Income Recognition from Cancellation of an Insurance Contract

The general rule is that that the proceeds of a life insurance contract, payable on the death of the insured, does not create taxable income. Consequently, even though the beneficiaries of a life insurance policy may realize a substantial economic gain by the receipt of the proceeds, this gain will not generally be taxable. However, one should be careful in dealing with an insurance policy during the lifetime of the insured. Some policy owners will borrow the cash surrender value prior to death to pay premiums, which may create a tax problem, as illustrated by a recent Tax Court decision.

In that case, a taxpayer purchased a life insurance policy and made premium payments for the first 13 years of the policy. The taxpayer elected an automatic loan premium provision in the event that the owner stopped making premium payments. Eventually, the taxpayer stopped making premium payments and the insurance company used the automatic loan premium provision to borrow the cash surrender value prior to death to pay the premiums. The policy provided it would lapse if its cash value could no longer cover the premium payments. This would occur if the outstanding loan balance and interest exceeded the policy's cash value.  The insurance company notified the taxpayer that the policy had lapsed because the outstanding loan balance and interest exceeded the policy's cash value.

To understand the consequences of this action it is important to understand that Internal Revenue Code Section 61(a) defines gross income as “all income from whatever source derived,” unless otherwise provided. Generally, any amount that is received under a life insurance contract prior to death is included in gross income to the extent it exceeds the investment in the contract. The phrase “investment in the contract” is defined generally as the aggregate amount of premiums or other consideration paid for the contract less the aggregate amount previously received under the contract, to the extent it was excludible from gross income. In the case at hand, the difference between the outstanding loan balance and the investment in the contract was $37,981, and the insurance company issued a Form 1099-R showing this taxable amount.

The taxpayer timely filed his personal income tax return but did not report the taxable amount shown on the Form 1099-R. The IRS eventually sent the taxpayer a notice of deficiency showing an adjustment to income of $37,981 for pensions and annuities. The taxpayer argued the amount was not income for purposes of income taxation.

The Tax Court determined that for Federal income tax purposes, loans against the cash value of a life insurance contract are true loans from the insurance company to the policyholder with the policy serving as collateral and thus not taxable distributions when received. When the insurance company terminated the policy, it charged the amounts of policy loans and capitalized interest against the proceeds from termination made available at that time. This constructive distribution in satisfaction of the loans had the effect of a payment of the policy proceeds to the taxpayer constituting income to the taxpayer to the extent it exceeded his investment in the policy.  In this case, of the Tax Court agreed with the IRS in charging penalties as well as interest because the taxpayer had knowledge of the income because he received the Form 1099-R.

When clients have financial difficulties, they will often use premium policy loans to carry the policy in difficult times, or may cancel the policy altogether. Due to the potential for unintended tax consequences clients considering these actions should seek professional help to determine policy parameters and tax consequences. 

Alan Ferrara

Confusion about Medicaid Planning

    In recent years, the number of seminars regarding Medicaid planning available to senior citizens has rapidly increased. While Medicaid planning is a portion of our practice, we often find that clients who believe they need Medicaid planning lack sufficient information about both the benefits of Medicaid and the Medicaid qualification process. 

     First, proper Medicaid planning does not involve assisting the client in hiding assets from the government, nor does it include any legally or ethically questionable actions. Proper Medicaid planning does include assisting clients in the Medicaid application process and using available strategies to ensure that a greater portion of the client’s assets remain available for non-Medicaid spouses or go to family members instead of getting consumed by the costs of long-term care. 

     It is important to remember that the process of qualifying for Medicaid means reducing the client’s assets and income to a very low value. Before engaging in such reductions, it is important for the client to understand what benefits Medicaid provides, because while Medicaid is often called “the best insurance money can’t buy” Medicaid qualification does mean a substantial limitation on the client’s care choices. Often, when faced with the reality of Medicaid, clients who previously expressed concern regarding what their children will inherit realize that their hard work and responsibility should result in their own increased comfort. 

     As I stated earlier, many clients come to us with Medicaid planning questions after attending a seminar presented by an “elder law” advisor. While some of these seminars provide senior citizens with good information and encourage them to explore options, there are many operated by less scrupulous individuals that exist to take advantage of seniors. When our clients ask about Medicaid planning we first discuss the scope of care choices that their current financial situation provides. Then we discuss the health issues that the client believes may lead to the need for long-term medical care. Finally, we address the scope of Medicaid benefits. Only then, if after those discussions the client is still interested in the planning process, do we begin discussion of the assets that Medicaid planning may protect for the benefit of spouses or loved ones. 

     Medicaid qualification is a complex area of law and clients should discuss any planning, gifting, or divestment of assets done in anticipation of a need for Medicaid with their advisors and attorneys in order to avoid actions that leave the client without sufficient assets and unable to qualify for Medicaid benefits.

Matt Ferrara

Eliminating Unrecorded Deeds

    In past blogs, we discussed the importance of properly funding a Living Trust to ensure that estate plans function as intended. Today's blog addresses a long-standing technique for funding real estate to a trust that has fallen out of favor in recent years, but is likely a part of many long-standing estate plans.

     Holding real estate jointly as husband and wife offers significant protection for the property against the claims of either spouse’s creditors. In the past, attorneys were unwilling to cause their clients to give up this protection with respect to real estate in order to fund a Living Trust while both spouses were alive. To address this issue many attorneys recommended executing a Quit Claim Deed from husband and wife to a Living Trust, but not recording the deed while both spouses were alive. Instead, the client or attorney would put the deed in a drawer (or safe) to record later, if something should happen to both husband and wife. Over the years, many unrecorded deeds were placed in drawers, safety deposit boxes, and safes for Successor Trustees and Personal Representatives to discover. Not only will a creditor's attorney argued that these are completed deeds and therefore the creditor protection of jointly owned real estate no longer exists, but these unrecorded deeds can create a great deal of confusion in the administration of an estate.

     In recent years a form of deed known as a Quit Claim Deed with Reserved Life Estate to Grantor, or more commonly a Ladybird Deed has become more widely used because it reduces the need for unrecorded deeds in estate planning. A Ladybird Deed allows the property owners to establish a lifetime right of ownership in the property, including the right to sell or dispose of the property in any way they choose. If the owners take no other action, at their death the property passes automatically to the person or entity, such as a Living Trust, named in the deed, without the need to pass through Probate. This allows a married couple to retain the creditor protection of jointly owning property while ensuring that their Living Trust ultimately controls the disposition of all their property without the necessity of Probate. This type of deed can also be effective for a single person who desires to avoid probate with respect to real estate, but is not ready to transfer property to children because they may have their own creditor issues or because it is impossible to sell property later without the children's permission.

     In most states (including Michigan), in order to be effective, a Ladybird Deed must contain particular language. For this reason, it is important to seek the advice and counsel of an attorney familiar with property transfers prior to signing any new deeds. Failure to include the correct language may result in unanticipated consequences, including loss of creditor protection, an unexpected transfer of the property, or an unwanted uncapping of the property value for the purposes of determining property taxes.

Matt Ferrara

Leveraging IRA Accounts using Life Insurance

One interesting item in President Obama's latest budget proposal is limiting IRA accounts to $3 million, or some number calculated to purchase a maximum benefit of $205,000 at retirement. In addition to limiting the amounts that can be tax-deferred under IRAs, this would probably have the effect of minimizing the benefit of "stretch IRAs". While this idea may never be a part of the final budget it does bring to mind a planning option I have used with IRAs in the right circumstances.

Because IRAs eventually are generally fully taxable, a $3 million IRA, or even a smaller IRA, will be subject to significant income taxation. If the taxpayer's estate is above the $5 million lifetime exemption, the total tax burden on the IRA only gets worse.

If a client desires to maximize the amount going to their heirs, they may want to consider leveraging their IRA using life insurance. The strategy works as follows:

1. Presuming the client does not need IRA distributions to support their lifestyle, Instead of delaying IRA distributions until age 70 1/2, a client begins taking distributions after 59 1/2 when there are no longer penalties for early distributions.
2. After paying the income tax on the IRA distribution, the client gifts the remainder of the distribution to an Irrevocable Trust benefiting family members.
3. The Irrevocable Trust Trustee purchases a life insurance policy on the life of the client. After satisfying some legal requirements (Crummey Notices), the Trustee uses the funds to pay the annual premium of the life insurance policy.
4. At the death of the client, the Trustee collects the insurance proceeds, income tax-free, and uses them for the benefit of the client's family.

The client has succeeded in turning a heavily income (and possibly estate) taxed IRA account into a tax-free account, of significantly greater value, depending on the size of the insurance policy.

If the beneficiaries are minors or adults without a good record of handling money, the Irrevocable Trust can protect them from themselves and their creditors. If all of the beneficiaries are adults and the client is comfortable with their maturity, the client can simply make gifts to the family members who will then use it to purchase a life insurance policy on the client. Either way, the proceeds are income tax-free and, if properly structured, are not part of the client's estate.

The client can go a step further if he/she does not like the idea that the IRA benefits are going to be income and possibly estate taxable after death. The client and the client’s spouse can have full use of the IRA account during their lifetimes, and then provide that at the second death the IRA account be distributed directly to a charity, tax-free. The family members get their benefit, the charity gets its benefit, and the only entity that loses is the Internal Revenue Service.

Most of my clients are not inclined towards making significant charitable gifts, but with the right strategy, they love the idea that their loved ones are protected, they can satisfy any charitable inclinations, and the IRS is essentially paying for it. With proper planning and the help of qualified professionals, family members are better protected.

Alan Ferrara

Dealing with Digital Assets

     In previous posts, we addressed handling tangible personal property after the death of the owner. However, in a world where a person's online presence increases on a daily basis, it is just as important to plan for the distribution of digital assets and securing a person's online presence after death. An online presence includes access to bank accounts, paying bills, viewing photos uploaded to Facebook, and any other online service.

     Certain services, such as Facebook and more recently Google, have begun to take steps to address what happens to their user’s information following that user’s death, and how a personal representative can gain access to such information. In the coming months and years, other services are very likely to follow suit, but this leaves a patchwork of different private organizations dictating the rules for handling an individual's personal information.

     One method to address this piecemeal collection of rules is to include specific language in a Will and Living Trust giving the designated representative under those documents the authority to gain access to online accounts. This is an untested and unknown area of law, but there is substantial legal basis for service providers to work with the personal representative to deal with digital assets.

     A second, and perhaps more practical approach, is to keep a careful record of login information and passwords in a location known to the designated representative, so that in the event of the owner's death, accounts and information are accessible. One commonly used method for creating this repository of passwords is the use of a cloud storage service, such as Google Drive, Dropbox, or  Amazon Cloud Drive, to store a document containing all the logins and passwords. The person then leaves the password to access that cloud storage service in a location with their estate planning documents or known to the designated representatives. While this method has a small chance of creating a security problem if the cloud storage service suffers a security breach, it is the most efficient way to keep track of the ever-growing number of logins and passwords used on a regular basis.

     One way to minimize security concerns is to ensure that the passwords you use, for sites you access regularly and for cloud storage services are strong. Many sites online can provide you with advice on creating strong passwords. My personal favorite is xkcd.com, which demonstrates how to create strong passwords using this comic at its website. Microsoft also provides a tool for checking password strength.

     Our online presence is unlikely to decrease in the coming years, and therefore it is important that we spend as much time securing our digital assets as we spend securing our tangible ones.

Matt Ferrara

Passing on Vacation Homes and Cottages

     As the temperature slowly inches upward, indicating the actual arrival of Spring, it is a good time to discuss vacation homes and cottages. These properties are common in Michigan and frequently represent a substantial portion of an estate's assets. With the substantial increase in property values over the past 30 years, long-held vacation properties purchased decades ago now likely have substantial resale value. 

      We posted previously about keeping a vacation home in the family. For those who wish to see a family vacation property enjoyed by future generations there are concerns about the best way to structure such a transfer. Clients need to balance their desire to make a well-intentioned gift that has provided so many positive memories with the possible unintended burden on beneficiaries that may cause strife among loved ones. Additionally the transfer of such high-value assets brings with it potential estate and gift tax implications. While the current estate tax exemption creates a situation where risk of potential tax liability is very low, few people wish to use up any more of that exemption than necessary. Therefore, strategies that take advantage of the annual gift exclusion and allow for transfer of the vacation home over time rather than at death remain popular. 

      One result of a current real property transfer is the possible increase of property taxes for a new owner because the value of the property for determining property taxes may increase following the transfer. Michigan law places limits on the amount that the appraised value of a piece of property may increase for the purposes of calculating property tax liability while an owner continues to own property. The county, however, reassesses the value of the property when the property is transferred to a new owner. This reassessment is commonly known as "property tax uncapping." Certain transfers of property, such as between husband and wife or to the current owners’ living trust, are exempt and do not cause the property to uncap. In addition, as long as a husband and wife own more than 50% of the property, there will be no property tax uncapping. 

      Until recently, the list of exempt transfers did not include the complete transfer of property between parents and their children. While clients could reap potential benefits by transferring real estate during their lifetime (and avoid estate tax at death), the consequences in terms of increased property taxes outweighed the benefits of the transfer. Late in 2012, the Michigan legislature approved a change to the list of exempt transfers that goes into effect on December 31, 2013. Starting on that date, transfers to a first generation blood relative, that is from an individual to their children or to their parents, does not cause the property to uncap for the purpose of determining property tax liability. This new rule allows the transfer of a greater portion of the property to other family members without increasing property taxes. 

     This change creates the opportunity for clients to transfer vacation property to their children, whether via gift or through direct sale, without exposing their children to substantially higher property taxes. Any clients considering transferring vacation homes should wait until the end of the year to do so. As with any other tax or gift planning strategy is important to understand each client individual circumstances and consult with their professionals to ensure that the planning will not have unforeseen consequences.

Matt Ferrara

A Further Look at Portability

As we discussed last week, there are benefits to the concept of portability in estate planning. However, portability has several limitations.

1. The unused Generation Skipping Tax (GST) Exemption of the spouse dying first is not portable and will be lost if not used. A client who wants to leave assets in trust for the benefit of future generations more remote than the first generation below the client’s will want to use a trust to take full advantage of the GST exemption.
2. Assets passing outright to the surviving spouse likely are subject to the claims of creditors of the survivor, including any subsequent spouse in a divorce. Placing property in trust provide better protection from such claims.
3. A trust provides independent management of the assets, protecting them from the unwise decisions of the beneficiaries. Even clients who believe that their spouse and children are competent managers may want to consider this benefit, because it avoids the potential adverse influence of unwise friends and in-laws.
4. As discussed previously, to secure portability the surviving spouse must file an estate tax return, even if one otherwise would not be due, and that may increase the costs of administering the estate of the first-deceased spouse.
5. The DSUE (Deceased Spousal Unused Exemption) amount is not indexed for inflation. Property passed via credit-shelter trust instead of relying on portability, may appreciate at a rate equal to or greater than inflation, allowing a greater amount of assets to pass free of estate tax when the surviving spouse dies.

        When counseling married couples who expect their combined wealth to fall well below the combined sum of two estate tax exemptions it may take several conversations to reach a decision about whether to use a credit-shelter trust or to rely on portability. In this situation, one option some may choose is to leave the entire estate to the surviving spouse but provide that to the extent the survivor disclaims the bequest, it will pass into a credit-shelter trust for the surviving spouse and, perhaps, for the couple's descendants.        Disclaimer planning that arguably does not save taxes may be a tough decision for a surviving spouse. Counting on the surviving spouse to disclaim in this situation and give up control of the assets may prove foolish.  In client discussions, consideration must be given to the benefits of a basis step-up on the second death.

Most Wills for married couples should now address the question of whether the executor should be required to elect portability, or be given discretion to elect portability. The document should reflect who should pay for the cost of the estate tax return, if it is filed solely to elect portability.  A married taxpayer who plans to use portability should direct his or her executor in his or her Will to file an estate tax return and make the election. Otherwise, the executor may decide not to incur the cost of filing the return

Portability also may become an important discussion for a provision in a prenuptial or postnuptial agreement, to ensure that the surviving spouse is required to use portability to minimize estate taxes on the first death, maximizing estate tax savings on the second death.

As with all estate planning options, the use of portability should be carefully reviewed with clients to make sure that the client takes into account not only estate tax savings, but also their own needs and desires. 

Alan Ferrara

Pros and Cons of Portability

     The most recent tax legislation made the concept of "portability" a permanent fixture in estate tax planning. Portability is the ability of a surviving spouse to use the deceased spouse's unused exemption amount (DSUE) and thus protect greater amounts against estate tax on the second spouse's death. Portability has the potential to be both a blessing for clients and a curse, if not used properly.

     Generally, estate planners used the credit-shelter (non-marital portion) trust to exclude an amount equal to the first deceased spouse's unused applicable exclusion amount from the gross estate of the surviving spouse, together with any appreciation and undistributed income on that share. This insured that on the death of the first spouse an amount equal to that person’s entire applicable exemption went into one trust, while any additional assets went into the marital portion and passed to the surviving spouse free of any estate tax. Now that portability is permanent, practitioners need to consider whether using a credit-shelter trust continues to be appropriate or whether reliance on portability is preferred.

     The conventional non-marital trust is a superior vehicle for reducing estate tax than is a portability election, because it avoids estate taxes not only on the initial value of assets allocated to the non-marital share, but also the appreciation and accumulated income in the non-marital share between the deaths of the two spouses. 

Portability, however, can be a superior technique in cases where

• The couple hold most of their assets in a form that cannot be used to fund a non-marital share, such as joint tenancy with a right of survivorship or contractual rights (such as life insurance and retirement benefits); 
• The estate consists largely of retirement benefits that will make funding a non-marital share less effective as a means of avoiding estate taxes; or 
• The decedent dies without having an estate plan that includes a non-marital trust. 

       Portability has a number of other significant benefits, the largest of which is simplicity. On the death of the first spouse, the entire estate can pass outright to the surviving spouse, giving that person total control over all assets. The Personal Representative of the deceased spouse's estate can file a timely Form 706 and elect to allow the surviving spouse to be able to use the DSUE amount and no part of the exemption of the first-deceased spouse is wasted. As an added benefit, the surviving spouse receives a automatic basis adjustment ("step up") when the surviving spouse dies for assets received from the first deceased spouse which are later included in the surviving spouse's estate

     Additionally, portability preserves the entire unused exemption of the first spouse to die, even if that spouse's estate was too small to use the entire exemption. A deceased spouse's estate that is valued at zero may still leave to the surviving spouse a DSUE amount equal to the entire unused applicable exclusion amount, if a timely estate tax return is filed and an election is made.

       Portability is especially useful when the first-deceased spouse's assets are largely items of income in respect of a decedent, such as retirement benefits (e.g., an IRA) and deferred annuities. Such assets are poor choices to fund a non-marital share, because they will be reduced by income taxes when they are received.

       Finally, portability is available when the assets of the first deceased spouse pass outside of the will or revocable trust, and are therefore unavailable to fund the non-marital share. This could occur if much of the decedent's assets are held jointly with the surviving spouse with a right of survivorship, or are contractual benefits, such as life insurance. Portability is still available in such circumstances.

     The permanence of portability brings many interesting planning opportunities, but it is not without its pitfalls. Next time we will discuss the drawbacks and potential traps of using portability.

Alan Ferrara

Simplifying Estate Planning

     Our last two posts discussed the increase in the applicable exclusion to $5,250,000, which vastly reduces the number of estates with potential estate tax liability, but makes for the possibility of problems for surviving beneficiaries if older estate plans are not updated. At the same time, under the other circumstances, the new estate law allows couples to simplify their estate plan significantly. 

     A common practice, because of lower applicable exclusion amounts in prior years, involved each spouse having a Living Trust and splitting the couple’s assets between the two Trusts. Using this strategy, each spouse’s Trust protected the applicable exclusion amounts at their death and there was only potential tax liability on the second death if the estate exceeded twice the applicable exclusion amount. 

     With the permanent applicable exclusion at $5,250,000 increased annually by the cost of living, couples who expect they will always have less than that amount may decide to simplify their planning by changing to one Joint Trust, where both parties control all the assets during their lifetime and the survivor of them controls all the assets until their death. This simplification is effective where both parties trust each other and where both spouses agree on the final takers under the trust. In these circumstances, the couple only requires one trust and all assets can be funded to that trust to minimize documentation, investment statements, and administration. 

     We would be remiss if we did not remind readers that even if the non-marital trust is not needed for estate tax purposes, the non-marital trust has significant benefits. If the typical marital/non-marital share is kept in place, the surviving spouse’s creditors cannot reach the principal of the non-marital share because it is irrevocable and the spouse cannot change or control the principal. The spouse can use the trustee and the trust terms as a shield against a possible new spouse, while still being able to use the trust income, preserving the principal for children and other loved ones. Additionally, if children are prone to asking for money, the non-marital trust allows the surviving spouse to say “no” due to their limited access. The trustee can also protect from children badgering mom or dad for money prior to the death of the second spouse. 

     Even without a tax concern, the non-tax reasons for maintaining two trusts continue to factor into the planning discussion. A client’s goals and concerns regarding asset protection, divorce and remarriage protection and protecting children remain important. Before making any changes it is important to discuss all aspects of a client’s situation and collaborate with the client’s other financial professionals to avoid costly errors.

Alan Ferrara