North Carolina Wealth Law Counselor : North Carolina Estate Planning Lawyers & Attorneys for Asset Protection & Trust Administration in Greensboro, Raleigh & Winston-Salem NC

Two recent Tax Court decisions illustrate the danger (and cost) of not paying attention to the details when it comes to life insurance policies and taxes.  In each case the taxpayer failed to dot their i’s and cross their t’s, which created adverse estate tax consequences in one case and adverse income tax consequences in the other.

In the first case, Estate of Dwight T. Fujishima  et al v. Commissioner, TC Memo 2012-6, the decedent was the record owner of three life insurance policies.  The decedent was severely injured after which his mother cared for him in her home.  The decedent’s mother fed him, clothed him, and paid his bills with her own funds.  The Tax Court noted she did this gratuitously, without expectation of payment.

Following the decedent’s death on January 23, 2005 the decedent’s estate filed a Form 706 (United States Estate and Generation Skipping Transfer Tax Return).  On the return the estate listed two of the three policies as owned by the decedent (and therefore includible in the decedent’s estate for federal estate tax purposes), but listed a third policy issued by West Coast Life Insurance Co., with a death benefit of $1,037,973, as “disputed ownership” and did not include it in the value of the decedent’s estate.

At trial the decedent’s mother claimed that because she paid the premiums the policy was really owned by her.  The Tax Court flatly rejected this contention noting that the estate listed two other policies as owned by the decedent despite the fact that the decedent’s mother paid the premiums on those policies as well.  The Tax Court went on to state, “record ownership of the West Coast policy is the most persuasive evidence [of ownership of the policy]”.

Had Mr. Fujishima and his mother simply transferred ownership of the policy to Ms. Fujishima or to an Irrevocable Life Insurance Trust (”ILIT”), the value of the policy, $1,037,973, would NOT have been included in Mr. Fujishima’s estate for federal estate tax purposes.

In the second case, Yulia Feder v. Commissioner, TC Memo 2012-10, the petitioner purchased a Northwestern Mutual life insurance policy with a death benefit of $50,000.00 in 1982.  The policy required quarterly premiums of $73.00.  Petitioner paid the premiums as they became due until November 1987. Shortly afterward, Ms. Feder sent Northwestern Mutual a letter requesting cancellation of the policy and asked that all future communications be sent to her new address.

Apparently Northwestern Mutual never received the letter.  Instead of canceling the policy as requested, when Ms. Feder stopped making premium payments the automatic loan provision of the policy went into effect and Northwestern began advancing the premiums from cash value of the policy until the cash value was exhausted.  In 2007, when the cash value was exhausted, the policy lapsed for non-payment of premiums.  Northwestern used the policy’s cash value of $12,654 to pay off the premium loans of the same amount and issued Ms. Feder a 1099-R showing income of $5,625 (Cash value of $12,654 - premiums paid of $7,029 = taxable distribution of $5,625).

At trial the Tax Court noted that Ms. Feder failed to introduce a copy of the policy at issue.  Had she done so the court may have found that she complied with the notice provisions of the policy and given effect to the cancellation that Northwestern said it never received.

When it comes to life insurance and taxes,  pay attention to the details.  Life insurance is afforded generous income and estate tax treatment when handled in the right manner.  Further, a number of states protect the cash value  and  death benefits of life insurance policies from the claims of various creditors -if structured properly. In each case had those involved simply dotted their i’s and crossed their t’s, these issues would have never arisen.

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The English proverb, "A fool and his money are soon parted" is particularly applicable in the context of tax schemes and bogus asset protection plans.  Sometimes half the battle is pointing out the bogus plans and scams and why those plans not only do not work, but subject the client to even greater losses.

The recent Tax Court case of Matthies v. Commissioner is such a case.  From the Tax Court's perspective, here is what happened and what went wrong. 

Mr. Matthies was the sole owner of a s-corporation.  The company had a profit-sharing plan ("PPS").  Mr. Matthies had an IRA as well. Mr. Matthies was the sole trustee of the PPS.

Mr. Matthies was "sold" a "Pension Asset Transfer" plan, which claimed it could "transfer qualified pension assets or IRA dollars to the participant or the participant's family without significant taxation."

Mr. Matthies made two transfers of $1,250,000 from his IRA to the PPS. The PPS purchased life insurance on Mr. Matthies inside the PPS, with the premiums paid by the PPS.  The PPS transferred the policy to Mr. Matthies for the policy's cash surrender value of $315,023, net of a $1,062,461 surrender charge. Mr. Matthies valued the policy at the cash value, net of the surrender charge, and reported no gain.  The IRS assessed a deficiency for the surrender charge amount and sought an accuracy related penalty.

The Tax Court ruled that under the regulation in effect at the time, the value of the policy was the entire cash value, inclusive of the surrender charge.  As a result, Mr. Matthies had to recognize the bargain element, i.e. the surrender charge of $1,053,304 he did not pay, as income.  The Tax Court declined to impose an accuracy related penalty because it was an issue of first impression.

As Paul Harvey said, "And now for the rest of the story."

Through an insurance agent, Mr. Matthies was put in touch with GSL Advisory Service who marketed a "Pension Asset Transfer" (PAT) plan.  Among other things, GSL represented that it:

• had "an IRS nationally approved prototype plan, the only plan with specific language to support this kind of purchase"
• its product would deliver 25% better results than comparable products (I thought it was the only one)
• a positive IRS determination letter is provided on each and every case (where was it in this case)

In his article, Court Orders Walnut Creek - Lafayette Man, Edwin Lichtig III, to Stop Peddling Unlawful Tax Schemes Tom Dunn reports that a federal court in San Francisco ordered one of GSL principal's Ed Lichtig, to stop promoting unlawful tax schemes including the PAT plan as well as the FROCO (Financed Roth Conversion Strategy), which "allegedly helped customers use annuities to transfer funds from their traditional IRAs to Roth IRAs without paying the proper amount of tax that is imposed on such transfers."

Beware tax schemes and asset protection plans that make too-good-to-be-true promises. GSL's representations were classic red flags.  The next time you or your client is approached by someone peddling such a plan, look closely. Ask competent tax counsel to review the deal before you leap.

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Failure to specify whether real property was deeded as tenants-in-common or tenants by the entirety created an additional $330,000 federal estate tax deficiency.  In Goldberg v. Commissioner, a recent Tax Court case arising in New York, the decedent executed deeds for two pieces of property, both located in New York, to "Oscar Goldberg and Judith Goldberg, as wife."  At the time the decedent, Oscar Goldberg, executed the deeds, he was married to Judith Goldberg.

After his wife's death in 2001, in that same year the decedent executed two deeds conveying all of Judith's interest in each of the two properties to a trust.  Following the decedent's death in 2004, his estate listed one-half the value of each piece of property on Schedule E of Form 706.  The Service assessed a deficiency of $330,432.96 based on its contention that the decedent owned the properties as tenants by the entirety with his wife, not as tenants-in-common.

State law determines whether and to what extent a taxpayer has an interest in property and federal law determines the tax effect of that ownership interest.  Under New York law, absent any further language in the deed, a conveyance to a husband and wife creates a tenancy by the entirety. The rule is the same in North Carolina.

If property is held as tenants by the entirety, the surviving spouse becomes the sole owner of the interest in property owned by the married couple at the death of the first spouse, regardless of what the spouse's will may say. As a result, there is no separate interest of the first spouse that could be passed by will, deed, or intestacy (dying without a will).

On the other hand, if property is held as tenants-in-common, each tenant-in-common owns an undivided interest in the property that it can be transferred by will, deed, or intestacy.  A tenant-in-common interest can also be reached by a creditor of just one of the tenants-in-common, while a tenancy by the entirety interest can only be reached by a creditor of both spouses on the same obligation.

This case does not mention Judith Goldberg's date of death, nor does it mention who were the beneficiaries of her trust.  Depending on the circumstances, Mr. Goldberg's executor may have been able to avoid the problem altogether by executing a qualified disclaimer, but the case is silent on this issue.

While most real property owned by a married couple in North Carolina is held as tenants by the entirety, there are circumstances where real property owned by couples should be held as tenants-in-common.  In that case, care must be taken to indicate that intention clearly in the deed, otherwise the law will deem the property to be held as tenants by the entirety, which defeats the planning goals and objectives.

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Is your Irrevocable Life Insurance Trust ("ILIT") funded by a universal life policy more than five years old? 

If so, your ILIT could go from a safe vehicle to leverage and shift wealth on a potentially estate and income tax free basis to a ticking time bomb that may implode when you need it the most. If your ILIT holds a universal life policy, now is a good time to dust off the policy and ask the carrier for a new illustration based on current assumptions. 

Here's why. Universal life policies are interest sensitive products, which means the illustrations the carrier gave when the policy was taken out were based on the prevailing interest rate environment at that time. In the early years of a universal life policy, the actual cost of insurance is for  far less than the premium and the insurance company invests the difference. The insurance company is betting it can make enough in the early years of the policy so that it can make up for the increased cost of insurance in the later years of the policy.

If the investment does not perform as the illustration shows, i.e. the internal rate of return on the investment is less than projected, the policy will terminate unless the owner infuses additional cash. If your universal life policy is older than five years, the interest rate assumptions contained in the illustration given when the policy was issued are probably unrealistically high, which means your policy is on a road to self-destruction.

A careful review of the illustration may show when the policy will implode due to these increased costs. But remember, that implosion date was determined based on the interest rate environment at the time the policy was issued. If the insurance company's return on investment is less than expected, the implosion will happened sooner, not later.

The good news is that in most cases the ticking time bomb can be diffused, sometimes on a tax neutral basis. It all starts with requesting a new illustration based on current assumptions, which the insurance company must provide upon request free of charge at least once a year. The new illustration based on current assumptions will show the new implosion date (date the policy lapses based on current assumptions).

With this information, you may be able to diffuse your bomb before it goes off and leaves nothing behind.

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In a recent decision, the normally unfriendly United States Tax Court ruled in favor of a taxpayer in a family limited partnership ("FLP") case. 

In Estate of Shurtz (.pdf), the Tax Court ruled that despite somewhat lax observations of the corporate formalities, a FLP was nevertheless formed for legitimate non-tax reasons and that the formation was a bona fide sale for full and adequate consideration.  The Tax Court held that asset protection and protection of the family business is a legitimate non-tax purpose. 

While the Shurtz' FLP followed ordinary formation procedures, the FLP:

• failed to open a checking account for at least 4 months
• made disproportionate distributions
• did not keep normal partnership records (accountant's records served as the paper trail to document capital accounts and other transactions). 

Nevertheless, the court ruled there was a bona fide sale for full and adequate consideration.  Reviewing the factors set out in Bongard (.pdf), a 2005 Tax Court case, the Shurtz Court noted:

1. The contributors received interests in the FLP proportionate to the ownership interest each contributed. The Shurtz engaged an accountant to calculate the value of a 1-percent general partnership interest in the FLP based on the value of the total property being contributed. The Shurtz each contributed property equal to the value of a 1-percent general partnership interest and the 98-percent limited partnership interest.
    
2. The respective assets contributed were properly credited to each partner's respective capital account.
    
3. Distributions from the FLP required a negative adjustment in the distributee partner's capital account.
    
4. Asset protection and protection of a family business is a legitimate and significant non-tax business reason for the establishment of the FLP.

For these reasons, the Tax Court was satisfied that the formation of the FLP and the contribution of property to the FLP were carried out in the way that ordinary parties to a business transaction would do business with each other. Consequently, the Tax Court ruled that the transfer of property to the FLP was made for adequate and full consideration.

FLPs, which include family limited liability companies, present a great opportunity to pass family wealth to future generations at discounted values, while at the same time providing significant asset protection features to preserve and protect a family's accumulated wealth.  However, the window of opportunity for passing wealth at discounted values may be closing soon.

The most recent proposal sent over by the White House substantially restricts valuation discounts.  If the legislation is passed in its current form, any entities formed and funded after the effective date of the legislation will lose valuable opportunities for discounting.  Once closed, the window may remain closed forever.

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