THE NATIONAL NEWSPAPER FOR SMALL-FIRM LAWYERS
Insurance policies as a successful estate planning
strategy in a number of his cases.
Selling a life
insurance policy to a third party has become an important option in a wide
range of estate planning, bankruptcy and divorce cases, experts tell Lawyers
A rapidly growing industry is buying these policies for far more than their cash surrender value. Sales totaled more than $1 billion in 1999 and are expected to increase dramatically over the next few years.
In estate planning, a sale of a policy is useful in many situations where the client no longer needs the policy or can make better use of the cash, experts say.
In bankruptcy, a policy owned by a company might be sold to provide additional cash for creditors.
In divorce, spouses can point to the sale value of a policy and argue that it should be treated as an asset.
Over a dozen
companies now buy policies from non-terminally ill people, and many more will
start soon. It’s “a booming new industry,” says estate planning attorney Jon
“I imagine only one
in 10 lawyers is even aware” that such policies can be sold, but “lawyers need
to know about it,” says
In addition to advising clients about selling their policies, lawyers might also be asked by clients about investing in other people’s policies through the companies that buy them.
When giving such
advice, lawyers need to be aware of how risky these investments can be, says
Stephan Leimberg of
One estate planning
attorney has already been sued for malpractice in giving such advice. The
client alleges that she lost $260,000 because the company fraudulently sold her
an investment in policies that didn’t even exist, according to the attorney
bringing the lawsuit, Craig Goldenfarb of
The client claims the attorney should have done more investigation of the company, says Goldenfarb.
Booming New Industry
When a policy is bought from a terminally ill person, the sale is called a “viatical settlement.” When it’s bought from someone who isn’t terminally ill, it’s typically called a “life settlement,” but is sometimes called a “senior settlement,” “lifetime settlement” or “high net worth transaction.”
The industry began in the early 1990s with companies buying policies from people with AIDS and other terminal illnesses. But in the last two years, they have also begun to buy them from anyone 65 or older who has developed a health problem and has a policy of $250,000 or more.
were writing viatical purchases found that the market dried up on them, so they
took the concept and went one step further,” says Howard Saks, a life insurance
The person’s health problem needn’t be extreme. However, companies generally require that it reduce the person’s life expectancy to 12 years or less.
It may be enough, for example, if the person is over 70 and has developed diabetes, which has shortened his or her life expectancy by three or four years, says John Mayer, an investment advisor in West Bloomfield, Mich.
Or it may be
enough that they had a stroke a couple years ago or have high blood pressure,
says Carole Fiedler, a life settlements broker in
If a person is
terminally ill, the policy can be much smaller than $250,000, says Alan
Buerger, CEO of Coventry Financial, a life settlements broker in
As a result of
the industry’s expansion, there is now over $108 billion of life insurance that
people 65 and older in the
What They’ll Pay
What a company will pay for a policy depends on a number of factors, including the person’s life expectancy, the size of the policy, the type of policy, the size of the premiums, and the insurance carrier’s “rating.”
The amounts that
different companies will pay for the same policy may vary widely, so it’s
important to use a broker who will “shop around,” says J.J. MacNab, an
insurance analyst in
Regulations in many states provide a schedule of minimum payments for policies where the insured person is terminally ill. For example, if the life expectancy is 6 to 12 months, the payment might have to be at least 70% of the policy’s death benefit, and if it’s 24 to 36 months, it might have to be at least 50%.
For people with longer life expectancies, the amount paid is generally between 6% and 40%, says MacNab.
A 65-year-old who suffers from diabetes and related complications, for example, might get 20%, says Gary Chodes, president of Viaticus, a Chicago company that buys policies.
Each company will have its own doctor review the insured person’s medical records. The whole process typically takes three to four months, says Morton Greenberg of Parker, Cob., who is a managing general agent for several companies that buy policies.
Here’s how experts say a sale or potential sale of someone’s life insurance policy can be useful in estate planning, bankruptcy and divorce:
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.
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
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 §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.
justified in claiming such treatment on their tax returns, says
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.
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
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
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
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
• 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.
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
• 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 §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 Galbo.
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
• 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.
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
“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.
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
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
“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
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
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, Teitser says.