TAX TREATMENT OF LIFE INSURANCE PROCEEDS

TAX TREATMENT OF LIFE INSURANCE PROCEEDS

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2 Hour(s) - Other Federal Tax

NASBA: 116347

CTEC Provider #: 6209CTEC Course #: 6209-CE-0045

IRS Provider #: UBWMFIRS Course #: UBWMF-T-00229-21-S

The information provided in this publication is for educational purposes only, and does not necessarily reflect all laws, rules, or regulations for the tax year covered. This publication is designed to provide accurate and authoritative information concerning the subject matter covered, but it is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

To the extent any advice relating to a Federal tax issue is contained in this communication, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

COURSE OVERVIEW.............................................................................................................................................................. 7

Course Description ....................................................................................................................................................................... 7

Learning Objectives ...................................................................................................................................................................... 7

CHAPTER 1 - LIFE INSURANCE DEATH BENEFITS............................................................................................................... 7

Introduction................................................................................................................................................................................... 7

Chapter Learning Objectives ....................................................................................................................................................... 7

Nature of Life Insurance .............................................................................................................................................................. 8

Taxation of Life Insurance Policy Death Benefit Proceeds ...................................................................................................... 8

Income Taxability of Viatical Settlement Proceeds.................................................................................................................15

Taxability of Accelerated Death Benefits .................................................................................................................................17

Death Benefits Received under Settlement Options..............................................................................................................17

Summary......................................................................................................................................................................................21

CHAPTER 2 - LIFE INSURANCE POLICY LIVING PROCEEDS ............................................................................................. 23

Introduction.................................................................................................................................................................................23

Chapter Learning Objectives .....................................................................................................................................................23

Definition of Life Insurance Impacts Tax-Deferred Accumulation........................................................................................23

Taxation of Living Proceeds of Life Insurance Policies...........................................................................................................24

Tax-Free Exchanges under IRC §1035 ......................................................................................................................................31

Tax Treatment of Life Settlement Proceeds ............................................................................................................................32

Life Insurance Living Proceeds Received under Settlement Options...................................................................................34

Summary......................................................................................................................................................................................38

GLOSSARY .......................................................................................................................................................................... 41

Glossary .......................................................................................................................................................................................41

Course Description 7

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COURSE OVERVIEW

COURSE DESCRIPTIONOne of the important considerations in many financial transactions is the tax treatment the transaction is given. Often, the impact of taxation is a consideration in the purchase of life insurance every bit as much as it applies to stock purchases, bond purchases and the establishment of qualified retirement plans.

In this course we will look at the tax treatment given proceeds from life insurance policies and will consider the taxation of death benefits, cash value withdrawals, loans and surrenders. In addition, we will examine the differences in tax treatment caused by a life insurance policy's:

Failure to meet the statutory definition of life insurance;

Being deemed a modified endowment contract;

Transfer of ownership to another person for a valuable consideration;

Sale in a viatical or life settlement transaction;

Ownership by an employer; and

Use in a qualified retirement plan.

LEARNING OBJECTIVESWhen you have completed this course, you should be able to:

Calculate the gain to be recognized as a result of various life insurance policy transactions, including: withdrawals, loans, surrenders, and payment of death benefits;

Identify the changes to the customary tax treatment of life insurance policy living proceeds resulting from the policy being deemed a modified endowment contract (MEC);

Calculate the reportable gain upon receipt of life insurance policy death benefits when the life insurance policy has been transferred for a valuable consideration, or was included in a qualified plan;

Recognize the types of life insurance exchanges that are tax-free under IRC section 1035;

Define the terms "terminally ill" and "chronically ill" as used in the Health Insurance Portability and Accountability Act; and

Identify the income tax treatment of accelerated death benefits, viatical settlements, and life settlements.

CHAPTER 1 - LIFE INSURANCE DEATH BENEFITS

INTRODUCTIONLife insurance generally enjoys favorable tax treatment. Although some of that favorable tax treatment applies to living proceeds from life insurance policies, the principal tax benefits are reserved to proceeds payable upon the death of the insured.

In this chapter, we will examine the tax treatment of death benefits whether taken in a single sum or in periodic payments. In addition, we will consider the tax treatment given to accelerated death benefits and viatical settlements.

CHAPTER LEARNING OBJECTIVESWhen you have completed this chapter, you should be able to:

Compare the customary income tax treatment given to life insurance policy death benefits with the income tax treatment given to such benefits under a life insurance policy transferred for a valuable consideration;

Calculate the taxable portion of life insurance death benefits under a policy included in a qualified plan;

8 Chapter 1 - Life Insurance Death Benefits

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Identify the tax treatment of death benefits received as periodic payments under a supplementary contract;

Define the terms "terminally ill" and "chronically ill" as used in the Health Insurance Portability and Accountability Act; and

Identify the income tax treatment of accelerated death benefits and viatical settlements.

NATURE OF LIFE INSURANCELife insurance is a contract between an insurer and a policy owner. The insurer promises to pay a specified death benefit if the person whose life is insured, i.e. the "insured" under the policy, dies while the coverage is in force in return for the policy owner's payment of premiums. In most cases, the insured is also the policy owner.

Life insurance coverage falls into two broad categories:

Term life insurance; and

Permanent life insurance.

Term life insurance generally provides coverage for a term period that may be as short as one year or for as long as 30 years. The coverage involves no cash value, and if the insured does not die by the end of the term period the coverage ends without further value.

Permanent life insurance is intended to cover an insured person for his or her entire life and builds cash value that may be borrowed against or withdrawn and which is available upon the policy owner's surrender of the policy.

PREMIUMS

Life insurance premiums, whether paid by the insured or another person, are a personal expense and not deductible. The total of such non-deductible premiums (less dividends taken in cash or left on deposit), however, constitute the policy owner's cost basis in the policy. That cost basis is tax-free when received by the policy owner.

CASH VALUE ACCUMULATION

Permanent life insurance policies build cash values as a result of the policy owner's premium payments and the insurer's interest crediting. To the extent that the cash value exceeds the total premiums (less dividends) paid for the coverage, the policy has a gain. Gain is tax-deferred until distributed during the insured's lifetime, provided the contract meets the statutory definition of life insurance. (See Chapter 2 for a discussion of the tax treatment of cash values under contracts failing to meet the statutory definition of life insurance.)

In contrast to policy gain received during the insured's lifetime, policy gain paid as part of a life insurance policy's death benefit is received tax-free by the beneficiary. Term life insurance policies do not build cash values.

TAXATION OF LIFE INSURANCE POLICY DEATH BENEFIT PROCEEDSThe general rule with respect to the income taxability of life insurance death benefit proceeds is that such proceeds are exempt from income taxation. Accordingly, beneficiaries normally are not required to recognize any income as a result of their receipt of death benefit proceeds from life insurance contracts.

Thus, a beneficiary who received a $100,000 life insurance death benefit under a life insurance policy for which only $100 of premium had been paid would normally have no reportable income, despite the extent of the "gain" payment of the death benefit would represent.

In order for life insurance death benefits to entirely avoid inclusion in the beneficiary's income, the life insurance contract must meet the statutory definition of life insurance contained in the Internal Revenue Code and not:

Have been transferred for a valuable consideration;

Be included in a qualified retirement plan; or

Be certain employer-owned life insurance policies.

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Taxation of Life Insurance Policy Death Benefit Proceeds 9

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Before examining these three exceptions to the non-taxability of death benefit proceeds, let's consider what is involved in the requirement that a life insurance contract meets the statutory definition of life insurance.

STATUTORY DEFINITION OF LIFE INSURANCE

In order to ensure that the favorable tax treatment given to life insurance—particularly the tax deferral of cash values and income-tax-free death benefits—was not given to contracts that were thinly disguised investments, Congress passed legislation that statutorily defined "life insurance." The legislation requires that life insurance contracts issued after December 31, 1984, meet the statutory definition of life insurance by meeting one of two alternative tests. Only by meeting one of these tests will the death proceeds be fully excludable from the beneficiary's income. (Note: a contract does not need to meet both tests.)

These tests are known as the:

Cash value accumulation test; and

Guideline premium and corridor test.

This legislation has been incorporated into the Internal Revenue Code as IRC §7702, section (a) of which is reproduced in the box below:

IRC §7702

(a) General rule

For purposes of this title, the term ''life insurance contract'' means any contract which is a life insurance contract under the applicable law, but only if such contract -

(1) meets the cash value accumulation test of subsection (b)

or

(2) (A) meets the guideline premium requirements of subsection (c), and

(B) falls within the cash value corridor of subsection (d).

Cash Value Accumulation Test

For a life insurance contract to meet the statutory definition of life insurance under the cash value accumulation test, its cash surrender value must not exceed the net single premium that would be needed at that time to fund future benefits under the policy. In simpler terms, if the policy's cash value exceeded the amount that was sufficient to cause the policy to become fully paid-up, it would fail the cash value accumulation test.

In prescribing the cash value accumulation test, the Congress limited the amount of cash value that could be accumulated per $1,000 of death benefit.

Guideline Premium and Cash Value Corridor Test

Under the alternative test, a life insurance contract must meet certain guideline premium requirements and maintain a prescribed corridor of net amount at risk. To meet the guideline premium test, the total premiums paid for the contract must not, at any time, exceed the:

Guideline single premium—the single premium needed to fund future benefits under the contract, determined at the time the contract is issued; or

Guideline level premiums—the level annual premium amount payable over a period not ending before the insured becomes age 95.


A contract meeting, the guideline premium part of the test must also meet the cash value corridor part of it. It will meet the cash value corridor part of the test if the death benefit payable is at least equal to the applicable percentage of the cash surrender value shown in the table below:

Insured's Attained Age at Startof Contract Year

Applicable Percentage DecreasesRatably for Each Full Year

More Than But NotMore Than

From To

0 40 250 250

40 45 250 215

45 50 215 185

50 55 185 150

55 60 150 130

60 65 130 120

65 70 120 115

70 75 115 105

75 90 105 105

90 95 105 100

Looking at the above chart of the required cash value corridors, we can see that a life insurance policy under which the insured is 50 years old and which has a cash value of $20,000 must have a death benefit of at least $37,000 ($20,000 × 185%) in order to have the corridor of net amount at risk required to meet the cash value corridor test prescribed under IRC §7702.

Taxation of Death Benefits under Contracts not Meeting Definition of Life Insurance

If a life insurance contract fails to meet the statutory definition of life insurance by meeting neither alternative test, its tax treatment becomes more like the tax treatment of other financial products rather than life insurance. Specifically, both the tax-deferral of the inside build-up of cash surrender values and the total exemption of death benefits are lost.

Under a life insurance contract failing to meet the IRC §7702 statutory definition of life insurance, the excess of the death benefit over the net surrender value plus any unrecovered basis is received by the beneficiary income tax-free. The balance of the death benefit must be included in the beneficiary's income.

Accordingly, the death benefits paid under a contract failing to meet the definition of life insurance would be subject to the income tax treatment depicted in the following hypothetical example:


Death benefits paid $100,000

Less net surrender value at date of death – 25,000

Received tax-free $75,000

Tentatively taxable amount $25,000

Less premiums paid – 15,000

Less cash value increases previously included in policy owner's income – 2,500

Beneficiary's taxable income $7,500

Transferred Policy Ownership

The transfer of ownership of a life insurance policy is done by the policy owner—referred to as the "assignor" when transferring ownership—signing a form absolutely assigning the policy to the new owner. The person to whom the life insurance policy is assigned is the "assignee."

In a policy thus assigned, all rights associated with ownership of the policy subsequently vest in the assignee. The assignee normally exercises the right to change the beneficiary by immediately naming himself or herself the policy's beneficiary.

The transfer of policy ownership may be made as a gift or as the result of a sale. The tax treatment of the life insurance death benefits received by the beneficiary upon the insured's subsequent death varies significantly depending on the nature of the transfer.

Policies Transferred as a Gift

When the assignment of a life insurance policy is made as a gift, rather than as the result of a sale of the policy, the tax treatment of the death benefits payable upon the death of the insured is the same as it would have been had the assignment never occurred. In other words, the death benefits are received by the beneficiary income tax-free.

Policies Transferred for Value

When the life insurance policy's ownership is transferred as part of a sale the transfer is deemed to be made for a valuable consideration. In short, it is considered a transfer for value, and its tax treatment comes under the transfer for value rule.

A transfer for value where a life insurance policy is assigned to a non-exempt assignee causes the death benefits to be includible in the assignee-beneficiary's income to the extent such death benefits exceed the total of the consideration paid for the policy and any subsequent premiums paid by the assignee.

For example, suppose Bob purchased his brother Bill's existing in-force $200,000 life insurance policy for $35,000, the amount of its cash value. Bill survived for 10 more years after the sale during which time Bob paid an additional $20,000 in premiums. Upon Bill's death, Bob received the death benefit of $200,000. Since Bob's cost basis in the life insurance policy is $55,000—comprised of his initial consideration plus subsequent premiums—his taxable gain is $145,000.


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The purchase of an existing in-force life insurance policy in a life or viatical settlement transaction is another example of a transfer for a valuable consideration. Since the purchase of an existing life insurance policy is a transfer for value, the purchaser of the policy would be subject to the tax treatment just described.

Any additional costs incident to the life or viatical settlement transaction—actuarial fees, review costs, commissions to a viatical settlement broker, etc.—would generally constitute deductible business expenses that could further offset the tax liability resulting from the amount of the death benefit includible in the recipient's income. (For taxation of proceeds received by a policy owner selling his or her policy, see Income Taxability of Viatical Settlement Proceeds and Income Taxability of Life Settlement Proceeds below.)

Exceptions to Transfer for Value Rule

When a life insurance policy has been transferred for value—"sold," in other words—the tax treatment of the death benefits payable under it generally changes dramatically. However, there are several exceptions to the transfer for value rule under which a policy may be sold without affecting the tax-free nature of the death benefits.

The exceptions to the transfer for value rule apply to a sale of an existing life insurance policy made to:

The person insured under the policy—For example, an employer may sell an employer-owned life insurance policy to a former key person upon his or her retirement;

A business partner of the insured under the policy;

A partnership in which the insured is a partner; or

A corporation in which the insured is an officer or shareholder.

LIFE INSURANCE IN QUALIFIED RETIREMENT PLANS

Although a qualified retirement plan exists primarily to provide retirement benefits to plan participants and beneficiaries, such plans may include "incidental" life insurance. In order for life insurance included in a qualified retirement plan to be considered incidental, it must meet one of the following tests:

The cost of providing current life insurance is less than 25% of the cost of providing all benefits under the plan; or

The life insurance death benefits do not exceed 100 times the monthly benefit provided under the plan.

Under the first incidental life insurance test, the premiums for term life insurance included in the plan must not exceed 25% of the cost of all benefits. However, if the life insurance in the plan is permanent life insurance rather than term life insurance the life insurance is considered incidental if the total premium for the permanent life insurance is less than 50% of the cost of providing all benefits under the plan.

Life insurance would be considered incidental under the second test, i.e. the 100-to-1 test, if the death benefit was not more than the participant's monthly retirement benefit multiplied by 100. For example, a plan participant whose traditional pension plan benefit at retirement is $4,000 monthly could have a pre-retirement death benefit provided by life insurance of $400,000 under the incidental rules.

Plan Participant Taxed on Current Life Insurance Benefit

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Since any life insurance provided under a qualified retirement plan is really a current benefit rather than a deferred benefit, the plan participant is taxed each year on the cost of the life insurance protection. Only the cost of the pure amount at risk is treated as a currently taxable distribution.

If the life insurance is term life insurance, the entire amount of the death benefit is considered a current benefit to the participant. Thus, the participant is taxed on the entire amount of the term life insurance death benefit protection.

If the life insurance in the qualified plan is permanent life insurance, the participant is taxed on the net amount at risk. The net amount at risk in a permanent life insurance policy is the difference between the death benefit and the cash surrender value.

The total of the amounts the plan participant must include in his or her income each year as a result of the life insurance becomes the participant's cost basis. The amount that must be included as taxable income is determined by multiplying the amount of the pure death benefit by the one-year term premiums per $1,000 contained in Table 2001. That table is reproduced, in part, below.

We can easily illustrate how the imputed taxable income is determined by looking at two examples, the first involving term life insurance and the second involving whole life insurance. Suppose an age 40 plan participant has $100,000 of term life insurance in the plan under which he is the insured. The imputed income is equal to 100 multiplied by the rate per thousand at age 40 shown in Table 2001. Thus, the income the participant must include in this case is $110 (100 × $1.10).

To illustrate the imputed taxable income resulting from the inclusion of permanent life insurance in the plan, suppose a 48-year-old plan participant has $100,000 of permanent life insurance in the plan. If the life insurance cash surrender value is $30,000, the pure death benefit is $70,000 ($100,000 – $30,000). The imputed income resulting from the inclusion of the life insurance in the plan is $138.60 (70 × $1.98).


Table 2001One Year Term Premiums for $1,000 of

Life Insurance Protection - One Life

Age Premium Age Premium Age Premium

20 $0.62 40 $1.10 59 $6.06

21 0.62 41 1.13 60 6.51

22 0.64 42 1.20 61 7.11

... ... ... ... ... ...

25 0.71 48 1.98 64 10.41

26 0.73 49 2.13 65 11.90

27 0.76 50 2.30 66 13.51

... ... ... ... ... ...

31 0.90 54 3,65 69 18.70

32 0.93 55 4.15 70 20.62

33 0.96 56 4.68 71 22.72

Beneficiary Taxed on Part of Qualified Plan Life Insurance Death Benefit

When a qualified plan participant dies before retirement and the plan's death benefit includes permanent life insurance, part of the death benefit provided by the life insurance is tax-free and part of it is includible in the beneficiary's income. The part of the death benefit that is received by the beneficiary tax-free is the pure death benefit, i.e. the amount of the death benefit in excess of the cash surrender value.

The balance of the life insurance policy's death benefit—the portion of the death benefit equal to the policy's cash surrender value—is included in the beneficiary's income for tax purposes. However, the amount included in the beneficiary's income is reduced by the total income amount reported by the plan participant each year for the pure death benefit included in the plan.

For example, suppose a plan participant died before retirement and part of his qualified plan death benefit was a $100,000 permanent life insurance policy with a $30,000 cash value. Further, suppose that the total imputed income the participant had included in income over the years for the life insurance was $5,000. The amount of the $100,000 life insurance policy death benefit that would be included in the beneficiary's income is $25,000 ($30,000 – $5,000). The balance of the death benefit, $75,000, is income tax-free to the beneficiary.

EMPLOYER-OWNED LIFE INSURANCE

Life insurance is often owned by business organizations on their employees to meet identified business objectives. Among such business objectives are a) to provide funds to implement a stock redemption agreement upon a close corporation stockholder's death, b) to compensate an employer when a key employee responsible for substantial

Income Taxability of Viatical Settlement Proceeds 15

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business profits dies, and c) to retire business debt upon the death of a business owner. Businesses enjoy the same tax-free life insurance death benefits as individuals do if the insured employee dies while employed by the business.

However, employees and business owners may retire or move on to other opportunities. When that occurs, the business may continue the life insurance policy in force. In such a case, a portion of the life insurance death benefits, when paid, may need to be recognized as income, unless an exception exists.

As required by the Pension Protection Act of 2006, life insurance death benefits paid to a former employer of the insured in excess of the employer's cost basis must be included in the former employer's gross income. Exceptions to the requirement that death benefits in excess of basis be included in a former employer's gross income apply if the death benefit is paid:

To the former employee-insured's heirs;

Upon the death of an insured employed by the policy owner within 12 months prior to death; or

Upon the death of an insured who was a director or highly compensated employee or individual at the time of policy issue.

Thus death benefits in excess of basis paid to a former employer are includible in the employer's income unless one of these three exceptions applies.

INCOME TAXABILITY OF VIATICAL SETTLEMENT PROCEEDSA viatical settlement is the sale of an existing life insurance policy to a third party—usually referred to as a "viatical settlement provider"—by a terminally ill individual with a life expectancy of 24 months or less. Depending on the circumstances, the proceeds may be:

Tax-free without limit;

Tax-free up to prescribed daily limits; or

Partially tax-free.

Let's examine each of these possibilities.

VIATICAL SETTLEMENT PROCEEDS MAY BE ENTIRELY TAX-FREE

The Health Insurance Portability and Accountability Act—legislation better known to many simply as HIPAA—settled the question of the income tax treatment of proceeds received by the insured from a life insurance policy in a viatical settlement involving a terminally ill insured.

When a viatical settlement payment is made by a viatical settlement provider to a life insurance policy owner due to the insured's terminally ill status such payment is entirely income tax-free, except in certain business situations (see below). HIPAA defines a terminally ill individual as a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months following such certification.

A terminally ill individual who receives a viatical settlement is not restricted as to its use in order for the proceeds to be tax-exempt. Thus, he or she may use the proceeds:

To obtain medical treatment;

To take a vacation; or

For any other purpose.

The terminally ill individual's use of the proceeds does not affect their tax-free nature.

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VIATICAL SETTLEMENT PROCEEDS MAY BE TAX-FREE UP TO DAILY LIMITS

HIPAA also addressed the taxability of viatical settlement proceeds made to a policy owner who is chronically ill. According to the legislation, a chronically ill individual is a person who:

Is not terminally ill; and

Meets one of the following criteria:

The individual has been certified by a licensed health care practitioner as being unable to perform, without substantial assistance, at least two activities of daily living for at least 90 days or a person with a similar level of disability, or

The individual requires substantial supervision to protect himself from threats to his health and safety due to severe cognitive impairment, and such condition has been certified by a healthcare practitioner within the previous 12 months.

The activities of daily living (ADLs) are:

Eating;

Toileting;

Transferring;

Bathing;

Dressing; and

Continence.

When a viatical settlement payment is made by a viatical settlement provider to a life insurance policy owner due to the insured's chronically ill status, the payments may also be income tax-free, up to certain limits, provided specified criteria are met. The criteria that must be met in order for such payments made on account of the insured's chronically ill condition to be exempt from income taxation are:

Payments must be for costs incurred for qualified long-term care services provided to the insured; and

The payer of the long-term care costs must not be compensated by insurance or otherwise.

However, unlike the entirely tax-free treatment of viatical settlements given to individuals who are terminally ill, chronically ill individuals have a more limited tax benefit. Viatical settlement proceeds paid to chronically ill individuals for purposes of paying the costs incurred for qualified long-term care services are limited to no more than the greater of:

A per diem limitation ($400 per day in 2021); or

The actual costs incurred for qualified long-term care services provided for the insured, less any reimbursement for such services.

Thus, a chronically ill individual receiving a viatical settlement upon the sale of his or her existing life insurance policy would enjoy only limited tax-free benefits not exceeding the greater of the per diem amount or the long-term care costs actually incurred.

VIATICAL SETTLEMENTS IN BUSINESS SITUATIONS AN EXCEPTION TO TAX-EXEMPTION

Although viatical settlements are generally income tax-free, an exception to that tax exemption applies in certain business situations. Specifically, the tax-exemption does not apply to any amount paid under a viatical settlement to a life insurance policy owner whose insurable interest in the insured is the result of the insured's status as the policy owner's:

Employee;

Officer; or

Taxability of Accelerated Death Benefits 17

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Director.

Thus, viatical settlement proceeds paid to an employer on its sale of a life insurance policy maintained on the life of a key executive would not be tax-exempt. Such proceeds would be subject to income taxation as though they were proceeds from a life settlement in contrast to a viatical settlement. (See Tax Treatment of Life Settlement Proceeds in next section.)

TAXABILITY OF ACCELERATED DEATH BENEFITSThe Health Insurance Portability and Accountability Act—legislation better known to many simply as HIPAA—settled the question of the income tax treatment of proceeds received by the insured from a life insurance policy in a viatical settlement and under an accelerated death benefit. The tax treatment, however, differs somewhat, depending upon whether the insured is:

Terminally ill; or

Chronically ill.

When a viatical settlement payment is made by a viatical settlement provider or an accelerated death benefit payment is made by an insurer to a life insurance policy owner due to the insured's terminally ill status such payment is entirely income tax-free, except in certain business situations (see below). HIPAA defines a terminally ill individual as a person who has been certified by a physician is having an illness or physical condition that can reasonably be expected to result in death within 24 months following such certification.

When an accelerated death benefit is paid or a viatical settlement payment is made by a viatical settlement provider to a life insurance policy owner due to the insured's chronically ill status, the payments may also be income tax-free provided certain criteria are met. The criteria that must be met in order for such payments made on account of the insured's chronically ill condition to be exempt from income taxation are:

Payments must be for costs incurred for qualified long-term care services provided to the insured; and

The payer of the long-term care costs must not be compensated by insurance or otherwise.

DEATH BENEFITS RECEIVED UNDER SETTLEMENT OPTIONSUp to this point, discussion has focused principally on the payment of death benefits in a single sum, i.e. a lump-sum payment made to a beneficiary upon the death of the policy's insured. However, insurers generally offer beneficiaries a wide range of options for receiving death benefits. These options—appropriately referred to as settlement options—include:

Interest only;

A temporary annuity; and

A life annuity.

In this section, we will discuss the tax treatment of death benefit payments received under these settlement options. It is important to bear in mind when reviewing the tax treatment of settlement option payments that the portion of the periodic payment representing payment of the original death benefit is tax-free; the balance constitutes interest that is taxable as ordinary income.

INTEREST-ONLY SETTLEMENT OPTION

Under the interest-only settlement option, a beneficiary elects to leave some or all of the death benefit proceeds with the insurer at interest. The insurer then makes interest payments to the beneficiary on the frequency requested. In other words, the beneficiary may choose to receive monthly, quarterly, semi-annual or annual interest payments. The beneficiary may also withdraw some or all of the death benefits being held by the insurer whenever desired.

All interest payments received by the beneficiary are taxable as ordinary income in the year received. Withdrawals of the death benefit held by the insurer are tax-free.


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TEMPORARY ANNUITY

A temporary annuity is an annuity under which the principal—the death benefit, in this case—is liquidated over a specific period of time, such as 5 years, 10 years, or some other duration. Unlike a life annuity, the payout is unaffected by the beneficiary's lifespan.

When the specified period of time over which the payments are made ends, the periodic payments cease. If the beneficiary dies before the end of the specified period, periodic payments continue to a secondary beneficiary until the specified period ends.

Each periodic payment is deemed to consist of:

Tax-free death benefit; and

Taxable interest.

In the case of death benefits paid under fixed amount periodic payments, determination of the tax-free portion involves the calculation of an exclusion ratio; the balance of each periodic payment constitutes taxable interest. The exclusion ratio is the ratio that the death benefits settled under the option bear to the total expected return. Thus, the exclusion ratio is derived simply by dividing the death benefit by the expected return. As an equation, the calculation looks like this:

For example, if the death benefit settled was $100,000 and the beneficiary will receive annual periodic payments of $12,000 for ten years under the temporary settlement option, the expected return would be $120,000 ($12,000 × 10 years). To determine the portion of each $12,000 periodic payment that is tax-free as death benefit, we need only to divide $100,000 by $120,000. By doing so, we see that .8333 ($100,000 ÷ $120,000) of each periodic payment is tax-free. Simply substituting the applicable numbers into the equation will give us the following:

Applying the exclusion ratio, .8333, in this case, to each $12,000 periodic payment we determine that $9,999.60 is tax-free, and the balance of $2,000.40 is taxable as interest ($12,000 × .8333 = $9,999.60).

LIFE ANNUITY

A beneficiary interested in receiving a death benefit in periodic payments rather than in a lump sum has an additional alternative to receiving interest only or a temporary annuity: a life annuity. Under a life annuity settlement option, the insurer guarantees to make periodic payments to the beneficiary for as long as he or she lives regardless of the duration of the beneficiary's life.

Under a basic life annuity settlement option, referred to as a straight life annuity, periodic payments are made for the annuitant's entire life whether the annuitant's lifetime is measured in months or decades. However, if the annuitant receives at least one periodic payment and then dies, no further payments are due.

The same general tax principle applicable to temporary annuity settlement options also applies to periodic payments received under a life annuity settlement option. Specifically, the portion of the periodic payment representing the death benefit is tax-free. However, the portion of the periodic payment that represents interest is taxable as ordinary income.

Determining the portion of each fixed amount life annuity periodic payment that is taxable requires the calculation of an exclusion ratio, just as in the case of a temporary annuity settlement option. The principal difference between the two lies in determining the expected return since, in the case of a life annuity, we don't know how long the death benefit beneficiary will live. Irrespective of that difference, however, the same exclusion ratio calculation applies:

Death Benefits Received under Settlement Options 19

Determining the expected return in the case of a life annuity settlement option simply requires referencing the appropriate annuity table. The annuity table provides an "expected return multiple" for each age that approximates the beneficiary's life expectancy. The following excerpt from annuity Table V provides the expected return multiples at various ages for a life annuity involving one life:

Table VOrdinary Life Annuities - One Life - Expected Return Multiples

Age Multiple Age Multiple Age Multiple

20 61.9 40 42.5 59 25.0

21 60.9 41 41.5 60 24.2

22 59.9 42 40.6 61 23.3

... ... ...

25 57.0 48 34.9 64 20.8

26 56.0 49 34.0 65 20.0

27 55.1 50 33.1 66 19.2

... ... ...

31 51.2 54 29.5 69 16.8

32 50.2 55 28.6 70 16.0

33 49.3 56 27.7 71 15.3

As we can see from Table V above, a 50-year-old beneficiary has an expected return multiple of 33.1 years. To determine the exclusion ratio for a 50-year-old beneficiary under a life annuity settlement option, we simply assume based on Table V that he or she will survive for exactly 33.1 years.

For example, suppose a 50-year-old beneficiary elected to receive a $100,000 death benefit under a life annuity settlement option that will provide her with $8,000 annual periodic payments for life. Since the expected return multiple at her age 50 is 33.1, her expected return is equal to the annual periodic payment multiplied by 33.1. Thus, her expected return is $264,800 ($8,000 × 33.1).

We can determine the appropriate exclusion ratio and the taxable amount of each annual periodic payment by entering the applicable numbers in the exclusion ratio calculation as follows:

By multiplying each $8,000 annual periodic payment by the .3776 exclusion ratio, we can see that $3,020.80 ($8,000 × .3776) each year is tax-free as payment of the tax-free death benefit. The balance of the periodic payment is taxable as interest. When the entire death benefit has been recovered tax-free, in 33.1 years, the remaining periodic payments are taxable in their entirety.

Variable Payout Settlement Options


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Determining the tax-free portion of periodic payments received under a variable settlement option employs the same tax principle as under a fixed amount settlement option. However, the process is a little different since the expected return under a variable settlement option cannot be known in advance because the payment amounts fluctuate based on investment performance.

In the case of a variable settlement option, the death benefit is divided by the length of the period over which payments will be made. In our earlier example involving the temporary annuity settlement option under which a beneficiary settled a $100,000 death benefit over 10 years, the annual tax-free amount under a variable temporary settlement option is $10,000 ($100,000 ÷ 10 years). In the case of a 50-year-old beneficiary settling $100,000 under a variable straight life annuity settlement option, the annual tax-free amount is $3,021.15 ($100,000 ÷ 33.1).

Life Annuity with Minimum Payment Guarantee

Not surprisingly, beneficiaries and their heirs may object to the loss of the entire death benefit—the result in a straight life annuity—if the beneficiary should die after receiving only a single periodic payment. A beneficiary that wants to receive periodic life annuity payments but also wants to be sure that a guaranteed minimum amount is paid out, regardless of death, has two choices:

A period certain, or

A refund annuity.

Under either approach, the insurer guarantees that an income will continue for the beneficiary's entire life, no matter how long that life is. It also guarantees, however, that at least a minimum amount will be paid even in the case of the beneficiary's early death. In order to obtain such a minimum payment guarantee, the beneficiary receives a smaller life annuity periodic payment.

When calculating the tax-free portion of the periodic payments, the value of that minimum payment guarantee must be subtracted from the death benefit before the calculation. The percent value of the refund guarantee is contained in annuity Table VII, reproduced, in part, below:

Summary 21

Table VII - Percent Value of Refund FeatureDuration of Guaranteed Amount

Age 5 yrs 10 yrs 15 yrs 20 yrs

48 1 1 2 4

49 1 2 3 4

50 1 2 3 5

...

54 1 2 4 7

55 1 2 4 7

56 1 3 6 9

...

59 1 4 6 10

60 2 4 7 11

61 2 4 8 13

We can illustrate how the addition of a minimum payment guarantee would affect the taxability of periodic payments by considering an example. Let's return to our previous example involving the 50-year-old beneficiary who settled a $100,000 death benefit under a straight life annuity. Assuming her annual periodic payments were $8,000, the tax-free portion would be $3,020.80.

However, if the death benefit was paid under a life annuity with a 20 year period certain settlement option and the periodic payments remained the same (actually, they would be somewhat lower to account for the minimum payment guarantee), the death benefit in the exclusion ratio calculation would need to be reduced by 5% (from table above).

By reducing the death benefit, solely for purposes of the exclusion ratio calculation, we can see that the exclusion ratio is reduced from .3776 to .3588.

By multiplying the $8,000 annual periodic payment by .3588 (instead of .3776) we can see that the amount of each periodic payment excluded from the beneficiary's income is now $2,870.40 ($8,000 × .3588). The addition of a 20-year minimum payment guarantee has reduced the tax-free portion of the periodic payment from $3,020.80 to $2,870.40 and has resulted in an additional $150.40 of income that must be recognized.

SUMMARYLife insurance premiums, whether paid by the insured or another person, are a personal expense and not deductible. The general rule with respect to the income taxability of life insurance death benefit proceeds is that such proceeds are exempt from income taxation. Accordingly, beneficiaries normally are not required to recognize any income as a result of their receipt of death benefit proceeds from life insurance contracts.

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However, in order for life insurance death benefits to entirely avoid inclusion in the beneficiary's income, the life insurance contract must meet the statutory definition of life insurance contained in the Internal Revenue Code and not:

Have been transferred for a valuable consideration;

Be included in a qualified retirement plan; or

Be certain employer-owned life insurance policies.

A transfer for value where a life insurance policy's ownership is assigned to a non-exempt assignee causes the death benefits to be includible in the assignee-beneficiary's income to the extent such death benefits exceed the total of the consideration paid for the policy and any subsequent premiums paid by the assignee.

When a qualified plan participant dies before retirement and the plan's death benefit includes permanent life insurance, part of the death benefit provided by the life insurance is tax-free and part of it is includible in the beneficiary's income. The part of the death benefit that is received by the beneficiary tax-free is the pure death benefit, i.e. the amount of the death benefit in excess of the cash surrender value. The balance of the life insurance policy's death benefit—the portion of the death benefit equal to the policy's cash surrender value—must be included in the beneficiary's income for tax purposes.

Life insurance death benefits paid to a former employer of the insured in excess of the employer's cost basis must be included in the former employer's gross income. Exceptions to the requirement that death benefits in excess of basis be included in a former employer's gross income apply if the death benefit is paid:

To the former employee-insured's heirs;

Upon the death of an insured employed by the policy owner within 12 months prior to death; or

Upon the death of an insured who was a director or highly compensated employee or individual at the time of policy issue.

Thus death benefits in excess of basis paid to a former employer are includible in the employer's income unless one of these three exceptions applies.

A viatical settlement is the sale of an existing life insurance policy to a third party—usually referred to as a "viatical settlement provider"—by a terminally ill individual with a life expectancy of 24 months or less. Depending on the circumstances, the proceeds may be:

Tax-free without limit;

Tax-free up to prescribed daily limits; or

Partially tax-free.

When a viatical settlement payment is made by a viatical settlement provider to a life insurance policy owner due to the insured's terminally ill status such payment is generally entirely income tax-free. When a viatical settlement payment is made by a viatical settlement provider to a life insurance policy owner due to the insured's chronically ill status, the payments may also be income tax-free, up to certain limits.

When otherwise tax-free death benefits are paid under a settlement option providing for periodic payments, the portion of the periodic payment representing payment of the original death benefit is tax-free; the balance constitutes interest that is taxable as ordinary income.

Introduction 23

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CHAPTER 2 - LIFE INSURANCE POLICY LIVING PROCEEDS

INTRODUCTIONGenerally, life insurance is either permanent insurance or term insurance. Term life insurance has many uses in both the individual and corporate marketplace. However, it is generally inappropriate for meeting long-term life insurance needs because of its significant premium costs at older ages. To meet such long-term needs, many families and businesses turn to permanent life insurance.

In addition to providing long-term death benefit coverage, permanent life insurance is characterized by having a cash value. That cash value normally accumulates on a tax-deferred basis, maybe borrowed against and, in the case of universal life insurance, accessed through withdrawals. Furthermore, such cash value, less any applicable surrender charges, is paid to the policy owner when the policy is surrendered.

In this chapter, we will discuss the tax implications of these transactions. Accordingly, the chapter will examine the tax treatment of life insurance living proceeds, including dividends, policy loans, withdrawals and policy surrenders. In addition, it will look at the tax treatment of life settlements—the sale of an existing life insurance policy that is similar in some respects to a viatical settlement but with much different tax consequences.

CHAPTER LEARNING OBJECTIVESWhen you have completed this chapter, you should be able to:

Recognize the customary income tax treatment given to life insurance policy withdrawals, loans and surrender proceeds;

Identify the changes to the tax treatment of life insurance policy living proceeds resulting from the policy being deemed a modified endowment contract;

Identify the types of life insurance exchanges that are tax-free under IRC §1035; and

Recognize the income tax treatment of life settlements.

DEFINITION OF LIFE INSURANCE IMPACTS TAX-DEFERRED ACCUMULATIONThe preceding chapter discussed the statutory definition of life insurance and the consequences on death benefit taxability of a failure to meet that definition. That adverse tax treatment also extends to the life insurance contract's cash value.

Thus, not all life insurance contracts offer policy owners tax-deferred growth of cash values. A life insurance contract that is issued after December 31, 1984, and which does not meet the statutory definition of life insurance under Internal Revenue Code §7702 (discussed in Chapter 1) loses the benefit of cash value tax-deferral. Thus, the gain on the cash value becomes currently taxable.

Determining the income that must be recognized on the cash value gain in a contract not meeting the definition of life insurance requires a three-step calculation:

First, determine the increase in the cash value over the current year by subtracting the contract's cash surrender value, less any applicable surrender charges, at the end of the current year from the cash surrender value, less any applicable surrender charges, at the end of the previous year.

Second, add the cost of the life insurance coverage for the current year to the increase in the contract's surrender value.

Third, subtract the year's paid premiums, less dividends.

For example, suppose Sally owned a life insurance contract that does not meet the statutory definition of life insurance and for which she paid premiums this year of $1,500. If the increase in the cash surrender value this year

24 Chapter 2 - Life Insurance Policy Living Proceeds

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was $3,000 and the cost of the life insurance coverage for the current year was $520, the income she must recognize on the cash value gain would be $2,020. We can see the calculation below:

Cash surrender value this year $35,000

Cash surrender value last year – 32,000

Increase in cash surrender value $3,000

Cost of life insurance coverage this year + 520

Total $3,520

Minus premiums paid – 1,500

Cash value gain to be recognized $2,020

The tax treatment of life insurance living proceeds under contracts that meet the IRC §7702 requirements is discussed below.

TAXATION OF LIVING PROCEEDS OF LIFE INSURANCE POLICIES

Living proceeds received under a life insurance policy that meets the IRC §7702 definition of life insurance are generally defined as proceeds received during the insured's lifetime. As such, living proceeds include:

Policy loans;

Policy dividends;

Cash value withdrawals; and

Surrender proceeds.

Let's turn our attention now to how these living proceeds are taxed when received.

POLICY LOANS NOT GENERALLY CONSIDERED DISTRIBUTIONS

Although policy loans are often seen as constituting living proceeds from a life insurance policy, they are not usually considered distributions from the policy and are normally received tax-free, provided the policy is not a modified endowment contract (MEC). (See Seven-Pay Test Determines MEC Status below.)

However, when determining the tax liability resulting from the receipt of surrender proceeds, any outstanding loans at the time of surrender are included, for tax purposes, in the surrender proceeds and considered distributions. For example, suppose a policy owner surrendered her life insurance policy at a time when the outstanding loan was $10,000. If the remaining cash surrender value was $20,000, the amount of the surrender proceeds, solely for purposes of determining taxable gain, would be $30,000.

POLICY DIVIDENDS GENERALLY CONSIDERED RETURN OF PREMIUM

Participating life insurance policies - policies that "participate" in the insurer's divisible surplus - may pay dividends to the policy owner if and when declared by the insurer. Such dividend payments paid or credited before the maturity or surrender of a life insurance contract are tax-exempt as a tax-free return of premium until the policy owner's cost basis has been entirely recovered.

Accordingly, dividends received under a life insurance policy are generally income tax-free until the total amount received or credited exceeds the aggregate gross premiums paid for the policy. Any dividends paid or credited in

Taxation of Living Proceeds of Life Insurance Policies 25

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excess of the total gross premiums paid for the life insurance policy are considered taxable income in the year in which received.

Dividends paid under a life insurance policy considered a MEC receive a somewhat different and far less favorable tax treatment as discussed below.

CASH VALUE WITHDRAWALS GENERALLY RECEIVE FIFO TAX TREATMENT

Withdrawals taken from the cash value of a life insurance policy that is not a MEC generally receive "first in first out" (FIFO) tax treatment. Under FIFO tax treatment, a withdrawal is considered a tax-free return of the policy owner's cost basis insofar as any basis remains under the contract. Only after all cost basis has been recovered tax-free is any further withdrawal deemed to be taxable gain. An example may provide clarification.

Suppose a policy owner has made aggregate premium payments of $10,000 towards a universal life insurance policy and currently has a total cash surrender value of $12,000. A cash value withdrawal of $11,000 would be deemed, for tax purposes, to consist of a $10,000 tax-free return of basis and a $1,000 distribution of gain. Accordingly, the policy owner would be required to recognize $1,000 of ordinary income.

For example, if Susan's life insurance policy, for which she paid $20,000 in premiums, had a cash value of $25,000, the cash value would consist of $5,000 of gain and $20,000 of premiums. Since she paid premiums with after-tax funds—in other words, they were not deductible—her total premiums represent her cost basis.

Any withdrawal she took from her cash value would simply draw down her cost basis and would be tax-free as a recovery of basis. Only after she withdrew her entire cost basis would any further withdrawal be considered a distribution of her taxable gain. In this case, Susan could withdraw $20,000 from her cash value without being required to include any part of the withdrawal in her income. However, any amount withdrawn in excess of $20,000 would be a taxable distribution of gain.

Thus, Susan's $21,000 withdrawal would be comprised of:

A $20,000 tax-free recovery of basis; and

A $1,000 distribution of taxable gain.

If the life insurance policy had been considered a MEC, the tax treatment would have been vastly different.

GAIN ON SURRENDER INCLUDIBLE IN INCOME

Not all life insurance policies terminate as death claims. Many policy owners whose life insurance needs have changed replace an existing life insurance contract for a different contract or surrender it for its cash value. When a life insurance policy is surrendered, the policy's cash surrender proceeds constitute taxable income to the policy owner to the extent they exceed his or her cost basis in the policy.

As noted earlier, the actual proceeds payable on surrender are increased, for tax purposes, by any outstanding policy loans at the time of surrender. The policy owner's cost basis in the policy is equal to the total premiums paid less any dividends and prior non-taxable distributions received.

For example, suppose a policy owner surrendered a life insurance policy and received net surrender proceeds (cash value less any applicable surrender charges) equal to $50,000. At the time of the policy surrender, she had a $15,000 outstanding loan on the policy. The policy owner had paid $60,000 in total premiums for the policy, had received $10,000 in dividends and had taken cash value withdrawals of $22,000, $20,000 of which was tax-free as a return of basis.

On such a surrender, the policy owner would have a gain of $35,000 includible as ordinary income as depicted below:


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Net surrender proceeds $ 50,000

Plus outstanding loans + 15,000

Total distribution $ 65,000

Total premiums paid $ 60,000

Less dividends paid – 10,000

Less prior tax-free distributions – 20,000

Total cost basis – 30,000

Taxable gain $ 35,000

SEVEN-PAY TEST DETERMINES MEC STATUS

It has been noted that a policy’s status as a modified endowment contract (MEC) changes the tax treatment given to certain transactions involving a life insurance policy. The tax treatment of policy loans, withdrawals and surrenders is fairly straightforward and not particularly onerous when the policy with respect to which the transactions are made is not a modified endowment contract (MEC). When the policy is a MEC, however, the tax treatment becomes distinctly unfavorable.

A life insurance policy becomes a modified endowment contract (MEC) if the total premiums paid by the life insurance policy owner in the first seven years exceed the amount of premiums that would have been required to make the policy paid-up in seven years. A life insurance policy that has previously met this 7-pay test but which undergoes a material change in its benefits or terms will be treated as though it were a new contract entered into on the day the material change was effective, and the 7-pay test must be met again.

It is important to bear in mind that once a life insurance policy has become a MEC, that status never changes. There is nothing the policy owner or the insurer can do to eliminate the policy's MEC status and its resultant unfavorable tax treatment.

Material Change

For purposes of the modified endowment contract rules, 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.

Tax Consequences of MEC Status

A life insurance policy's becoming a MEC changes the tax treatment of non-death benefit distributions from it. The tax treatment changes resulting from a life insurance policy taking on MEC status affect life insurance policy:

Dividends;

Cash value withdrawals;

Loans; and

Surrenders.

However, a life insurance policy's status as a MEC does not affect the favorable income tax treatment of death benefits.


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Dividends Taxable

In the discussion of dividends received under a life insurance policy that isn't a MEC, it was noted that dividends are considered a tax-free refund of unearned premiums. Only to the extent that the total dividends received exceed the total premiums paid are they taxable to the policy owner. That tax treatment is modified in the case of a MEC.

Dividends paid under a MEC, unless used to purchase paid-up additions, are considered amounts received under the contract. To the extent there is a gain on the contract, such dividends constitute taxable income in the year in which they are paid or credited.

Dividends received from a MEC are considered taxable income to the extent of any gain under the policy. Dividends paid in cash, accumulated under the policy or retained by the insurer to pay principal or interest on a policy loan are deemed amounts received under the contract and, therefore, taxable income to the policy owner to the extent of any policy gain under the contract. Dividends applied to purchase paid-up additions, however, are not taxable in the year received.

Cash Value Withdrawals

In the case of a cash value withdrawal, a policy owner makes a partial surrender of a permanent life insurance policy and receives a portion of the policy's cash value. We noted earlier that, if the withdrawal was made from a life insurance policy that was not a MEC, the tax treatment given the withdrawal would be "first in first out" (FIFO). Under FIFO tax treatment, the policy owner would not be deemed to have withdrawn any taxable gain under the policy until all tax-free cost basis (equal to net premiums) had been distributed.

A life insurance that has become a MEC turns FIFO tax treatment of withdrawals on its head. Thus, cash value withdrawals from a MEC receive "last in first out" (LIFO) tax treatment instead of the far more favorable FIFO tax treatment. Accordingly, withdrawals from a MEC are considered, for tax purposes, to be taxable gain to the extent of any gain on the policy. All gain is thus deemed to be withdrawn before any tax-free recovery of basis.

Let's return to our earlier withdrawal example. We noted in that example that Susan had paid $20,000 in premiums and her policy had a $25,000 cash value. Accordingly, the policy had a $5,000 gain. If Susan's life insurance policy was a MEC, her $21,000 cash value withdrawal would be comprised of:

A $5,000 distribution of taxable gain; and

A $16,000 tax-free recovery of basis.

Thus, instead of having to recognize $1,000 in the year of withdrawal, she would be required to recognize $5,000.

Loans Considered Distributions

Loans from a life insurance policy that is not considered a MEC are tax-free, but any outstanding loans are considered distributed if the policy is surrendered. If the policy is a MEC, the story changes considerably.

When policy loans are taken from a life insurance policy deemed to be a MEC, such loans are considered distributions and subject to the same tax treatment given to cash value withdrawals from MECs. As a result, a loan from a MEC under which there is a gain on the contract will result in taxable income to the policy owner equal to the lesser of the loan and the amount of the gain.

For example, suppose a life insurance policy owner whose policy was a MEC borrowed $15,000 from the policy's cash value. Further, suppose that the policy owner had paid $50,000 in premiums for the policy, and its cash value was $75,000. Since the policy has a $25,000 gain the entire $15,000 loan would be deemed a distribution of taxable gain that would need to be recognized as ordinary income.


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Gain Included in Cash Surrender Proceeds Taxable

Although the MEC status of a life insurance policy affects the tax treatment of dividends, policy loans, and withdrawals, it plays a somewhat smaller role in the tax treatment of the proceeds of a complete surrender. As noted earlier, in the case of a complete surrender of a life insurance policy any amounts received by the policy owner in excess of his or her cost basis are considered ordinary income and taxable in the year of surrender.

However, MEC status makes the tax treatment less favorable in surrenders as well. In addition to the requirement that the policy gain be included in income in the year the policy is surrendered, the MEC status of the policy results in the imposition of a penalty tax applicable to the amount of the proceeds considered gain.

MEC Tax Penalty May Apply

A 10% MEC penalty tax generally applies to any amount includible in income received from a MEC by an individual before attainment of age 59 1/2. The tax penalty does not apply—even if the policy owner was younger than age 59 1/2— if the distribution from the MEC was made:

After the taxpayer becomes disabled; or

The distribution is part of a series of substantially equal periodic payments made for the taxpayer's life or life expectancy.

For example, suppose a policy owner borrowed $10,000 from a life insurance policy that was a MEC at a time when the policy owner's cost basis was $30,000 and the cash value of the policy was $50,000. (The policy would have a $20,000 gain.) Since the loan would be considered a distribution under the MEC rules and the applicable tax treatment was LIFO—the taxable gain was deemed to be distributed before the tax-free basis was distributed—the $10,000 loan would be includible in the policy owner's income in its entirety. If the policy owner was not age 59 1/2 or older and neither of the exceptions to the tax penalty applied, the policy owner would also be assessed a tax penalty of $1,000 ($10,000 × 10%), in addition to being required to pay the income tax due on the $10,000 gain.

Qualified Long-Term Care Charges from MECs Exempt

The Pension Protection Act (PPA) of 2006 made changes in the tax treatment of distributions from life insurance policies considered MECs only when the distributions are used to provide qualified long-term care coverage. Those changes became effective in 2010. The changes facilitate the use of life insurance policies to deliver long-term care insurance benefits and ensure that distributions from a life insurance policy to pay for qualified long-term care insurance coverage are not includible in current gross income.

Distributions in Payment of Long-Term Care Insurance Coverage

We noted earlier that distributions from a life insurance policy classified as a MEC are normally subject to adverse taxation, which includes:

Unfavorable LIFO tax treatment under which distributions are considered taxable gain and includible in gross income in an amount equal to the lesser of:

Gain on the policy, or

Distribution; and

A 10% tax penalty on most distributions received before age 59 1/2 that are includible in gross income.

That adverse tax treatment was changed by PPA for tax years on and after 2010 only when the distribution of cash value from a life insurance policy is used to pay the premium costs for qualified long-term care insurance coverage. In order for the charges against the cash value to avoid normal MEC tax treatment, the qualified long-term care insurance coverage must be a) part of the basic provisions of the life insurance policy, or b) included as a rider on the life insurance policy. In other words, a charge against a MEC's cash value to pay premiums on long-term care insurance coverage that is not a part of the policy will not qualify for the exemption.


Although a charge against the cash value of a MEC, when used to pay for qualified long-term care insurance coverage that is part of the policy or provided by rider, will not result in current income tax liability the total charges made against the life insurance policy's cash value will reduce the policy's cost basis.

For example, suppose a policy owner had paid premiums of $50,000 for a life insurance deemed a MEC had a current cash value of $80,000 (resulting in a $30,000 gain on the contract). If the policy owner had used cash value to pay the cost of qualified long-term care insurance coverage included in the contract or provided by rider on the contract, such distribution would be deemed to be from the $50,000 cost basis—FIFO tax treatment, in other words—rather than from the gain. That tax treatment would apply even though the life insurance policy was a MEC and normally subject to less-favorable LIFO tax treatment.

Assuming the charge for the qualified long-term care insurance coverage was $1,000, the contract owner's cost basis after the distribution would be $49,000 ($50,000 – $1,000). No gain would be deemed distributed, and, thus, no part of the charge would be includible in income.

IRC §72 is amended, in part, to read as shown in the inset:

Sec. 72. Annuities; certain proceeds of endowment and life insurance contracts

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e) Amounts not received as annuities

(2) General rule Any amount to which this subsection applies -

(A) if received on or after the annuity starting date, shall be included in gross income, or

(B) if received before the annuity starting date -

(i) shall be included in gross income to the extent allocable to income on the contract, and

(ii) shall not be included in gross income to the extent allocable to the investment in the contract.

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(5) Retention of existing rules in certain cases

(C) Certain life insurance and endowment contracts Except as provided in paragraph (10) and except to the extent prescribed by the Secretary by regulations, this paragraph shall apply to any amount not received as an annuity which is received under a life insurance or endowment contract.

...

(11) Special rules for certain combination contracts providing long-term care insurance.

Notwithstanding paragraphs (2), (5)(C), and (10), in the case of any charge against the cash value of an annuity contract or the cash surrender value of a life insurance contract made as payment for coverage under a qualified long-term care insurance contract which is part of or a rider on such annuity or life insurance contract—

(A) the investment in the contract shall be reduced (but not below zero) by such charge, and

(B) such charge shall not be includible in gross income.

Tax Deduction for LTC Premiums Denied

IRC §213(a) permits a taxpayer to deduct "the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a dependent..., to the extent that such expenses exceed 10 percent of adjusted gross income." IRC §213 provided temporary special rules for taxable years 2013 through 2018, taxpayers age 65 or older could deduct medical expenses that exceed 7.5% of AGI and taxpayers

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younger than age 65 could deduct medical expenses only insofar as they exceeded 10% of AGI. However, these temporary special rules only applied for 2013 through 2016, as the Tax Cuts and Jobs Act of 2017 (TCJA), changed the threshold for 2017 and 2018. Under the TCJA, for taxable years beginning after December 31, 2016, and ending before January 1, 2019, the threshold for deducting medical expenses was 7.5% of AGI for all taxpayers. Therefore, for 2013 through 2016, taxpayers age 65 or older could deduct medical expenses that exceed 7.5% of AGI and taxpayers younger than age 65 could deduct medical expenses that exceeded 10% of AGI, and for 2017 and 2018, all taxpayers, regardless of the taxpayer’s age, could deduct medical expenses that exceeded 7.5% of AGI. For taxable years beginning January 1, 2019, the threshold for deducting medical expenses was set to increase to 10% of AGI for all taxpayers who itemize deductions, however, the passage of the Taxpayer Certainty and Disaster Tax Relief Act of 2019extends the 7.5% of AGI deduction threshold until December 31, 2020. The medical deduction threshold has changed yet again, under the Consolidated Appropriations Act, 2021, IRC §213(a) is amended by striking ‘‘10 percent’’ and inserting ‘‘7.5 percent’’, this amendment shall apply to taxable years beginning after December 31, 2020. After this amendment, IRC §213(a) now permits a taxpayer to deduct medical expenses "...to the extent that such expenses exceed 7.5 percent of adjusted gross income." Therefore, starting in 2021, the threshold for deducting medical expenses is 7.5% of AGI.

Later in the Code section, it defines "medical care" to include "...amounts paid...for qualified long-term care services...or...for any qualified long-term care insurance contract...."

Thus, a taxpayer may normally include the premiums paid for qualified long-term care insurance (not exceeding specific dollar amounts) as part of the expenses for medical care that he or she may deduct to the extent such medical care expenses exceed 7.5% of adjusted gross income (starting in 2021). However, when qualified long-term care insurance coverage is paid for by a non-taxable charge against the cash value of a life insurance policy, the tax deduction for such charge is denied.

The amended IRC §7702B, relative to the denial of the deduction for qualified long-term care insurance coverage premiums paid by a charge to cash value, is shown in part in the inset below:

Sec. 7702B. Treatment of qualified long-term care insurance

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e) Treatment of coverage provided as part of a life insurance or annuity contract.

Except as otherwise provided in regulations prescribed by the Secretary, in the case of any long-term care insurance coverage (whether or not qualified) provided by a rider on or as part of a life insurance contract or an annuity contract

(1) In general, this title shall apply as if the portion of the contract providing such coverage is a separate contract.

(2) Denial of deduction under section 213.

No deduction shall be allowed under section 213(a) for any payment made for coverage under a qualified long-term care insurance contract if such payment is made as a charge against the cash surrender value of a life insurance contract or the cash value of an annuity contract.

(3) Portion defined.

For purposes of this subsection, the term 'portion' means only the terms and benefits under a life insurance contract or annuity contract that are in addition to the terms and benefits under the contract without regard to long-term care insurance coverage.

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Tax-Free Exchanges under IRC §1035 31

TAX-FREE EXCHANGES UNDER IRC §1035Although the surrender of a life insurance policy on which there is a gain—the cash value exceeds the net premiums paid for the policy, in other words—will result in taxable income to the policy owner, a policy owner seeking to terminate an existing life insurance contract may exchange it for another type of contract without being required to recognize any gain. The IRC §1035 tax-free exchange rules permit the exchange of a life insurance policy for certain other contracts.

Section 1035 of the Internal Revenue Code (IRC) enables a life insurance policy owner to exchange his or her policy or contract for another policy or contract without tax consequences, provided certain rules are followed. Pursuant to IRC §1035 a life insurance policy owner may exchange a life insurance policy for another life insurance policy, an endowment contract, an annuity contract, or a qualified long-term care insurance policy.

For example, suppose a life insurance policy owner had paid $100,000 in net premiums for a policy whose current cash value is $140,000. If the policy owner had simply surrendered the existing policy and purchased a new life insurance policy or annuity contract without following the IRC §1035 rules, he or she would be required to include the $40,000 gain in income in the year the policy was surrendered. By making an otherwise identical exchange under IRC §1035, the $40,000 gain under the existing life insurance policy would be carried over to the new policy and continue to be tax-deferred. In addition, the $100,000 cost basis of the replaced life insurance policy would become the cost basis for the replacement policy or contract.

IRC §1035, authorizing tax-free exchanges, is shown in the inset below:

Sec. 1035. Certain exchanges of insurance policies

a) General rules No gain or loss shall be recognized on the exchange of -

(1) a contract of life insurance for another contract of life insurance or for an endowment or annuity contract or for a qualified long-term care insurance contract; or

(2) a contract of endowment insurance (A) for another contract of endowment insurance which provides for regular payments beginning at a date not later than the date payments would have begun under the contract exchanged, or (B) for an annuity contract, or (C) for a qualified long-term care insurance contract; or

(3) an annuity contract for an annuity contract or for a qualified long-term care insurance contract.

(4) a qualified long-term care insurance contract for a qualified long-term care insurance contract.

b) Definitions For the purpose of this section -

(1) Endowment contract A contract of endowment insurance is a contract with an insurance company which depends in part on the life expectancy of the insured, but which may be payable in full in a single payment during his life.

(2) Annuity contract An annuity contract is a contract to which paragraph (1) applies but which may be payable during the life of the annuitant only in installments. For purposes of the preceding sentence, a contract shall not fail to be treated as a life insurance contract solely because a qualified long-term care insurance contract is a part of or a rider on such contract.

(3) Life insurance contract A contract of life insurance is a contract to which paragraph 1) applies but which is not ordinarily payable in full during the life of the insured. For purposes of the preceding sentence, a contract shall not fail to be treated as a life insurance contract solely because a qualified long-term care insurance contract is a part of or a rider on such contract.


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TAX TREATMENT OF LIFE SETTLEMENT PROCEEDSViatical settlements, under which viatical settlement providers purchase existing life insurance policies from terminally ill or chronically ill insured policy owners, were discussed in the preceding chapter. Viatical settlement providers have expanded their market, however, to purchase existing life insurance policies from insured policy owners who are neither terminally ill nor chronically ill.

This expanded market involves the purchase of existing life insurance policies under which the insured policy owners are older and, while they have somewhat impaired health, are relatively healthy. These settlements are known as life settlements rather than viatical settlements. Not surprisingly, the settlements provided are smaller under life settlements than under viatical settlements.

As discussed in the preceding chapter, the income tax treatment of viatical settlements is clear and straightforward. However, the income tax treatment of life settlements remained somewhat unsettled until the IRS published Revenue Ruling 2009-13. In that ruling, the IRS distinguished between the portion of life settlement proceeds subject to capital gains tax treatment and the portion of such proceeds subject to ordinary income tax treatment.

Determining the tax treatment of proceeds received under a life settlement is a two-step process. Those steps involve:

Calculating the gain; and

Identifying the tax treatment to which the gain is subject.

Let's begin by calculating the policy owner's gain when he or she sells an existing life insurance policy in a life settlement.

CALCULATING THE LIFE SETTLEMENT GAIN

The gain realized by the policy owner in a life settlement is equal to the payment made to the policy owner by the life settlement provider minus the policy owner's adjusted cost basis in the policy. Revenue Ruling 2009-13 states that in order to "...measure a taxpayer's gain upon the sale of a life insurance contract, it is necessary to reduce basis by that portion of the premium paid for the contract that was expended for the provision of insurance before the sale."

So, if a policy owner received a $50,000 payment from a life settlement provider for a life insurance policy in which he or she had a $20,000 adjusted cost basis, his overall gain on the life settlement would be $30,000 ($50,000 – $20,000). Determining the adjusted basis varies somewhat, depending on whether the policy being sold in the life settlement is a cash value policy or a term life insurance policy.

Determining Adjusted Basis in a Cash Value Policy

To determine the adjusted basis in a life insurance policy having a cash value, the cost of current insurance coverage—the total of the monthly deductions made by the insurer to cover its pure insurance risk—must be deducted from the total premiums paid for the policy.

For example, suppose the policy owner paid total premiums of $25,000 for his $100,000 universal life insurance policy. If the total cost of insurance (COI) deductions amounted to $5,000 over the period during which he owned the policy, his adjusted cost basis for calculating the overall gain would be $20,000 ($25,000 – $5,000).

Determining Adjusted Basis in a Term Life Insurance Policy

Just as it does in a cash value policy, a determination of the policy owner's adjusted cost basis in a term life insurance policy requires that the cost of insurance be deducted from the policy owner's total policy premiums. However, in the case of a term life insurance policy, the cost of insurance is presumed to equal the total premiums paid for the coverage under the policy. (That is another way of saying that no part of a term life insurance premium is used to build any cash values.)

For example, suppose a policy owner paid annual premiums of $1,000 for five years for his $100,000 term life insurance policy and sold the policy to a life settlement provider at the end of the fifth year. Thus, the policy owner's

Tax Treatment of Life Settlement Proceeds 33

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total premiums were $5,000. Since the cost of the insurance coverage in a term life insurance policy is presumed to equal the premiums paid, the policy owner's adjusted basis in the policy would be zero.

IDENTIFYING THE TAX TREATMENT OF THE LIFE SETTLEMENT GAIN

When the overall gain in a life settlement has been determined by subtracting the policy owner's adjusted cost basis from the life settlement payment, the next step is to determine the nature of the gain. In other words, in step two we determine whether the gain receives capital gains treatment or a combination of capital gains and ordinary income tax treatment.

The tax treatment of the gain realized by a policy owner under a life settlement depends on whether the policy sold was a:

Term life insurance policy; or

Cash-value life insurance policy.

Let's consider each of these policy sales separately.

Sale of Term Life Insurance Policy Results in Capital Gains Treatment

Because there is no cash value in a term life insurance policy, no ordinary income normally results from the sale of a term life insurance policy in a life settlement. Instead, the gain on the sale of a term life insurance policy in a life settlement receives capital gains treatment. If the policy has been owned by the policy owner for more than one year, the gain receives long-term capital gains tax treatment.

For example, suppose a term life insurance policy owner sold his $100,000 term life insurance policy in a life settlement for $20,000. Further, suppose the policy owner paid total net premiums of $5,000. Since the total premiums paid for the policy are presumed to equal the cost of the life insurance coverage provided—the "cost of insurance," in other words—the policy owner has a zero adjusted cost basis in the policy. Thus, the entire life settlement would constitute taxable income. Since the policy contained no cash value, the gain under which would have been taxed as ordinary income, the entire life settlement is taxable as capital gains.

SALE OF CASH VALUE POLICY MAY RESULT IN CAPITAL GAINS AND ORDINARY INCOME

Unlike the tax treatment given to term life insurance policies, under which the entire gain realized in a life settlement is capital gains, the gains realized in life settlements involving cash value policies may be partly capital gains and partly ordinary income. Determining the amount of the gain subject to each tax treatment requires the calculation of:

The gain realized; and

The amount of any gain that would have been realized if the policy had been surrendered for its cash value rather than sold in a life settlement transaction.

As noted earlier, the gain realized on a life settlement is equal to the life settlement paid to the policy owner minus the policy owner's adjusted basis in the policy.

To illustrate, suppose a policy owner sold his $100,000 universal life insurance policy in a life settlement under which he received a $50,000 payment. If the policy owner paid $20,000 in total net premiums for the policy and $5,000 was the total cost of insurance over the life of the policy, he would have an adjusted basis in the policy of $15,000 ($20,000 – $5,000). The overall gain the policy owner realized on the life settlement would be $35,000 ($50,000 – $15,000).

Now that we know the total taxable gain realized by the policy owner—$35,000 in this case—we need to determine how much of the gain, if any, is taxable as ordinary income rather than capital gains. To do that, let's add additional facts to our previous example.


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Suppose that the policy's cash surrender value at the time of the life settlement was $25,000. Since the policy owner had paid total premiums of $20,000, his taxable gain if he had surrendered the policy would have been $5,000 ($25,000 – $20,000), and the entire gain would have been ordinary income. Thus, of the overall $35,000 gain on the life settlement, $5,000 would be considered ordinary income and the $30,000 balance of the gain would be considered capital gains. The remaining $15,000 of the life settlement would be received tax-free by the policy owner as a recovery of basis.

LIFE INSURANCE LIVING PROCEEDS RECEIVED UNDER SETTLEMENT OPTIONSIn the preceding chapter, we discussed the settlement of life insurance death benefit proceeds under various settlement options offered by the insurer. A policy owner whose policy matures or who surrenders his or her life insurance policy may normally elect to receive the surrender proceeds under those sale settlement options. Thus, a policy owner could elect to receive payments under an:

Interest-only settlement option; or

An installment settlement option.

In this section, we will discuss the tax treatment of maturity and surrender proceeds received under these settlement options. Unlike death benefit payments received under settlement options in which the portion of the periodic payment that represents the payment of death benefits is tax-free, when maturity or surrender proceeds are being settled under an installment option, i.e. a temporary or life annuity, only the portion of each periodic payment representing the policy owner's cost basis in the policy is received tax-free; the balance is taxable as ordinary income.

INTEREST-ONLY SETTLEMENT OPTION

Under the interest-only settlement option, a policy owner elects to leave some or all of the maturity or surrender proceeds with the insurer at interest. The insurer then makes interest payments to the policy owner on the frequency requested. All interest payments received are taxable as ordinary income in the year received.

Under some circumstances, the policy owner's election of an interest option will enable him or her to postpone recognition of the policy gain on surrender or maturity—and the resultant income tax liability. If the interest-only option is elected by the policy owner before the date of maturity or surrender and the policy owner does not reserve the right to withdraw the proceeds, the proceeds are not deemed to be constructively received and recognition of the gain is postponed. The policy gain becomes taxable income to the person who ultimately receives the surrender or maturity proceeds.

If the policy owner retains the right to withdraw some or all of the surrender or maturity proceeds placed under an interest-only settlement option or the election to place the proceeds under the interest-only settlement option is made on or after maturity or surrender, the proceeds are deemed to have been constructively received in the year of maturity or surrender. In such a case, the gain is taxable as ordinary income at the time of maturity or surrender.

SURRENDER OR MATURITY PROCEEDS SETTLED IN INSTALLMENTS

It was noted in the preceding chapter that life insurance policy death benefits could be settled under options providing for a temporary annuity or a life annuity, i.e. in installments. The same settlement options are normally available to policy owners settling surrender or maturity proceeds.

If a policy owner whose life insurance policy is maturing or who is surrendering a life insurance policy elects, before the date of surrender or maturity, to receive the proceeds under a temporary or life annuity settlement option, taxation of the gain under the policy will be spread over the period during which periodic payments are received rather than in the year of surrender or maturity. In addition, if a policy owner elects within 60 days following the surrender or maturity to receive the proceeds as periodic payments and has received no payments in cash during the 60-day period, the gain will be taxed over the installment period.

Life Insurance Living Proceeds Received under Settlement Options 35

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Thus, if the election is timely made, a policy owner may avoid immediate taxation of policy gains on surrender or maturity by settling the proceeds under a:

Temporary annuity; or

Life annuity.

Temporary Annuity

As noted in connection with death benefit settlement options, a temporary annuity is an annuity under which the proceeds are liquidated over a specific period of time. When the specified period of time over which the periodic payments are made ends, the periodic payments cease. Each periodic payment is deemed to consist of:

Tax-free recovery of basis; and

Taxable interest.

The portion of the proceeds paid under a settlement option providing a fixed amount that is tax-free is determined by calculating an exclusion ratio; the balance of each periodic payment constitutes taxable interest. The exclusion ratio is the ratio that the cost basis of the proceeds settled under the option bear to the total expected return. (Note that, unlike the exclusion ratio calculated for death benefits settled under an optional mode of settlement, the calculation of the exclusion ratio in the case of surrender or maturity proceeds requires that the policy owner's cost basis be divided by the expected return.) Thus, the exclusion ratio is derived simply by dividing the policy owner's cost basis by the expected return. As an equation, the calculation looks like this:

For example, suppose the surrender or maturity proceeds settled under a temporary annuity option was $100,000, the policy owner's cost basis was $70,000 and the policy owner will receive annual periodic payments of $12,000 for ten years. Based on those numbers, the expected return would be $120,000 ($12,000 × 10 years).

In order to determine the portion of each $12,000 periodic payment that is tax-free as a recovery of the policy owner's cost basis, we need only to divide the policy owner's $70,000 cost basis by $120,000. By doing so, we see that .5833 ($70,000 ÷ $120,000) of each periodic payment is tax-free. Simply substituting the applicable numbers into the equation will give us the following:

Applying the .5833 exclusion ratio to each $12,000 periodic payment we determine that $6,999.60 is tax-free as a recovery of the policy owner's cost basis, and the balance of $5,000.40 is taxable as interest ($12,000 × .5833 = $6,999.60).

Life Annuity

If a policy owner elects to settle surrender or maturity proceeds under a basic life annuity settlement option, periodic payments are made for the policy owner-annuitant's entire life but terminate upon the annuitant's death. The same general tax principle that applies to temporary annuity settlement options also applies to periodic payments received under a life annuity settlement option. Specifically, the portion of the periodic payment representing the policy owner's cost basis is tax-free, and the portion of the periodic payment that represents interest is taxable as ordinary income.

Determining the portion of each fixed amount life annuity periodic payment that is taxable requires the calculation of an exclusion ratio, just as in the case of a temporary annuity settlement option. The principal difference between the two lies in determining the expected return since, in the case of a life annuity, we don't know how long the policy owner-annuitant will live. Irrespective of that difference, however, the same exclusion ratio calculation applies:


Determining the expected return in the case of a life annuity settlement option simply requires referencing the appropriate annuity table. The annuity table provides an "expected return multiple" for each age that approximates the policy owner-annuitant's life expectancy. The following excerpt from annuity Table V provides the expected return multiples at various ages for a life annuity involving one life:

Table VOrdinary Life Annuities - One Life - Expected Return Multiples

Age Multiple Age Multiple Age Multiple

20 61.9 40 42.5 59 25.0

21 60.9 41 41.5 60 24.2

22 59.9 42 40.6 61 23.3

... ... ...

25 57.0 48 34.9 64 20.8

26 56.0 49 34.0 65 20.0

27 55.1 50 33.1 66 19.2

... ... ...

31 51.2 54 29.5 69 16.8

32 50.2 55 28.6 70 16.0

33 49.3 56 27.7 71 15.3

As we can see from Table V above, a 50-year-old policy owner-annuitant has an expected return multiple of 33.1 years. To determine the exclusion ratio for a 50-year-old annuitant under a life annuity settlement option, we assume, based on Table V, he or she will survive for exactly 33.1 years.

For example, suppose a 50-year-old policy owner elected to receive $100,000 life insurance surrender proceeds for which her cost basis (total net premiums) was $70,000 under a life annuity settlement option that will provide her with $8,000 annual periodic payments for life. Since the expected return multiple at her age 50 is 33.1, her expected return is equal to the annual periodic payment multiplied by 33.1. Thus, her expected return is $264,800 ($8,000 × 33.1).

We can determine the appropriate exclusion ratio and the taxable amount of each annual periodic payment by entering the applicable numbers in the exclusion ratio calculation as follows:

By multiplying each $8,000 periodic payment by the .2644 exclusion ratio, we can see that $2,115.20 ($8,000 × .2644) each year is tax-free as a recovery of her cost basis. The balance of the periodic payment is taxable as interest. When the policy owner's entire cost basis has been recovered tax-free, in 33.1 years, the remaining periodic payments are taxable in their entirety.

Variable Payout Settlement Options

Life Insurance Living Proceeds Received under Settlement Options 37

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Determining the tax-free portion of periodic payments received under a variable settlement option employs the same tax principle as under a fixed amount settlement option. The process is somewhat different to account for the varying amount of the periodic payments.

In the case of a variable settlement option, the policy owner's cost basis (rather than the amount settled under the option) is divided by the length of the period over which payments will be made. In our earlier example involving the temporary annuity settlement option under which a policy owner with a $70,000 cost basis settled $100,000 surrender proceeds over 10 years, the annual tax-free amount under a variable temporary settlement option is $7,000 ($70,000 ÷ 10 years).

In the case of a 50-year-old policy owner-annuitant with a $70,000 cost basis settling $100,000 under a variable straight life annuity settlement option, the annual tax-free amount is $2,114.80 ($70,000 ÷ 33.1) until the entire cost basis has been recovered tax-free. The balance of each fluctuating periodic payment is taxable as ordinary income. When the entire cost basis has been recovered, all future periodic payments are taxable.

Life Annuity with Minimum Payment Guarantee

Just as in the case of death benefits settled under a life annuity, a policy owner settling surrender or maturity proceeds under a life annuity can elect a life annuity that also provides a minimum payment guarantee. Thus, a policy owner-annuitant may elect:

A life annuity with a period certain, or

A refund annuity.

Under either approach, the insurer guarantees that an income will continue for the policy owner-annuitant's lifetime, regardless of its length. However, the minimum payment guarantee provides that at least a minimum amount will be paid even in the case of the annuitant's early death. In order to obtain such a minimum payment guarantee, the policy owner-annuitant receives a smaller life annuity periodic payment.

When calculating the tax-free portion of the periodic payments under a settlement option with a minimum payment guarantee, the value of that guarantee must be subtracted from the policy owner's cost basis before the calculation. The percent value of the refund guarantee is contained in annuity Table VII, reproduced, in part, below:


Table VII - Percent Value of Refund FeatureDuration of Guaranteed Amount

Age 5 Yrs. 10 Yrs. 15 Yrs. 20 Yrs.

48 1 1 2 4

49 1 2 3 4

50 1 2 3 5

...

54 1 2 4 7

55 1 2 4 7

56 1 3 6 9

...

59 1 4 6 10

60 2 4 7 11

61 2 4 8 13

We can illustrate how the addition of a minimum payment guarantee would affect the taxability of periodic payments by considering an example. Let's return to our previous example involving the 50-year-old policy owner who settled $100,000 of surrender proceeds under a straight life annuity. Assuming her annual periodic payments were $8,000 and her cost basis was $70,000, the tax-free portion would be $2,114.80.

However, if the surrender proceeds were settled under a life annuity with a 20 year period certain settlement option and the periodic payments remained the same (actually, they would be somewhat lower to account for the minimum payment guarantee), the policy owner's cost basis in the exclusion ratio calculation would need to be reduced by 5% (per table above).

By reducing the death benefit, solely for purposes of the exclusion ratio calculation, we can see that the exclusion ratio is reduced from .2644 to .2511.

By multiplying the $8,000 annual periodic payment by .2511 (instead of .2644) we can see that the amount of each periodic payment excluded from the policy owner-annuitant's income is now $2,008.80 ($8,000 × .2511). The addition of a 20-year minimum payment guarantee has reduced the tax-free portion of the periodic payment from $2,115.20 to $2,008.80 and has resulted in an additional $106.40 of income that must be recognized.

SUMMARYA life insurance contract that is issued after December 31, 1984, and which does not meet the statutory definition of life insurance under Internal Revenue Code §7702 loses the benefit of cash value tax-deferral. Similarly, a life insurance policy that fails to meet the 7-pay test becomes a modified endowment contract, and such failure significantly affects the tax treatment of living proceeds. Living proceeds received under a life insurance policy are generally defined as proceeds received during the insured's lifetime. As such, living proceeds include policy loans, policy dividends, cash withdrawals, and surrender proceeds. Although policy loans are often seen as constituting living

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Summary 39

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proceeds from a life insurance policy, they are not usually considered distributions from the policy and are normally received tax-free, provided the policy is not a modified endowment contract (MEC).

Participating life insurance policies may pay dividends to the policy owner if and when declared by the insurer. Such dividend payments paid or credited before the maturity or surrender of a life insurance contract are tax-exempt as a tax-free return of premium until the policy owner's cost basis has been entirely recovered.

Withdrawals taken from the cash value of a life insurance policy that is not a MEC generally receive "first in first out" (FIFO) tax treatment. Under FIFO tax treatment, a withdrawal is considered a tax-free return of the policy owner's cost basis insofar as any basis remains under the contract. Only after all cost basis has been recovered tax-free is any withdrawal deemed to be taxable gain. When a life insurance policy is surrendered, the policy's cash surrender proceeds constitute taxable income to the policy owner to the extent they exceed his or her cost basis in the policy.

The tax treatment of policy loans, withdrawals and surrenders is fairly straightforward and not particularly onerous when the policy with respect to which the transactions are made is not a modified endowment contract (MEC). When the policy is a MEC, however, the tax treatment becomes distinctly unfavorable. Dividends paid under a MEC, unless used to purchase paid-up additions, are considered amounts received under the contract. To the extent there is a gain on the contract, such dividends constitute taxable income in the year in which they are paid or credited.

Cash value withdrawals from a MEC receive "last in first out" (LIFO) tax treatment instead of the far more favorable FIFO tax treatment. Accordingly, withdrawals from a MEC are considered, for tax purposes, to be taxable gain to the extent of any gain on the policy. All gain is thus deemed to be withdrawn before any tax-free recovery of basis.

When policy loans are taken from a life insurance policy deemed to be a MEC, such loans are considered distributions and subject to the same tax treatment given to cash value withdrawals from MECs. As a result, a loan from a MEC under which there is a gain on the contract will result in taxable income to the policy owner equal to the lesser of the loan and the amount of the gain. In the case of a complete surrender of a life insurance policy any amounts received by the policy owner in excess of his or her cost basis are considered ordinary income and taxable in the year of surrender.

A 10% penalty tax generally applies to any amount includible in income received from a MEC by an individual before attainment of age 59 1/2. The tax penalty does not apply—even if the policy owner was younger than age 59 1/2—if the distribution from the MEC was made:

After the taxpayer becomes disabled; or

The distribution is part of a series of substantially equal periodic payments made for the taxpayer's life or life expectancy.

That adverse tax treatment was changed by PPA for tax years on and after 2010 only when the distribution of cash value from a life insurance policy is used to pay the premium costs for qualified long-term care insurance coverage. In order for the charges against the cash value to avoid normal MEC tax treatment, the qualified long-term care insurance coverage must be a) part of the basic provisions of the life insurance policy, or b) included as a rider on the policy.

Section 1035 of the Internal Revenue Code (IRC) enables a life insurance policy owner to exchange his or her policy or contract for another policy or contract without tax consequences, provided certain rules are followed. Pursuant to IRC §1035 a life insurance policy owner may exchange a life insurance policy for another life insurance policy, an endowment contract, an annuity contract, or a qualified long-term care insurance policy.

A life settlement, i.e. a sale of an existing life insurance policy to a life settlement provider by a policy owner who is neither chronically ill or terminally ill, involves additional income tax issues. The gain realized by the policy owner in a life settlement is equal to the payment made to the policy owner by the life settlement provider minus the policy owner's adjusted cost basis in the policy. When the overall gain in a life settlement has been determined by


subtracting the policy owner's adjusted cost basis from the life settlement payment, the nature of the gain, i.e. as ordinary income or capital gains, must then be determined.

Because there is no cash value in a term life insurance policy, no ordinary income normally results from the sale of a term life insurance policy in a life settlement. Instead, the entire gain on the sale of a term life insurance policy in a life settlement receives capital gains treatment. In contrast, the gains realized in life settlements involving cash value policies may be partly capital gains and partly ordinary income.

Glossary 41

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GLOSSARY

GLOSSARY

Accelerated death benefits (life insurance policy)

Death benefits paid to a living, terminally ill insured life insurance policy owner.

Activities of daily living Six activities, each of which is generally considered central to leading a normal life, comprise the activities of daily living. They are bathing, continence, dressing, eating, toileting and transferring.

Assignee (life insurance policy)

The person to whom ownership of a life insurance policy is transferred.

Assignment (life insurance policy)

The transfer of ownership of a life insurance policy is done by the policy owner—referred to as the "assignor" when transferring ownership—signing a form absolutely assigning the policy to the new owner.

Assignor (life insurance policy)

The person who transfers the ownership of his or her life insurance policy to another person.

Cash value withdrawal (life insurance policy)

A partial surrender of a universal life insurance policy under which a policy owner receives a portion of the policy's cash value in cash.

Chronically ill A chronically ill individual is a person who is not terminally ill and who meets one of the following criteria:

The individual has been certified by a licensed health care practitioner as being unable to perform, without substantial assistance, at least two activities of daily living for at least 90 days or a person with a similar level of disability, or

The individual requires substantial supervision to protect himself from threats to his health and safety due to severe cognitive impairment, and such condition has been certified by a healthcare practitioner within the previous 12 months.

Cost basis (life insurance policy)

The total of non-deductible premiums (less dividends taken in cash or left on deposit) paid for a permanent life insurance policy constitute the policy owner's cost basis in the policy.

Dividends (life insurance policy)

Dividend payments paid or credited before the maturity or surrender of a life insurance contract are tax-exempt as a tax-free return of premium until the policy owner's cost basis has been entirely recovered.

FIFO tax treatment (life insurance policy)

Under FIFO tax treatment, a cash-value withdrawal is considered a tax-free return of the policy owner's cost basis insofar as any basis remains under the contract. Only after all cost basis has been recovered tax-free is any withdrawal deemed to be taxable gain.

Gain (life insurance policy)

A permanent life insurance policy's cash value to the extent it exceeds the total premiums (less dividends) paid for the coverage.

Interest-only settlement option

A settlement option under which a beneficiary leaves some or all of the death benefit proceeds with the insurer at interest who makes interest payments to the beneficiary on the frequency requested.

42 Glossary

Life annuity An annuity under which an insurer guarantees to make periodic payments to a payee for as long as an annuitant lives regardless of the duration of the annuitant's life.

Life insurance (statutory definition)

Any contract which is a life insurance contract under the applicable law, but only if it:

(1) meets the cash value accumulation test, or

(2) meets the guideline premium requirements and falls within the cash value corridor.

Glossary 43

Life settlement (life insurance policy)

The purchase by a life settlement provider of an existing life insurance policy under which the insured policy owner is older and relatively healthy.

Living proceeds (life insurance policy)

Living proceeds received under a life insurance policy are proceeds received during an insured's lifetime and include policy loans, policy dividends, cash withdrawals, and surrender proceeds.

MEC tax penalty A 10% penalty tax generally applies to any amount includible in income received from a MEC by an individual before attainment of age 59 1/2.

Minimum payment guarantee (annuity settlement options)

A life annuity guarantee, called a "period certain" or "refund" under which an insurer guarantees that an income will continue for the annuitant's entire life and also guarantees that at least a minimum amount will be paid in the case of the annuitant's early death.

Modified endowment contract (life insurance policy)

A life insurance policy becomes a modified endowment contract (MEC) if the total premiums paid by the life insurance policy owner in the first seven years exceed the amount of premiums that would have been required to make the policy paid-up in seven years.

Permanent life insurance

Life insurance intended to cover an insured person for his or her entire life. It builds cash value that may be borrowed against or withdrawn and which is available upon the policy owner's surrender of the policy.

Policy loan (life insurance policy)

A loan from an insurer collateralized by the cash value of a life insurance policy issued by the insurer.

Qualified retirement plan

An employer-sponsored retirement plan that exists primarily to provide retirement benefits to plan participants and beneficiaries and which receives special income tax treatment.

Settlement options Alternative methods of receiving benefits payable under a life insurance policy or annuity contract, characterized by regular periodic payments.

Tax-free exchanges (life insurance policy)

The IRC §1035 tax-free exchange rules permit the exchange of a life insurance policy for certain other contracts.

Temporary annuity An annuity under which a principal is liquidated over a specific period of time, such as 5 years, 10 years, or some other duration.

Term life insurance Life insurance generally providing coverage for a term period that may be as short as one year or for as long as 30 years. The coverage involves no cash value, and if the insured does not die by the end of the term period the coverage ends without further value.

Terminally ill HIPAA defines a terminally ill individual as a person who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death within 24 months following such certification.

Transfer for value Transfer of a life insurance policy's ownership as part of a sale (in contrast to a gift).

Viatical settlement A sale of an existing life insurance policy to a third party—usually referred to as a "viatical settlement provider"—by a terminally ill individual with a life expectancy of 24 months or less.

Documents

TAX TREATMENT OF LIFE INSURANCE PROCEEDS