One of my favorite plays is Guys and Dolls. My daughter and I occasionally attempt to sing Sit Down You're Rocking the Boat. You should be glad this is a text blog and not You-tube. Trust me. At any rate, at an early point in the play, somebody proposes a bet to Sky Masterson. He then tells a story about his father explaining to him that someday someone would come up to him with a fresh pack of cards, with an unbroken seal and offer to bet that the jack of spades would jump out of the pack and squirt cider in his ear. Sky's father tells him to not take the bet, because he can be certain that if he does there will be cider in his ear.
I can picture my son someday reflecting on the various pieces of wisdom he may have garnered from me. If he were to craft a parable like the jack of spades story, it might well involve someone saving vast amounts of income tax by purchasing a life insurance policy. Of course the poor kid has had to listen to his sister and I attempting Sit Down You're Rocking the Boat, so he may be more focused on old people not attempting to sing.
Life insurance actually is a very tax efficient vehicle. The build-up in value, if there is any, is tax deferred and proceeds paid by reason of death are free of income tax. The claim that it saves estate taxes is somewhat fallacious. The key there is to have the policy owned by an entity that is not includable in the taxable estate. Any appreciating asset that goes into an entity not included in the estate will achieve the same result. What is particularly good about the life insurance is that it provides liquidity just when it is needed. Or when your heirs need it to be a little more glum.
Despite all its merits, life insurance is a product that is sold more often than it is bought. And when you are trying to sell something, particularly something financial, there is nothing like a tax gimmick to help the sale along. So when presented with a complex plan involving life insurance, bear in mind the fate of Karl and Deborah Mathies who were featured in 134 TC 6 this February.
The plan that the Mathies's bought into was called PAT - for Pension Asset Transfer. How did the Mathies learn about the plan ? Well it was like this :
1998 petitioners employed an attorney of their long acquaintance, Philip Spalding, Sr., to help plan their estate. Philip Spalding, Sr., introduced petitioner to his son, Philip Spalding, Jr., who was an insurance agent. The Spaldings proposed, among other things, that petitioner use some of his IRA funds to buy life insurance through a profit-sharing plan pursuant to a so-called Pension Asset Transfer (PAT) plan marketed by GSL Advisory Service (GSL) and Hartford Life Insurance Co. (Hartford Life).
The plan called for a roll over of IRA funds into a profit-sharing plan of their S corporation. Then the S corporation makes a very large premium payment on a life insurance policy. Next the taxpayer buys the policy and transfers it to an irrevocable life insurance trust. The irrevocable life insurance trust then trades it for a fully paid up policy. So what's the trick ? The trick is that the policy has a very large surrender charge. (I'm shifting to round numbers here.) The pension plan paid 2,500,000 for an $80,000,000 "interest sensitive" second-to-die policy. At the time of the transfer, the policy had a cash value of 1,300,000, but a surrender charge of $1,000,000. The theory was that if the pension plan were to ask the insurance company for a check, the plan would get a check for 300,000, so why should it expect to get anything more from a plan beneficiary.
When the irrevocable trust received the policy, it was able to convince the company to waive the surrender charge by exchanging the policy for a fully paid up second-to-die policy for almost 20,000,000. The IRS contended that the policy was really worth 1,300,000 and tagged Mr. and Mrs. Mathies with 1,000,000 of additional income. The tax court agreed with the IRS. So the Mathies have too come up with an additional $300,000 in taxes plus about 9 years worth of interest. They were residents of California at the time, so there is probably close to another $100,000 on the tab.
I am putting this forth as a cautionary tale, because this could be an incredible disaster for the Mathies if they don't have the odd half million or so to pay the tax bill that they hadn't planned on when they first went into the plan. Presumably the asset in the irrevocable trust isn't available for that purpose. We also don't know if there was any gift tax assessment or if that just slid by. Assuming for the sake of argument, that there was no gift tax problem and then they had put some money aside for the income tax contingency, the plan doesn't seem to have done that badly. They had 2.5 million in an IRA and the assumed side fund that I just made up. They don't have either of those now, but when they die their heirs get almost 20 million free of income and estate taxes. At least one of them has to live a really long time for that to not be a fairly decent deal.
It is worth noting that in 2008, the IRS got an injunction against promoters of the PAT plan (US v Lichtig 102 AFTR 2d 2008-7064). The tax court did not sustain an accuracy related penalty against the Mathies, but such will likely not be the fate of people who in the future attempt variants of this particular scheme.