Estate Planning and Life Settlements

In some cases, the decision whether to sell is easy, say experts, because the purpose for having the policy has completely disappeared and if the policy isn't sold, the client will either surrender it for its cash surrender value, if any, or just stop paying premiums and allow it to lapse.

In such cases, the policy should be sold as long as the sale price is higher than the cash surrender value, which will usually be the case for any policy that companies are interested in buying, experts say.

" Anytime a client wants to get rid of a policy, where they don't need it anymore and would rather surrender it, they will want to consider a sale," says Miami attorney Sherwin Simmons, a former regent of the American College of Trust and Estate Counsel.

For example, the purpose of a policy on the life of a business's "key person" may disappear when the person retires, or the purpose of a policy intended to fund a buy-sell agreement may disappear when a business is sold.

In other cases, however, the decision whether to sell may require a careful weighing of the usefulness of having the policy against the usefulness of receiving some cash for it right away, experts say.

" You need to analyze whether the policy is still the most economic use of the money," says Gallo.

In this weighing, a factor to consider is that unless the insured person is "terminally" or "chronically" ill as defined by the Tax Code, income tax will have to be paid on the sale proceeds, less the basis in the policy — whereas if the person kept the policy or gave it to someone else or to a trust, the death benefits would be tax-free. (IRC Sect. 101(g).)

However, if the proceeds are taxed, they could arguably be treated as capital gain to the extent they exceed the policy's cash surrender value, experts say.

For example, if the basis in a policy is $200,000, the cash surrender value is $300,000, and the policy is sold for $500,000, then $100,000 of the gain would be treated as ordinary income, but $200,000 of it could be treated as capital gain.

People are justified in claiming such treatment on their tax returns, says Adams.
But it's not clear that the IRS would agree. The Service might reject this and say all the gain is ordinary income, and courts might agree with it, experts warn.

Another drawback of selling is that an insurance policy owned by an individual is generally protected from creditors, but this protection might not apply to the proceeds from a sale of the policy, says New York estate planning attorney Sanford Schlesinger.

Also, the value of a policy above its cash surrender value is generally not counted as an asset for purposes of qualifying for Medicaid, but all the proceeds from a sale might be, says Emily Starr, an elder law attorney in Worcester, Mass.

Despite the drawbacks, experts say that in many situations it might make sense to sell a policy. These include:

The insurance has become less useful.

For instance, it was purchased to provide liquidity for paying estate taxes, but the client's estate has become smaller or more liquid.

" The client may have given away enough assets that he's no longer concerned about estate taxes," says New York attorney Glenn Kurlander. Or the client may have invested in the stock market "and made so much money that insurance is a lesser factor and he or she is more open to lifetime use of it," says Adams.

The insurance has become too expensive.

For example, with a "universal" life policy, the premiums can rise substantially if the policy's cash surrender value doesn't grow as fast as expected because of low interest rates, says Gallo.

" Clients may make the decision they don't want to pay the premiums anymore, because they're paying them longer than they anticipated, it's more costly than they thought, and they are frustrated," says Greenberg.

The client wants a different type of policy.

For instance, a couple with a "single life" policy on one spouse wants to replace this with a "second-to-die" policy, says Greenberg.

Currently, "this is probably the most common reason a life insurance policy is not needed anymore," he says. For an older couple, a second-to-die policy may be more useful for estate planning purposes, and is likely to have lower premiums and provide a higher death benefit, says Chodes.

Cash is needed to pay for medical expenses or long-term care.

For example, "a client may be suffering from cancer or Alzheimer's and says he doesn't know what to do, and his only asset is a life insurance policy," says attorney Joseph Dorta of Holmdel, N.J.

However, clients should also consider just borrowing the policy's cash value, says MacNab. And they should see if they qualify for an "accelerated death benefit," which many policies provide where the insured person has a life expectancy of less than 12 or 24 months, she says.

The cash can be used to fund discounted transfers to heirs.

For instance, if the policy is in an irrevocable trust, of which the client's children are the beneficiaries, the trustee might sell the policy and use the sale proceeds to purchase a discounted interest in the client's closely-held business, says Mayer.

Alternatively, if the policy is not in a trust but owned by the client, the sale proceeds could be used to pay the gift tax on a gift the client makes to his children of an interest in his closely held business, says Adams.

The client wants to give the cash rather than the policy to heirs.

That way the client avoids the risk that the policy will be included in his or her estate if he or she dies within three years after making the gift (under IRC Sect. 2035). The idea would be to give the cash tax-free using the annual $10,000 gift tax exclusion.

" You may not have as much going to the heirs as with the insurance, but it's not subject to estate tax," says Gallo.
This strategy would make sense only if the client faces a high risk of dying within three years, experts agree.
But even if a client's actual chances of dying soon are low, the client may still want to do it if he or she nevertheless believes that the chances are high, says Adams.

The client wants to give the cash to charity.

This can result in a larger deduction than if the policy is given, since the deduction for a gift of a policy to a charity is limited to the lower of the replacement value of the policy or the donor's basis in the policy, says Leimberg.
It also allows a client to make the gift without selling other assets, such as stock the client doesn't want to sell, says Chodes.

Alternatively, the client may want to use the cash to live on and give other assets, such as highly appreciated property, to charity, he says.

Bankruptcy

While life insurance owned by an individual is generally protected from creditors, a policy owned by a corporation is not, and a sale of the policy may be useful for satisfying the claims of creditors, experts say.

In a corporate liquidation, "creditors want to make sure the trustee realizes the value of the policy," says Ross Reeves, a bankruptcy attorney in Norfolk, Va.

" It's an interesting way to find an asset," says Ray Warner, a professor at the University of Missouri-Kansas City School of Law. If the policy has a sale value greater than its cash surrender value, "then maybe the trustee should sell it," he says. "I don't see any reason why not."

A term policy on a "key person" in the corporation, for example, might have a high sale value because the person is ill, says Warner.

In a corporate reorganization, the corporation also may want to sell a policy, such as a key-person policy, to raise cash where the policy is no longer needed, says Reeves.

And creditors can argue that the potential sale of a policy should be taken into account in determining a corporation's liquidation value for purposes of confirming a reorganization plan, he says.

In addition, a lender who receives a life insurance policy as collateral after a default may want to sell the policy to get more money, he says.

Lenders may want to anticipate this possibility when they draft security agreements covering life insurance policies by making sure the agreement covers proceeds from a policy sale and gives the lender consent to sell the policy, Reeves suggests.

Such consent may be important because the policy probably can't be sold without the insured person's cooperation, since any potential buyer of the policy will want to review the person's medical records, he says.

Divorce

Where a divorcing spouse has a life insurance policy, courts frequently require him or her to name the other spouse as a beneficiary in order to secure an obligation to pay alimony or support, divorce lawyers say.

In other cases, the court may treat the cash surrender value of the policy as an asset subject to equitable distribution. "The cash is considered savings," says Cary Cheifetz, a divorce attorney in Summit, N.J.

Now, in cases where the policy can be sold, the other spouse can argue that the policy itself is an asset subject to equitable distribution, says William Teltser, a divorce attorney in Roseland, N.J.

" The argument is that it's an asset because it was acquired during the marriage and sustained with marital funds and has a presently ascertainable value," says Teltser.

Lawyers can argue "that the true value of the policy is the present value of the death benefits as of today's date, as opposed to the cash value," says divorce attorney Terrence Kapp of Cleveland.

It "raises an interesting question of whether the potential for a sale converts the death benefit into an asset," says divorce attorney Robert Durst of Princeton, N.J.

If you can establish that the death benefit is an asset, you can then argue that it should be treated like pension benefits and allocated on a percentage basis, says Teltser. It can be divided on that basis when the spouse with the insurance dies.

Alternatively, the sale value of the policy can just be taken into account in the division of property in the divorce, he says.

Or, in some cases, such as where medical bills are substantial, it might make sense for the court to compel a sale of the policy, Teltser says.

Lawyers Weekly - By James L. Dam