April 15 is just a few short months away, which means your clients will be coming to you with questions. Lots of them. Are life insurance proceeds paid after the insured's death taxable to the beneficiary? When will a life insurance trust result in income tax savings? If you're looking for answers to these and other critical questions, you've come to the right place.
1. Are annual increases in the cash surrender value of a life insurance policy taxable income to the policyholder?
In a case involving a cash basis taxpayer, the Tax Court held that the cash values were not constructively received by the taxpayer where the taxpayer could not reach them without surrendering the policy. The necessity of surrendering the policy constituted a substantial "limitation or restriction" on their receipt. Likewise, the Tax Court has held that the cash surrender values of paid-up additions are not constructively received by the policyholder. Similarly, it would appear that the same "limitation or restriction" would prevent accrual for an accrual basis taxpayer, because income does not accrue until "all the events have occurred" that fix the right to receive the income. The same rule applies whether the policy is a single premium policy or a periodic premium policy.
Tax on the "inside buildup" of cash surrender values generally is not deferred in the case of contracts issued after December 31, 1984, that do not meet the statutory definition of a "life insurance contract." In such cases, the excess of the sum of (1) the increase in net surrender value (cash surrender value less any surrender charges) during the taxable year and (2) the cost of life insurance protection for the year over premiums paid under the contract during the year is taxable to the policyholder as ordinary income. "Premiums paid" generally means those paid under the contract less amounts received but excludable from income under IRC Section 72(e) (e.g., dividends). The cost of life insurance protection is the lesser of the cost of individual insurance on the life of the insured determined on the basis of uniform premiums or the mortality charge, if any, stated in the contract. If the contract originally meets the statutory definition and then ceases to do so, income on the contract for all prior years is included in gross income in the year it ceases to meet the definition.
If a variable insurance contract is an insurance contract under applicable state law and would otherwise meet the definitional requirements of IRC Section 7702, the annual increases in cash surrender value may nevertheless be taxed under the rules in the above paragraph if the underlying segregated asset account is not adequately diversified.
If a policy does not meet the IRC Section 7702(a) definition of a life insurance contract, the income on the contract for the year is considered a nonperiodic distribution and is subject to certain reporting and withholding requirements. The same is true for a variable life insurance contract that does not meet the diversification requirements of regulations under IRC Section 817(h).
The "inside buildup" of cash surrender values of corporate-owned life insurance is generally included in the calculation of the alternative minimum tax.
2. What are the rules for taxing living proceeds received under life insurance policies and endowment contracts?
Generally speaking, living proceeds are proceeds received during an insured's lifetime. The rules in IRC Section 72 govern the income taxation of amounts received as living proceeds from life insurance policies and endowment contracts. IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns.
Payments to which IRC Section 72 applies are of three classes: (1) "amounts not received as an annuity," (2) payments of interest only, and (3) annuities.
When living proceeds are held by an insurer under an agreement to pay interest, the interest payments are taxable in full. Periodic payments on a principal amount that will be returned intact on demand are interest payments.
All amounts taxable under IRC Section 72 other than annuities and payments of interest are classed as amounts not received as an annuity. These include policy dividends, lump-sum cash settlements of cash surrender values and endowment maturity proceeds, and cash withdrawals and amounts received on partial surrender.
The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of death proceeds. However, the rules for taxing such payments are similar to IRC Section 72 annuity rules.
Living proceeds received under life insurance contracts and endowment policies are taxed according to the same rules, whether they are single premium or periodic premium policies. Except for interest and annuity settlements, they are taxed under the "cost recovery rule" no matter when the contract was entered into or when premiums were paid. In other words, such amounts are included in gross income only to the extent they exceed the investment in the contract (as reduced by any prior excludable distributions under the contract). Living proceeds or distributions received from a life insurance policy that has failed the seven pay test of IRC Section 7702A(b) and, therefore, is classified as a modified endowment contract are taxed under different rules.
Planning Point. Assuming no policy loans, dividends, or prior cash value surrenders, a life insurance contract can be surrendered with no taxable gain, provided the aggregate premiums are equal to or exceed the cash values. Assume after fifteen years the aggregate premiums of a universal life policy are equal to the cash values, the policy is surrendered, and nothing is included in gross income. Over the life of this contract untaxed interest earnings have been used to pay the mortality charges (i.e., the amount-at-risk element of the contract). In contrast, if term insurance had been originally purchased, premiums would have come from after-tax income. –Donald F. Cady, J.D., LL.M, CLU.
3. How will material changes in the benefits or terms of a life insurance contract be treated?
If there is a material change in the benefits or terms, the contract will be treated as a new contract entered into on the day the material change was effective and the seven pay test, with appropriate adjustments to reflect the cash surrender value of the contract, must be met again. Modification of a life insurance contract after December 31, 1990, that is made necessary by the insurer's financial insolvency, however, will not cause commencement of a new seven year period for purposes of the seven pay test.
For a contract that has been materially changed, the seven pay premium for each of the seven years following the change is reduced by the cash surrender value of the contract as of the effective date of the material change multiplied by a fraction, the numerator of which is the seven pay premium for future benefits under the contract and the denominator of which is the net single premium for future benefits under the contract.
A material change is defined as any increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract. However, any increase due to the payment of premiums necessary to fund the lowest level of the death benefit and qualified additional benefits payable in the first seven contract years or to the crediting of interest or other earnings, including dividends, is not considered a material change. Additionally, to the extent provided in IRS regulations, any cost-of-living increase funded over the period during which premiums are required to be paid under the contract and that are based on a broad-based index is not considered a material change.
For purposes of IRC Sections 101(f), 7702, and 7702A, a material change to a contract does not occur when a rider that is treated as a qualified long term care insurance contract under IRC Section 7702B is issued or when any provision required to conform any other long term care rider to these requirements is added.
4. Are dividends payable on a participating life insurance policy taxable income?
As a general rule, all dividends paid or credited before the maturity or surrender of a contract are tax-exempt as return of investment until an amount equal to the policyholder's basis has been recovered. More specifically, when aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums, the excess is taxable income.
It is immaterial whether dividends are taken in cash, applied against current premiums, used to purchase paid-up additions, or left with the insurance company to accumulate interest. Thus, accumulated dividends are not taxable either currently or when withdrawn (but the interest on accumulated dividends is taxable) until aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums. At that point, the excess is taxable income. It is immaterial whether the policy is premium-paying or paid-up. However, dividends paid on life insurance policies that are classified as modified endowment contracts under IRC Section 7702A may be taxed differently .
Dividends are considered to be a partial return of basis; hence they reduce the cost basis of the contract. This reduction in cost must be taken into account in computing gain or loss upon the sale, surrender, exchange, or lifetime maturity of a contract.
5. What are the income tax consequences to the owner of a life insurance or endowment contract who sells the contract, such as in a life settlement?
Until 2009, the question of whether the cost of insurance protection should be subtracted or not from the premiums paid was unsettled. A commonly held view was that the cost of insurance protection should not be subtracted from the premiums paid (thus decreasing the amount of taxable gain), and this view was supported by case law. Conversely, in 2005 guidance, the IRS had indicated that on a sale of a life insurance policy, it would consider the basis of the contract to be the premiums paid minus the cost of insurance protection – thus, increasing the amount of taxable gain.
In 2009, the IRS issued Revenue Ruling 2009-13, which provides definitive guidance to policyholders who surrender or sell their life insurance contracts in life settlement transactions. Essentially, according to the revenue ruling, the basis is not adjusted for the cost of insurance protection when a policy is surrendered (Situation 1,), but the cost of insurance protection is subtracted from the premiums paid when the policy is sold (Situations 2 and 3).
Surrender of Cash Value Policy (Situation 1)
Facts: On January 1, 2001, John Smith bought a cash value life insurance policy on his life. The named beneficiary was a member of John's family. John had the right to change the beneficiary, take out a policy loan, or surrender the policy for its cash surrender value. John surrendered the policy on June 15, 2008, for its $78,000 cash surrender value, including a $10,000 reduction for the cost of insurance protection provided by the insurer (for the period ending on or before June 15, 2008). Through that date, John paid policy premiums totaling $64,000, and did not receive any distributions from or loans against the policy's cash surrender value. John was not terminally or chronically ill on the surrender date.
Amount of income recognized: The IRS determined that the "cost recovery" exception (to the "income first" rule) applied to the non-annuity amount received by John. Under that exception, a non-annuity amount received under a life insurance contract (other than a modified endowment contract) is includable in gross income to the extent it exceeds the "investment in the contract." For this purpose, "investment in the contract" means the aggregate premiums (or other consideration paid for the contract before that date) minus the aggregate amount received under the contract before that date that was excludable from gross income. The IRS ruled that John must recognize $14,000 of income: $78,000 (which included a $10,000 reduction for cost of insurance) minus $64,000 (premiums paid).
Character of income recognized: The IRS concluded that the $14,000 was ordinary income, not capital gain. The IRS determined that the life insurance contract was a "capital asset" described in IRC Section 1221(a). However, relying on earlier guidance, the IRS reiterated that the surrender of a life insurance contract does not produce a capital gain, and further determined that IRC Section 1234A (which applies to gains from certain terminations of capital assets) does not change this result.
Sale of Cash Value Policy (Situation 2)
In Situation 2, the IRS takes the position that the cost of insurance protection must be subtracted from the premiums paid when determining the adjusted basis in the contract.
Facts: The facts are the same as in Situation 1, above, except that on June 15, 2008, John sold the cash value policy for $80,000 to B, a "person" unrelated to John and who would suffer no economic loss upon John's death.
Amount of income recognized: The IRS first stated the general rule that gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis for determining gain. The IRS determined that the amount John realized from the sale of the life insurance policy was $80,000.
The adjusted basis for determining gain or loss is generally the cost of the property minus expenditures, receipts, losses, or other items properly chargeable to the capital account. The IRS specifically pointed out that Section 72, which involves the taxation of certain proceeds of life insurance contracts, has no bearing on the determination of the basis of a life insurance policy that is sold because that section applies only to amounts receivedunder the policy, which was not the case in this situation.
Next, the IRS noted the IRC's and the courts' acknowledgment that a life insurance policy – while only a single asset – may have both investment and insurance characteristics.
The IRS then stated that to measure a taxpayer's gain on the sale of a life insurance policy, the basis must be reduced by the portion of the premium paid for the policy that has been expended for the provision of insurance before the sale.
Against that backdrop, the IRS determined that John had paid premiums totaling $64,000 through the date of sale, and that $10,000 would have to be subtracted from the policy's cash surrender value as cost of insurance charges. Thus, John's adjusted basis in the policy as of the date of sale was $54,000 ($64,000 premiums paid – $10,000 expended as the cost of insurance). Accordingly, the IRS ruled that John would have to recognize $26,000 of income upon the sale of the life insurance policy, which is the excess of the amount realized on the sale ($80,000) over John's adjusted basis in the contract ($54,000).
Character of income recognized: The "substitute for ordinary income" doctrine (which essentially holds that ordinary income that has been earned but not recognized by a taxpayer cannot be converted into capital gain by a sale or exchange) was held by the IRS to be applicable in this situation. The IRS stated, however, that the doctrine is limited to the amount of income that would be recognized if a policy were surrendered (i.e., to the inside build-up under the policy). Thus, if the income recognized on a sale (or exchange) of a policy exceeds the "inside build-up" under the policy, the excess may qualify as gain from the sale or exchange of a capital asset.
In Situation 2, because the "inside build-up" in John's life insurance policy was $14,000 ($78,000 cash surrender value – $64,000 aggregate premiums paid), the IRS concluded that that amount would constitute ordinary income under the doctrine. Because the policy was a capital asset (under Section 1221) and had been held by John for more than one year, the remaining $12,000 of income represented long-term capital gain.
Effective date: The IRS has declared that the holding in Situation 2 will not be applied adversely to sales occurring before August 26, 2009.
Sale of Term Policy (Situation 3)
In Situation 3, the IRS takes the position that the cost of insurance protection must be subtracted from the premiums paid.
Facts: The facts in Situation 3 are the same as stated in Situation 2, above, except that the policy was a fifteen-year level premium term life insurance policy with a $500 monthly premium. John paid $45,000 total premiums through June 15, 2008, and then sold the policy for $20,000 on the same date to B (a person unrelated to John, and who would suffer no economic loss upon John's death).
Amount and character of income recognized: The IRS stated that absent other proof, the cost of the insurance provided to John each month was presumed to equal the monthly premium under the policy ($500). Consequently, the cost of insurance protection provided to John during the 89.5-month period was $44,750 ($500 monthly premium times 89.5 months). Thus, John's adjusted basis in the policy on the date of sale to B was $250 ($45,000 total premiums paid – $44,750 cost of insurance protection). The IRS concluded that John was required to recognize $19,750 long-term capital gain upon the sale of the term life policy ($20,000 amount realized – $250 adjusted basis).
Effective date: The IRS has declared that the holding in Situation 3 will not be applied adversely to sales occurring before August 26, 2009.
6. Are life insurance proceeds payable by reason of the insured's death taxable income to the beneficiary?
No. As a general rule, death proceeds are excludable from the beneficiary's gross income. Death proceeds from single premium, periodic premium, or flexible premium policies are received income tax-free by the beneficiary regardless of whether the beneficiary is an individual, a corporation, a partnership, a trustee, or the insured's estate. With some exceptions (as noted below), the exclusion generally applies regardless of who paid the premiums or who owned the policy.
Note that death proceeds from certain employer-owned life insurance contracts will not be excluded from income unless certain requirements are met.
Proceeds from group life insurance can qualify for the exclusion as well as proceeds from individual policies. Under certain conditions, accelerated death benefits paid prior to the death of a chronically or terminally ill insured may qualify for this exclusion. On the other hand, death benefits under annuity contracts do not qualify for the exclusion because they are not proceeds of life insurance within the meaning of IRC Section 101(a)(1).
In order to come within the exclusion, the proceeds must be paid "by reason of the death of the insured." In other words, the exclusion applies only to proceeds that are payable because the insured's death has matured the policy. When the policy has matured during the insured's lifetime, amounts payable to the beneficiary, even though payable at the insured's death, are not "death proceeds." Proceeds paid on a policy covering a missing-in-action member of the uniformed services were excludable, even though no official finding of death had been made by the Defense Department.
If death proceeds are paid under a life insurance contract, the exclusion extends to the full amount of the policy proceeds. For example, if an insured dies after having paid $6,000 in premiums on a $100,000 policy, the full face amount of $100,000 is excludable from the beneficiary's gross income (not just the $6,000 that represents a return of premiums). The face amount of paid-up additional insurance and the lump sum payable under a double indemnity provision also are excludable under IRC Section 101(a)(1). When the death proceeds are received in a one sum cash payment, the entire amount is received income tax-free. However, the exclusion does not extend to interest earned on the proceeds after the insured's death. Thus, if the proceeds are held by the insurer at interest, the interest is taxable. If the proceeds are held by the insurer under a life income or other installment option, the tax-exempt proceeds are prorated over the payment period, and the balance of each payment is taxable income.
