MARKET TREND: A need for more revenue sources has led to a growing trend among states to attempt to tax retirement income paid to current nonresidents based on amounts previously earned in that state. This could create unanticipated tax liabilities, particularly for retirees that choose to relocate to low or no-tax states, such as Florida or Nevada. An understanding of the federal “Source Tax Law” can enable advisors to help clients avoid unexpected taxation of retirement income by states in which they do not live. 

SYNOPSIS: Typically, an individual is subject to income taxation by the state in which he or she lives when the income is received. Some states, however, attempt to tax nonresidents on this income on the basis that it was earned, or had its source, in the first state. Retirement income has been a key target of this type of state taxation. Under the federal “Source Tax Law,” however, retirement income meeting certain conditions will be taxable only by the recipient’s state of residence at the time of payment, regardless of its “source.”
 
TAKE AWAYS: The Source Tax Law generally protects current nonresidents from being taxed on retirement income by states where they previously lived while employed. It covers retirement income paid from tax-favored vehicles such as tax-qualified retirement plans and IRAs. It also protects income from nonqualified deferred compensation arrangements if the income either is paid from a certain type of plan or in substantially equal periodic payments over life or life expectancy or a period of at least ten years. Thus, properly structuring deferred compensation payouts (including compliance with Internal Revenue Code (“Code”) § 409A) may provide significant state tax savings, depending on the states involved. 

MAJOR REFERENCES: 4 U.S.C. § 114..

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MARKET TREND: As planning approaches and products become more complex, care must be taken to avoid the retention or acquisition by the insured of powers over the policies that would cause the proceeds to be included in the insured’s estate at death.  Product sophistication using long term care riders and investment approaches with high cash value products has increased the array of planning options, offering insureds more flexibility but higher risks as well.

SYNOPSIS: Life insurance proceeds will be included in the insured’s estate for federal estate tax purposes if, at death, the insured has any right to the economic benefits, so-called incidents of ownership, in the policy, even if the insured does not actually own the policy.  “Incidents of ownership” include the power, directly or indirectly, to change the beneficiary or the contingent beneficiary, surrender or cancel the policy, assign the policy or to revoke an assignment, pledge the policy as collateral for a loan, and obtain a loan from the carrier against the surrender value of the policy.  In order to avoid inclusion of the proceeds in the insured’s estate, the insured must avoid holding any and all such incidents of ownership, even if attributed indirectly.  For example, if the insured holds a controlling interest in a corporation that owns policies on the insured’s life, the proceeds will be included in the insured’s estate to the extent the proceeds are not payable to or for the benefit of the corporation.  Policies purchased with community property funds also may cause both spouses to have incidents of ownership in the policies.  Second-to-die policies may give both insureds incidents of ownership and generally should not be transferred to an ILIT of which one of the insureds is a beneficiary.

TAKE AWAYS:  Inclusion of life insurance death benefits in the insured’s estate will occur if the insured holds any incidents of ownership in the policy.  “Incidents of ownership” encompass far more rights than actual policy ownership, including the ability to name policy beneficiaries or pledge a policy for a loan.  In addition, incidents of ownership may be attributed to an insured indirectly depending on the acquisition or ownership structure, such as with a corporate-owned policy where the insured is a majority shareholder, or a trust-owned policy where an insured is a trustee of the trust.  Thus, advisors can add value to the services they provide by helping clients identify situations where the insured may have retained or may acquire an incident of ownership and reviewing alternatives to eliminate the possibility for incidents of ownership and the potential estate tax exposure. 

MAJOR REFERENCES: IRC §2042; Private Letter Ruling 201327010; Chief Counsel Advice 201328030. 

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