The American College: HS 321 Income Taxation

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The American College HS 321Income Taxation

• Class 10 Chapters 16 and 17
• Income Taxation of Life Insurance

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Death Benefits
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Life Insurance Proceeds

• Generally, life insurance death benefits payable
  by reason of the death of the insured are
  excludible from the gross income of the
  beneficiary.

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Accelerated Death Benefits

• Must be paid by insurer or licensed viatical
  settlement provider
• Terminally ill means death is expected within
  24 months of physicians certification
• Payments to Chronically ill insured must be
  made pursuant to qualified LTC rider

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Policy Benefit Options
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Taxation of Policy Benefit Options

• Policy in Force Dividends treated as return of
  capital withdrawals generally taxed on FIFO
  basis
• Lump-Sum Payments Gain taxed as ordinary income
• Interest-Only Option Interest taxable
• Installment Options Interest portion of payment
  taxable
• Contingent beneficiary taxed in generally the
  same way as primary beneficiary
• Consider 60-Day Rule for surrendered policies

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LIFO VS FIFO
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5-15 Withdrawals

• Taxed on LIFO basis if associated with a
  reduction in policy benefits during first 15
  policy years
• Greater taxable amount during first 5 policy
  years
• Ceiling applies to taxable amount
• Typically associated with universal life policies

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MECs

• MEC is a policy that has failed the 7-Pay Test
• Partial withdrawals, loans and collateralizations
  subject to LIFO (Last in, First-out) taxation
• 10 Percent penalty, if applicable, applies only
  to taxable portion of transaction with policy
• 7-Pay Test applies again if policy experiences a
  Material Change

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Material Changes

• Substantial increases in death benefits due to
  large deposits of premium
• Reduction in benefits during first 7 policy years
• Reduction in benefits anytime for survivorship
  policies
• Term conversions
• 1035 exchanges

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Surrender of Policy
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Surrender of Policy

• Face Amount of Policy 50,000
• Cash Surrender Value 8,000
• Premiums Paid 9,000
• Dividends Paid on Policy 2,000
• Amount Taxable 8,000 (9,000 - 2,000)
  1,000

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Quiz Questions
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Short Quiz 1

• Life insurance death benefits are excluded from
  gross income of an individual beneficiary but are
  taxable income to a trust.
• True
• False

15
Short Quiz 1

• Accelerated death benefits paid under a life
  insurance contract to a terminally ill insured
  are generally excludible from gross income as
  amounts paid by reason of death.
• True
• False

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Transfer-for-Value Rule
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Transfer-for-Value Rule

• A tax law providing that where a policy
  transferred by assignment or otherwise for a
  valuable consideration matures by reason of
  death, the transferee will be liable for income
  tax on the amount of death proceeds in excess of
  the actual value of the consideration paid for
  the contract plus the total of net premiums and
  other amounts subsequently paid by the transferee.

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Example

• Face amount of policy 100,000
• Amount paid for policy by transferee 20,000
• Premiums subsequently paid by transferee 10,000
• Amount taxable to transferee upon death of
  insured 100,000 (20,000 10,000) 70,000

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Transfer For Value EXCEPTIONS

• Transfers to the insured
• Transfers to a partner of the insured
• Transfers to a partnership in which the insured
  is a partner
• Transfers to a corporation in which the insured
  is a shareholder or officer
• Transfers to which carryover basis rules apply

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Transfer For ValueNON-EXCEPTION

• Transfers from one shareholder in a corporation
  to a fellow shareholder!

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Insurable Interest
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Insurable Interest

• The legal principle that requires the policy
  owner under a life insurance policy to have a
  sufficient business or personal relationship with
  the insured at the time of policy inception.

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Premium Payments
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Nondeductibility of Premiums

• NEVER deductible if taxpayer paying premiums is
  directly or indirectly a policy beneficiary
• If payor is NOT a policy beneficiary, premiums
  are deductible only if they qualify under a
  specific rule of tax law (e.g., Alimony,
  Compensation, or Charitable Contribution)

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Interest on Policy Loans
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Interest on Policy Loans

• Interest is deductible only if business-owned
  policy insures Key Person
• Key person must be either an officer or 20
  percent owner of taxpayer/business
• No business can have more than 20 Key Persons
• Interest deductible only to extent of 50,000 of
  loan principal per insured
• Moodys rates must be used

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Quiz Questions
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Short Quiz 2

• A corporation may take a deduction for premium
  payments made for insurance on the life of an
  officer of the corporation if the beneficiary is
  the corporation.
• True
• False

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Short Quiz 2

• An employer who pays the premiums on an
  individual policy owned by an employee and
  insuring the employees life may deduct these
  payments as additional compensation to the
  employee.
• True
• False

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Short Quiz 2

• Interest on a life insurance policy loan of
  50,000 may be deductible if the insured is a
  key person with respect to the taxpayer.
• True
• False