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.
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.
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.
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).
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.
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.
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.
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?
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.
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