Death Proceeds

March 13, 2024

69 / How are proceeds taxed if a life insurance policy is owned by someone other than the insured?

<div class="Section1">The proceeds are taxed in the same manner as if the insured owned the policy. When a person retains all the incidents of ownership in an endowment or annuity contract but designates another to receive the maturity proceeds, the proceeds will be taxed to the owner rather than to the payee ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="579">579</a>). For possible gift tax consequences when a policy is owned by one individual but insures another, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="214">214</a>.</div>

March 13, 2024

64 / Is the death benefit under the double indemnity clause of a life insurance policy subject to federal income tax?

<div class="Section1">No. The death benefit is generally tax-exempt as proceeds payable by reason of an insured’s death.<a href="#_ftn1" name="_ftnref1">1</a> If the proceeds are held under a settlement option, the regular rules apply ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="70">70</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a>).<div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 101(a); Treas. Reg. § 1.101-1(a)(1). </div></div>

March 13, 2024

63 / Are life insurance proceeds payable by reason of the insured’s death taxable income to the beneficiary?

<div class="Section1"> Generally, no. As a general rule, death proceeds are excludable from the beneficiary’s gross income.<a href="#_ftn1" name="_ftnref1">1</a> 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.<a href="#_ftn2" name="_ftnref2">2</a> 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 received by the employer as beneficiary will not be excluded from the employer’s taxable income unless certain requirements are met ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8776">8776</a>).<a href="#_ftn3" name="_ftnref3">3</a> <hr> Planning Point: When presenting a key person proposal it is important to ask the prospect, “How much additional gross sales would it take to equal the income-tax-free benefits of life insurance?” Also point out that the sales revenue will be needed at a time when the business has lost a person critical to the creation of that revenue. William H. Alley, CLU, ChFC, MSFS, LUTCF, Alley Financial Group, LLC. <hr> 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 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="54">54</a>). 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.<a href="#_ftn4" name="_ftnref4">4</a> If death proceeds are paid under a life insurance contract (as defined in IRC Section 7702 and discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>), 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 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="70">70</a>). 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 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a>). Generally, in the case of a contract issued after 1984 that is a life insurance contract under applicable law but that does not meet the definitional requirements explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>, only the excess of the death benefit over the net surrender value (cash surrender value less any surrender charges) will be excludable from the income of the beneficiary as a death benefit.<a href="#_ftn5" name="_ftnref5">5</a> Generally, the exclusion is similarly limited to the amount of the death benefit in excess of the net surrender value in the case of a flexible premium contract that is subject to, but fails to meet, the guidelines of IRC Section 101(f) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>). Nevertheless, in either case, a part of the cash surrender value also will be excludable as a recovery of basis to the extent the basis has not been previously recovered; presumably, when a contract subject to the definition of a life insurance contract in IRC Section 7702 fails to meet that definition, or when a variable contract is not adequately diversified, unrecovered cash value increases previously includable in income will be recoverable tax-free as a part of basis. In addition, all or part of the proceeds may be taxable income in the following circumstances: <blockquote> <ul> <li>In some instances, the policy or an interest in the policy has been transferred for valuable consideration ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="77">77</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a>);</li> <li>The proceeds are received under a qualified pension or profit-sharing plan ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3968">3968</a>);</li> <li>The proceeds are received under a tax-sheltered annuity for an employee of a tax-exempt organization or public school ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4051">4051</a>);</li> <li>The proceeds are received under an individual retirement endowment contract ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3674">3674</a>);</li> <li>The proceeds are received by a creditor with no other insurable interest from insurance on the life of the debtor ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="135">135</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="136">136</a>);</li> <li>There is no insurable interest in the life of the insured ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="292">292</a>);</li> <li>The proceeds are received as corporate dividends or compensation ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="291">291</a>);</li> <li>The proceeds are received as alimony by a divorced spouse ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="106">106</a>);</li> <li>The proceeds are received as restitution of embezzled funds ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="293">293</a>); and</li> <li>Proceeds received by a corporation may be subject to an alternative minimum tax ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="316">316</a>) (but note that the corporate AMT was repealed for tax years beginning after 2017).</li> </ul> </blockquote> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 101(a)(1). <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.101-1(a)(1). <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 101(j). <a href="#_ftnref4" name="_ftn4">4</a>.     Rev. Rul. 78-372, 1978-2 CB 93. <a href="#_ftnref5" name="_ftn5">5</a>.     IRC § 7702(g)(2). </div></div>

March 13, 2024

65 / What is a “life insurance contract” for purposes of the death benefit exclusion for contracts issued after December 31, 1984?

<div class="Section1"> Under IRC Section 7702, for death proceeds of a life insurance contract (including an endowment contract) issued after December 31, 1984, to be fully excludable from the beneficiary’s gross income, the contract generally must be a life insurance contract under applicable state (or applicable local foreign) law and must meet one of two alternative tests: the cash value accumulation test ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="66">66</a>) or the guideline premium and corridor test ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="67">67</a>).<a href="#_ftn1" name="_ftnref1">1</a> Any plan or arrangement provided by a church or a convention or association of churches to its employees or their beneficiaries that provides for the payment of a death benefit is not required to meet the requirement that the arrangement constitute a life insurance contract under applicable law.<a href="#_ftn2" name="_ftnref2">2</a> The IRS may waive an insurer’s failure to satisfy the requirements of IRC Section 7702(a) if the errors were reasonable and reasonable steps to remedy the errors have been taken.<a href="#_ftn3" name="_ftnref3">3</a> For example, when six life insurance policies were temporarily out of compliance with the guideline premium test requirements due to the inadvertence of the insurer’s employees during a change in computer systems, the IRS granted such a waiver after the insurer increased the policy death benefits.<a href="#_ftn4" name="_ftnref4">4</a> When a combination of clerical errors (including lost records, missed testing dates, and the failure to make scheduled premium adjustments) and the conversion of the insurance company’s policy administration system from a manual procedure to a fully computerized one caused policies to be out of compliance, the IRS granted a waiver, but required that the policies be brought into compliance within 90 days.<a href="#_ftn5" name="_ftnref5">5</a> When a clerk failed to realize that a certificate holder had paid in additional premiums that put a group universal life certificate out of compliance, the IRS granted a waiver provided that the company refund the excess premiums, with interest, or increase the policy death benefit from the time of noncompliance.<a href="#_ftn6" name="_ftnref6">6</a> The IRS refused to waive an insurer’s failure to satisfy these requirements, however, when several policies were discovered to be out of compliance due to the company’s use of a software program that contained an “inherent structural flaw.”<a href="#_ftn7" name="_ftnref7">7</a> Modification of a life insurance contract after December 31, 1990 that is necessitated 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.<a href="#_ftn8" name="_ftnref8">8</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 7702(a). <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 7702(j). <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 7702(f)(8). <a href="#_ftnref4" name="_ftn4">4</a>.     Let. Rul. 9042039. See also Let. Ruls. 9801042, 9727025, 9621016. <a href="#_ftnref5" name="_ftn5">5</a>.     Let. Rul. 9416017. See also Let. Ruls. 200006030, 199924028, 9834020, 9838014. <a href="#_ftnref6" name="_ftn6">6</a>.     Let. Rul. 9623068. See also Let. Ruls. 200027030, 9805010, 9601039, 9517042, 9322023, 9146016, 9146011. <a href="#_ftnref7" name="_ftn7">7</a>.     Let. Rul. 9202008. <a href="#_ftnref8" name="_ftn8">8</a>.     Rev. Proc. 92-57, 1992-2 CB 410; Let. Rul. 9239026. See also Let. Rul. 9305013. </div></div>

March 13, 2024

67 / How is the guideline premium and cash value corridor test met?

<div class="Section1"> To meet the guideline premium and cash corridor test, the contract must first meet certain guideline premium requirements and, second, the contract must fall within the cash value corridor. For the contract to meet the guideline premium requirement, the sum of the premiums paid under the contract must not at any time exceed the greater of (1) the guideline single premium as of such time, or (2) the sum of the guideline level premiums to such date.<a href="#_ftn1" name="_ftnref1">1</a>Premiums paid for purposes of this section means those paid under the contract less excludable amounts that are not received as an annuity under IRC Section 72(e) (e.g., dividends).<a href="#_ftn2" name="_ftnref2">2</a> The guideline single premium is the premium necessary to fund future benefits under the contract, determined at the time the contract is issued using the same factors as for the net single premium ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="66">66</a>), except that the annual effective rate of interest is 6 percent instead of 4 percent.<a href="#_ftn3" name="_ftnref3">3</a> The guideline level premium is the level annual amount payable over a period not ending before the insured reaches age 95, computed in the same manner as the single guideline premium, except the annual effective rate remains at the greater of 4 percent or the rate guaranteed in the contract.<a href="#_ftn4" name="_ftnref4">4</a> The IRC sets forth certain rules for computing the guideline premiums and benefits and provides special rules that, in limited circumstances, make exceptions for failing to meet the guideline premium requirements or allow premiums paid to be returned at the end of the year to correct such failures.<a href="#_ftn5" name="_ftnref5">5</a> A contract falls within the cash value corridor if the death benefit payable under the contract at any time is at least equal to an applicable percentage of the cash surrender value. <table border="1" align="center"> <tbody> <tr> <td style="text-align: center;" colspan="4" width="540">Table</td> </tr> <tr> <td style="text-align: center;" colspan="2" width="291">In the case of an insured with an attained age as of the beginning of the contract year of:</td> <td style="text-align: center;" colspan="2" width="250">The applicable percentage decreases by a ratable portion for each full year:</td> </tr> <tr> <td style="text-align: center;" width="142">More than</td> <td style="text-align: center;" width="149">But not more than</td> <td style="text-align: center;" width="145">From</td> <td style="text-align: center;" width="104">To</td> </tr> <tr> <td style="text-align: center;" width="142">0</td> <td style="text-align: center;" width="149">40</td> <td style="text-align: center;" width="145">250</td> <td style="text-align: center;" width="104">250</td> </tr> <tr> <td style="text-align: center;" width="142">40</td> <td style="text-align: center;" width="149">45</td> <td style="text-align: center;" width="145">250</td> <td style="text-align: center;" width="104">215</td> </tr> <tr> <td style="text-align: center;" width="142">45</td> <td style="text-align: center;" width="149">50</td> <td style="text-align: center;" width="145">215</td> <td style="text-align: center;" width="104">185</td> </tr> <tr> <td style="text-align: center;" width="142">50</td> <td style="text-align: center;" width="149">55</td> <td style="text-align: center;" width="145">185</td> <td style="text-align: center;" width="104">150</td> </tr> <tr> <td style="text-align: center;" width="142">55</td> <td style="text-align: center;" width="149">60</td> <td style="text-align: center;" width="145">150</td> <td style="text-align: center;" width="104">130</td> </tr> <tr> <td style="text-align: center;" width="142">60</td> <td style="text-align: center;" width="149">65</td> <td style="text-align: center;" width="145">130</td> <td style="text-align: center;" width="104">120</td> </tr> <tr> <td style="text-align: center;" width="142">65</td> <td style="text-align: center;" width="149">70</td> <td style="text-align: center;" width="145">120</td> <td style="text-align: center;" width="104">115</td> </tr> <tr> <td style="text-align: center;" width="142">70</td> <td style="text-align: center;" width="149">75</td> <td style="text-align: center;" width="145">115</td> <td style="text-align: center;" width="104">105</td> </tr> <tr> <td style="text-align: center;" width="142">75</td> <td style="text-align: center;" width="149">90</td> <td style="text-align: center;" width="145">105</td> <td style="text-align: center;" width="104">105</td> </tr> <tr> <td style="text-align: center;" width="142">90</td> <td style="text-align: center;" width="149">95</td> <td style="text-align: center;" width="145">105</td> <td style="text-align: center;" width="104">100</td> </tr> </tbody> </table> The determination of whether a variable life insurance contract meets either the cash value accumulation test ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="66">66</a>) or the guideline premium cash corridor test must be made whenever the death benefit under the contract changes, but at least once during each twelve-month period.<a href="#_ftn6" name="_ftnref6">6</a> <hr> Planning Point: Generally, use of the guideline premium test will provide higher policy cash values than the cash value corridor test when cash accumulation is the primary purpose of the policy. However, it is advisable to run the product illustration using both tests to optimize the product design. <hr> A variable life insurance contract will not be treated as a life insurance contract, and taxed accordingly, for any period that the underlying investments of the segregated asset account are not “adequately diversified” ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="552">552</a>).<a href="#_ftn7" name="_ftnref7">7</a> The IRS has ruled that sub-accounts within variable life policies that were invested in hedge funds available to the general public would be considered owned by the policy owners, and thus currently taxed on the income.<a href="#_ftn8" name="_ftnref8">8</a> Sub-accounts within a variable life contract may invest in mutual funds that are available to the general public.<a href="#_ftn9" name="_ftnref9">9</a> The IRS has clarified what is meant by the phrase “general public.”<a href="#_ftn10" name="_ftnref10">10</a> In Revenue Procedure 2010-28, the IRS provides a safe harbor addressing the application of IRC Sections 7702 and 7702A to life insurance contracts that mature after the insured individual reaches age 100. The Revenue Procedure also addresses the treatment of amounts received under a life insurance contract after it has matured. Under the safe harbor, the IRS will not challenge the qualification of a contract as a life insurance contract under IRC Section 7702, or assert that a contract is a modified endowment contract under IRC Section 7702A ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="13">13</a>), provided that the contract satisfies the requirements of those provisions using all of the Age 100 Testing Methodologies in Section 3.02 of Revenue Procedure 2010-28.<a href="#_ftn11" name="_ftnref11">11</a> Contracts issued after June 30, 1984 that provide an increasing death benefit and have premium funding more rapid than ten-year level premium payments must satisfy the definition generally applicable to contracts issued after 1984, with certain exceptions.<a href="#_ftn12" name="_ftnref12">12</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.       IRC § 7702(c).   <a href="#_ftnref2" name="_ftn2">2</a>.       IRC § 7702(f)(1). <a href="#_ftnref3" name="_ftn3">3</a>.       IRC § 7702(c)(3).   <a href="#_ftnref4" name="_ftn4">4</a>.       IRC § 7702(c).   <a href="#_ftnref5" name="_ftn5">5</a>.       IRC § 7702(f)(1)(B).   <a href="#_ftnref6" name="_ftn6">6</a>.       IRC § 7702(h)(9).   <a href="#_ftnref7" name="_ftn7">7</a>.       IRC § 817(h).   <a href="#_ftnref8" name="_ftn8">8</a>.       Rev. Rul. 2003-92, 2003-33 IRB 350.   <a href="#_ftnref9" name="_ftn9">9</a>.       Let. Rul. 200420017.   <a href="#_ftnref10" name="_ftn10">10</a>.     Rev. Rul. 2007-7, 2007-7 IRB 468.   <a href="#_ftnref11" name="_ftn11">11</a>.     Rev. Proc. 2010-28; 2010-2 C.B. 270.   <a href="#_ftnref12" name="_ftn12">12</a>.    DEFRA § 221(d)(2). </div></div>

March 13, 2024

66 / How is the cash value accumulation test met?

<div class="Section1"> To satisfy the cash value accumulation test, the cash surrender value of a contract, according to its terms, must not at any time exceed the net single premium that would be necessary at such time to fund future benefits (death benefits, endowment benefits, and charges for certain additional benefits, such as a disability waiver) under the contract.<a href="#_ftn1" name="_ftnref1">1</a> The cash surrender value of a contract is its cash value, disregarding any surrender charges, policy loans, or reasonable termination benefits. The net single premium is determined by using (1) an annual effective interest rate of 4 percent or the interest rate(s) guaranteed in the contract, whichever is greater, (2) the mortality charges specified in the contract or if none are specified, the charges used in figuring the statutory reserves for the contract, and (3) any other charges specified in the contract. For contracts issued on or after October 21, 1988, the mortality charges used must be reasonable charges that meet the requirements, if any, identified in the applicable regulations and that do not exceed the mortality charges specified in the “prevailing commissioners’ standard tables” at the time the contract is issued.<a href="#_ftn2" name="_ftnref2">2</a> The 2017 tax reform legislation modified the definition of the prevailing commissioners’ standard tables. The exercise of an option to change a policy’s death benefit after October 21, 1988, added to the policy by endorsement prior to this date, did not cause the policy to become subject to the reasonable mortality requirements of IRC Section 7702(c)(3)(B)(i), as amended by Technical and Miscellaneous Revenue Act (TAMRA).<a href="#_ftn3" name="_ftnref3">3</a> Proposed regulations provide three safe harbors for meeting the reasonable mortality charge requirement in contracts that insure only one life and that are entered into on or after October 21, 1988.<a href="#_ftn4" name="_ftnref4">4</a> A contract issued before October 21, 1988 will meet the reasonable mortality charge requirements if it has mortality charges that do not differ materially from the charges actually expected to be made.<a href="#_ftn5" name="_ftnref5">5</a> Any other reasonable charges taken into account for purposes of determining the net single premium must be reasonably expected to actually be paid and must be actually specified in the contract.<a href="#_ftn6" name="_ftnref6">6</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 7702(b). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 7702(c)(3)(B)(i). The prevailing commissioners’ standard tables are defined in IRC Section 807(d)(5). See also 2001 CSO Table. The 2017 tax reform legislation (Pub. Law No. 115-97) modified the definition of “prevailing commissioners’ standard tables” to include the most recent NAIC tables used for computing reserves under the laws of at least 26 states’ insurance laws when the contract was issued. If there is any change in these tables from one year to the next, the issuer may use the prevailing commissioners’ standard tables as of the beginning of the preceding calendar year with respect to any contract issued after the change and before the close of the 3-year period beginning on the first day of the year of change. <a href="#_ftnref3" name="_ftn3">3</a>. Let. Rul. 9853033. <a href="#_ftnref4" name="_ftn4">4</a>. Prop. Treas. Reg. § 1.7702-1. <a href="#_ftnref5" name="_ftn5">5</a>. TAMRA ’88 § 5011(c). <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 7702(c)(3)(B)(ii). </div>

March 13, 2024

70 / If life insurance death proceeds are left on deposit with the insurance company under an interest-only option, is the interest taxable income to the beneficiary?

<div class="Section1"> Yes. All amounts paid or credited to a beneficiary as interest (excess and guaranteed) must be included in the beneficiary’s gross income regardless of whether the insured or the beneficiary elected the option.<a href="#_ftn1" name="_ftnref1">1</a> The interest is taxable in the first year that it can be withdrawn. If the beneficiary elects an option under which there is no right to withdraw either principal or interest for a specified number of years, the entire amount of accumulated interest is taxable in the year during which it first becomes withdrawable.<a href="#_ftn2" name="_ftnref2">2</a> But if the beneficiary has a right to withdraw principal, the interest is taxable when credited even though the agreement stipulates that the interest cannot be withdrawn.<a href="#_ftn3" name="_ftnref3">3</a> The principal amount held by the insurer, representing the value of the proceeds at the insured’s death, is income tax-free to the recipient when withdrawn ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="63">63</a>). For a discussion of the tax treatment when proceeds are held for a period under the interest option and subsequently paid under a life income or installment settlement, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 101(c); Treas. Reg. § 1.101-3(a). <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.101-4 (g), Ex. 1. <a href="#_ftnref3" name="_ftn3">3</a>.     Strauss v. Commissioner, 21 TC 104 (1953); see also Rev. Rul. 68-586, 1968-2 CB 195. </div></div>

March 13, 2024

68 / What is a “life insurance contract” for purposes of the death benefit exclusion for policies issued before January 1, 1985?

<div class="Section1"> A policy issued before January 1, 1985 that is exchanged for one issued after December 31, 1984 will be treated as a contract issued after 1984 and subject to the definitional requirements of IRC Section 7702 discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>, according to the General Explanation of the Deficit Reduction Act of 1984 (the General Explanation). The General Explanation states that a change in policy terms after December 31, 1984, could be considered an exchange that would bring the policy under the IRC Section 7702 definitional requirements. Examples of “changes in terms” are changes in “amount or pattern of death benefit, the premium pattern, the rate or rates guaranteed on issuance of the contract, or mortality and expense charges.”<a href="#_ftn1" name="_ftnref1">1</a> A change in minor administrative provisions or a loan rate change generally would not be considered to result in an exchange, the General Explanation adds. 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 101(f).<a href="#_ftn2" name="_ftnref2">2</a> Otherwise, universal life insurance and any other flexible premium contract, issued before January 1, 1985, qualify for the death proceeds exclusion only if (1) the sum of the premiums does not exceed at any time a guideline premium and the death benefit is not less than a certain percentage of the cash value (140 percent until the start of the policy year the insured attains age 40, thereafter reducing 1 percent for each year over 40, but not below 105 percent) or (2) the contract provides that the cash value may not at any time exceed the net single premium for the death benefit at that time. The guideline premium is the greater of (1) the single premium necessary to fund future benefits under the contract based on the maximum mortality rates and other charges fixed in the contract and the minimum interest rate guaranteed in the contract at issue, but at least 6 percent, or (2) the aggregate level annual amounts payable over the life of the contract (at least 20 years but not extending beyond age 95, if earlier) computed in the same manner as the single premium guideline (using an annual effective rate of 4 percent instead of 6 percent). The IRS can allow excessive premiums paid in error to be returned (with interest) within 60 days after the end of the policy year; in such case, the policy will still qualify as life insurance.<a href="#_ftn3" name="_ftnref3">3</a> The death benefit of a flexible premium contract entered into before January 1, 1983, will be excludable if the contract met the requirements on September 3, 1983. In determining if the level annual premium guideline is met by such a contract, an annual effective interest rate of 3 percent may be substituted for 4 percent.<a href="#_ftn4" name="_ftnref4">4</a> For life insurance contracts (other than flexible premium contracts) issued before January 1, 1985, there is no clear definition of “life insurance” for purposes of the tax-free death benefit. Despite this, the death proceeds are not considered proceeds of life insurance unless the contract under which they are paid provided protection against the risk of early death. The IRS has taken the position that, for income tax purposes, a contract is a life insurance contract if it contained an element of life insurance risk at any time.<a href="#_ftn5" name="_ftnref5">5</a> Thus, the IRS apparently has not attempted to tax the proceeds of a retirement income contract, even when the insured’s death has occurred after the cash value has exceeded the face amount but before the maturity of the contract. This ruling involved a contract purchased by a qualified retirement plan and the IRS could attempt to limit its position to such contracts.<a href="#_ftn6" name="_ftnref6">6</a> On the other hand, the Tax Court has held that a retirement income contract is an annuity contract once the element of risk has disappeared.<a href="#_ftn7" name="_ftnref7">7</a> The IRS also has ruled that the exclusion applies to variable life insurance death benefits that may increase or decrease, but not below a guaranteed minimum amount, on each policy anniversary depending on the investment experience of the separate account of the prior year’s net premium.<a href="#_ftn8" name="_ftnref8">8</a> Regulations provide that death benefits having the characteristics of life insurance proceeds payable by death under contracts such as workers compensation and accident and health contracts are excludable under IRC Section 101(a).<a href="#_ftn9" name="_ftnref9">9</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     General Explanation of the Deficit Reduction Act of 1984 at p. 656. <a href="#_ftnref2" name="_ftn2">2</a>.     Rev. Proc. 92-57, 1992-2 CB 410; Let. Rul. 9239026. <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 101(f). <a href="#_ftnref4" name="_ftn4">4</a>.     TEFRA § 266(c). <a href="#_ftnref5" name="_ftn5">5</a>.     Rev. Rul. 66-322, 1966-2 CB 123. <a href="#_ftnref6" name="_ftn6">6</a>.     GCM 38934 (12-8-82); GCM 39022 (8-12-83). <a href="#_ftnref7" name="_ftn7">7</a>.     Evans v. Commissioner, 56 TC 1142 (1971). <a href="#_ftnref8" name="_ftn8">8</a>.     Rev. Rul. 79-87, 1979-1 CB 73. <a href="#_ftnref9" name="_ftn9">9</a>.     Treas. Reg. § 1.101-1(a)(1). </div></div>