Ah, tax season: that time of year when clients and advisors alike are faced with a string of uncertainties and unanswered questions. How are single premium life insurance policies taxed? How can the generation-skipping transfer tax exclusion be leveraged using an ILIT? Find answers to these and other ponderings in our timely tax primer.
Q: Are premiums paid on personal life insurance deductible for personal tax purposes?
A: No. Premiums paid on personal life insurance are a personal expense and are not deductible. Internal Revenue Service ("IRS") regulations specifically provide that "[p]remiums paid for life insurance by the insured are not deductible." It is immaterial whether the premiums are paid by the insured or by some other person. For example, premiums paid by an individual for insurance on the life of his or her spouse are nondeductible personal expenses of the individual. Premiums are not deductible regardless of whether the insurance is government life insurance or regular commercial life insurance. Although life insurance premiums, as such, are not deductible, they may be deductible as the payment of alimony or as charitable contributions.
Q: Is the interest increment earned on prepaid life insurance premiums taxable income?
A: Yes. Any increment in the value of prepaid life insurance or annuity premiums or premium deposit funds constitutes taxable income in the year it is applied to the payment of a premium or is made available for withdrawal, whichever occurs first. The interest treated as taxable income, however, will be included in the cost basis of the contract. Thus, for purposes of IRC Section 72, the cost of the contract would be the amount of premiums paid other than by discount, plus the amount of discounted funds and any increments on such funds that were subject to income taxation. The rule taxing interest increments has no applicability, however, to single premium policies. A later ruling explains in detail how the interest will be taxed.
Q: How are single premium life insurance policies, including single premium variable life insurance policies, taxed?
A: A single premium life insurance policy generally is treated in the same manner as a multiple-premium life insurance policy for income tax purposes. For all life insurance policies that meet the definition of life insurance, cash surrender value increases generally are not taxed until received and death proceeds generally are received income tax free.
The tax treatment of policy loans depends on whether the policy is treated as a modified endowment contract ("MEC"). Most single premium policies are considered MECs; policies entered into on or after June 21, 1988, that do not meet the seven pay test of IRC Section 7702A(b) are classified as MECs. Loans from MECs are taxable as income at the time received to the extent that the cash value of the contract immediately before the payment exceeds the investment in the contract.These distributions also may be subject to a penalty tax of 10 percent.
Life insurance policies, including single premium policies, issued prior to June 21, 1988, generally are grandfathered and are not subject to the seven pay test. Loans from these policies will not be treated as taxable income. Loans from policies that are not grandfathered but that meet the requirements of the seven pay test also are not treated as taxable income. Any outstanding loan becomes taxable income at the time of policy surrender or lapse, however, to the extent that the loan exceeds the owner's basis in the contract. If policy death proceeds are tax free, the amount of the loan is not taxed but is treated as part of the tax free death proceeds. Note that a grandfathered policy may lose its grandfathered status if it undergoes a material change in its terms or benefits or is exchanged for another life insurance policy under IRC Section 1035.
Q: How is the value of a life insurance policy determined for income tax purposes?
A: Transfers of property after June 30, 1969, in connection with the performance of services are governed by IRC Section 83. For transfers before February 13, 2004, Treasury Regulation Section 1.83-3(e) provided that, "In the case of a transfer of a life insurance contract, retirement income contract, endowment contract, or other contract providing life insurance protection, only the cash surrender value of the contract is considered to be property."
For transfers after February 12, 2004, however, new regulations recently have been issued under IRC Section 83. These regulations change the definition of what constitutes property with respect to a life insurance contract. The new definition generally treats the policy's fair market value (specifically the policy cash value and all other rights under the contract, including any supplemental agreements to the contract, whether or not they are guaranteed, other than current life insurance protection) as property. For transfers of life insurance contracts that are part of split dollar arrangements that are not subject to the split dollar regulations, however, only the cash surrender value of the contract is considered property.
The IRS has provided a safe harbor on how to determine the fair market value of a life insurance contract. The fair market value of a life insurance contract may be the greater of either: (1) the interpolated terminal reserve and any unearned premiums, plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year, or (2) the product of the "PERC amount" (PERC stands for premiums, earnings, and reasonable charges) and the applicable "Average Surrender Factor."
The PERC amount for a life insurance contract that is not a variable contract is the aggregate of:
(1) the premiums paid on the policy without a reduction for dividends that offset the premiums, plus
(2) dividends that are applied to purchase paid-up insurance, plus
(3) any other amounts credited or otherwise made available to the policyholder, including interest and similar income items but not including dividends used to offset premiums and dividends used to purchase paid up insurance, minus
(4) reasonable mortality charges and other reasonable charges, but only if those charges are actually charged and those charges are not expected to be refunded, rebated, or otherwise reversed, minus
(5) any distributions (including dividends and dividends held on account), withdrawals, or partial surrenders taken prior to the valuation date.
The PERC amount for a variable life contract is the aggregate of:
(1) the premiums paid on the policy without a reduction for dividends that offset the premiums, plus
(2) dividends that are applied to increase the value of the contract, including dividends used to purchase paid-up insurance, plus or minus
(3) all adjustments that reflect the investment return and the market value of the contract's segregated asset accounts, minus
(4) reasonable mortality charges and other reasonable charges, but only if those charges are actually charged on or before the valuation date and those charges are not expected to be refunded, rebated, or otherwise reversed, minus
(5) any distributions (including dividends and dividends held on account), withdrawals, or partial surrenders taken prior to the valuation date.
The Average Surrender Factor is 1.0 when valuing life insurance contracts for purposes of the rules regarding group term life (Section 79), property transferred in connection with the performance of services (Section 83), and certain transfers involving deferred compensation arrangements (Section 402(b)). This is because under these rules no adjustment for potential surrender charges is allowed.
The IRS pointed out that the formulas in its safe harbor rules must be interpreted in a reasonable manner, consistent with the purpose of determining the contract's fair market value. Specifically the rules are not allowed to be interpreted in such a way to understate a contract's fair market value.
For transfers of property before July 1, 1969, the IRS ruled that the value of an unmatured policy is determined for income tax purposes in the same manner as for gift tax purposes. In one case, the court accepted the value stipulated by the parties in an arm's length agreement.
Q: May a life insurance beneficiary be required to pay estate tax attributable to death proceeds?
A: Yes, under either of two circumstances: (1) Where the decedent/insured has directed in his or her will that the life insurance beneficiary pay the share of death taxes attributable to the proceeds; and (2) where the state of the decedent's domicile has a statute that apportions the burden of death taxes among probate and nonprobate beneficiaries in absence of any direction from the decedent regarding where the burden of death taxes should fall.
Most states have statutes that apportion death taxes (federal, state, or both) among the beneficiaries of an estate, probate and nonprobate, under circumstances where the decedent has not directed otherwise. A few states place the death tax burden on the probate estate (technically, the residuary estate).