Russell E. Towers, JD, CLU, ChFC,

When a life insurance policy is sold to a life settlement company, certain tax rules must be followed by the policy owner/seller.  This taxation is governed by Rev. Rul. 2009-13 where the IRS contrasted the taxation of a policy which has been surrendered with the taxation of a policy which has been sold to a settlement company.

Also, the IRS ruling differentiated between the sale of a permanent insurance policy and the sale of a term insurance policy.  Here’s a summary of the important issues which the ruling clarified.

Surrender of a Policy by a Policy Owner

Where a policy owner simply surrenders the policy for cash, Rev. Rul. 2009-13 confirms that the cash payment is reduced by the amount of aggregate premiums paid (cost basis) to determine the taxable gain without any basis reduction for “cost of insurance” (COI).  The ruling concluded that the gain amount is ordinary income.

In a hypothetical example based on Situation #1 of Rev. Rul. 2009-13, assume a policy in a gain position has cash surrender value of $780,000 with aggregate premiums paid (cost basis) of $640,000.  The cumulative COI charges were $100,000.  The ordinary income gain would be $780,000 minus $640,000 = $140,000 and the COI charges would be disregarded.

Sale of a Policy to a Life Settlement Company

However, when a policy owner sells a permanent policy to a life settlement company, the IRS stated that the policy owner’s adjusted cost basis is not equal to the amount of aggregate premiums paid.  The aggregate premiums paid must be reduced by the portion of the premiums allocated for the pure cost of insurance (COI charges).  This rule for reduction of cost basis by the COI charges went into effect for sales of policies to settlement companies on August 26, 2009 or later.

For the sale of a permanent policy, the IRS confirmed that a portion of any gain can be in the nature of long term capital gain. The part of any gain allocated to “inside buildup” of cash value (cash value minus aggregate premiums paid) is ordinary income which can be taxed at a federal rate up to 39.6 percent under current law.  However, any gain in excess of “inside buildup” is long term capital gain which can be taxed at a federal rate of only 15 percent or 20 percent under current law.

For the sale of a term policy (no cash surrender value) all premiums are presumed to be COI charges. Since term policies generally do not have an “inside buildup” component, any gain from the sale of a term policy would be all long term capital gain.  

Sale of a Permanent Policy in a “Gain” Position

In a hypothetical example based on Situation #2 of Rev. Rul. 2009-13, assume a policy in a “gain” position has a cash surrender value of $780,000 with a cost basis (aggregate premiums) of $640,000.  The cumulative cost of insurance (COI charges) was $100,000.  Then, the policy is sold to a life settlement company for $800,000.  Therefore, the adjusted cost basis is $640,000 minus $100,000 COI = $540,000.  So, the gain amount on the sale of the policy is $800,000 minus the adjusted cost basis amount of $540,000 = $260,000.

Of this $260,000 gain amount, $140,000 represents ordinary income allocated to “inside buildup” ($780,000 cash value minus $640,000 aggregate premiums paid) and the remaining $120,000 is long term capital gain.

Sale of a Permanent Policy in a “Loss” Position

In another hypothetical example based on Situation #2 of Rev. Rul. 2009-13, assume a policy in a “loss” position has a cash surrender value of $300,000 with a cost basis (aggregate premiums) of $640,000.  The cumulative cost of insurance (COI charges) was $100,000.  Then, the policy is sold to a life settlement company for $800,000.  Therefore, the adjusted cost basis is $640,000 minus $100,000 COI = $540,000.  So, the gain amount on the sale of the policy is $800,000 minus the adjusted cost basis amount of $540,000 = $260,000.

Since the policy is in a loss position, (cash value less than cost basis), the full $260,000 of gain from the sale is long term capital gain taxed at lower capital gain tax rates.    

Sale of a Term Policy

In a hypothetical term insurance example based on Situation #3 of Rev. Rul. 2009-13, the term insurance policy had $0 cash value.  The policy was sold to a settlement company for $50,000.  The cumulative premium paid up to the date of sale was $80,000.  The cumulative expired “cost of insurance” portion of the premium was $77,000.  The unexpired “cost of insurance” portion of the cumulative premium is the adjusted cost basis of $3,000 ($80,000 minus $77,000).  

Accordingly, the seller must recognize $47,000 of capital gain on the sale ($50,000 sale price minus $3,000 adjusted cost basis for unexpired premium).  Since the term insurance policy had no cash surrender value, there was no “inside buildup” under the contract. 

Using a so-called “Zero-Gift” Grantor Retained Annuity Trust (GRAT) coupled with an Irrevocable Life Insurance Trust (ILIT) can provide estate, gift, and income tax free transfer of estate assets to heirs in an economically efficient manner.  

Treasury regulations officially sanctioned the use of zero-gift GRATs after the tax court upheld the concept in the famous Walton v. Commissioner Tax Court case. These zero-gift GRATs are commonly known as “Walton GRATs” after one of the Walton family members transferred Walmart stock to a GRAT and successfully withstood an IRS challenge. 

The 2016 budget of the Obama administration has proposed significant restrictions for GRATs.  This would include provisions that would require a calculated remainder value for gift tax purposes equal to the greater of 25 percent of the value of the assets placed in the GRAT or $500,000.  And the GRAT would have to last for a minimum of 10 years.  If these restrictions ever became law, it would basically eliminate the use of “short term” GRATs and eliminate the concept of the zero-gift GRAT.  However, with the continuing Republican majority in Congress, this GRAT proposal has not gained any traction. 

Take a look at the long list of GRAT advantages available under current law:

Legal Design and Taxation
• Property transferred to a zero-gift GRAT means exactly that… it has zero value for gift tax purposes.  In other words, the “present value of the remainder amount” is zero!  S Corp stock, rental real estate, and investment portfolio securities are good assets to consider for transfer to a GRAT.  The cost basis of these capital assets will be their “carryover basis” for any future capital gains purposes.

• The GRAT is a retained interest for a term of years.  This means that all the income earned by the assets in the GRAT will be taxed to the GRAT grantor during the specified term.  The fixed retained annuity amount is distributed to the grantor estate owner each year as ordinary income or capital gain depending on the character of the income.

• At the end of the GRAT term, the remainder beneficiary of the GRAT receives a distribution of the assets as a tax free distribution of trust principal.  The remainder beneficiary of the GRAT could be the adult children of the grantor or an Irrevocable Trust for the benefit of those adult children. In other words, one trust (irrevocable trust) can be the remainder beneficiary of another trust (GRAT).  The irrevocable trust could even be an ILIT that also holds insurance on the life or lives of the estate owners.

• The remaining GRAT asset value at the end of the GRAT term and any future appreciation accrue estate tax free for the benefit of the heirs of the grantor.

• The grantor can use some or all of the after-tax GRAT annuity payments to make annual exclusion gifts to the ILIT to pay premiums for the life insurance owned by the ILIT.  Eventually, the trustee of the ILIT will manage both the GRAT assets as remainder beneficiary of the GRAT and the income and estate tax free life insurance death benefit.

Case Example of a Zero-Gift GRAT in Tandem with an ILIT
Assume an individual estate owner is 60 years old with a current gross estate of $10 million.  The estate is largely made up of rental real estate and non-qualified investment securities.  The estate owner is concerned about current estate taxes and the growth of the estate in a 50 percent combined federal and state estate tax bracket going forward into the future.  The estate owner assumes that the real estate will appreciate at a seven percent growth rate due to a favorable location in a growing commercial area.  And the investment portfolio is also assumed to grow at seven percent based on professional asset management from a well-known firm.

• Consider a transfer of $2 million of rental real estate and investment securities to a 20 year term certain GRAT with an assumed growth rate of seven percent.  

• Assuming an AFR rate of 2.2 percennt, if the GRAT pays the grantor a fixed annual annuity of exactly $140,822 for 20 years (payout rate of 7.04111 percent), the value of the gift for gift tax purposes is zero.

• The grantor uses some of the after-tax GRAT annuity payments to make annual exclusion premium gifts to a $3 million 20-pay no-lapse Universal Life (UL) policy owned by an ILIT for the benefit of the adult children.  The guaranteed premium payment years (20 years) could match the payout term of years for the GRAT (20 years).  The guaranteed no-lapse 20-pay premium from a competitive carrier is $57,350. The internal rate of return (IRR) on the death benefit at year 25 life expectancy is a tax free 5.98 percent.  The pre-tax equivalent IRR assuming a 30 percent tax rate is 8.54 percent.   

• At the end of 20 years, the hypothetical non-guaranteed value of the GRAT assets ($1,562,000) is distributed estate tax free to the ILIT which is the remainder beneficiary of the GRAT. At a 50 percent combined federal and state estate tax rate, the estate tax savings on the projected $1,562, 000 remaining GRAT value is $781,000.

• Both the GRAT value ($1,562,178 and all future growth) plus the no-lapse UL life insurance death benefit of $3 million will be estate tax free to the heirs.  

• A 20-pay no-lapse Survivorship Universal Life (SUL) product could be used as an alternative in a situation where the clients are a married couple.

As you can see, when a zero-gift GRAT and the ILIT are paired together, they offer a great tax free estate planning combination.  Keep in mind that the projected GRAT rate of return on the assets transferred to the GRAT is not guaranteed.  All the more reason to buy guaranteed no-lapse life insurance if the underlying financial economics of the GRAT does not work out as originally projected. 

Often, a financial professional will encounter a client with two IRA accounts that may have been created at different times with different funding products. Some might of opened one for precious metal investments for example through Lear Capital (you can learn more about them at finance.yahoo) Or a financial professional may recommend two separate IRA accounts with different financial purposes for different designated beneficiaries.  In either event, the Treasury regulations treat certain IRA accounts differently when it comes to distributing Required Minimum Distributions (RMDs) from these accounts when the client reaches age 70½ .

Of course, these multiple IRA accounts can be funded with different financial products.  These financial products usually fall into the following categories: Mutual fund IRAs, deferred annuity IRAs (i.e. fixed, indexed, variable), and single premium immediate annuity IRAs (SPIA IRAs).  What are the RMD requirements and options for different product combinations when a client owns two IRA accounts from these product categories?

First, the type of IRA account must be categorized by whether it’s considered to be a “defined contribution” type of account or a “defined benefit” type of account.  Mutual fund IRAs and deferred annuity IRAs are considered to be “defined contribution” type of accounts, where RMDs are governed by Treas. Regs. 1.401(a)(9)-5 which were issued in 2002.  Immediate annuity IRAs are considered to be “defined benefit” type of accounts where RMDs are governed by Treas. Regs. 1.401(a)(9)-6 which were issued as distinctly separate regulations  in 2004.  Given the fact that two separate sets of Treasury regulations exist for RMDs, how can we determine RMD requirements when a client owns two IRAs from different product categories?

Possible Combinations of Mutual Fund IRAs, Deferred Annuity IRAs, and SPIA IRAs:

1) SPIA IRA #1 and SPIA IRA #2

• These SPIA IRAs are “defined benefit” accounts governed by the 2004 Treasury regulations.  As such, each SPIA IRA must satisfy RMD requirements on its own.

• No aggregation of accounts is permitted.  An actual RMD distribution will come from each SPIA IRA account.

• Permitted SPIA IRA settlement options which satisfy RMD rules include: Life only, Life and Guaranteed for no longer than the one-time age related RMD factor from the Uniform Lifetime Table, and Period Certain Only for no longer than the one-time age related factor from the Uniform Lifetime Table.

2) Mutual Fund IRA #1 and Mutual Fund IRA #2

• These mutual fund IRAs are “defined contribution” accounts governed by the 2002 Treasury regulations.  As such, the client must use the 12/31 account values from the prior year to determine RMDs based on the age related factor from the Uniform Lifetime Table each year.

• Aggregation of the accounts is mandatory.  However, the actual RMD may come from each account or may be taken from only one of the aggregated accounts if desired.

3) Deferred Annuity IRA #1 and Deferred Annuity IRA #2

• These deferred annuity IRAs (i.e. fixed, indexed, variable) are “defined contribution” accounts governed by the 2002 Treasury regulations.  As such, the client must use the 12/31 account values from the prior year to determine RMDs based on the age related factor from the Uniform Lifetime Table each year.

• Aggregation of the accounts is mandatory.  However, the actual RMD may come from each account or may be taken from only one of the aggregated accounts if desired.

4) Mutual Fund IRA #1 and Deferred Annuity IRA #2

• The mutual fund IRA and the deferred annuity IRA are “defined contribution” accounts governed by the 2002 Treasury regulations.  As such, the client must use the 12/31 account values from the prior year to determine RMDs based on the age related factor from the Uniform Lifetime Table each year.

• Aggregation of the accounts is mandatory.  However, the actual RMD may come from each account or may be taken from only one of the aggregated accounts if desired.

5) SPIA IRA #1 and Mutual Fund IRA #2

• The SPIA IRA is a “defined benefit” account governed by the 2004 Treasury regulations.  The mutual fund IRA is a “defined contribution” account governed by the 2002 Treasury regulations.  As such, each IRA must satisfy RMD requirements on its own.

• No aggregation of accounts is permitted.  An actual RMD distribution will come from both the SPIA IRA and the mutual fund IRA.

• SPIA IRA settlement options include Life Only, Life and Guaranteed for no longer than the one-time age related RMD factor from the Uniform Lifetime Table, and Period Certain Only for no longer than the one-time age related factor from the Uniform Lifetime Table.

• The Mutual Fund IRA must use the 12/31 account value from the prior year to determine RMDs based on the age related factor from the Uniform Lifetime Table each year.

6) SPIA IRA #1 and Deferred Annuity IRA #2

• The SPIA IRA is a “defined benefit” account governed by the 2004 Treasury regulations.  The deferred annuity IRA (i.e. fixed, indexed, variable) is a “defined contribution” account governed by the 2002 Treasury regulations. As such, each IRA must satisfy RMD requirements on its own.

• No aggregation of accounts is permitted.  An actual RMD distribution will come from both the SPIA IRA and the deferred annuity IRA.

• SPIA IRA settlement options include Life Only, Life and Guaranteed for no longer than the one-time age related RMD factor from the Uniform Lifetime Table, and Period Certain Only for no longer than the one-time age related factor from the Uniform Lifetime Table.

• The Deferred Annuity IRA must use the 12/31 account value from the prior year to determine RMDs based on the age related factor from the Uniform Lifetime Table each year.

Multiple accounts can arise for many different planning situations.  Here is a short list of reasons why multiple IRA accounts can be useful planning tools for IRA owners:

 1) Marital-credit shelter type of estate planning may dictate one type of IRA for the benefit of a spouse alone and the other IRA for the benefit of the children alone or a trust for the benefit of the children alone.

2) Second marriage situations may require one type of IRA for the benefit of the second spouse and the other IRA for the benefit of the children from the first marriage.

3) One type of IRA may be more oriented to growth with underlying equity investments while the other IRA account may be more oriented to fixed type of accounts (i.e. bond mutual funds, U.S. government securities mutual funds or fixed annuities).

4) Special needs planning for certain disadvantaged children may require a special needs trust for that child to be the beneficiary of one IRA while the other IRA account may name the other adult children as designated beneficiaries.

5) One type of IRA account may have an individual named as designated beneficiary while the other IRA account may name a trust as the designated beneficiary.  The trust can provide for the long term management of “inherited” post-death IRA distributions after the death of the IRA owner.

6) A classic approach is to have one IRA account invested for growth with the other IRA account providing a guaranteed income stream from a SPIA IRA.

Note: One important rule to keep in mind when planning for multiple IRA accounts is the “one rollover per year” rule that IRS announced in 2014.  The IRS has interpreted IRC Section 408(d)(3)(B) to mean that an IRA owner can do only one 60 day IRA to IRA rollover per year.  However, the IRS also reaffirmed that an unlimited number of “direct transfers” can be made when transferring funds directly from one IRA account to another IRA account. 

The benefits of a charitable remainder trust (CRT) working in tandem with an irrevocable life insurance trust (ILIT) are significant for charitable-minded estate owners looking to benefit a public charity or their own private charitable foundation.

How does a CRT work, and what are the valuable benefits it can provide? The CRT can be formed either as a charitable remainder annuity trust (CRAT) which can provide a fixed lifetime income to the donor or as a charitable remainder unitrust (CRUT) which can provide a fixed percentage end of year value lifetime income to the donor.

Some of the great tax benefits that accrue to the grantor of a CRT:

 • A lifetime income stream for the single life or joint lives of the donor(s).

 • Capital gain on capital assets transferred to the CRT can be spread over the lifetime of the donor.

 • A significant income tax deduction for the present value of the remainder amount donated.

 • The assets remaining in the CRT at the donor’s death are allowed a 100 percent charitable estate tax deduction.

 • Part of the after-tax lifetime income stream and part of the tax savings on the income tax deduction can be used to fund the insurance premiums of the ILIT for the benefit of the donor’s heirs.

 • At the donor’s death, the charity receives a significant deferred gift to use for its own charitable purposes.

Case Studies of Single Life CRT

and Joint Life CRT

Here are examples of a CRUT, first for a single donor and then for joint donors. Assume $1 million of appreciated stocks or equity mutual funds are transferred to the CRUT. Life #1 is age 65 and life #2 is also age 65. Assume the current adjusted federal midterm rate (AFMR) is 2.2 percent. The stated quarterly payout rate in the CRUT document is 5 percent and the assumed rate of growth of the CRUT assets is also 5 percent.

Single life CRUT and single life ILIT:

 • The donor receives a lifetime income stream of +/- $50,000 per year. Part of each annual payment is ordinary income (tier 1) and part is capital gain (tier 2).

 • The donor receives an income tax deduction of $448,980. This deduction is subject to either the 30 percent annual AGI limit (public charities) or the 20 percent annual AGI limit (private foundations) with a five year carry-forward for unused deductions.

 • At the death of the donor, +/- $1 million of asset value (non-guaranteed) is transferred to the designated charity as the remainder beneficiary of the CRUT.

 • Part of the after-tax income stream and/or part of the income tax savings are used to fund a $1 million no-lapse universal life (UL) policy owned by an ILIT to restore for the heirs the remaining asset value that passes to the charity at the donor’s death.

Joint life CRUT and survivorship life ILIT:

 • The donors receive a lifetime income stream of +/- $50,000 per year for their joint lives. Part of each annual payment is ordinary income (tier 1) and part is capital gain (tier 2).

 • The donors receive an income tax deduction of $337,670. This deduction is subject to either the 30 percent annual AGI limit (public charities) or the 20 percent annual AGI limit (private foundations) with a five year carry-forward for unused deductions.

 • At the death of the surviving donor, +/- $1 million of asset value (non-guaranteed) is transferred to the designated charity as the remainder beneficiary of the CRUT.

 • Part of the after-tax income stream and/or part of the income tax savings are used to fund a $1 million no-lapse survivorship universal life (SUL) policy owned by an ILIT to restore for the heirs the remaining asset value that passes to the charity at the donor’s death.

The trustee of the CRT may invest the donated assets in a wide variety of financial assets including stocks, bonds, mutual funds and rental real estate. It is even permissible for a CRT to invest in deferred annuity products if desired. The deferred annuity should have a feature which allows partial withdrawals without surrender charge penalties so that the CRT trustee can make the annual required lifetime payment to the donor(s).

The specific wording of a DPA critically affects the likelihood that your clients’ wishes

will be fulfilled by insurance owned within irrevocable life insurance trusts.

As people age into their 80s with longer life expectancies, their mental capacity is often diminished when it comes to managing their financial affairs. This declining capacity brings to mind an interesting issue which can impact whether or not continued gifting of premiums to Irrevocable Life Insurance Trusts (ILITs) can take place.

Many ILITs have been funded with no-lapse universal life (UL) and no-lapse survivorship universal life (SUL) since the late 1990s. In a typical design, the account cash value falls to zero by the time insureds reach their 80s. If the insured estate owner develops a reduced mental capacity such as Alzheimer’s, they may be unable to manage their financial affairs. It would be easy to miss premium payments into a no-lapse UL or SUL type of product, which may cause the policy to quickly lapse for non-payment. How can your client take the necessary steps to make sure this unfortunate scenario does not take place?

A durable power of attorney document is a critical piece of a good estate plan for wealthy clients who have ILITs they are depending upon to offset federal estate taxes, state death taxes and other final expenses. This legal document allows the lasting power of attorney to execute specific legal and financial transactions on behalf of the incapacitated person. It may be crucial to a wealthy individual’s estate plan that a planned giving program be continued all the way until the death of the estate owner. This is of particular importance if continued premium gifts to an ILIT must be made to keep the policy in force all the way until death. The durable power holder would have to make premium gifts on behalf of the incapacitated estate owner. Therefore, it is critical that the power holder have clear and specific authority in the durable power document to make these gift transfers.

A number of tax court cases and IRS rules have held that a durable power of attorney document must contain specific clauses which allow the power holder to make gifts of the incapacitated person’s property for purposes of the gift tax annual exclusion, the lifetime gift exemption or the generation-skipping exemption. If the document is silent with respect to this gifting power, then the power holder is presumed not to have the power to make gifts. This lack of the power to make continued premium gifts could cause a no-lapse UL or SUL type of policy to lapse quickly for non-payment of the required annual premium.

A number of U.S. tax court cases basically have taken the position that, in the absence of state law to the contrary, the power holder does not have the authority to make gifts of the incapacitated person’s property where that authority is not expressly conferred in the document. Most states also support this view with state statutory laws.

In addition to the power to make gifts, a good durable power of attorney document can allow the power holder to perform a number of other important legal and financial functions:

 • The estate owner must have sufficient mental capacity to execute the durable power document in the first place. This mental capacity is much the same as whether or not a person has the mental capacity to execute a will.

 • The power to acquire life insurance on the lives of family members of the grantor of the durable power in whom the grantor has an insurable interest.

 • The power to retain any investments and to change and vary the form of any investments owned by the estate owner.

 • The power to invest in fixed and variable annuities and stocks, bonds and mutual funds as the power holder deems advisable, including cash and money market accounts.

 • The power to sell, exchange or convey any property owned by the grantor of the durable power.

 • The power to manage, operate, mortgage and lease any real estate of the grantor.

 • The power to continue and to operate any business entity in which the grantor owns shares.

 • The power to compromise and settle any legal claim due to the grantor or against the grantor.

 • The power to borrow money for any purpose connected with the protection, preservation and improvement of the grantor’s assets.

 • The power to employ agents such as attorneys, accountants, investment professionals and real estate brokers whose services may be required to administer the assets of the grantor.

 • The power to make gifts or gratuitous transfers to a spouse, descendants or charitable organizations. The maximum gift permitted each year to a non-charitable donee shall normally be limited to the maximum gift tax annual exclusion permitted under IRC Section 2503(b) and the unlimited educational and medical expense gifts permitted under IRC Section 2503(e). However, for estate planning purposes the power holder may make additional gifts up to an amount equal to any remaining lifetime gift exemption as permitted by IRC Section 2505(a), as amended from time to time.

 • The grantor should also designate a successor power holder in case the original power holder dies, resigns or becomes incapacitated themselves.

Case example of a no-lapse SUL policy owned by an ILIT: Mr. and Mrs. Jones created an ILIT for the benefit of their three children to be the owner and beneficiary of a $1,700,000 no-lapse guaranteed SUL policy fourteen years ago when they were each 72 years old. They also executed a durable power of attorney document which permits their power holder daughter to make gifts on their behalf. They have gifted the guaranteed annual premium of $34,000 each year to the trust using their “Crummey” power gift tax annual exclusions. A cumulative total of $476,000 has already been gifted to the ILIT for premiums. The nominal account cash value of the policy has fallen to zero. Mr. Jones died three years ago and Mrs. Jones (now age 86) has recently been placed into an extended care facility and requires her durable power holder daughter to manage her financial affairs.

It is absolutely critical that the power holder daughter continue to make the $34,000 annual premium gifts to the ILIT to keep the $1,700,000 no-lapse SUL policy in force. If the policy ever lapsed for non-payment of premium because the cash gifts were not made to the ILIT, the valuable income and estate tax-free benefit of $1,700,000 would be lost to the heirs.

Included in this article are two charts of the income tax treatment of “standalone” long term care (LTC) premiums for certain business owners and non-owner key executives. As you will see, the tax treatment for both the business entity and the insured is very favorable in many situations.

Sometimes, when filing a Corporate tax return, you’ll notice that the deduction for standalone LTC is limited to only part of the premium for certain business owners who are classified as self-employed under IRC Section 162(l). This partial deduction is determined by the indexed table of IRC Section 213(d)(10). These partial deduction rules apply to S corporation owners, LLC owners and sole proprietors.

IRC Section 213(d)(10) Limits  (see Chart 1)

Other situations allow a deduction of the full standalone LTC premium for the business entity. Those rules apply to C corporation owners and qualified personal service corporation (QPSC) owners. In all cases, any standalone LTC policy claim benefits actually received are income tax-free.

Here are the typical legal business entities and corresponding tax forms for IRS reporting purposes that would reflect the business taxation of standalone LTC:

 • C corporation (Form 1120)

 • QPSC (Form 1120)

 • S corporation (Form 1120S and K-1 “pass-through” to Form 1040)

 • Partnerships and LLCs (Form 1065 and K-1 “pass-through” to Form 1040)

 • Sole proprietor (Schedule C of Form 1040)

 • Section 501(c) tax exempt organization (Form 990)

Business Tax Treatment of Standalone LTC Premiums  (see Chart 2)

The idea is to use the cash flow of the business entity to fund LTC premiums for a personally owned standalone LTC policy that may be an annual pay-qualified LTC contract. The contract may or may not have a return of premium (ROP) option. The contract may or may not have inflation adjustable benefits. Finally, the contract may be subject to premium increases depending on claims experience of the carrier, interest rates in the economy and other actuarial factors.

Nevertheless, the ability to use the business checkbook to pay LTC premiums for a personal benefit plan can be the deciding factor to purchase the standalone LTC product as opposed to using the personal checkbook to pay premiums.

Client Profile:

Your clients are successful C corporation, QPSC, S corporation and LLC business owners and professionals. These clients wish to provide LTC insurance benefits to offset any LTC expenses that may accrue based on costs of extended care.

Key Phrases to Use with Your Business

Owner Client for Standalone LTC:

 • Use your business checkbook to transfer the risk of long term care costs to an insurance carrier at the low present value cost of “pennies on the dollar.”

 • LTC premium payments are either fully tax deductible or partially tax deductible as a business expense depending on tax status of your business (C corporation, QPSC, S corporation, LLC).

 • Premiums paid from business cash flow are either fully tax free to you or only partially taxable to you depending on tax status of your business (C corporation, QPSC, S corporation, LLC).

 • Tax-free LTC benefit payments to you to offset actual extended care costs.

 • The plan can be offered selectively to you and your non-owner key executives without covering any other employees.

There are a number of different ways LTC coverage can be funded with different types of policies other than a standalone LTC contract. LTC coverage can also be funded via: a) a “linked-benefit” single premium or limited premium combo life insurance–LTC product; b) an annual premium no-lapse UL or indexed UL policy with a “reimbursement” type of LTC rider; c) an annual premium no-lapse UL or indexed UL policy with an “indemnity” type of LTC rider. 

However, business cash flow used to fund personally owned linked-benefit combo life­–LTC products or reimbursement or indemnity riders on a universal life base policy are defined as life insurance contracts for tax purposes and will be considered to be taxable bonus compensation under IRC Section 162. As such, the annual premium will be deductible to the business as current compensation paid and fully taxable to the policyowner as current compensation received. Nevertheless, any LTC benefit claims paid from LTC riders of these types of UL life insurance products will be income tax-free.

Acharitable gift annuity (CGA) is a simple way to make a gift to a charity while retaining a lifetime income stream for the donor. It offers your clients a way to increase their income and get a substantial tax deduction, and the option to restore the value of the charitable gift for their heirs with life insurance.

A simple one-page legal agreement between the charity and the donor is all that it takes to make the plan a reality. The charity agrees to make a private annuity payment to the donor for life. The charity has the option to transfer the financial risk of making these payments to the donor by purchasing a commercial annuity from an insurance carrier. This annuity will be in the form of a single premium immediate annuity (SPIA) which provides the charity with a guaranteed stream of income to meet its obligation to make lifetime private annuity payments to the donor.

The donor can use some of the tax savings and/or income stream to purchase a life insurance policy to restore for heirs the value donated to charity. This “wealth restoration” would take place in the form of an income tax-free life insurance death benefit.

Does this concept sound like something that would interest your charitable minded clients? Let’s take a closer look at this dynamic concept. Listed below are a number of significant tax and benefit advantages for the donor as well as a few important advantages for the charitable organization.

Advantages to Donor

 • Converts appreciated capital asset into a lifetime guaranteed income.

 • Income tax deduction for present value of remainder interest to charity.

 • Asset is removed from estate for estate tax purposes.

 • Capital gain on donated asset is spread over donor’s life expectancy.

 • Donor can use part of annuity payment to purchase estate tax-free life insurance to “restore” asset for heirs.

 • Part of each annuity payment is taxed at lower capital gain rates.

Advantages to Charity

 • Charity receives a significant donation.

 • Purchase of SPIA commercial annu­ity by charity guarantees private annuity payments to donor and transfers mortality risk to carrier.

 • Donated funds not needed for SPIA purchase may be added to charity endowment portfolio or used for current needs.

 • Charity tax-exempt status allows it to sell capital asset with no tax consequences.

 • Simple unsecured gift annuity agreement and minimal paperwork.

In order to illustrate the value of the concept more closely, take a look at the hypothetical case scenarios.

Gift of Securities

Example one shows the effect of placing $500,000 of appreciated securities into a CGA arrangement. The capital asset will be donated to the charity and then be sold by the charity. The charity will take the cash proceeds and purchase an SPIA to guarantee its private annuity obligation to the donor. As you can see, there is even a significant amount left over after the purchase of the SPIA for the charity to add to its endowment or use for current charitable purposes.

Female, age 75, wishes to benefit local college and needs more income than her $500,000 of securities is currently providing. If she gives $500,000 to the charity in the form of a CGA, what are the financial results?

Assumptions

 Applicable Federal Rate: 2.0 percent

 Payout Rate: 5.8 percent (American Council on Gift Annuities recommended amount)

 Cost Basis for Securities: $250,000

 Adjusted Gross Income: $150,000

Results

 • Annual Income to Donor for Life: $29,000 ($5,940 ordinary income, $11,530 capital gain, $11,530 tax free basis).

 • Income Tax Deduction: $223,384 (Subject to 30 percent annual AGI limit with five-year carry forward for unused deductions—year one, $45,000; year two, $45,000; year three, $45,000; year four, $45,000; year five, $43,384). In a 35 percent combined tax bracket, this saves $78,184 of taxes over five years.

 • Charity purchases $352,473 SPIA to guarantee lifetime payout of $29,000 per year.

 • Charity adds $147,527 to its endowment portfolio or spends it for current needs.

 • If desired, donor uses part of after-tax annuity payments and/or tax savings to purchase $500,000 life insurance owned by irrevocable life insurance trust or adult children for “asset restoration” purposes.

 • An impaired risk SPIA could also be underwritten if the annuitant has a medical impairment. This would decrease the principle sum needed to guarantee the $29,000 per year lifetime SPIA payout.

Gift of Cash

Example two shows the effect of placing $100,000 of cash which has been withdrawn from a low interest bearing account and placed into a CGA arrangement. Even with this more modest amount, an amount is left over after the purchase of the SPIA for the charity to use for current charitable purposes.

Female, age 75, wishes to benefit local college and needs more income than her $100,000 money market account is currently providing. If she gives $100,000 of cash to the charity in the form of a CGA, what are the financial results?

Assumptions

 Applicable Federal Rate: 2.0 percent

 Payout Rate: 5.8 percent (American Council on Gift Annuities recommended amount)

 Cost Basis for Cash: $100,000

 Adjusted Gross Income: $50,000

Results

 • Annual Income to Donor for Life: $5,800 ($1,189 ordinary income, $4,611 tax free basis).

 • Income tax deduction: $44,677 (Subject to 50 percent annual AGI limit with 5-year carry forward for unused deductions—year one, $25,000; year two, $19,677.) In a 25 percent combined tax bracket, this saves $11,169 of taxes over two years.

 • Charity purchases $70,578 single premium immediate annuity to guarantee a lifetime payout of $5,800 per year.

 • Charity adds $29,422 to its endowment portfolio or spends it for current needs.

 • If desired, donor uses part of after-tax annuity payments and/or tax savings to purchase $100,000 life insurance for “asset restoration” purposes.

 • An impaired risk SPIA could also be underwritten if the annuitant had a medical impairment. This would decrease the principle sum needed to guarantee the $5,800 per year lifetime SPIA payout.

Combination of American Taxpayer Relief Act and Affordable Care Act Pushes Up Tax Rates for High Earners

Certain high earners will face a double-barrel shot of higher federal income taxes for 2013. The American Taxpayer Relief Act of 2012 (ATRA 2012) increased the tax rate for certain high earners from a maximum of 35 percent in 2013 up to a maximum of 39.6 percent in 2013.

In addition, provisions of the Affordable Care Act of 2010 (ACA) finally go into effect in 2013. For certain high earners, ACA provides for an additional 3.8 percent health care surtax on passive investment income under IRC Section 1411.

ATRA 2012 and ACA each have a different definition of who is classified as a high earner and who will be subject to the increase in tax rates.

Let’s take a look at the basic provisions of ATRA and ACA individually and then we’ll take a look at the combined tax effect for those who will get the double-barrel tax hit.

American Taxpayer Relief Act of 2012

Here is a summary of who will pay higher income taxes in 2013 based on ATRA 2012:

 • For married couples with total taxable income (below the line after itemized deductions) greater than $450,000 and single individuals with taxable income greater than $400,000, the top marginal tax rate will be 39.6 percent. This is up from a 35 percent maximum rate in 2012.

 • These tax brackets are indexed for inflation just as the income tax rates have been indexed since the early 1980s.

 • For married couples with total taxable income greater than $450,000 and single individuals with taxable income greater than $400,000, long term capital gain income and qualified dividend income will be taxed at a rate of 20 percent. This is up from a 15 percent maximum rate in 2012.

Affordable Care Act of 2010

Here is a summary of who will pay the health care surtax in 2013 based on ACA.

 • For married couples with modified adjusted gross income (above the line before itemized deductions) in excess of $250,000 and single individuals with modified adjusted gross incomes in excess of $200,000, there will be an additional 3.8 percent health care surtax on passive investment income.

 • These $250,000 and $200,000 thresholds are not indexed for inflation.

 • Passive income is defined as interest, rents, royalties and taxable annuity amounts and is taxed at ordinary income rates as high as 39.6 percent.

 • Passive income is also defined as long term capital gains and qualified dividends, taxed at the capital gain/dividend rates of 15 or 20 percent.

Combined Effect of ATRA 2012 and ACA

Chart 1 illustrates a summary of the combined effect in 2013 for those who will be subject to the increased tax rates of both ATRA 2012 and ACA. Note the threshold differences between ATRA 2012 and ACA. The $450,000/$400,000 threshold (indexed) of ATRA 2012 is based on excess taxable income above the threshold. The $250,000/$200,000 threshold (not indexed) of the ACA is based on excess modified adjusted gross income (MAGI) above the threshold.

                                 Combined Effect of ATRA 2012 and ACA

                                                           Top Tax Rate    Health Care Tax      Top Total Rate

Earned Income, Interest, Rents,            39.6%         +        3.8%         =         43.4%

Royalties, Taxable Annuity Amounts (Ordinary Income)

Long Term Capital Gain and                 15.0%         +        3.8%         =         18.8%

Qualified Dividends — MAGI

Married $250,000 / Single $200,000

Long Term Capital Gain and                  20.0%        +       3.8%         =         23.8%

Qualified Dividends — Taxable Income

Married $450,000 / Single $400,000

Additional Important Notes Regarding Passive Investment Income

 • Passive investment income under ACA is defined specifically as the lesser of net investment income or the excess of MAGI over the threshold amount (i.e., $250,000 married and $200,000 single).

 • Some common types of income are not considered passive investment income. This includes wages, salaries and bonuses (i.e., earned income); Social Security benefits; tax exempt interest; excluded gain on the sale of a personal residence; distributions from any type of a qualified retirement plan or IRA; and tax-free Roth IRA distributions.

 • Taxable distributions from qualified plans and IRAs and taxable amounts from IRA conversions to Roth IRAs will increase MAGI and could trigger the 3.8 percent tax for those with total income over the threshold amounts.

Example 1: 3.8 percent health care tax (investment income greater than excess MAGI over threshold).

Assume married taxpayers have a MAGI of $300,000 which includes passive investment income of $100,000. Since they are over the threshold of $250,000, they are subject to the additional 3.8 percent surtax.

 • The excess of $300,000 MAGI over the $250,000 threshold equals $50,000.

 • The surtax applies to the lesser of the excess MAGI over the threshold ($50,000) or the amount of net passive investment income ($100,000).

 • Thus the extra tax would be 3.8 percent of $50,000, or $1,900.

Example 2: 3.8 percent health care tax (investment income less than excess MAGI over threshold).

Assume these same married taxpayers have a MAGI of $400,000 which includes passive investment income of $100,000. Since they are over the threshold of $250,000, they are subject to the additional 3.8 percent surtax.

 • The excess of $400,000 MAGI over the $250,000 threshold equals $150,000.

 • The surtax applies to the lesser of the excess MAGI over the threshold ($150,000) or the amount of the net passive investment income ($100,000).

 • Thus, the extra tax will be 3.8 percent of $100,000, or $3,800.

The Effect of Higher Combined Tax Rates on Choice of Financial Assets

As a result of combined tax rates edging higher under current law (add state income taxes to combined federal rates), clients will consider certain types of financial assets more favorably. For example, tax-deferred and tax-free financial assets will become more attractive as the combined income tax rate on other alternative financial assets becomes higher. In 2013 the combined federal and state marginal tax rates for certain high earners can approach or exceed 50 percent.

The tax-favored financial products that might become even more attractive as combined income tax rates rise will generally fall into these categories:

 • Non-qualified fixed and indexed annuity products where the account value gain is tax deferred and withdrawals are taxed under the last-in-first-out (LIFO) method of taxation.

 • Non-MEC cash accumulation universal, indexed or whole life insurance where the cash value gain is tax deferred, withdrawals to basis are first-in-first-out (FIFO) and loans and death benefits are tax free.

 • Qualified retirement plans such as 401(k)s, 403(b)s, 457(b)s, IRAs, SEP plans, profit sharing plans and defined benefit plans where tax deductions and elective deferral contributions can be maximized.

 • “Standalone” long term care policies where the premium is either fully deductible or partially deductible to C corporations, S corporations and LLC business owners, and where any long term care benefit claim payments are tax free.

Technical Note: At this time, it is unclear whether any ordinary income taxation on life insurance policies will be considered passive investment income and subject to the 3.8 percent surtax. IRC Section 1411(c) does not specifically mention life insurance under the definition of net investment income. However, a liberal reading of the wording of IRC Section 1411(c)(1)(A)(iii) (“net gain attributable to the disposition of property”) could bring any income taxation of certain life insurance transactions under the definition of net investment income for purposes of the 3.8 percent surtax. Life insurance would seem to be a form of “property” that could incur a “net gain” under certain circumstances:

 • Surrender of a policy in a gain position.

 • Elimination and discharge of a policy loan in the process of a Section 1035 exchange.

 • Lapse of a heavily loaned policy in a gain position.

 • Withdrawals in excess of cost basis.

 • LIFO withdrawals/loans from a modified endowment contract (MEC) in a gain position.

 • “Force-outs” in the first 15 years from a policy under the IRC Section 7702(f)(7) definition of life insurance.

 • Sale of a policy in a gain position to a life settlement company.

All of these taxable transactions will generate a Form 1099R from the insurance carrier to the policyowner with a copy to the IRS.

What price would you accept if a potential buyer made an offer to buy your business today? Anyone with any knowledge of selling businesses will know this is a very simplistic way of looking at how to sell a business but I am just trying to paint a picture. The reality is not enough people are aware of how much their business is worth. The answer to the above question can help determine the buyout price for a written buy/sell agreement between two willing parties. It can also help determine how big the business acquisition loans need to be to fund such an agreement. It can also help calculate life insurance in the event one party passes away before the agreement is settled. In order to help business owner clients zero in on the estimated “fair market value” of their company, a business valuation using accepted IRS valuation factors can help determine that important number.

There are time-tested valuation factors based on Revenue Ruling 59-60 that are still valid for use today to estimate fair market value. Fair market value is generally defined as “the amount at which the asset would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of all relevant facts.”

Here are some of the important factors from Revenue Ruling 59-60 that may be relevant to determine the fair market value of a business for buy/sell and IRS valuation purposes:

??Nature and history of the business regarding growth, sales and stability.

??Economic outlook of the particular industry in which the business operates.

??Book value of the business as reflected in the balance sheet: assets minus liabilities equals book value.

??Earning capacity of the business, as reflected by the net profit of the income statement (profit and loss), may be the most important factor in determining business value. Net profit is simply total business revenue minus deductible business expenses. Net profit is sometimes called net earnings or net income for tax accounting purposes.

??Cash flow dividend paying capacity of the company.

??Nature of any intangible assets (such as goodwill) which can represent an excess of net profit over and above a fair rate of return for similar businesses in a particular industry. Or which can represent an excess of net profit over and above an alternative low risk rate of return.

The business factors described above can be quantified by a few basic business valuation methods used by professionals who are experts in valuing the stock of closely held business enterprises.

If you’re considering selling up, you can get independent valuations from sites like https://businessforsaleinrichmondva.com/. Here are four commonly used valuation methods that may provide a hypothetical estimate of business value for buy/sell agreement purposes:

Book Value. The net worth on the balance sheet (assets minus liabilities). Certain assets may be adjusted upward to reflect fair market value rather than the depreciated value shown on the balance sheet.

Straight Capitalization. The amount of capital that would have to be invested at a specified capitalization rate to yield the current net profit. Net profit may be adjusted upward to reflect excess shareholder salaries, bonuses and fringe benefits. This method is based solely on net profit from the income statement (profit and loss).

Capitalization of Earnings. Assumes that part of net profit is attributed to book value and any excess profit above a fair rate of return is capitalized by a business risk multiplier rate. The capitalized value of this excess profit is then added to book value.

Year’s Purchase. A conservative low-risk alternative rate of return is used to determine net profit attributed to book value. The excess balance is assumed to be attributed to goodwill. Then, this excess balance is multiplied by the number of years goodwill is expected to last. The value of this excess goodwill profit is then added to book value.

Following is a hypothetical example of an informal valuation of a retail, wholesale or manufacturing business where capital and profits are important factors. Acme Plumbing Supply, Inc. is a wholesale firm that has been in the plumbing supply business for 25 years. There are two shareholders, each with a 50 percent ownership interest. Its current book value is $2 million and its average net profit is $550,000. The fair rate of return on book value for firms of this type is 10 percent; goodwill is expected to last three years; the assumed capitalization risk multiplier rate is 20 percent; and the conservative low risk alternative rate of return on book value is 5 percent.

Table 1 shows a comparison of four basic valuation methods using this financial information.

In this example, the estimated fair market value of Acme Plumbing Supply, Inc. is about $3 million. With 50-50 stock ownership, each shareholder could be insured for $1.5 million to cover the purchase and sale obligation of a well-drafted cross-purchase agreement or stock redemption (entity) agreement.

This estimated value may serve as a starting point for further discussion with an attorney and CPA representing the client for purposes of a written buy/sell agreement. And, the preferred way to assure tax-free funding of this buy/sell obligation when one of the shareholders dies is a life insurance policy structured as either a cross-purchase plan or stock-redemption (entity) plan.

Note: The valuation methods described above should not be considered as the only alternative to a detailed analysis from a professional business appraiser. Business owners are encouraged to seek advice and expert analysis from a qualified business valuation appraiser. The designation ABV (Accredited in Business Valuation) is held by some CPAs who have completed additional coursework to attain this professional designation.