Leimberg’s

Think About It

Think About It is written by Stephan R. Leimberg, JD, CLU

and co-authored by Linas Sudzius

March 2009#397

Ending the Recession:

Five Ideas to Use Today

Introduction

The National Bureau of Economic Research (NBER) announced in December of 2008 that the economy of the United States had started its recession in December of 2007.

Aren’t you tired of it?

While the timing of a recovery is uncertain, it may start soon—or it may have started already. Statistics from the NBER show that recessions last for a limited time. For example, the longest U.S. economic contraction of the 20th century lasted 43 months—during the heart of the Great Depression. On the other hand, the recovery from the internet bust of 2001 started afterjust eight months.

What can we do to speed up the recovery? Plenty of ideas—some routine, others more creative—have been making the rounds:

  • Cut taxes
  • Privatize federal tax enforcement
  • Develop alternative, “green” energy sources
  • Legalize and tax the sale and use of marijuana
  • Eat much more junk food as a nation

While those ideas are interesting, they don’t provide much real guidance for us. Any effort to overcome a set of financial challenges on the individual or small business front requires focused personal effort.

As a suggested roadmap toward the goal of personal prosperity, we offer five ideas that that life insurance producers can use now.

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1

Two strategies are based in recent rule changes that have generated an opportunity for life professionals:

  • Section 101(j) review
  • Section 409A checkup

Three other activities should be good now or anytime in the future:

  • Beneficiary designation review
  • Buy-sell review
  • ILIT checkup

The point of each of these efforts is to provide a valuable service for your customers and prospects, while maximizing your ability to promote profitable relationships.

Section 101(j) Review

Section 101 (j) applies to all life contracts issued after August 17, 2006, and all contracts materially modified after the same date.

Thecode section provides that the death benefit received by an employer from life insurance on an employee will be taxable to the extent the death benefit exceeds premiums paid. If certain conditions regarding notice and other matters are met, the death benefit can still be tax free.

Making sure that clients and prospects have conformed to the requirements of 101 (j) is the main point of the review.

All of the following notice requirements must be met before the life insurance contract is issued, or, in the case of a pre-August 19, 2006 policy, prior to its material modification.

  • The employee must be notified in writing that the employer intends to insure the employee’s life, stating the maximum amount of insurance involved;
  • The employee must provide written consent to being insured and consent to the employer continuing coverage after termination of employment; and
  • The employee must be informed in writing that the employer will be named beneficiary.

The IRS has not given any guidance on how to cure a failure of the notice requirements. For example, if the employee signs a notice and consent form afterthe policy is issued, instead of before, the notice requirement is probably not met. Since we’re not sure the failure can be fixed, the only remedy might be to seek new life coverage.

In addition to the notice requirement, one of the following exceptions must apply in order for thedeath benefit to be tax-free:

  1. The insured was an employee at any time during the 12-month period prior to the insured’s death, or
  2. The insured, at the time the life insurance contract was issued, was either a director or a highly compensated employee, or
  3. The death benefits are paid to the insured’s heirs.

A thorough Section 101 (j) checkup means asking questions to make sure at least one of the exceptions applies to the policy. For example, if the insured left the employ of the business in 2007, the insured was not a director or highly compensated employee at the time the coverage was purchased, and if the company is the beneficiary, Section 101 (j) says the death benefit will be taxable when paid to the company. The company should make a conscious decision about whether retaining the coverage is sensible.

In order to do aSection 101 (j) review, the following information is needed:

  • Copy of the policy, including application
  • Copy of the Notice and Consent form
  • Statement from a company official regarding insured’s current relationship to the company, as well as relationship at the time the coverage was procured or modified
  • Copy of any beneficiary change documents

In addition to making sure the 101(j) requirements are met, the review should also check to make sure the company is properly reporting the existence of any business-related life policies. IRS Form 8925 must be filed by an employer owning life insurance to report the number of employees covered by employer-owned life insurance contracts issued after August 17, 2006. The form also reports the total amount of employer-owned life insurance in forceon those employees at the end of the tax year. The policyholders must also indicate whether a valid consent has been received from each insured employee, and the number of insured employees for which a valid consent has not been received.

Section 409A Checkup

The basic motivation behind Revenue Code Section 409A is that the federal government believed that many deferred compensation plans that were created in the past unfairly deferred income taxes. The federal government has mandated if the plan does not meet some very restrictive requirements, the income tax result for the plan participant is accelerated.

The regulations for Section 409A have been finalized. For those employers who have implemented some type of nonqualified deferred compensation, the focus of a Section 409A review is to check the plan document and the plan’s administration for conformance with the regulations.

Please note that Section 409A is highly technical, and a thorough checkup requires the input of a competent attorney and accountant. However, it is possible to make some general observations:

  • Section 409A is broad in its scope—potentially including supplemental executive retirement plans (SERPs), phantom stock plans, severance plans and split dollar plans.
  • The deadline for strict compliance with the regulations—for both the plan document and plan administration—was December 31, 2008.
  • Failure to comply means a potential immediate income tax result for the participant plus a 20% extra tax on all amounts deferred.

If your client or prospect isn’t sure their plan is in compliance, it’s your opportunity to

  • Get a copy and have an expert take a look at it or
  • Get in a 409A discussion with the client’s own advisors.

It may be too late to fix a plan that is flawed for this year’s taxes, but you can make sure the client’s plan conforms to 409A’s requirements going forward. And if you’ve picked up a copy of the plan, you have an opportunity to do a more robust review—including checking the plan’s funding through life insurance and other financial products.

Beneficiary Designation Review

To do a beneficiary review for a life policy requires knowing who the current primary and contingent beneficiaries are. The most reliable way to get the information is to check with the life insurance company.

Once the information is obtained, here’s what should be checked:

  1. Are the named beneficiaries consistent with the client’s current distribution intentions? For example, is the client’s ex-spouse still the primary beneficiary of the policy? If so, perhaps the designation should be changed.
  1. Are the beneficiary designations consistent with the client’s other estate planning documents? Perhaps the client’s children are named contingent beneficiaries. If those children are minors or spendthrifts, naming them beneficiaries may be unwise. It may be smarter to name a trust created under the client’s will as the beneficiary—so more controls are in place.
  1. Is either the primary or contingent beneficiary the client’s estate? If so, the client may be better served to name a beneficiary instead. If the estate is the beneficiary, the access of the heirs to any money associated with the financial product is delayed because the money must go through probate. With probate, in some cases, the delay can be a year or more. Any asset forced through the probate process becomes part of the public record, so privacy is lost. In most jurisdictions life insurance that goes to the estatealso becomes subject to the claims of creditors of the decedent.
  1. Does the beneficiary designation make tax sense? If a wife owns a policy on her husband’s life and names the kids the beneficiaries, the wife is making a taxable gift to the kids at the husband’s death. Do the parties intend that result? Probably not. If the designation does not make tax sense, it’s an opportunity to talk to the client about the alternatives.
  1. Is the beneficiary designation technically correct? As with other legal documents, the words used for a beneficiary designation matter. See the April, 2008 issue of Think About It for suggested beneficiary language that can be used for a variety of situations. However, make sure you check with the life company, as well as the client’s advisors, to make sure any beneficiary change accomplishes what’s intended.

Buy-Sell Review

Many of our business owner clients have buy-sell agreements in place. Properly drafted and funded, a buy-sell agreement can be a godsend to family members in the event of a business owner’s death.

If a buy-sell agreement is wrong, it can lead to family strife, litigation, unintended financial consequences and the failure of the business.

Here’s a quick list of the most important things to visit with business owner clients about when performing a review:

  1. Is the buy-sell agreement adequately funded with life insurance? If Al and Bob each own 50% of a business worth $5 million, they ought to consider having at least $2.5 million of coverage on each of their lives.
  1. Does the structure of the insurance funding match the buy-sell obligations? For example, in a cross-purchase arrangement, the parties might have mistakenly let each insured own the policy on the insured’s own life. Or in a redemption arrangement, the parties may have mistakenly named the insured’s spouse the beneficiary of the policy—instead of the corporation. The funding structure should be fixed to match the buy-sell agreement.
  1. Is the structure of the buy-sell agreement optimized for tax and practical objectives? The agreement may be structured as a redemption when a cross-purchase plan is indicated—or vice-versa. Checking this creates an opportunity to engage the client’s tax advisor to be part of the conversation, to check if the agreement is efficient for the parties.
  1. Are all the relevant buyout triggers included in the agreement? Life insurance professionals usually focus on the death buyout trigger in a buy-sell agreement. However, business owners may be interested in others—including disability, retirement, divorce and bankruptcy. The agreement should be checked against the objectives of the business owners.
  1. Is the buyout price stale? If the buy-sell agreement is more than a few years old, the price set in the buy-sell agreement may not reflect the true current value of the business. The parties might need to update the price or convert to a formula valuation method. They may also need to modify their funding to conform to the new terms.
  1. Are all the relevant businesses included in the scope of the buy-sell agreement? Entrepreneurs are funny—sometimes they get in the habit of creating businesses. Often even those who have one main business will also be the sole or part owner of the building where the business is located. Each business, including each business property, should be separately evaluated for inclusion in a buy-sell agreement.
  1. Are there any special family issues that have not been adequately addressed? Is the situation one with a blended family, where multiple family members work in the business? If so, the buy-sell agreement needs to be tightly integrated with the overall estate plan. Is fixing the value of the business important for estate tax reasons? Then Section 2703 requirements should be taken into consideration.

For a checklist you can use to do a thorough buy-sell review with a business owner, see the June, 2008 issue of Think About It.

ILIT Checkup

For those who have an irrevocable life insurance trust in place to pay for estate taxes, a checkup of the ILIT should include:

  • Reviewing the trust words to ensure they match distribution intentions
  • Documenting the implementation steps to solve any potential lingering tax issues
  • Listing annual administrative procedures to check conformity with
  • Trust requirements
  • Tax requirements
  • Evaluating performance of the trust-owned life policies for due diligence purposes

Making Sure the Trust Terms Match Intentions

One of the biggest drawbacks of an irrevocable trust is this: irrevocable means irrevocable.

What are the alternatives if the grantor’s original intentions no longer match the current situation? For example, what if the grantor and his spouse are divorced? Or what if the grantor has become estranged from one or more children?

There are a few ways that it may be possible to undo an irrevocable trust when its terms have become stale, or inappropriate. None of these alternatives should be attempted without the active advice and guidance of the client’s attorney.

  1. Stop feeding the trust and start over with a new one. If the existing ILIT has not been funded with lots of money, and if the insured can qualify for new coverage, ending the trust contributions may be the easiest way to fix a broken ILIT. The grantor would simply stop supporting the existing ILIT and its policies, and start over with a new ILIT and new coverage.
  1. Reform the trust with a non-judicial settlement agreement. Each of the states has its own rules about how trusts may be administered. In some states, the trustee and beneficiaries have a limited ability to change the provisions of an ILIT. In general, to make such a change, all the beneficiaries and the trustee must agree on the change to be made. This kind of change is called a non-judicial settlement agreement. An agreement of this type may allow the parties to fix problems with an ILIT – but may be difficult if some of the beneficiaries are minors or under a legal disability.
  1. Reform the trust through a court petition. ILITs can sometimes be modified through court action. A petition to amend a trust is more likely to be successful if all the beneficiaries and the trustee agree. This technique of changing an ILIT is usually a tool of last resort, and it is relatively expensive and the result can be uncertain.
  1. Use the trust terms as an escape hatch. The ILIT terms themselves can suggest a way to sensibly undo an ILIT. For example, say that Brian’s ILIT purchased insurance on his life. The ILIT is for the benefit of Brian’s wife Amy during her lifetime, and their three children at the second death. If Brian becomes estranged from one of his children, and if the ILIT has the right kind of words, the trustee may have the discretion to distribute the policy to Amy. If the trustee does so, Brian and Amy may be able to work together to start over with the existing policy and a new ILIT.

Checking Up on Implementation Steps

In a perfect world, CrummeyILITs are implemented this way:

  1. The ILIT is created and funded by the grantor.
  2. The trustee of the ILIT sends Crummey notices to the beneficiaries.
  3. The beneficiaries decide not to withdraw the money.
  4. The trustee decides to apply for insurance on the life of the grantor.
  5. The insurance is approved.
  6. The trustee pays the premium.

The reason for these theoretical steps is to conform to the requirements of the Crummey case and its subsequent set of rules, regulations and cases.

The procedure described is NOT the only way to achieve estate tax exclusion of the death benefit. However, some variations from the perfect implementation may create a danger of inclusion in the grantor’s estate for three years after the purchase of the insurance.

For example, say that the proposed insured applies for coverage prior to the creation of the ILIT. To conditionally bind the coverage, the insured sends a check in with the application. After the coverage is approved, the insured creates an ILIT. The insurance company issues an amendment to the original application reflecting the fact that the ILIT is the owner of the coverage.