Policy Valuation for Income, Gift, or Sale Purposes
When transferring ownership of life insurance policies, these common questions often arise:
- •What is the value of a life insurance policy when it’s transferred from one policy owner to another?
- •Are there any guidelines to determine the value for income tax or gift tax purposes?
- •What are the guidelines to determine value for the purpose of selling the policy?
Treasury Regulations and IRS Revenue Procedures provide some guidance to rely upon in certain situations. Here’s a summary of some typical fact patterns where policy ownership is transferred and a value needs to be determined to account for taxation on the transaction.
I. TRANSFER OF A POLICY FROM A QUALIFIED PLAN TO A PARTICIPANT
These Regulations state that a policy must be valued at its “fair market value” when transferred from a Qualified Plan to a Participant under IRC Section 402(a) and IRS Treasury Regulation 1.402(a)-1(a).*
Taxpayers must determine this “fair market value” taking into account cash surrender value, interpolated terminal reserve, and all other rights under the contract. IRS then issued Revenue Procedure 2005-25 which described the so-called “Safe Harbor Valuation” method for income tax valuation.
Under Revenue Procedure 2005-25, the fair market value for transfer from a qualified plan to a participant is the GREATER of:
(1) the interpolated terminal reserve plus any unearned premium OR
(2) the so-called PERC amount multiplied by the Average Surrender Charge Factor which can be no less than 70% (a 30% discount).
The PERC amount is defined as:
* Final Regulations on valuation of life insurance policies for income tax purposes became effective on August 29, 2005.
II. TRANSFER OF A POLICY FROM AN EMPLOYER TO AN EMPLOYEE
This employer to employee transfer was also covered in Revenue Procedure 2005-25 which described the “Safe Harbor Valuation” method for income tax valuation.*
Under Rev. Proc. 2005-25, the fair market value for transfer from an employer to employee is the GREATER of (1) the interpolated terminal reserve plus any unearned premium OR (2) the PERC amount multiplied by the Average Surrender Charge Factor which can be no less than 100% (a 0% discount).
* The Final Regulations of August 29, 2005 also stated that a policy must be valued at its “fair market value” when transferred from an Employer to an Employee under IRC Section 83 and Treasury Rgeulation 1.83-3(e).
III. TRANSFER OF A POLICY FROM AN INDIVIDUAL TO A THIRD PARTY BY GIFT (i.e. GIFT of policy to an IRREVOCABLE LIFE INSURANCE TRUST)
However, gift tax regulations have been in place for many years which provide a determination of value for gift tax purposes. Treasury Regulation 25.2512-6(a) states that if the gift is a gift of a policy on which further premiums are payable, the value for gift purposes is determined by adding the “interpolated terminal reserve” plus the value of the unearned portion of the last premium. The amount of any policy loan outstanding at the time of the gift would be subtracted from this determined value. (Depending on the determined gift value of the policy, the taxpayer may need to file a IRS Form 709 U.S. Gift Tax return and allocate any available lifetime gift exemption to the transfer.)
* The Final Regulations of August 2005 and Revenue Procedure 2005-25 do NOT expressly address life insurance valuation for gift tax purposes.
IV. SALE OF A POLICY FROM ONE IRREVOCABLE LIFE INSURANCE TRUST TO ANOTHER IRREVOCABLE LIFE INSURANCE TRUST (ILIT)
Sometimes a life insurance policy owned by ILIT #1 may need to be transferred to another ILIT (ILIT #2). The trustees of the ILITs have a fiduciary responsibility to the beneficiaries of each trust. So, to accomplish the transfer from ILIT #1 to ILIT #2, the trustee of ILIT #2 will usually buy the policy from ILIT #1. If the sale price exceeds the cost basis of the policy, ILIT #1 would report the gain amount as ordinary income.
A question often arises as to what the purchase price of the policy should be. There are no existing Treasury Regulations which specifically define the value of a policy when a sale of a policy from one ILIT to another ILIT is contemplated.
Clearly, it’s not a gift so gift tax Regulation 25.2512-6(a) should NOT apply. Clearly, it’s not a transfer from a qualified plan to a participant or from an employer to an employee so the income tax Final Regulations of August 2005 and Revenue Procedure 2005-25 should NOT apply. The transfer in question here is clearly a sale of the policy. As with the sale of any asset between two parties in an “arms length” transaction, the parties to the sale (the trustee of each ILIT acting as a fiduciary) should be free to negotiate a reasonable price that would be acceptable to a willing buyer and willing seller.
It seems that a practical starting point to negotiate a reasonable selling price is either:
- the interpolated terminal reserve of the policy as determined by the gift tax rules above or
- the PERC value as determined by the income tax rules stated above.
While neither of these methods is legally binding for purposes of determining the value of a policy for sale purposes, they can serve as a reasonable starting point for a negotiated sale price between the trustees of each ILIT.
IN-FORCE POLICY HOLDER SERVICE SUPPORT FROM CARRIERS
All life insurance carriers have a “Policy Holder Service” or “Contract Services” support unit for administration of in-force policies. Specialists within these carrier support units can calculate either the “interpolated terminal reserve” (ITR) amount or the “PERC” amount for the policy in question. These internal carrier valuations will give an accurate indication of policy value for income tax purposes or gift tax purposes.
Contact your BSMG Life Advisor when your client is considering transferring ownership of their life insurance policy purchased through BSMG. BSMG will contact the carrier and ask for an IRS Form 712 Life Insurance Statement of Policy Valuation that can be provided to your client’s professional advisors for income or gift tax purposes.
Russell E. Towers JD,CLU, ChFC
Vice President-Business & Estate Planning
Brokers’ Service Marketing Group
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