Life Insurance Liquidity


Reprinted by permission of the Los Angeles Business Journal™

Purchase of Life Insurance is More Than Just a Question of Liquidity

by Barry Boscoe, CFP

Have you ever asked yourself, “Why should I buy life insurance?”  You may have more than enough liquidity in your estate in the form of stocks, bonds, ready cash and real estate that you can sell. Your objection seems reasonable, since the principal purpose of a life insurance death benefit is to provide liquidity to an estate for the payment of required death taxes and administration expenses with “ease and dispatch.”  If your estate is already liquid, why pay for life insurance?  This article focuses on the “ease” and “dispatch” of payment that life insurance offers.

Owners of substantially liquid estates who object to life insurance should know about Private Letter Ruling 94-49-011.  The liquid estate in this ruling will eventually be settled, but not with “ease” and “dispatch.”  The estate in the Ruling consisted primarily of liquid assets in the form of listed stocks, bonds and cash.

At the death of the owner, the estate didn’t have enough cash to pay federal estate taxes and state inheritance taxes.  In addition, the estate owner died when the market value of the estate’s investment portfolio was depressed.  Because the heirs had confidence that the value of the investments would rebound, the estate obtained a loan from a bank to pay taxes, debts and administration expenses.

The heirs planned to pay the interest payments on the loan for approximately 20 years.  The estate’s executor also used the loan proceeds to make the necessary tax distributions to estate beneficiaries so that the estate could close.

This strategy seemed reasonable – the heirs would close the estate, gradually pay off the bank loan and watch their liquid investments increase.  However, hope for “ease” and “dispatch” of dissolution created unanticipated problems for the estate.

The key issue in the ruling was that the interest payments on the loan will not be deductible on the estate income tax return.  The IRS ruled that such interest does not qualify as business or investment interest under Section 163 of the Code.  The interest was allocable to loans made to pay the estate taxes, and was not related to business or investment assets.

Interest paid on loans to pay estate taxes is not considered a trade or business under Section 163(h)(2) of the Code.  (Investment interest is generally deductible if the taxpayer has taxable investment income.)  Thus, the IRS concluded that interest on loans to pay estate taxes is personal interest and therefore not deductible on the estate’s 1041 Income Tax Return.

If the IRS should rule negatively on the estate income tax deduction, the estate planned to deduct the interest as an administration expense taken against the gross estate under Section 2053 of the Code.  However, since indeterminable interest will be payable for many years into the future, the precise amount of the eventual estate tax payable by the estate will not be paid with “ease” and “dispatch.”

The estate was able to pay the estate tax with the loan proceeds, but each year when interest is paid on the loan, a new deduction is created by the payment of interest, generating an annual refund of estate tax to the estate.

Under the regulations of Code Section 6511, claims against estate taxes must generally be filed within the later of three years from the time the estate tax return was filed, or two years from the time the tax was paid.

The IRS indicated another problem in its ruling.  The estate assumed that it was automatically entitled to deduct loan interest under Section 2053 as an expense of administering the estate.   Revenue ruling 84-75 says that interest on a loan obtained by the executor of an estate is a deductible administrative expense provided the loan was reasonable and necessarily incurred in the administration of the estate.

In the case of the revenue ruling, because the loan was obtained in order to avoid a forced sale of assets, the loan was reasonably and necessarily incurred in administering the estate.  However, the IRS’ national office was unable to decide whether the loan was reasonable and necessary, a determination that is within the jurisdiction of the local district director.

One of the problems the estate will have is convincing the district director that the loan is reasonable and necessary under Regulation Section 20.2053-3(a), which provides that expenditures not essential to the proper settlement of the estate, but incurred for the individual benefit of the heirs or other legal claimants, may not be taken as a deduction.

Although the district director ruled that the loan obtained by the estate was necessary to avoid a forced sale of assets under Rev. Rule 84-75, the estate faced yet another roadblock.

Because annual interest payments will require a recalculation and subsequent reduction of the state tax due to periodic interest deductions, most of these annual claims for a refund will be outside the statute of limitation for refunds (the three-year period).

According to the IRS ruling, the estate will have to file a protective election:  “In order to protect the right to a refund of estate taxes based upon payments of interest after the statutory period, the taxpayer must file a Form 843 constituting a protective claim before the expiration of the statutory period of limitations, setting forth the basis of the claim.

In each succeeding year in which interest payments are made, the taxpayer must file a Form 843, setting forth grounds for the claim.  The factual basis of the claim required verification under penalties of perjury, and an appropriate reference to the original protective claim.  See Revenue Ruling 83-15.”

For the next 20 years, the estate must file refund claims that include the directors’ approval for the annual filing of protective elections.

The estate could have had “ease” and “dispatch” in settling the estate tax bill if the estate owner had taken a small piece of investment income or capital and put it into a permanent life insurance contract for 20 years.  The difficulties and expenses of settling an estate can be avoided by using life insurance to provide instant liquidity for quick and easy payment of taxes, gifts and administration expenses.