F 1

1
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime
• Life insurance defined
• Contracts must contain elements of risk shifting
  and risk distribution
• Contracts must meet IRC Section 7702 requirements
• Cash Value Accumulation Test (CVAT) or
• Meet certain guideline premium requirements
• If contract meets the definition of life
  insurance
• Cash value grows tax deferred
• Death benefits are income tax free
• Withdrawals up to the policy basis and policy
  loans are income tax deferred

2
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime
• Cash value increases
• Grow income tax deferred
• Dividends
• Until total dividends received in cash exceed the
  policyowner's basis, these distributions are
  income tax free
• Election to make policy paid-up
• Applying cash value as a single premium to
  purchase a paid-up policy at a reduced face
  amount does not create a taxable event
• Cash values were never constructively received by
  the policy owner
• However if an outstanding loan is reduced during
  this transaction, the policyowner may incur some
  taxation

3
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• National service life insurance
• No gain is subject to income tax
• Policy withdrawals
• Withdrawal is a partial surrender of a policy
• No taxable income until withdrawals exceed
  policyowner's basis
• Exception income tax liability is accelerated
  if a cash distribution occurs within the first 15
  years of the policys issue and
• That distribution is coupled with a reduction in
  the policys death benefit
• Does not apply to policies issued after 1985

4
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• Surrender, redemption of maturity of policy
• Lump sum cash-in
• Excess over investment in the contract is a
  ordinary income
• Interest only option
• Interest is taxable as received
• Definition of investment in the contract
• Total premiums paid less total amount of
  nontaxable distributions (dividends, unrepaid
  loans, tax free withdrawals)
• Annuity taxation
• Annuity systematic liquidation of principal and
  interest over a fixed or contingent period of
  time
• Annuitant can exclude from tax a fixed (return of
  cost) portion of each payment from gross income
  and pay income tax at ordinary rates on the
  balance of each payment

5
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• Deductibility of premium payments
• No deduction allowed for premiums paid on
  personally owned policy
• No deduction for business policyowners if they
  are directly or indirectly a beneficiary under
  the policy
• Policy loan interest
• Trade or business situations
• Contracts purchased before June 21, 1986 are not
  subject to any limit on deductibility of interest
• 1996 Legislation interest deductible for
  corporate owned polices insuring a key employee
  up to 50,000 of indebtedness
• Number of persons who may be treated as key
  employees is limited to the greater of (1) five
  employee or (2) the lessor of 5 of total
  officers and employees or twenty individuals

6
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• Policy loan interest (cont'd)
• Investment or passive activity situations
• Where policyowner can document that proceeds of a
  policy loan were used to purchase an investment
  or expended on a passive activity
• Interest should be considered investment interest
• Deductible subject to investment interest
  limitations
• Personal situations
• Interest not deductible
• Single premium contracts
• No deduction allowed for interest paid or accrued
  on indebtedness incurred to purchase or continued
  in effect a single premium life insurance
  contract
• Single premium substantially all the premiums
  are paid within four years after the policy was
  purchased

7
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• Policy loan interest (cont'd)
• Financing the policy through policy loans
• No deductions is allowed for interest payments
• Exceptions
• Four out of seven premiums paid without borrowing
• 100 exception - for interest less than 100
• Unforeseen events (1) There was an unforeseen
  substantial increase in the policyowners
  financial liability or (2) the policyowner
  suffered an unforeseen substantial loss in income
• Interest paid on conversion of term policy
• For original age conversions back premiums plus
  interest payments made to insurance company

8
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• Timing of interest deduction
• Accrual basis policyowners take deduction in year
  interest accrues
• Cash basis policyowners take deduction in the
  year interest is paid
• Only policyowner can take deduction and only if
  they made the interest payment
• Assignee cannot deduct interest that accrued
  before policy was transferred to him/her
• Taxation of policyowner or insured in business
  situations
• If the employer is directly or indirectly the
  beneficiary of the insurance contract the
  insured-employee is not taxed on corporation
  payment of policy premiums
• Exceptions (1) Proceeds payable to employees
  beneficiary or estate.
• (2) Proceeds paid to a personal
  beneficiary or estate of an employee

9
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• Taxation of policyowner or insured in business
  situations (cont'd)
• Stock redemption premiums not taxed to any
  shareholder
• Buy-sell where policy used to fund a buy-sell
  agreement is personally owned by a shareholder
  and shareholder has named a personal beneficiary
  or designated his or her estate as beneficiary,
  corporate premium payments may be considered a
  distribution of dividend
• Taxation of policyholder in creditor situation
• Creditor receives proceeds in satisfaction of a
  debt proceeds are tax free
• Taxation of policyholder in alimony situation
• Premium payments are taxable as alimony to
  non-insured spouse owner

10
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• Taxation of advance premium deposits
• Discount allowed to a policyowner who pays
  premiums more than one year before they come due
• IRS taxes the interest increment earned on those
  pre-paid premiums
• Taxation of accelerated death benefits
• Amounts received under a life insurance policy on
  the life of a (1) terminally ill person or (2)
  chronically ill insured
• Treated as an amount paid by reason of death of
  the insured
• Amounts paid to chronically ill persons subject
  to same limitation that apply to long term care
• In 2006 - 250 per day

11
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation during the insured lifetime (cont'd)
• Sale of a life insurance policy
• Gain on sale taxable as ordinary income
• No loss deduction is allowed
• If policy sold for less than fair market value
• Difference may be taxable to buyer
• Corporate distribution of policy
• Corporation buys back its own stock or purchases
  land and, in return, pays for the purchase by
  distributing a life insurance policy on the life
  of the selling shareholder or landowner
• Seller of stock would realize gain equal excess
  of stock over (1) value of policy over (2)
  sellers basis in the stock or land

12
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation at and after the insureds death
• Implication of meeting definition
• If contract meets definition of life insurance
  under IRC Section 7702, then proceeds are
  generally income tax exempt
• Proceeds payable at insureds death
• Generally income tax free
• Even if proceeds are payable to
• Corporation
• Trust
• LLC
• partnership
• Paid in lump sum or installments
• From riders on the policy (accidental death
  benefits)

13
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation at and after the insureds death
  (cont'd)
• Proceeds payable at a date later than death
• If delay results in payment of interest in
  addition to proceeds
• Interest is taxable as ordinary income to the
  recipient
• Payments taken in installments
• Amount of proceeds systematically liquidated over
  time
• Part of each payment considered tax free and part
  will be taxable, in much the same way annuities
  are taxed
• Tax free portion called amount held by insurer
• Step 1 - Compute amount held by insurer
• Step 2 - Determine number of years in the payment
  period
• Step 3 Dividend step 1 answer by step 2 answer

14
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation at and after the insureds death
  (cont'd)
• Life Income option elected
• Tax free amount continues regardless of how long
  the beneficiary lives
• Even if beneficiary outlives the life expectancy
  (from step 2), these amounts remain income tax
  free
• Fixed period option elected
• Beneficiary can chose to take insurance proceeds
  over a number of years
• The same three-step process is used to determine
  the taxable and non-taxable portion of each
  payment

15
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation at and after the insureds death
  (cont'd)
• Fixed amount option elected
• Beneficiary selects an amount to be paid to them
• Length of time over which lump sum will be paid
  depends on size of the proceeds and amount of
  payments selected
• Three-step procedure applies
• If the primary beneficiary dies before end of the
  guaranteed period, the secondary beneficiary can
  also exclude from gross income the same amount of
  pro-rated principal
• Interest only option
• Beneficiary leaves proceeds with insurer and
  takes only interest payments
• Interest is fully taxable to the beneficiary

16
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation at and after the insureds death
  (cont'd)
• Exception for government life insurance
• None of the interest element payable is subject
  to income tax if proceeds are payable under
  government life insurance
• Exception to the general rule for transfer for
  value
• Where a policy, or an interest in a policy
  transferred in return for any type of valuable
  consideration in money or moneys worth
• Proceeds, except to the extent of the dollar
  value of that consideration and any premiums paid
  after the transfer by the new policy owner lose
  their income tax free status
• Exception where proceeds are considered
  compensation or dividends
• Insured never reports income from corporation
  payment of premiums on policy owned by employee
  or third party
• Tax on premiums plus interest and penalties
  payable by the estate
• Proceeds would still be income tax free

17
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation at and after the insureds death
  (cont'd)
• Exception where proceeds are considered
  compensation or dividends (cont'd)
• If corporation owns and is the beneficiary of the
  policy and pays all premiums
• Proceeds received income tax free
• May be subject to the AMT tax
• If those proceeds are subsequently paid out to
  the beneficiary of the employee
• Payments taxable to the beneficiary
• Corporation can take deduction for those payments
  as compensation
• Corporation owns policy and pays all premiums but
  proceeds are payable to an employee or employee
  shareholder's beneficiary
• Payments are compensation in the case of an
  employee
• Payments are dividends in the case of a
  shareholder employee

18
Taxation of Benefits
Appendix F Tools Techniques of Life Insurance
Planning

• Taxation at and after the insureds death
  (cont'd)
• Exception where policy owned but a qualified
  retirement plan
• Portion of proceeds equal to the cash surrender
  value will be taxable as ordinary income when
  death benefits are paid from the qualified plan
• The net amount at risk portion of the proceeds
  are income tax free