a year using a present-interest exclusion approach with a Crummey power. In this way, the parents could exclude the annuity from their estates and still avoid the application of the non-natural person rule because the trust is a single beneficiary trust. Such a trust should work as an IRAT.

Note also that the IRS has stated that when an annuity is distributed to the trust beneficiary from a single beneficiary trust, that transfer is not a taxable gift of the annuity under IRC Sec. 72(e)(4)(C) because the trust making the transfer is not an "individual" within the meaning of that subsection. (See PLR 9204010.)

Although an IRAT may be a suitable technique in certain situations, it seems to lack major potential for general application. The IRAT presents certain problems. First, when an existing annuity is transferred to a trust by an individual, both a transfer tax and an income tax event will likely occur. Transfers of life insurance policies result only in a transfer tax event. Second, only certain types of trusts qualify for the agency exception to the non-natural person rule, as we have just discussed. Third, annuities do not present the same estate planning opportunity for amplification of wealth at death that life insurance does.

Question 3: Can a deferred annuity be used to fund a credit shelter (bypass) trust for estate tax planning purposes?

Answer: No. Such a trust is not a single beneficiary trust or a grantor trust. Use of an annuity in such a trust would trigger recognition of all existing gain in the contract, the same as if the contract had been surrendered. (See IRC Sec. 72(u)(2)(A).)

Question 4: Can a partnership or limited liability company own an annuity as an "agent for a natural person"?

Answer: We don’t know. The legislative history of IRC Sec. 72(u) indicates that a major reason for the enactment of the rule was to prevent the use of annuities for nonqualified deferred compensation plans. The timing of taxable compensation to an owner would not be an issue with a pass-through tax entity such as a partnership or LLC. However, as previously discussed, entities that exist for the benefit of more than one person have not been the subject of any rulings on the agency exception. There would be a significant downside tax risk, therefore, in placing a deferred annuity in a partnership without a favorable IRS ruling on the issue.

What Should Be Done?

If you have a situation, such as annuity ownership by a trust, that could result in problems with the non-natural person rule, you must consider the downside risk. Violation of the rule has serious tax consequences. 

 

Most people think of the rule, if it applies, as resulting in the immediate taxation of the income on the contract to the contract owner. That is true, and it’s not good. However, there are other implications that you may not have considered.

 

Since an annuity contract that violates the non-natural person rule is not treated as an annuity for tax purposes, consequences other than the taxation of income on the contract may result. For example, the contract would no longer qualify for a Sec. 1035 exchange. How can this be significant? For one thing, it has been suggested that a possible exit strategy for life insurance policies that carry an economic loss (where basis is higher than cash value) would be to exchange the policy for an annuity, then perhaps sometime later (for valid economic reasons) to surrender the annuity at a deductible loss, using the carryover basis from the life policy. But what if the owner of the life policy is an entity, such as a bank or a corporation, and exchanges the policy for an annuity contract that violates the non-natural person rule? Simply paying tax on the annual annuity income might not be so bad if the loss upon surrender would still be deductible. But this technique won’t work. There will be no valid Sec. 1035 exchange because the annuity received in the exchange is not an "annuity for income tax purposes." Therefore, there will be no carryover basis and the exchange will be treated as a taxable surrender of the life policy, which will not result in a deductible loss.

 

It should be noted that to the extent that income on the contract is taxed, the contract owner receives additional basis in the contract, which can later be recovered upon disposition or annuitization. This ameliorates somewhat the harsh effects of the rule. However, it still doesn’t make it a good rule.

 

Where Can I Find Out More?

• IRC Sec. 72(u).
• PLR 9639057.
• PLR 9322011.
• PLR 9316018.
• PLR 9204014.
• PLR 9204010.
• PLR 9120024.
• Ann St. Laurent, Esq. "Estate Planning with Tax-Deferred Annuities—Special Problems under Sec. 72," Tax Management Estates, Gifts & Trusts Journal, vol. 211, no. 6.
• James F. Ivers III. "Current Income Tax Considerations for the Insurance Professional," 13th Annual Tax Conference, The American College, 1996. Video tape, audio tape, and outline.

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Chapter 2a