Life Income And Installment Options

<div class="Section1">The “amount held by the insurer” is divided by the number of installment payments to be made in the fixed period. The quotient is the portion of each payment that is excludable from the beneficiary’s gross income as a return of principal. The balance of each guaranteed payment generally must be included in the beneficiary’s gross income. In addition to the prorated amount of principal, the surviving spouse of an insured who died before October 23, 1986, may exclude up to $1,000 of interest each year (guaranteed and excess).<a href="#_ftn1" name="_ftnref1">¹</a> If the primary beneficiary dies before the end of the fixed period, the secondary beneficiary may exclude the same amount of prorated principal from gross income, but all interest (guaranteed and excess) is includable.<a href="#_ftn2" name="_ftnref2">²</a><br /> <blockquote><em>Example.</em> Insured spouse died after October 22, 1986. Insured’s widow elects to receive $50,000 of proceeds in ten annual installments of $5,500 each. As a second payment, she receives $5,950 (guaranteed payment plus $450 excess interest). She may exclude $5,000 of the payment as a return of principal ($50,000 ÷ 10). Consequently, she must include in income the balance of the payment ($950).</blockquote><br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Treas. Reg. § 1.101-4(a)(2), Ex. 1 and 2.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.101-4(a)(2), Ex. 3.<br /> <br /> </div>

<div class="Section1">The “amount held by the insurer” is divided by the number of payments required to exhaust principal and guaranteed interest. The quotient is the portion of each payment that is excludable from the beneficiary’s gross income as a return of principal. The balance of each guaranteed payment generally must be included in the beneficiary’s gross income.<a href="#_ftn1" name="_ftnref1">¹</a> The surviving spouse of an insured who died before October 23, 1986, may exclude up to $1,000 of interest each year in addition to the prorated amount of principal. Payments extending beyond the guaranteed period (payments comprised entirely of excess interest) are fully taxable. (There is a difference of opinion as to whether the surviving spouse’s $1,000 annual interest exclusion, even if otherwise available, can be applied to these additional excess interest payments.) If the primary beneficiary dies before the end of the guaranteed payment period, the secondary beneficiary may exclude the same amount of prorated principal from gross income.</div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Treas. Reg. § 1.101-4(g), Ex. 2.<br /> <br /> </div>

<div class="Section1"><br /> <br /> Generally, the donee steps into the shoes of the donor. Thus, the entire proceeds are exempt if they would have been exempt had the policy been retained by the donor. If the donor purchases the policy from another owner and no exceptions to the transfer for value rule ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="77">77</a>) apply, however, then only the consideration paid by the donor, plus net premiums (and certain other amounts) subsequently paid by the donor and donee, is exempt.<br /> <br /> As an exception to this general rule, however, the proceeds will be wholly tax-exempt &ndash; despite any previous transfer for value &ndash; if the final transfer is made to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is an officer or shareholder. For tax years beginning after 2017, these exceptions will not apply if the policy was transferred in a reportable policy sale.<a href="#_ftn1" name="_ftnref1">¹</a> The IRS has ruled that when a life insurance policy subject to a policy loan is transferred, there is a transfer for value; if the transfer is partly a gift, it may come within one of the exceptions to the transfer for value rule ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a>).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.101-1(b); <em>Hacker v. Commissioner</em>, 36 BTA 659 (1937).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 69-187, 1969-1 CB 45; Let. Rul. 8951056.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The &ldquo;amount held by the insurer&rdquo; (usually the one-sum proceeds payable at the insured&rsquo;s death) is prorated over the payment period. (If the settlement arrangement involves a life income with a guaranteed refund, or a guaranteed number of payments, the value of the guarantee must be subtracted from the one-sum proceeds before making the proration.) These prorated amounts determine the portion of each payment that may be treated as a return of principal. Consequently, the beneficiary may exclude this portion of each payment from gross income.<a href="#_ftn1" name="_ftnref1">¹</a> All amounts received in excess of these prorated amounts are treated as interest, and are taxable as ordinary income to any beneficiary other than the surviving spouse of an insured who died before October&nbsp;23, 1986. Such a surviving spouse is entitled to exclude up to $1,000 of such interest annually in addition to the prorated amount of principal.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <em>See</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="72">72</a> for a discussion of the treatment of a life income option, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="73">73</a> for a discussion of the treatment of a fixed period option and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="74">74</a> for a discussion of the treatment of death proceeds payable in installments based on a fixed amount.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(d)(1); Treas. Reg. &sect;&nbsp;1.101-4(a)(1)(i).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(d)(1)(B), prior to repeal by TRA &rsquo;86 &sect;&nbsp;1001(a); Treas. Reg. &sect;&nbsp;1.101-4(a)(1)(ii).<br /> <br /> </div></div><br />

<div class="Section1">In addition to the prorated exclusion of principal (<em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="74">74</a>), the surviving spouse of an insured <em>who died prior to October&nbsp;23, 1986,</em> is entitled to exclude from gross income up to $1,000 of interest (guaranteed and excess) in each taxable year. (The surviving spouse&rsquo;s $1,000 annual exclusion was repealed for surviving spouses of insureds who die after October&nbsp;22, 1986.) No more than $1,000 of interest may be excluded annually with respect to one insured, regardless of the number of policies. But if the beneficiary is the surviving spouse of more than one insured, the beneficiary is entitled to a $1,000 annual interest exclusion with respect to policies on the life of each insured.<a href="#_ftn1" name="_ftnref1">¹</a> To qualify for this additional exclusion, the surviving spouse must have been married to the insured when the insured died. An absolute divorce disqualifies the beneficiary, although a legal separation or an interlocutory decree does not.<a href="#_ftn2" name="_ftnref2">²</a> The surviving spouse&rsquo;s remarriage does not affect his or her qualification.<a href="#_ftn3" name="_ftnref3">³</a> This $1,000 annual exclusion is available only with respect to the interest element in life income or installment payments; it is not available with respect to interest payments under an interest-only option. In other words, the settlement must provide for a substantial diminution of principal during the period the interest is received.<a href="#_ftn4" name="_ftnref4">⁴</a> It would appear that because payments of proceeds (including interest) from National Service Life Insurance (NSLI) otherwise are exempted from taxation, the receipt of NSLI proceeds under an installment settlement will not reduce the $1,000 annual exclusion ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="139">139</a>).<div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(d)(1)(B), prior to repeal by TRA &rsquo;86 &sect;&nbsp;1001(a); Treas. Reg. &sect;&nbsp;1.101-4(a)(2), Ex. 2.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.101-4(a)(1)(ii); see <em>Eccles v. Commissioner</em>, 19 TC 1049 (1953), <em>aff&rsquo;d,</em> 208 F.2d 796 (4th Cir. 1953).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 72-164, 1972-1 CB 28.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.101-3(a).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> <em>Editor&rsquo;s Note:</em> The 2017 tax reform legislation restricted the availability of the exceptions to the transfer for value rule for commercial transfers (i.e., life settlement transactions or viatical settlements).<br /> <br /> As a general rule, death benefit proceeds received by the beneficiary of the policy are wholly exempt from income tax ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="63">63</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>). An exception to this rule, however, is that the proceeds are not wholly exempt if the policy, or any interest in the policy, has been transferred, by assignment or otherwise, for valuable consideration.<a href="#_ftn1" name="_ftnref1">¹</a> This exception is known as the &ldquo;transfer for value rule.&rdquo; Under this rule, the proceeds will be subject to income tax to the extent that they exceed the consideration paid (and premiums subsequently paid) by the person to whom the policy is transferred. Also, for contracts issued after June&nbsp;8, 1997 (in taxable years ending after this date), any interest paid or accrued by the transferee on indebtedness with respect to the policy is added to the amount exempt from tax after the transfer if the interest is not deductible under IRC Section&nbsp;264(a)(4).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> This unfavorable result is avoided if the transfer for value is &ldquo;to the insured, to a partner of the insured, or to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer, or if the basis of the policy in the hands of the transferee must be determined (at least in part) by reference to the transferor&rsquo;s basis (e.g., carryover basis). For tax years beginning after 2017, these exceptions will not apply if the policy was transferred in a reportable policy sale (<em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a>).&rdquo;<a href="#_ftn3" name="_ftnref3">³</a> (For application of the transfer for value rule to business insurance, <em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="290">290</a>.)<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> If a transfer is contemplated and no exception is available, it is generally accepted that creation of a partnership between the insured and the transferee at or near the time of transfer can avoid the application of the transfer for value rule. This newly created partnership, however, should have a valid purpose (other than tax avoidance) so as to not be disregarded by the IRS. Likewise, a transfer for less than adequate consideration may be considered part gift/part sale such that it qualifies as an exception under the so-called &ldquo;basis exception.&rdquo; Please note that the exceptions above do NOT include a transfer to a fellow shareholder of a corporation in which the insured is a shareholder. It is often (wrongly) assumed that a transfer to a fellow shareholder or officer is an exception since the transfer to a fellow partner is an exception.<br /> <br /> <hr><br /> <br /> The unfavorable result, however, is not avoided merely because the person to whom the policy is transferred has an insurable interest in the insured. For example, often an insured will transfer his or her policy to a son or daughter. If the transfer is a gift, the named beneficiary will receive the proceeds wholly free of income tax. But if the insured receives valuable consideration for the transfer, the proceeds will be taxable income to the beneficiary (to the extent they exceed the consideration, premiums, and other amounts subsequently paid).<a href="#_ftn4" name="_ftnref4">⁴</a> The fact that no money was exchanged for the policy does not necessarily mean that the transfer was a gift and therefore was not subject to the transfer for value rule. For example, when two insured individuals assign policies on their own lives to each other at about the same time, it could be argued that neither transfer was a gift. The transfer of a policy subject to a nonrecourse loan may be a transfer for value ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="280">280</a>).<br /> <br /> However, when a policy is owned by someone other than the insured, a transfer for value to the insured will not cause loss of tax exemption for the proceeds. Moreover, in the case of successive transfers, the proceeds will be wholly tax-exempt if the final transfer, or the last transfer for value, is to the insured or to his or her partner, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer (<em>see</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a>).<a href="#_ftn5" name="_ftnref5">⁵</a> <em>See</em> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="79">79</a> for a transfer to a spouse (or former spouse, if incident to a divorce).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(a)(2).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(a)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect;&nbsp;101(a)(2), 101(a)(3).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; Treas. Reg. &sect;&nbsp;1.101-1(b); <em>Bean v. Commissioner,</em> TC Memo 1955-195.<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(a)(2)(B); Treas. Reg. &sect;&nbsp;1.101-1(b).<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> The transfer of a life insurance policy between spouses (or former spouses if incident to a divorce, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="106">106</a>) generally will not result in the loss of exemption for the death proceeds if the transfer occurs after July&nbsp;18, 1984, (unless the transfer is pursuant to an instrument in effect on or before such date), or after December&nbsp;31, 1983, and both spouses (or former spouses if incident to a divorce) elect to have the nonrecognition rules of IRC Section&nbsp;1041 apply.<br /> <br /> The transferee is treated as having acquired the policy by gift and the transferor&rsquo;s basis is carried over to the transferee.<a href="#_ftn1" name="_ftnref1">¹</a> IRC Section&nbsp;101(a)(2)(A) provides that the transfer for value rule does not apply if the basis of the contract for determining gain or loss in the hands of the transferee is determined by reference to the basis of the contract in the hands of the transferor. If a life insurance policy with a loan is transferred in trust and gain is recognized by the transferor ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="106">106</a>), the basis in the transferee&rsquo;s hands is adjusted to reflect the gain, but the transfer may nonetheless come within an exception to the transfer for value rule ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="279">279</a>).<br /> <br /> If the transfer occurs either prior to July&nbsp;19, 1984, or after July&nbsp;18, 1984, but pursuant to an instrument in effect before such date <em>and</em> no election to have the nonrecognition rules of IRC Section&nbsp;1041 apply has been made, then the nature of the transfer determines whether the transfer for value rule applies. If the transfer was made pursuant to a property settlement agreement incident to a divorce, then the policy may be considered to have been transferred for value (e.g., in exchange for the release of marital rights). If the transfer between spouses was in the nature of a gift, then no loss of the exemption would result.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;1041.<br /> <br /> </div></div><br />

<div class="Section1"><br /> <br /> If the installments are payable for the lifetime of the beneficiary (a life income option), the “amount held by the insurer” is divided by the beneficiary’s life expectancy to determine the amount that may be excluded from gross income each year as a return of principal. In the case of amounts paid with respect to deaths occurring after October 22, 1986, the beneficiary’s life expectancy must be determined using IRS annuity tables V and VI.<a href="#_ftn1" name="_ftnref1">¹</a> In the case of amounts paid with respect to deaths occurring before October 23, 1986, the beneficiary’s life expectancy is taken from the mortality table that the insurer uses in determining the amount of the installments (not from the IRS annuity tables).<a href="#_ftn2" name="_ftnref2">²</a> If there is a refund or period-certain guarantee, the amount held by the insurer must be reduced by the present value of the guarantee before prorating for the exclusion.<a href="#_ftn3" name="_ftnref3">³</a> The present value of the guarantee is determined by using the insurer’s interest rate and the applicable mortality table. The excludable amount, once determined, remains the same even though the beneficiary outlives his or her life expectancy. The balance of the payments is taxable income to any beneficiary other than the surviving spouse of an insured who died before October 23, 1986. The spouse of such an insured may exclude up to $1,000 of interest each year in addition to excluding the prorated amount of principal. If the beneficiary dies before receiving all guaranteed amounts, the secondary beneficiary receives the balance of the guaranteed refund, or guaranteed payments, tax-free.<a href="#_ftn4" name="_ftnref4">⁴</a> Excess interest allowed by the company in addition to the guaranteed refund would be taxable income to the secondary beneficiary, however.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <blockquote><em>Example.</em> Insured husband died after October 22, 1986. Insured’s widow elects to receive $75,000 of death proceeds under a refund life income option. The company guarantees her payments of $4,000 a year. According to Table V and the interest rate used by the insurer, her life expectancy is 25 years and the present value of the refund guarantee is $13,500. The $75,000 must first be reduced by the value of the refund guarantee ($75,000 – $13,500 = $61,500). This reduced amount, $61,500, is then divided by her life expectancy to find the amount that she may exclude from gross income each year as return of principal. This amount is $2,460 ($61,500 ÷ 25). Her taxable income from the guaranteed payment is $1,540 a year ($4,000 – $2,460). If the widow dies before receiving the full $75,000, the balance of the guaranteed amount will be received tax-free by the secondary beneficiary.</blockquote><br /> If a joint-and-survivor option is elected, the “amount held by the insurer” is divided by the life expectancy of the beneficiaries as a group to determine the annual exclusion of principal. The same amount of principal is excludable during the joint lives and the lifetime of the survivor.<a href="#_ftn6" name="_ftnref6">⁶</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 101(d)(2)(B)(ii); Treas. Reg. § 1.101-7.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.101-4(c).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     Treas. Reg. § 1.101-4(e).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     Treas. Reg. § 1.101-4(d)(3).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     Treas. Reg. § 1.101-4(d)(3) and (g), Ex. 7.<br /> <br /> <a href="#_ftnref6" name="_ftn6">6</a>.     Treas. Reg. § 1.101-4(d)(2) and (g), Ex. 5.<br /> <br /> </div>

<div class="Section1">The surviving spouse of an insured who died before October&nbsp;23, 1986, is not precluded from obtaining the benefits of the $1,000 annual interest exclusion at a later date simply because the surviving spouse originally elected to leave the proceeds with the insurer under the interest-only option. A new election to take the proceeds under a life income or other installment option will entitle the surviving spouse to the annual interest exclusion.<a href="#_ftn1" name="_ftnref1">¹</a> During the time the proceeds are held under the interest-only option, the interest will be fully taxable to him or her as received ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="70">70</a>). Payments under the life income or installment option will be treated as explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="71">71</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="74">74</a>.<br /> <p style="text-align: center;"><strong>Insured Died Before August&nbsp;17, 1954</strong></p><br /> In tax years beginning before January&nbsp;1, 1977, the full installment or life income payment was tax-free to the beneficiary except excess interest, provided the option was elected under a contract right.<a href="#_ftn2" name="_ftnref2">²</a> Effective for tax years beginning on or after January&nbsp;1, 1977, IRC Section&nbsp;101(f) was repealed.<a href="#_ftn3" name="_ftnref3">³</a> As a result, these payments fall within the general rules (above) applicable where the insured died after August&nbsp;16, 1954.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 65-284, 1965-2 CB 28.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&nbsp;101(f) as in effect prior to January&nbsp;1, 1977.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; TRA &rsquo;76 &sect;&nbsp;1901(a)(16).<br /> <br /> </div></div><br />