In Brief

The Tax Cuts and Jobs Act of 2017 will have far-reaching effects on many areas of financial planning, and life insurance is no exception. The authors detail four changes with important ramifications for life insurance planning. The authors detail several strategies affected individuals can use to modify their arrangements in order to remedy deficiencies and take advantage of new opportunities.

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The passage of the Tax Cuts and Jobs Act of 2017 (TCJA) will mean sweeping changes in many areas of federal tax law. There are four provisions of the TCJA that will have the greatest affect on life insurance planning: 1) the increased lifetime gift tax exclusion, 2) the lower 21% maximum corporate tax rate, 3) new rules for life settlements, and 4) new rules for life insurance company reserves and deductions.

Using the Increased Lifetime Gift Tax Exclusion

The TCJA increased the basic exclusion amount under Internal Revenue Code (IRC) section 2001(c)(3)(C) from $5 million to $10 million, further adjusted for inflation. Even with the new use of the Chained CPI (C-CPI-U) mechanism for computing the inflation-adjusted amount, the result will be a significantly higher lifetime exclusion for estate and gift tax purposes. In 2018, an individual’s exclusion will be $11.18 million, and a married couple using portability will have an exclusion of $22.36 million. In addition, the generation-skipping transfer (GST) tax exemption will also be approximately $11.18 million in 2018, although portability is not applicable. With such large exclusion amounts, many new planning opportunities using life insurance have become available.

As significant as these increases are, however, they are currently temporary provisions. The lifetime exemption amounts are scheduled to sunset—returning to their pre-TCJA amount, as adjusted for inflation under the Chained CPI methodology—beginning in 2026. That means that financial planners have eight years, beginning with 2018, to help individual clients make the most of these large exclusion amounts. Therefore, the greatest opportunities for planning present themselves with respect to lifetime gifts and GSTs rather than in the context of the estate tax. If there is a change in which party controls Congress and the White House, there is also the possibility that these amounts could go down sooner.

This level of lifetime exclusion applies primarily to wealthy individuals and families, many of whom may have previously used at least part of their lifetime exclusion. Consequently, it is the amount of the additional increase that could now prove useful to such individuals. Some of the situations that may utilize the increased exclusion amounts could, however, be applied to individuals at almost any level of wealth.

There is at least one disadvantage to individuals making large gifts now: assuming they are gifting an asset that has a very low basis, that basis is going to be carried over and can present an income tax problem when the asset is finally sold. One would have to weigh the potential growth in the value of the asset (outside the estate, if gifted) versus the potential capital gains tax at the point of sale.

Existing life insurance policies.

Should those with more modest estates, (i.e., less than $10 million) drop existing insurance policies because they are no longer exposed to the estate tax? There are several important considerations here:

  • The increased exclusion amounts are temporary and are scheduled to sunset in 2026. The insurance may be needed, assuming the policyholders survive the next eight years.
  • People can develop medical problems and lose their insurability.
  • Many existing permanent insurance policies have significant cash values and represent a conservative savings vehicle.

The greatest opportunities for planning present themselves with respect to lifetime gifts and GSTs rather than in the context of the estate tax.

Most individuals have retained their life insurance policies over the last 20 years even as the estate tax exemption amount has increased from $600,000 to $11.18 million.

Specific strategies.

Besides the obvious idea of making a gift to a dynastic trust, one possibility might be to use the increased exclusion to fund the purchase of a large amount of life insurance. Assuming that a married couple has previously used their lifetime exclusion, they now have another $11.18 million available for gifts. If they purchase a life insurance policy with premiums of $100,000 per year (or $3 million over 30 years), and if, as a result of present value discounts, a gift today of approximately $2.4 million will fund those 30 years of premium payments, that amount can be gifted to an irrevocable life insurance trust to prepay the life insurance premiums. If a guaranteed premium product such as guaranteed universal life is used, there will never be a need for future gifts to fund the premiums.

One caveat is that when funding insurance policy premiums upfront, it is important not to run afoul of the modified endowment contract (MEC) rules. This involves the “seven-pay test” (i.e., the amount of money needed to fund the premiums over a seven-year period). The main problem with an MEC is that it can have adverse tax consequences when taking money out of the policy’s cash value later. Taking the above example and assuming that the cash value is now $3 million, an individual might identify a $600,000 gain ($3.0 million − $2.4 million) and want to take out $100,000. Unfortunately, that $100,000 would be considered taxable income, regardless of whether it is taken out as a withdrawal or a loan.

Most individuals who are buying life insurance for estate liquidity purposes—especially those buying guaranteed universal life, which does not build up much cash value—will not be overly concerned about this issue, but advisors should make them aware of it. In other cases, where the policy is going to build up cash value that can be used to pay for a house or make other distributions to the children while the parents are still alive, it will be desirable to spread the gifts over at least three or four years to avoid the MEC characterization.

Another possible strategy could be employed in a situation where the client has income-producing assets such as real estate that would provide sufficient cash flow to pay the premiums. For example, assume that an individual owns commercial real estate, held in an LLC, and that the real estate produces a net income of $300,000 annually. One-third of the LLC interest could be gifted into a trust, and the trust could use the $100,000 per year to pay life insurance premiums; then there would be no need to make further gifts to fund the policy premiums.

A third possibility would involve exit strategies from two life insurance arrangements: split-dollar and premium financing. In a split-dollar arrangement, a donor, which could be a family business or a parent or grandparent, funds the premiums into a trust for the benefit of children or grandchildren. At some point, when the arrangement is terminated or the insured dies and the death benefits are paid out, the donor is to be paid back the premiums funded over the years. One of the problems with split-dollar is that the value of the economic benefit (the value of the term insurance element of the policy that is essentially given to the beneficiaries each year) must be picked up as a gift each year. In an employment split-dollar arrangement, there could be income tax ramifications as well.

The amount of economic benefit may become burdensome over time. For example, assume that an employer is owed $2 million for all of the premiums it has paid over time for a split-dollar arrangement. With the increased exclusion amount, it is possible to make a gift of $2 million to the trust to pay back the past premiums and terminate the split-dollar arrangement, thereby ending the need to report the gift tax or income tax ramifications of the arrangement. Terminating a split-dollar arrangement can, however, trigger tax problems. For example, a grandfathered split-dollar arrangement established before the 2003 regulations may have built-up equity (the excess of cash value over the premiums paid) subject to income tax. Advisors should be cognizant of this possibility when terminating a split-dollar arrangement.

Exiting a premium financing arrangement is also a possibility. Premium financing refers to an arrangement where the trust that owns the policy has been borrowing money to pay the premiums from a family member, a family business, or a third-party lender such as a bank. Each year the premiums are funded by a loan, and the interest on the loan, which grows annually, has to be paid. Returning to the above example of a $100,000 annual premium, a 3% interest payment would be $3,000 in the first year, $6,000 in the second year (3% × $200,000), and $9,000 in the third, increasing in this fashion with each subsequent year. This can become burdensome, and the parties may prefer to extricate themselves from the loan arrangement. Assuming the situation is analogous to the split-dollar example above, a $2 million gift could be made to the trust, allowing the trust to pay off the loan. One significant difference is that parties do not face the same potential adverse tax consequences with a loan as they would in the split-dollar situation.

Another opportunity is available for individuals whose life insurance policy is owned by a retirement plan that would be includible in their estate at death. The increased lifetime exclusion amounts would allow such a policy to be moved out of the retirement plan and into a life insurance trust. There is a Prohibited Transaction Exemption (PTE 92-6) that allows for the sale of an insurance policy from a retirement plan to a participant, so long as the policy is sold for its fair market value. (The required Form 712 can be obtained directly from the insurance company.) In addition, the Department of Labor (DOL) subsequently amended PTE 92-6 (September 3, 2002) to allow for the sale of an insurance policy from a retirement plan to a trust. Under these circumstances, the client would make a gift to the trust in an amount sufficient to purchase the policy; the trust would purchase the policy from the plan, and the plan would then distribute the policy to the trust. The DOL has also issued an Advisory Opinion (2006-03A) stating that the sale of a second-to-die policy from a profit-sharing plan to the insured and spouse would qualify for the exemption as well.

One strategy that could benefit under the new laws would be to use the retained earings in a C corporation to fund a split-dollar arrangement.

Using the Lower Maximum Corporate Tax Rate

Other major provisions of the TCJA resulted in lowering the maximum corporate income tax rate to 21% and eliminated the corporate alternative minimum tax (AMT) altogether. These provisions were aimed primarily at large, publicly held businesses operating as C corporations. Historically, at least part of the appeal of S corporations and LLCs over C corporations was the tax advantage; C corporations faced higher overall rates and the possibility of double taxation because of tax imposed both at the corporate level and on individual shareholders for dividends paid to them by the corporation.

Nevertheless, some individuals do operate their businesses as C corporations, and under the TCJA, others may be considering converting to a C corporation. A company with significant capital needs may find it beneficial to convert to a C corporation rather than leave retained earnings in an S corporation exposed to personal income tax rates, potentially as high as 37% (or 29.6%, assuming eligibility for the new 20% deduction for pass-through entities).

Converting to a C corporation or forming a new C corporation is not an easy decision. Many factors may be involved, and this is an issue that clients should discuss with their accountants and other tax advisors before reaching a decision.

One strategy that could benefit under the new laws would be to use the retained earnings in a C corporation to fund a split-dollar arrangement. This strategy avoids the double taxation issue because it would not be deemed a distribution to the shareholder except for a relatively small amount: the P.S. 58 cost or the economic benefit of the insurance coverage. Accordingly, this is an opportunity to move dollars that are subject to the relatively low 21% level of taxation into an insurance trust as part of the split-dollar arrangement.

Another opportunity would be to purchase key-person or buy-sell insurance. Typically, term insurance is used in these situations, but there may be a legitimate reason to buy permanent insurance (e.g., to use the cash value to fund a deferred compensation agreement, or because the long-term expectations for the business are generally favorable and term insurance is not an appropriate long-term insurance vehicle). Of course, the premiums are going to be higher with permanent insurance than with term, but again, the ability to use funds subject to lower tax rates to buy insurance makes this option much more attractive than it was previously.

New Rules for Life Settlements

In reviewing the TCJA, there are some changes involving life insurance that may have escaped the attention of many professionals. The most important of these changes relates to life settlements. Although life settlements occupy a fairly narrow space in the life insurance sector, the changes could certainly be significant to those individuals who do use them. The new rule, which is found in section 13521(a) of the TCJA, is a very favorable one that basically reverses the IRS’s previous position on these vehicles.

Although life settlements occupy a fairly narrow space in the insurance sector, the changes could certainly be significant to those individuals who do use them.

Life settlements allow holders of policies that would otherwise be cancelled, resulting in little or no return, to instead recoup part of their losses by finding an institutional buyer willing to pay a percentage (e.g., 15%) of the face amount of the policy, particularly if the life expectancy of the insured party is less than normal (i.e., 10 years or fewer). Although some tax may be owed on that amount, the net is generally more than if there was no life settlement market.

In amending IRC section 1016(a)(1), the TCJA provides that, in determining the basis of a life insurance or annuity contract, no adjustment will be made for mortality, expense, or other reasonable charges incurred under the contract. This change reverses the position taken by the IRS in Revenue Ruling 2009-13 (IRB 2009-21, 1029) that, upon the sale of a cash value life insurance contract, the insured’s (seller’s) basis was reduced by the cost of insurance for mortality, expense, or other reasonable charges incurred. This change also applies retroactively to transactions entered into after August 25, 2009, which coincides with the effective date of Revenue Ruling 2009-13 [TCJA section 13521(b)].

In other words, under the old law, assuming a policy had a basis of $80,000 and the cost of insurance over the life of the policy was $10,000, it was necessary to adjust the policy’s basis downward by $10,000, thus increasing any gain from the sale of the policy. With the law change, that is no longer necessary, and taxpayers who paid additional tax as a result of Revenue Ruling 2009-13 and have returns from open tax years could potentially apply for a refund.

As with any financial transaction, it is important to do an in-depth analysis of any possible life settlement. For example, when dealing with an insured party who is in poor health and dies in a relatively short time frame after the life settlement transaction is completed, beneficiaries may be very upset, questioning why they will now receive a much smaller amount than the death benefit they would have received otherwise. They may very well decide to sue the trustee as a result, and the trustee should have a well-documented rationale for recommending the life settlement.

The TCJA also added some new reporting requirements that apply to sales occurring after December 31, 2017, and the payment of reportable death benefits after December 31, 2017 (IRC section 6050Y). The new law refers to a “reportable policy sale,” which means the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in the life insurance contract. This would include acquisition of an interest in a partnership, trust, or other entity that holds an interest in the life insurance contract.

Any person who acquires a life insurance contract or any interest in a life insurance contract in a reportable policy sale during a tax year must make a return setting forth the—

  • name, address, and taxpayer identification number (TIN) of the person;
  • name, address, and TIN of each recipient of payment in the reportable policy sale;
  • date of the sale;
  • name of the issuer of the life insurance contract sold and the policy number of the contract; and
  • amount of each payment.Anyone required to make the return must furnish to each person named in the return a written statement showing the—
  • name, address, and phone number of the information contact of the person required to make the return; and
  • information required to be shown on the return with respect to such person (except that in the case of an issuer of a life insurance contract, the statement is not required to include the amount of each payment).


___ Should the individual keep existing insurance policies?

___ Should the individual make large gifts to a dynastic trust?

___ Can a life insurance policy be prefunded with a large gift now?

___ Will a prefunded policy become an MEC?

___ Can income-producing assets be given to a life insurance trust to fund insurance premiums?

___ Can a large gift to a life insurance trust facilitate an exit from a split-dollar plan?

___ Can a large gift to a trust facilitate an exit from a premium finance arrangement?

___ Can a large gift to a trust be used to buy a policy from a retirement plan and remove it from the insured’s estate?

___ Does the individual have a C corporation with retained earnings?

___ Can the retained earnings in a C corporation be used to fund a split-dollar plan, key-person insurance, or buy-sell insurance?

___ Has the individual sold a policy in a life settlement transaction in the last three years?

___ Can this individual apply for a tax refund based on the new basis rules for life settlements?

MEC=Modified Endowed Contract

In addition, the TCJA provides that, for transfers made after December 31, 2017, the exceptions to the transfer-for-value rules do not apply to a transfer of a life insurance contract, or any interest in such a contract, that is a reportable policy sale [IRC section 101(a)(3)(A)]. As for the impact of this provision, in the typical life settlement, the acquirer is a hedge fund or a bank, which will likely know that it does not fall under an exception to the transfer-for-value rule. Thus, this provision is presumably intended to cut off the possibility of creating some mechanism to avoid the transfer-for-value rule, because it is going to apply to any reportable policy sale as that term is now defined.

The overall drop in the corporate tax rate should improve the after-tax situation for most life insurance companies and thus may offset the changes being made to the treatment of life insurance reserve accounts and deductions.

New Rules for Life Insurance Company Reserves and Deductions

The TCJA also made changes that affect certain accounts held by life insurance companies. A detailed discussion of these changes is beyond the scope of this article, but one change, contained in TCJA section 13519, concerns IRC section 848. Under that provision, the required time period for the capitalization and amortization of specified policy acquisition expenses for insurance companies has been increased from 10 years (120 months) to 15 years (180 months). This change could potentially increase the amount of an insurance company’s income and thus potentially affect the pricing of life insurance products. As this could affect individual clients like those discussed above, advisors should be aware of this possibility. The overall drop in the corporate tax rate to a maximum of 21% should serve to improve the after-tax situation for most life insurance companies and thus may offset the changes being made to the treatment of life insurance reserve accounts and deductions.

Sidney Kess, JD, LLM, CPA is of counsel to Kostelanetz & Fink and a senior consultant to Citrin Cooperman & Co., LLP. He is a member of the NYSSCPA Hall of Fame and was awarded the Society’s Outstanding CPA in Education Award in May 2015. He is also a member of The CPA Journal Editorial Advisory Board.
Lee Slavutin, MD, CLU, AEP is a principal at Stern Slavutin-2 Inc., New York, N.Y.

This article is based on an article previously published by CCH Wolters Kluwer in the Estate Planning Review, February 2018. Reprinted with permission from CCH.