10 more life insurance tax facts you need to know

April 15 is just a few short months away, which means your clients will be coming to you with questions. Lots of them. Are life insurance proceeds paid after the insured's death taxable to the beneficiary? When will a life insurance trust result in income tax savings? If you're looking for answers to these and other critical questions, you've come to the right place.

See also: 10 life insurance tax facts you need to know

1. Are annual increases in the cash surrender value of a life insurance policy taxable income to the policyholder?

In a case involving a cash basis taxpayer, the Tax Court held that the cash values were not constructively received by the taxpayer where the taxpayer could not reach them without surrendering the policy. The necessity of surrendering the policy constituted a substantial “limitation or restriction” on their receipt. Likewise, the Tax Court has held that the cash surrender values of paid-up additions are not constructively received by the policyholder. Similarly, it would appear that the same “limitation or restriction” would prevent accrual for an accrual basis taxpayer, because income does not accrue until “all the events have occurred” that fix the right to receive the income. The same rule applies whether the policy is a single premium policy or a periodic premium policy.

Tax on the “inside buildup” of cash surrender values generally is not deferred in the case of contracts issued after December 31, 1984, that do not meet the statutory definition of a “life insurance contract.” In such cases, the excess of the sum of (1) the increase in net surrender value (cash surrender value less any surrender charges) during the taxable year and (2) the cost of life insurance protection for the year over premiums paid under the contract during the year is taxable to the policyholder as ordinary income. “Premiums paid” generally means those paid under the contract less amounts received but excludable from income under IRC Section 72(e) (e.g., dividends). The cost of life insurance protection is the lesser of the cost of individual insurance on the life of the insured determined on the basis of uniform premiums or the mortality charge, if any, stated in the contract. If the contract originally meets the statutory definition and then ceases to do so, income on the contract for all prior years is included in gross income in the year it ceases to meet the definition.

If a variable insurance contract is an insurance contract under applicable state law and would otherwise meet the definitional requirements of IRC Section 7702, the annual increases in cash surrender value may nevertheless be taxed under the rules in the above paragraph if the underlying segregated asset account is not adequately diversified.

If a policy does not meet the IRC Section 7702(a) definition of a life insurance contract, the income on the contract for the year is considered a nonperiodic distribution and is subject to certain reporting and withholding requirements. The same is true for a variable life insurance contract that does not meet the diversification requirements of regulations under IRC Section 817(h).

The “inside buildup” of cash surrender values of corporate-owned life insurance is generally included in the calculation of the alternative minimum tax.

2. What are the rules for taxing living proceeds received under life insurance policies and endowment contracts?

Generally speaking, living proceeds are proceeds received during an insured’s lifetime. The rules in IRC Section 72 govern the income taxation of amounts received as living proceeds from life insurance policies and endowment contracts. IRC Section 72 also covers the tax treatment of policy dividends and forms of premium returns.

Payments to which IRC Section 72 applies are of three classes: (1) “amounts not received as an annuity,” (2) payments of interest only, and (3) annuities.

When living proceeds are held by an insurer under an agreement to pay interest, the interest payments are taxable in full. Periodic payments on a principal amount that will be returned intact on demand are interest payments.

All amounts taxable under IRC Section 72 other than annuities and payments of interest are classed as amounts not received as an annuity. These include policy dividends, lump-sum cash settlements of cash surrender values and endowment maturity proceeds, and cash withdrawals and amounts received on partial surrender.

The income tax treatment of life insurance death proceeds is governed by IRC Section 101, not by IRC Section 72. Consequently, the annuity rules in IRC Section 72 do not apply to life income or other installment payments under optional settlements of death proceeds. However, the rules for taxing such payments are similar to IRC Section 72 annuity rules.

Living proceeds received under life insurance contracts and endowment policies are taxed according to the same rules, whether they are single premium or periodic premium policies. Except for interest and annuity settlements, they are taxed under the “cost recovery rule” no matter when the contract was entered into or when premiums were paid. In other words, such amounts are included in gross income only to the extent they exceed the investment in the contract (as reduced by any prior excludable distributions under the contract). Living proceeds or distributions received from a life insurance policy that has failed the seven pay test of IRC Section 7702A(b) and, therefore, is classified as a modified endowment contract are taxed under different rules.

Planning Point. Assuming no policy loans, dividends, or prior cash value surrenders, a life insurance contract can be surrendered with no taxable gain, provided the aggregate premiums are equal to or exceed the cash values. Assume after fifteen years the aggregate premiums of a universal life policy are equal to the cash values, the policy is surrendered, and nothing is included in gross income. Over the life of this contract untaxed interest earnings have been used to pay the mortality charges (i.e., the amount-at-risk element of the contract). In contrast, if term insurance had been originally purchased, premiums would have come from after-tax income. --Donald F. Cady, J.D., LL.M, CLU.

3. How will material changes in the benefits or terms of a life insurance contract be treated?

If there is a material change in the benefits or terms, the contract will be treated as a new contract entered into on the day the material change was effective and the seven pay test, with appropriate adjustments to reflect the cash surrender value of the contract, must be met again. Modification of a life insurance contract after December 31, 1990, that is made necessary by the insurer’s financial insolvency, however, will not cause commencement of a new seven year period for purposes of the seven pay test.

For a contract that has been materially changed, the seven pay premium for each of the seven years following the change is reduced by the cash surrender value of the contract as of the effective date of the material change multiplied by a fraction, the numerator of which is the seven pay premium for future benefits under the contract and the denominator of which is the net single premium for future benefits under the contract.

A material change is defined as any increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit under the contract. However, any increase due to the payment of premiums necessary to fund the lowest level of the death benefit and qualified additional benefits payable in the first seven contract years or to the crediting of interest or other earnings, including dividends, is not considered a material change. Additionally, to the extent provided in IRS regulations, any cost-of-living increase funded over the period during which premiums are required to be paid under the contract and that are based on a broad-based index is not considered a material change.

For purposes of IRC Sections 101(f), 7702, and 7702A, a material change to a contract does not occur when a rider that is treated as a qualified long term care insurance contract under IRC Section 7702B is issued or when any provision required to conform any other long term care rider to these requirements is added.

4. Are dividends payable on a participating life insurance policy taxable income?

As a general rule, all dividends paid or credited before the maturity or surrender of a contract are tax-exempt as return of investment until an amount equal to the policyholder’s basis has been recovered. More specifically, when aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums, the excess is taxable income.

It is immaterial whether dividends are taken in cash, applied against current premiums, used to purchase paid-up additions, or left with the insurance company to accumulate interest. Thus, accumulated dividends are not taxable either currently or when withdrawn (but the interest on accumulated dividends is taxable) until aggregate dividends plus all other amounts that have been received tax-free under the contract exceed aggregate gross premiums. At that point, the excess is taxable income. It is immaterial whether the policy is premium-paying or paid-up. However, dividends paid on life insurance policies that are classified as modified endowment contracts under IRC Section 7702A may be taxed differently .

Dividends are considered to be a partial return of basis; hence they reduce the cost basis of the contract. This reduction in cost must be taken into account in computing gain or loss upon the sale, surrender, exchange, or lifetime maturity of a contract.

5. What are the income tax consequences to the owner of a life insurance or endowment contract who sells the contract, such as in a life settlement?

Until 2009, the question of whether the cost of insurance protection should be subtracted or not from the premiums paid was unsettled. A commonly held view was that the cost of insurance protection should not be subtracted from the premiums paid (thus decreasing the amount of taxable gain), and this view was supported by case law. Conversely, in 2005 guidance, the IRS had indicated that on a sale of a life insurance policy, it would consider the basis of the contract to be the premiums paid minus the cost of insurance protection – thus, increasing the amount of taxable gain.

In 2009, the IRS issued Revenue Ruling 2009-13, which provides definitive guidance to policyholders who surrender or sell their life insurance contracts in life settlement transactions. Essentially, according to the revenue ruling, the basis is not adjusted for the cost of insurance protection when a policy is surrendered (Situation 1,), but the cost of insurance protection is subtracted from the premiums paid when the policy is sold (Situations 2 and 3).

Surrender of Cash Value Policy (Situation 1)

Facts: On January 1, 2001, John Smith bought a cash value life insurance policy on his life. The named beneficiary was a member of John’s family. John had the right to change the beneficiary, take out a policy loan, or surrender the policy for its cash surrender value. John surrendered the policy on June 15, 2008, for its $78,000 cash surrender value, including a $10,000 reduction for the cost of insurance protection provided by the insurer (for the period ending on or before June 15, 2008). Through that date, John paid policy premiums totaling $64,000, and did not receive any distributions from or loans against the policy’s cash surrender value. John was not terminally or chronically ill on the surrender date.

Amount of income recognized: The IRS determined that the “cost recovery” exception (to the “income first” rule) applied to the non-annuity amount received by John. Under that exception, a non-annuity amount received under a life insurance contract (other than a modified endowment contract) is includable in gross income to the extent it exceeds the “investment in the contract.” For this purpose, “investment in the contract” means the aggregate premiums (or other consideration paid for the contract before that date) minus the aggregate amount received under the contract before that date that was excludable from gross income. The IRS ruled that John must recognize $14,000 of income: $78,000 (which included a $10,000 reduction for cost of insurance) minus $64,000 (premiums paid).

Character of income recognized: The IRS concluded that the $14,000 was ordinary income, not capital gain. The IRS determined that the life insurance contract was a “capital asset” described in IRC Section 1221(a). However, relying on earlier guidance, the IRS reiterated that the surrender of a life insurance contract does not produce a capital gain, and further determined that IRC Section 1234A (which applies to gains from certain terminations of capital assets) does not change this result.

Sale of Cash Value Policy (Situation 2)

In Situation 2, the IRS takes the position that the cost of insurance protection must be subtracted from the premiums paid when determining the adjusted basis in the contract.

Facts: The facts are the same as in Situation 1, above, except that on June 15, 2008, John sold the cash value policy for $80,000 to B, a “person” unrelated to John and who would suffer no economic loss upon John’s death.

Amount of income recognized: The IRS first stated the general rule that gain realized from the sale or other disposition of property is the excess of the amount realized over the adjusted basis for determining gain. The IRS determined that the amount John realized from the sale of the life insurance policy was $80,000.

The adjusted basis for determining gain or loss is generally the cost of the property minus expenditures, receipts, losses, or other items properly chargeable to the capital account. The IRS specifically pointed out that Section 72, which involves the taxation of certain proceeds of life insurance contracts, has no bearing on the determination of the basis of a life insurance policy that is sold because that section applies only to amounts receivedunder the policy, which was not the case in this situation.

Next, the IRS noted the IRC’s and the courts’ acknowledgment that a life insurance policy – while only a single asset – may have both investment and insurance characteristics.

The IRS then stated that to measure a taxpayer’s gain on the sale of a life insurance policy, the basis must be reduced by the portion of the premium paid for the policy that has been expended for the provision of insurance before the sale.

Against that backdrop, the IRS determined that John had paid premiums totaling $64,000 through the date of sale, and that $10,000 would have to be subtracted from the policy’s cash surrender value as cost of insurance charges. Thus, John’s adjusted basis in the policy as of the date of sale was $54,000 ($64,000 premiums paid - $10,000 expended as the cost of insurance). Accordingly, the IRS ruled that John would have to recognize $26,000 of income upon the sale of the life insurance policy, which is the excess of the amount realized on the sale ($80,000) over John’s adjusted basis in the contract ($54,000).

Character of income recognized: The “substitute for ordinary income” doctrine (which essentially holds that ordinary income that has been earned but not recognized by a taxpayer cannot be converted into capital gain by a sale or exchange) was held by the IRS to be applicable in this situation. The IRS stated, however, that the doctrine is limited to the amount of income that would be recognized if a policy were surrendered (i.e., to the inside build-up under the policy). Thus, if the income recognized on a sale (or exchange) of a policy exceeds the “inside build-up” under the policy, the excess may qualify as gain from the sale or exchange of a capital asset.

In Situation 2, because the “inside build-up” in John’s life insurance policy was $14,000 ($78,000 cash surrender value - $64,000 aggregate premiums paid), the IRS concluded that that amount would constitute ordinary income under the doctrine. Because the policy was a capital asset (under Section 1221) and had been held by John for more than one year, the remaining $12,000 of income represented long-term capital gain.

Effective date: The IRS has declared that the holding in Situation 2 will not be applied adversely to sales occurring before August 26, 2009.

Sale of Term Policy (Situation 3)

In Situation 3, the IRS takes the position that the cost of insurance protection must be subtracted from the premiums paid.

Facts: The facts in Situation 3 are the same as stated in Situation 2, above, except that the policy was a fifteen-year level premium term life insurance policy with a $500 monthly premium. John paid $45,000 total premiums through June 15, 2008, and then sold the policy for $20,000 on the same date to B (a person unrelated to John, and who would suffer no economic loss upon John’s death).

Amount and character of income recognized: The IRS stated that absent other proof, the cost of the insurance provided to John each month was presumed to equal the monthly premium under the policy ($500). Consequently, the cost of insurance protection provided to John during the 89.5-month period was $44,750 ($500 monthly premium times 89.5 months). Thus, John’s adjusted basis in the policy on the date of sale to B was $250 ($45,000 total premiums paid - $44,750 cost of insurance protection). The IRS concluded that John was required to recognize $19,750 long-term capital gain upon the sale of the term life policy ($20,000 amount realized - $250 adjusted basis).

Effective date: The IRS has declared that the holding in Situation 3 will not be applied adversely to sales occurring before August 26, 2009.

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

No. As a general rule, death proceeds are excludable from the beneficiary’s gross income. 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. With some exceptions (as noted below), the exclusion generally applies regardless of who paid the premiums or who owned the policy.

See also: 10 estate planning tax facts you need to know

Note that death proceeds from certain employer-owned life insurance contracts will not be excluded from income unless certain requirements are met.

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. 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.

If death proceeds are paid under a life insurance contract, 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. 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.

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 under IRC Section 7702, 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. 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). 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:

•In some instances, the policy or an interest in the policy has been transferred for valuable consideration;

•The proceeds are received under a qualified pension or profit-sharing plan;

•The proceeds are received under a tax-sheltered annuity for an employee of a tax-exempt organization or public school;

•The proceeds are received under an individual retirement endowment contract;

•The proceeds are received by a creditor from insurance on the life of the debtor;

•There is no insurable interest in the life of the insured;

•The proceeds are received as corporate dividends or compensation;

•The proceeds are received as alimony by a divorced spouse;

•The proceeds are received as restitution of embezzled funds; and

•Proceeds received by a corporation may be subject to an alternative minimum tax.

7. What are the income tax results when an individual transfers an existing life insurance policy to or purchases a policy for the individual’s former spouse in connection with a divorce settlement?

IRC Section 1041 Transfer of Policy

No gain generally is recognized by the transferor if an existing policy is transferred to a spouse, or former spouse incident to a divorce, after July 18, 1984, unless the transfer is pursuant to an instrument in effect on or before such date or the transfer is, under certain circumstances, in trust.

When no gain is recognized, the transferee will be treated as having acquired the policy by gift and the transferor’s cost basis for the policy (net premiums paid) is carried over to the transferee. In addition, any such transfer of an existing policy will not cause the proceeds to be includable in the income of the transferee under the transfer for value rule. A transfer is incident to a divorce if the transfer occurs within one year after the date the marriage ceases or is related to the cessation of the marriage. Thus, a transfer of property occurring not more than one year after the date on which the marriage ceased need not be related to the cessation of the marriage to qualify for Section 1041 treatment. A transfer of a policy is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument and the transfer occurs not more than six years after the date on which the marriage ceases.

See also: Letter to an ex

If property is transferred in trust for the benefit of the spouse or former spouse, however, gain will be recognized by the transferor to the extent that the sum of the liabilities assumed plus the amount of liabilities to which the property is subject exceed the total of the adjusted basis of all property transferred. Therefore, when a policy with a loan is transferred in trust, gain will be recognized to the extent the total liabilities of all property transferred to the trust exceed the total basis of all items of property transferred. When gain is recognized on a transfer in trust, the transferee’s basis is adjusted to reflect the amount of gain recognized by the transferor. Payments from an insurance trust to which the property is transferred for the benefit of a spouse or former spouse will be taxed to the spouse or former spouse as a beneficiary and not taxed as alimony.

Both spouses or both former spouses may elect to have these rules apply to all transfers after 1983 and also may elect to have these rules apply to transfers after July 18, 1984, under divorce or separation instruments in effect before July 19, 1984.

8. How are split-dollar life insurance arrangements treated for gift tax purposes?

Gifts may arise in a split-dollar arrangement when a donor provides a benefit to a donee. For example, an employee or shareholder who irrevocably assigns his or her interest in a compensatory or shareholder split-dollar arrangement to a third party (such as a family member) may make gifts to such third party (including annual gifts of the amount the employee or shareholder is required to include in income). Also, a donor may make gifts to an irrevocable life insurance trust under a private split-dollar arrangement.

The treatment of split-dollar arrangements may differ depending on whether the arrangement was entered into or modified after September 17, 2003.

Post-September 17, 2003, Arrangements

Regulations generally provide that the treatment of a split-dollar arrangement depends on whether the donor is the owner of the life insurance contract. Even if the donee is named as the policy owner, the donor may be treated as the owner if the only economic benefit provided to the donee is the value of current life insurance protection.

If a life insurance trust is the owner of the policy, the donor makes premium payments, and the donor is entitled to recover an amount equal to the premiums, the donor is treated as making a loan to the trust in the amount of the premium payment. If the loan is repayable on the death of the donor, the term of the loan is equal to the donor’s life expectancy on the date of the payment (under Treasury Regulation Section 1.72-9 (see Table V in Appendix A)). The value of the gift equals the premium payment less the present value (determined under IRC Section 7282) of the donor’s right to receive repayment. If there is no right to repayment, the value of the gift equals the premium payment.

If the donor is treated as the owner of the policy, the donor is treated as making a gift to the trust. The value of the gift equals the economic benefits provided to the trust, less the amount of premium paid by the trustee. If the donor’s estate is entitled to receive the greater of (1) the aggregate premiums paid by the donor or (2) the cash surrender value, the gift is equal to the cost of life insurance protection less premiums paid by the trustee. If the donor’s estate is entitled to receive the lesser of (1) the aggregate premiums paid by the donor or (2) the cash surrender value, the gift is equal to the cost of life insurance protection, plus the amount of cash surrender value to which the trust has current access (except to the extent taken into account in an earlier year) and any other economic benefit provided to the trust (except to the extent taken into account in an earlier year), less premiums paid by the trustee. If the donor is treated as the owner of the policy, amounts received by the life insurance trust under the contract (e.g., dividends or policy loan) are treated as gifts from the donor to the trust.

No matter who is treated as the owner of the life insurance policy, there may be a gift upon transfer of an interest in a policy to a third party. See Revenue Ruling 81-198, below.

Pre-September 18, 2003, Arrangements

In a 1978 ruling, a wife owned a policy on the split-dollar plan on the life of her husband. The husband’s employer paid the portion of the premiums equal to annual cash value increases and was entitled to reimbursement from death proceeds. The IRS ruled that the value of the life insurance protection provided by the employer, which the IRS also ruled was included in the husband’s income, was deemed to be a gift from the husband to the wife, subject to the gift tax.

In Revenue Ruling 81-198, an employee made a gift of his rights under a basic plan of split-dollar insurance in which the insurance was premium paying and was in force for some time. The IRS ruled that three elements are valued. First, the value of the insured’s rights in the policy at the date of the gift is the interpolated terminal reserve plus the proportionate part of the last premium paid before the date of the gift covering the period beyond that date, reduced by the total of premiums paid by the employer. Second, the premiums paid by the insured following the date of the gift are gifts on the date paid. Third, the value of the life insurance protection provided by the employer, included in the employee’s gross income, is deemed to be a gift by the employee.

A letter ruling dated December 4, 1972, provided that a gift of the amount at risk under a split-dollar plan is valued as the greater of (1) the value of the insurance protection as computed for income tax purposes or (2) the difference between the premium payment and the increase in the cash surrender value of the policy. A later technical advice memorandum stated that, with respect to a split-dollar plan, a gift may be made of (1) the value of the insurance protection and (2) increases in cash surrender values in excess of premiums paid by, and returnable to, the corporation.

9. Does the income taxation of a life insurance policy that insures more than one life differ from the taxation of a policy that insures a single life?

Basically, no.

Multiple-life policies may insure two or more lives. Typically, a “first-to-die” or “joint life” policy pays a death benefit at the death of the first insured person to die while a “second-to-die” or “survivorship” policy does not pay a death benefit until the death of the survivor. Estate planning and business continuation planning are two of the more common uses for these types of policies.

Generally, multiple-life policies are subject to the same definition of life insurance applicable to policies insuring a single life. One exception is that for purposes of calculating the net single premium under IRC Section 7702, multiple-life policies may not take advantage of the three safe harbor tests set forth in proposed regulations for meeting the reasonable mortality charge requirement.

For multiple-life policies that meet the definition of life insurance, cash surrender value increases generally are not taxed until received and death proceeds generally are received income tax-free. Multiple-life policies are subject to the seven pay test of IRC Section 7702A(b) in the same manner as single life policies. Distributions from life insurance policies entered into before June 21, 1988, or from policies entered into on or after this date that meet the seven pay test, are included in gross income only to the extent they exceed the investment in the contract. Policies entered into on or after June 21, 1988 that do not meet the seven pay test become classified as modified endowment contracts. Distributions, including loans, from modified endowment contracts are subject to taxation rules that generally are less favorable than the rules governing the taxation of distributions from life insurance policies that are not modified endowment contracts.

In a private letter ruling, the IRS concluded that exchanges involving policies insuring a single life for a policy insuring two lives did not qualify for nonrecognition treatment under IRC Section 1035. The IRS reached this outcome in five similar fact patterns.

In another private ruling, however, the IRS approved IRC Section 1035 treatment of the exchange of a joint and last survivor life insurance policy, following the death of one of the insured persons, for a universal variable life insurance policy that insured the survivor.

There has been no formal guidance from the IRS as to which rates should be used to measure economic benefit when a multiple-life policy is used in an arrangement that requires the insured or insureds to include the economic benefit of the coverage in income. The most frequently used rates have been those derived from U.S. Life Table 38, which also is used to derive the P.S. 58 rates. P.S. 58 rates generally may not be used in arrangements entered into after January 27, 2002; however, in those situations, Table 2001 may be used. According to the IRS, taxpayers should make appropriate adjustments to the Table 2001 rates if the life insurance protection covers more than one life. When the policy death benefit is payable at the second death, it generally is believed that following the first death, the Table 2001 rates (or P.S. 58 rates, if appropriate) for single lives should be used to measure the survivor’s economic benefit. See volume 2, Appendix G for P.S. 58 and Table 2001 rates.

10. When will a life insurance trust result in income tax savings for the grantor?

No income tax savings can be achieved by the creation of an unfunded life insurance trust. Additionally, a life insurance policy creates no currently taxable income regardless of whether it is placed in trust. Income tax savings can result only when income-producing property is placed in trust to fund the premium payments, and only if tax liability is shifted from the grantor to a lower bracket taxpayer – that is, to the trust or to a trust beneficiary.

A funded revocable trust will not result in income tax savings. If the trust is revocable, the income from the funding property will be taxed to the grantor. Even if the trust is irrevocable, however, there are other conditions that will cause the trust income to be taxed to the grantor.

Generally speaking, trust income is taxable to the grantor if the:

(1) grantor or trustee, or both, can revoke the trust without the beneficiary’s consent;

(2) trust income is, or in the discretion of the grantor or a non-adverse party, or both, may be (a) distributed to the grantor or the grantor’s spouse, (b) accumulated for future distribution to the grantor or the grantor’s spouse, or (c) applied to pay premiums on insurance on the life of the grantor or the grantor’s spouse;

(3) income is or may be used for the support of the grantor’s spouse or is actually used for the support of a person whom the grantor is legally obligated to support, or is or may be applied in discharge of any other obligation of the grantor;

(4) grantor retains certain administrative powers or the power to control beneficial enjoyment of trust principal or income; or

(5) value of a reversionary interest, at the inception of the trust, exceeds 5 percent of the value of the trust.

If the income of the trust is payable to a lineal descendant of the grantor and the trust provides that the grantor’s reversionary interest takes effect only on the death of the beneficiary before the beneficiary attains age twenty-one, the income of the trust will not be taxed to the grantor even though the value of the grantor’s reversionary interest exceeds 5 percent of the value of the trust.

Planning Point: One of the more common planning tools is the “so-called” sale to “intentionally defective trust” or “IDIT.” The sale to the IDIT can be a very effective estate planning technique, but it should be remembered that income tax earned by the IDIT will remain taxable to the grantor of the trust. While this may not seem problematic at the time the IDIT is created, in some instances, with good planning and successful investment within the IDIT, situations sometimes arise where the income tax attributable from the IDIT to the grantor can become burdensome. It may be advisable to consider making the IDIT such that the grantor trust power (i.e., the retained power causing grantor trust status for income taxes) can be “turned off” at a future point if the it no longer makes sense that the grantor pay the trust’s income taxes. Creating an IDIT should only be done with the assistance of competent tax council.

For more tax planning tips, visit LifeHealthPro.com/taxplanning.


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