In today’s climate of tax uncertainty, it should come as no surprise to hear that the Treasury regulations governing the valuation of life insurance policies for gift tax purposes not only do no more than approximate the value of the gift, but they are based on the use of a factor that is generally impossible to calculate!
We all know that for gift tax purposes, the Treasury regulations establish the general rule that gifts are to be valued at fair market value, which is defined as the price at which the gifted property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. Treas. Reg. §25.2512-1. This general rule is applied to life insurance in Treas. Reg. §25.2512-6, which states that the fair market value of a life insurance policy “is established through the sale of the particular contract by the company.” However, because the secondary market did not exist in the 1960s when these regulations were written, the regulations tell us that since sales of comparable contracts are not readily ascertainable, if the policy has been in force “for some time,” its value “may be approximated” by adding together the interpolated terminal reserve of the policy and the unused portion of the last premium and dividend accumulations, minus outstanding policy loans at the time of the gift. Treas. Reg. §25.2512-6(a). The Service does not explain what is meant by “some time.”
If, because of the “unusual nature of the contract,” approximating the value of the insurance policy in accordance with the Treasury regulations is not “reasonably close to the full value,” the approximating method may not be used. Presumably, this exception applies to situations in which the insured is uninsurable at the time of the transfer, in which case the fair market value of the policy would be substantially higher than the amount computed pursuant to Treas. Reg. §25.2512-6(a). Under these circumstances, a facts and circumstances test is employed. For example, in Pritchard v. Comm’r, 4 TC 204 (1944), the decedent sold an insurance policy for its cash surrender value a month before he died of cancer. The estate argued that the policy had been transferred for full and adequate consideration and hence was not included in the decedent’s gross estate for estate tax purposes. The tax court held that where death was imminent and the insured was uninsurable, the cash surrender value “would be only helpful as a criterion of the minimum value to be placed on the policies. ...” Id. at 208.
If the vagueness of Treas. Reg. §25.2512-6 is not sufficiently worrisome, consider the fact that for most modern life insurance policies, a central valuation criterion—the policy’s interpolated terminal reserve (ITR)—cannot be calculated! In fact, the insurance industry cannot even agree on what should be calculated in place of the policy’s ITR!
The Reserve Calculation Conundrum
When the IRS published Treas. Reg. §25.2512-6, there were only two types of insurance policies available for purchase: whole life and annual renewable term. All aspects of a whole life policy, including cash values, were fixed and guaranteed by the insurer. Under regulations promulgated in part by NAIC (the National Association of Insurance Commissioners) and in part by the individual insurance commissioners and legislatures of various states, carriers offering whole life policies were required to set aside a reserve each year to meet their contractual obligations to the owners of the insurance policies. The amount of the reserve at the start of the year was known as the “initial reserve” and the reserve at the end of the year was known as the “terminal reserve.” (Thus the terminal reserve at the end of year one becomes the initial reserve at the start of year two and so on, ad infinitum.) Because all aspects of a whole life policy were fixed, one could actuarially determine in advance the amount of the terminal reserve at the end of any year. If the terminal reserve had to be calculated at any point between the start and end of the policy year, that amount could be calculated—for example, it could be interpolated in the language of the Treasury regulations—by reference to the year’s initial reserve and the actuarially calculated terminal reserve for the end of the year. For example, if the initial reserve of a whole life policy at the start of year two was $5,000 and the terminal reserve of that same policy at the end of year two would be $8,000, the policy would have an interpolated terminal reserve of $6,500 18 months after issuance. Annual renewable term policies did not have a terminal reserve because the policy matured at the end of each year and had to be renewed or lapsed.
In the years since Treas. Reg. §25.2512-6 was published, life insurance companies have introduced such contracts as universal life, variable universal life, indexed universal life, guaranteed no-lapse universal life, and 10- to 30-year level-term policies. All of these products have reserves. However, because all of these products are current assumption products—both current mortality experience and investment performance are passed through to the policy owner—the terminal reserve as of the actual anniversary date of the policy cannot be calculated until that date, which makes it impossible to interpolate a terminal reserve for purposes of the Treasury regulations.
In addition, the proliferation of insurance products since the 1960s has resulted in there being several different types of reserve calculations, including:
- The tax reserve, which is the amount used by the insurance company for purposes of calculating federal income tax.
- The statutory reserve, which is the amount used by the insurance company to comply with the reserve requirements of various states. (The difference between the tax reserve and the statutory reserve is primarily attributable to the interest factor that must be used. Usually, these two reserves are close together in a low interest environment and begin to differ as the interest rate environment increases.)
- The AG 38 reserve (Actuarial Guidance 38), which is the amount used for current assumption products with no-lapse secondary guarantees. The AG 38 reserve is generally higher than either the tax reserve or the statutory reserve, and it usually results in a higher reserve than for policies that do not offer secondary guarantees.
- The deficiency reserve, which is employed for certain current assumption policies for which a minimum reserve calculation is required by the XXX regulations of the National Association of Insurance Commissioners. An AG 38 reserve that includes a deficiency reserve will be higher than an AG 38 reserve without a deficiency reserve.
Unfortunately, there is no guidance for gift tax purposes regarding which reserve is to be used when attempting to comply with the ITR requirement of Treas. Reg. §25.2512-6. Moreover, the life insurance industry is not in agreement about which reserve is to be used when attempting to comply with the Treasury regulations. Some insurance companies do not even bother with using the reserves for calculation purposes. A few use the cash surrender value/cash accumulation value as the ITR and an even smaller minority use the California method—a calculation methodology permitted by the California Department of Insurance—which treats the ITR as the mean of the cash surrender value and the cash accumulation value.
A study presented at the 2009 Annual Meeting of the AALU (Association for Advanced Life Underwriting) entitled “Life Insurance Valuation: Navigating Uncharted Waters,” reported on a valuation survey of 14 carriers. Most of the carriers based their ITR calculation on either the tax reserve or the statutory reserve. A couple of carriers used the California method and one carrier used cash surrender value when calculating ITR. When valuing universal life policies with no-lapse guarantees, five of the carriers used the tax reserve, eight used the statutory reserve, and eight included a deficiency reserve.
Although the Service has provided guidance in Revenue Procedure 2005-25 for valuing a life insurance policy for income tax purposes, this procedure does not apply to the valuation of life insurance policies for gift tax purposes. Rather, it is limited to IRC §79 (cost of permanent benefits provided under a group life plan), IRC §83 (property transferred in connection with performance of services), and IRC §402 (qualified plan distributions).
What to Do About It
At least three suggestions can be derived from this confusion:
- If you have a client who owns a current assumption policy without secondary guarantees and intends to both (1) engage in a 1035 exchange for a policy with secondary guarantees and (2) transfer the policy to an irrevocable life insurance trust (ILIT), it would be a good idea to consider transferring the policy to the ILIT and allowing the ILIT to engage in the 1035 exchange. The gift tax value of the policy without secondary guarantees should be lower (and possibly substantially lower) than the gift tax value of the policy after the 1035 exchange.
- By the same token, if the client owns a current assumption policy with secondary guarantees and intends to both (1) engage in a 1035 exchange for a policy without secondary guarantees and (2) transfer the policy to an ILIT, it would probably be a good idea for the client to engage in the exchange before transferring the policy to the ILIT, because the gift tax value of a current assumption policy without secondary guarantees should be lower (and possibly substantially lower) than the value of the same policy with secondary guarantees before the exchange.
- When acquiring a life insurance policy that might later be transferred to an ILIT, the valuation methodology of the carrier should be considered.
If you shudder a bit to realize that we are relying on Treasury regulations that require us to use a concept (ITR) that does not apply to most contemporary insurance products in order to obtain an “approximation” of the value of a gift, welcome to the group!