Life insurance is a complex financial planning tool, accompanied by a number of intricate tax provisions. Most clients know that premiums paid on a personal policy are not tax-deductible, but that may be where their wisdom ends. As an advisor, this means you likely face a lot of questions around the tax implications of individual policies — especially at this time of year.
In the spirit of answering some of these questions before they're asked, we've compiled 15 little-known tax facts that you and your clients may need to know. Curious whether the "seven pay test" applies to a policy, or when death proceeds are includable in an insured's gross estate? Now you'll know.
If you have questions about the taxation of life insurance that are not answered here, please let us know in the comments section below.
1. Can a taxpayer deduct interest paid on a loan to purchase or carry a life insurance, endowment, or annuity contract?
Interest paid or accrued on indebtedness incurred to purchase or continue in effect a single-premium life insurance, endowment, or annuity contract purchased after March 1, 1954, is not deductible. For this purpose, a single-premium contract is defined as one on which substantially all the premiums are paid within four years from the date of purchase, or on which an amount is deposited with the insurer for payment of a substantial number of future premiums. One court has held that payment in the first four years of 73 percent of total annual premiums for a limited-pay policy did not constitute payment of "substantially all" of the premiums. Another court has ruled that payment of eight annual premiums in the first four years on a whole life policy was neither "substantially all" nor a "substantial number" of the premiums.
When a single-premium annuity is used as collateral to either obtain or continue a mortgage, the IRS has found that Internal Revenue Code (IRC) Section 264(a)(2) disallows the allocable amount of mortgage interest to the extent that the mortgage is collateralized by the annuity. However, this result does not hold when a taxpayer's use of available cash to purchase an annuity results in a larger home mortgage or when a taxpayer does not surrender an annuity even though cash obtained from the surrender would make it possible to reduce the amount of the mortgage. A general counsel memorandum has concluded that borrowing against the cash value of a single-premium life insurance policy is equivalent to using the policy as collateral.
In restating the rule concerning single-premium contracts, the conference committee report accompanying the Tax Reform Act of 1986 (TRA '86) states that "no inference is intended that universal life insurance policies are always treated as single-premium contracts." It is still unclear whether the four exceptions applicable to contracts other than single-premium contracts can be used in the case of universal life contracts.
Other than single-premium contract
A deduction is denied under IRC Section 264(a)(3) for interest on indebtedness incurred or continued to purchase or carry a life insurance, endowment, or annuity contract, that is not a single-premium contract, if it is purchased pursuant to a plan of purchase that contemplates the systematic direct or indirect borrowing of part or all of the increases in the cash value of such contract (either from the insurer or otherwise).
2. Are there any exceptions to the rule that disallows a deduction for interest paid on a loan to purchase or carry a life insurance, endowment or annuity contract?
There are four exceptions to this disallowance rule. However, with respect to interest paid or accrued on policies or contracts covering an individual who is a "key person," the deduction may be limited as explained here, even if one of the four exceptions to this disallowance rule is met, or even denied.
The four exceptions are:
1. The seven-year exception. The deduction will not be disallowed under this rule when no part of four of the annual premiums due during the seven-year period, beginning with the date of payment for the first premium on the contract, is paid by means of indebtedness. If there is a substantial increase in the premiums, a new seven-year period for the contract commences on the date the first increased premium is paid. However, a new seven-year period does not begin upon transfer of the policy, whether for value or by gift. A new seven-year period does not commence if modification of a life insurance policy after December 31, 1990, becomes necessary because of the insurer's financial insolvency. The addition to a policy of a provision that interest on policy loans is payable in arrears rather than in advance will not cause a new seven-year period to begin. A systematic plan of purchase will be presumed when there is borrowing in connection with more than three of the annual premiums due during the seven-year period, but will not be presumed earlier.
Once a taxpayer has used borrowed funds to pay the first four premiums, the taxpayer cannot undo the effect of this action by repaying the policy loan. If in any year during the seven-year period, the taxpayer, in connection with any premium, borrows more than an amount necessary to pay one annual premium, the excess will be treated as though he or she borrowed to pay premiums that were paid in prior years with non-borrowed funds (beginning with the first prior year and working backwards).
Example. Taxpayer, in Year 1, purchased a $100,000 policy and the annual premium was $2,200. The taxpayer paid the first four premiums without borrowing. In Year 5, the taxpayer borrowed $10,000 with respect to the policy. The borrowing will be attributed first to paying the premium for Year 5 and then attributable to paying the premium for Years 4, 3, 2, and 1 (in part).
If borrowing in connection with any premium in any year exceeds the premium for that year plus premiums paid in prior years without borrowing, the excess will be attributed to premiums (if any) paid in advance for future years. However, once the seven-year exception has been satisfied, and the seven-year period has expired, there would appear to be no limit under this exception to the amount that might be borrowed (from the policy or otherwise) to pay premiums on the policy. (But if a substantial number of premiums are prepaid, the policy might be considered a single-premium policy – see previous question.)
Thus, three of the first seven annual premiums may be borrowed, and the interest deduction would not be disallowed by reason of this rule, provided the balance of premiums during the seven-year period is paid with non-borrowed funds. But if the seven-year exception is not met, and the taxpayer cannot rebut the presumption of a systematic plan of borrowing, the interest deduction will be disallowed under this rule for all future years and for all prior years not closed by the statute of limitations. This assumes, of course, that none of the other exceptions to this rule applies.
2. $100-a-year exception. Regardless of whether there is a systematic plan of borrowing, the interest deduction will not be disallowed under this rule for any taxable year in which the interest (in connection with such plans) does not exceed $100. But when such interest exceeds $100, the entire amount of interest (not just the amount in excess of $100) is nondeductible under IRC Section 264(a)(3).
3. Unforeseen event exception. If indebtedness is incurred because of an unforeseen substantial loss of income or unforeseen substantial increase in the taxpayer's financial obligations, the deduction will not be disallowed under this rule even though the loan is used to pay premiums on the contract. An event is not "unforeseen," however, if at the time the contract was purchased it could have been foreseen.
4. Trade or business exception. If indebtedness is incurred in connection with the taxpayer's trade or business, the interest deduction will not be denied under IRC Section 264(a)(3). Thus, if an insurance policy is pledged as part of the collateral for a loan, the interest deductions will come within this exception if the taxpayer can show that the amounts borrowed actually were used to finance the expansion of inventory or other similar business needs. The IRS has ruled privately that a company that borrowed against key-person life insurance policies to take advantage of the policies' lower interest rate and generally to improve its financial position by reducing its overall debt was considered to have incurred the policy loan interest in connection with its trade or business. But borrowing to finance business life insurance (such as key person, split dollar, or stock purchase plans) is not considered to be incurred in connection with the borrower's trade or business. Systematic borrowing to finance a life insurance policy is not debt incurred in connection with an employer's trade or business even when the net death proceeds and the amounts borrowed in excess of premiums are used to fund employee retirement benefits.
The interest deduction will not be disallowed under IRC Section 264(a)(3) if any one of these exceptions applies. For example, even though the purchase of business life insurance does not come within the trade or business exception, the interest deduction may be allowed if the borrowing comes within the four-out-of-seven exception, provided no other IRC section operates to disallow or limit the interest deduction.
3. How are cash distributions received as a result of changes in the benefits of a life insurance contract taxed?
Cash distributions received as a result of certain changes in the benefits of a contract may not be taxed under the cost recovery rule, but are taxed under the "interest-first" rule. Any change in the benefits under a life insurance contract or in other terms of the contract (other than automatic increases such as change due to the growth of the cash surrender value, payment of guideline premiums, or changes initiated by the company) that was not reflected in any earlier determination or adjustment will require a redetermination as to whether the definitional guidelines of IRC Section 7702 are still satisfied. (A modification made to a life insurance contract after December 31, 1990, that is necessitated by the insurer's financial insolvency, however, will not cause retesting under IRC Sections 7702(f)(7)(B)-(E).) If such a change occurs during the fifteen-year period beginning on the issue date of the policy and reduces the benefits under the contract, then any cash distribution made to the policyholder as a result of such change will be taxed as ordinary income to the extent there is income on the contract; however, the amount to be included will be limited to the applicable recapture ceiling.
If the change occurs during the five-year period beginning on the issue date of a traditional life policy (that is, a policy that originally qualified under IRC Section 7702 by satisfying the cash value accumulation test), the recapture ceiling is the excess of the cash surrender value of the contract immediately before the reduction over the net single premium immediately after the reduction. If the change occurs during the five-year period beginning on the issue date of a universal life policy (that is, a policy that originally qualified under IRC Section 7702 by satisfying the guideline premium/cash value corridor tests), the recapture ceiling is the greater of (1) the excess of the aggregate premiums paid under the contract immediately before the reduction over the guideline premium limitation for the contract, taking into account the proper adjustment for the change in benefits, or (2) the excess of the cash surrender value of the contract immediately before the reduction over the cash value corridor immediately after the reduction.
If the change occurs after the five-year period and during the fifteen-year period beginning on the date of issue of the policy, the recapture ceiling is the excess of the cash surrender value of the contract immediately before the reduction over the cash value corridor immediately after the reduction.
Distributions made in anticipation of a reduction in benefits under the contract will be treated as resulting from a change in the contract. Any distribution that reduces the cash surrender value of a contract and that is made within two years before a reduction in benefits under such contract will be treated as made in anticipation of a reduction.
The IRS has provided examples of how these rules work.
4. What is the "seven pay test" and how does it apply to a modified endowment contract (MEC)?
A life insurance contract will fail the seven pay test if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of the seven level annual payments. Generally, the "amount paid" under the contract is defined as the premiums paid less distributions, not including amounts includable in gross income. An amount received as a loan or the repayment of a loan does not affect the amount paid under the contract. Additionally, amounts paid as premiums during the contract year but returned to the policyholder with interest within sixty days after the end of the contract year will reduce the sum of the premiums paid during the contract year. The interest paid on the premiums returned must be included in gross income.
When a whole life insurance policy is coupled with an increasing whole life rider plus a term insurance rider, and the amount of coverage provided under the term rider increases or decreases solely in relation to the amount of coverage provided by the base policy and whole life rider, the IRS has ruled privately that the policy's "future benefits" for purposes of IRC Section 7702A(b) are equal to the aggregate amount of insurance coverage provided under the base policy, the whole life rider, and the term insurance rider at the time the policy is issued. When a variable whole life policy is coupled with a twenty-year decreasing term rider, the future benefits for purposes of IRC Section 7702A(b) are equal to the coverage under the base policy plus the lowest amount of coverage under the term rider at any time during the first seven contract years.
The seven level premiums are determined when the contact is issued, and the first contract year death benefit is deemed to be provided to the contract's maturity, disregarding any scheduled death benefit decrease after the first seven years. In one private letter ruling, the death benefit for purposes of applying IRC Section 7702A(c)(1)(B) was the policy's "target death benefit," defined as the sum of the base policy death benefit and a rider death benefit.
If there is a reduction in benefits under the contract within the first seven contract years, the seven pay test is applied as if the contract had originally been issued at the reduced benefit level. Any reduction in benefits due to the nonpayment of premiums is not taken into account, however, if the benefits are reinstated within ninety days after the reduction.
In the case of a contract that pays a death benefit only on the death of one insured that follows or occurs at the same time as the death of another insured, if the death benefit is reduced below the lowest level of death benefit provided during the contract's first seven years, the MEC rules must be applied as if the contract had originally been issued at that lower benefit level. This rule is effective for contracts entered into on or after September 14, 1989.
5. Which life insurance contracts are subject to the seven pay test?
Subject to the following exceptions, life insurance contracts entered into after June 20, 1988, are subject to the seven pay test. Contracts entered into prior to this date are "grandfathered" for purposes of the seven pay test.
If the death benefit under a grandfathered contract increases by more than $150,000 over the death benefit in effect as of October 20, 1988, the contract becomes subject to the material change rules and may lose its grandfathered status. This rule does not apply if the contract required at least seven annual premiums as of June 21, 1988, and the policyholder continued to make at least seven annual premium payments. In determining whether a material change has occurred, the death benefit payable as of June 20, 1988, rather than the lowest death benefit payable during the first seven years, is applicable.
A policy entered into before June 21, 1988, may lose its grandfathered status and, therefore, may be treated as if it were entered into after this date, if (1) the policy death benefit is increased or an additional qualified benefit is purchased after June 20, 1988, and (2) prior to June 21, 1988, the contract owner did not have the right to obtain such an increase or addition without providing additional evidence of insurability. If a term life insurance contract is converted after June 20, 1988, to a policy that is not term insurance, without regard to the right of the owner to such a conversion, the policy will lose its grandfathered status. A policy entered into before June 21, 1988, did not lose its grandfathered status when the insurer changed the policy loan provision to make interest payable in arrears rather than in advance.The IRS has stated that modification of a life insurance contract after December 31, 1990, that is made necessary by the insurer's insolvency will not affect the date on which the contract was issued, entered into, or purchased for purposes of IRC Section 7702.
6. What are the tax consequences of leaving life insurance cash surrender values or endowment maturity proceeds with the insurer under the interest-only option?
The interest is fully taxable to the payee as it is received or credited.
Under some circumstances, election of the interest option will postpone tax on the proceeds. If the option is elected before maturity or surrender without reservation of the right to withdraw the proceeds, the proceeds are not constructively received in the year of maturity or surrender. But if the right of withdrawal is retained, the IRS apparently considers the proceeds as constructively received when they first become withdrawable. (It can be argued, however, that the proceeds are not constructively received when the policyholder has a contractual right to change to another option.) If the option is elected on or after the maturity or surrender date, the proceeds are constructively received in the year of maturity or surrender. The sixty-day extension rule, applicable to the election of a life income or installment option, does not apply to an election of the interest option.
If the proceeds are constructively received, the entire gain on the contract (if any) is taxable in the year of constructive receipt as if the proceeds had been actually received in a one sum settlement. If the proceeds are not constructively received, the gain will be taxable to the person who ultimately receives the proceeds.
7. What are the tax results when life insurance or endowment dividends are used to purchase paid-up insurance additions?
Normally, no tax liability will arise at any time when life insurance or endowment dividends are used to purchase paid-up insurance additions. Dividends not in excess of investment in the contract are not taxable income (see here, however, with regard to modified endowment contracts), the annual increase in the cash values of the paid-up additions is not taxed to the policyholder, and death proceeds are tax-free. In effect, dividends reduce the cost basis of the original amount of insurance and constitute the cost of the paid-up additions. Consequently, upon maturity, sale, or surrender during an insured's lifetime, gross premiums, including the cost of paid-up additions, are used as the cost of the insurance in computing gain upon the entire amount of proceeds, including proceeds from the additions.
The treatment of cash value increases and the death benefit of a contract subject to the definitional requirements of IRC Section 7702 will be different if the contract fails to meet certain requirements.
