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Creative uses of life insurance.


Policies can be an important factor in financial plans.

Life insurance policies can help clients achieve many estate and financial planning objectives. Strategies can be devised to ensure estate liquidity, equalize inheritances, ensure proper business continuation, enhance qualified plan distributions and shelter assets from creditors' claims, among other goals.

CPAs often know more than other financial professionals about their clients' financial affairs and thus are well suited to assist clients in identifying objectives and how life insurance can help achieve them. This article illustrates a few key strategies to enhance clients' financial plans.


Restrictive new tax laws have made estate liquidity a vital concern for wealthy individuals. For example, three laws--(1) Internal Revenue Code section 2036(c), which eliminates most estate freezing techniques, (2) the 15% penalty tax on excess pension accumulations and (3) the expanded generation-skipping transfer tax--now prevent many estate owners from avoiding substantial transfer taxes at death.

Careful planning is necessary, therefore, to ensure estate liquidity for wealthy clients. If an estate lacks sufficient cash or assets that are readily convertible into cash, the heirs may have to liquidate valuable and productive assets (such as property with high appreciation potential) to pay death taxes and administrative costs. Thus, cash is needed in order to preserve these assets' benefits for family members or their heirs.

Life insurance can be a good solution to this dilemma. It can be the least expensive way to cover estate settlement costs because the death benefit is always tax-free. And if the insured is not the owner of the policy--that is, if another party, such as a trust, has control over the policy's structure, can change benefits or receive dividends--the proceeds need not be included in the insured's estate for tax purposes.

Life insurance's discounted-dollar approach is another advantage. Beneficiaries receive far more cash than is paid into a policy. For an illustration of how this works, see exhibit 1 on page 42.


Because current federal estate tax law provides an unlimited marital deduction for qualified property, delaying payment of federal estate tax until the second spouse dies has become a popular estate planning strategy. This has led to the growth in popularity of the so-called second-to-die life insurance policy. The policy names a married couple as joint insureds and pays the death benefit only at the death of the second spouse.

While second-to-die policies offer low premiums, they are worthwhile only if the unlimited marital deduction continues indefinitely. In addition, they don't provide the liquidity and flexibility often needed on the first spouse's death.

A few insurance companies have recognized these failings and designed a solution. This approach, illustrated in exhibit 2 on page 45, begins with a life insurance policy on each spouse and an irrevocable trust as owner and beneficiary of the insurance. A "survivorship increase option rider" is attached to each policy. It guarantees that, when the first spouse dies, the surviving spouse may increase the face amount of his or her contract by a multiple of the original face amount. In addition, the first death benefit can be deposited into the surviving spouse's policy or taken in cash to pay costs at the first spouse's death.

If the surviving spouse chooses to deposit the death benefit into his or her policy, the policy must be tested for modified endowment contract status, which is covered in IRC section 7702A. This test was designed to limit the investment aspect of life insurance. Since second-to-die policies are used to provide death benefits, the test, if applicable, should have very little impact.

If the trustee is directed to pay estate costs or make proceeds available to the estate representative, the proceeds will be taxed as part of the insured's estate. To avoid the estate's constructive receipt of the proceeds, the trust instrument should permit the trustee a choice--either to purchase estate assets outright or to lend funds to the estate representative.


Quite often, estate values include a valuable family business interest the estate owner wants to pass on to children active in its operation. If the business is the majority of the estate, clients may worry about providing for other children who aren't involved in its operations. Life insurance may be the ideal way to ensure equal treatment for all of the client's heirs.

For example, a client, George, has a family business worth $3 million. He wants to leave it to the three of his four children actively involved in the business. If George takes out a $1 million life insurance policy and names the fourth child as beneficiary, each child ultimately will inherit assets worth $1 million.


A business owner with a substantial estate consisting mainly of a closely held business interest may arrange for the orderly disposition or continuation of the business interest through a buy-sell agreement. These agreements establish that an owner's heirs will sell their inherited business interest to the surviving owners at a specific price. The agreements thus establish the value of the business interest for federal estate tax purposes and help ensure that heirs receive full value for their business interests. The agreements can guarantee the sale and the purchase price.

A buy-sell agreement funded with life insurance often is the most practical option. For example, a closely held business might hold insurance policies on each of its five stockholders that equal the value of their individual interests in the business. When one dies, the company uses the policy proceeds to buy the deceased owner's interest from his or her heirs.

Life insurance guarantees a specific payout at death, whenever it occurs. And because premium costs are lower than the final payout, it also typically is the most economical method of prepaying the purchase price for a business interest. Other methods of funding a buy-sell agreement involve varying degrees of additional expense and uncertainty for a business owner's family.

For example, prefunding the future cost with aftertax dollars by creating a sinking fund or reserve can be expensive for the prospective purchaser. In addition, the sinking fund may not accumulate rapidly enough to provide sufficient funds if the owner dies prematurely.

If the purchase price is borrowed from a bank or other financial institution, the purchaser must be able to service the debt from the business's earnings--and prove the company's credit is strong enough to obtain a loan after an owner's death. Relying on current business earnings or a sale of business assets may jeopardize the company's strength and the inheritance.


Several strategies involving life insurance enable the charitably inclined to make the most out of their gifts. Donors frequently use the tax savings generated by the charitable gift to purchase life insurance, the proceeds of which replace the assets given to charity or provide estate liquidity.

Other options include naming a charity as the irrevocable beneficiary of an existing policy or as the owner and beneficiary of a new one. These strategies allow donors to make substantial charitable gifts without large out-of-pocket costs during their lifetimes. Since life insurance operates on the discounted-dollar approach, a small premium provides a sizable gift to the charity at the insured's death.


Most distributions from qualified pension plans have some restrictions and limited survivorship options. Generally, the employee must choose between a high level of retirement income with no survivorship benefits at death (life annuity option) or lower retirement income with one-half or two-thirds of that income available to survivors should the retiree die prematurely (joint and survivor option).

When faced with this choice, clients can pick the higher-paying life annuity option and use life insurance to provide survivorship benefits at the retiree's death. This strategy not only eliminates the need to choose between options but also may provide more total income than would have been received if the client had chosen the joint and survivor option.


Life insurance often is included in education funding strategies. However, its usefulness for this purpose was reduced greatly when the Internal Revenue Service rule on modified endowment contracts limited the favorable tax treatment of policy distributions and imposed a 10% penalty on those made before age 59 1/2 for policies issued after June 20, 1988.

Policyholders also may borrow against the cash value of their policies for college tuition. Since such loans are considered personal debt, clients should consider the limits on interest deductions imposed by the Tax Reform Act of 1986 when using this strategy. In 1990, taxpayers can deduct 10% of personal debt interest and the deduction drops to zero in 1991 and thereafter.

A final option for tuition planning is to buy a policy on an employed parent's life to guarantee the necessary funds will be available for a child's education even if the parent dies before saving enough to cover college costs.


Clients who have poor credit or are unable to obtain it may be able to borrow against their insurance contracts. Insurers allow policyholders to borrow a certain percentage of policies' cash value--normally up to 95%--at competitive market interest rates.

The TRA classified interest expense on loans against insurance policies as personal debt and imposed several restrictions on the deductibility of such interest expenses for policies purchased after June 20, 1986. These limits fall under IRC section 264 and should be reviewed before this strategy is considered.


One often-overlooked advantage of life insurance is its general exemption from creditors' claims against the insured, and in some cases, the policy owner and beneficiary as well (the scope and extent of the exemption varies by state). It is important to note, however, that in most states the exemption of life insurance will not apply to premiums paid specifically to defraud creditors. Large sums paid into insurance policies as "premiums" just before the policy owner divorces or declares bankruptcy, for example, generally do not receive this protection.


Life insurance policies offer a number of opportunities that should be considered in helping clients achieve their estate and planning goals. The strategies discussed in this article involve complex estate, gift and income tax issues that will affect what product is used and how insurance contracts should be structured to obtain the desired results. With the help of insurance and legal professionals, CPAs can incorporate the benefits of life insurance policies into successful financial plans. [Exhibit 1 and 2 Omitted]

JOHN H. STEHMAN, CPA, is a fee-only financial planner in Philadelphia. JERRY S. ROSENBLOOM, PhD, CLU, CPCU, is chairman and professor of insurance at the Wharton School of the University of Pennsylvania, Philadelphia.
COPYRIGHT 1990 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Rosenbloom, Jerry S.
Publication:Journal of Accountancy
Date:May 1, 1990
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