The American College: HS 321 Income Taxation

1. The American College: HS 321Income Taxation Class 10: Chapters 16 and 17 Income Taxation of Life Insurance

2. Death Benefits

3. Life Insurance Proceeds Generally, life insurance death benefits payable by reason of the death of the insured are excludible from the gross income of the beneficiary.

4. Accelerated Death Benefits Must be paid by insurer or licensed viatical settlement provider “Terminally ill” means death is expected within 24 months of physician’s certification Payments to “Chronically ill” insured must be made pursuant to qualified LTC rider

5. Policy Benefit Options

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

7. “LIFO” VS “FIFO”

8. “5-15” Withdrawals Taxed on LIFO basis if associated with a reduction in policy benefits during first 15 policy years Greater taxable amount during first 5 policy years “Ceiling” applies to taxable amount Typically associated with universal life policies

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

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

11. Surrender of Policy

12. Surrender of Policy Face Amount of Policy: $50,000 Cash Surrender Value: $8,000 Premiums Paid: $9,000 Dividends Paid on Policy: $2,000 Amount Taxable: $8,000 – ($9,000 - $2,000) = $1,000

13. Quiz Questions

14. Short Quiz #1 Life insurance death benefits are excluded from gross income of an individual beneficiary but are taxable income to a trust. True False

15. Short Quiz #1 Accelerated death benefits paid under a life insurance contract to a terminally ill insured are generally excludible from gross income as amounts paid by reason of death. True False

16. Transfer-for-Value Rule

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

18. Example Face amount of policy: $100,000 Amount paid for policy by transferee: $20,000 Premiums subsequently paid by transferee: $10,000 Amount taxable to transferee upon death of insured: $100,000 – ($20,000 + $10,000) = $70,000

19. Transfer For Value EXCEPTIONS Transfers to the insured Transfers to a partner of the insured Transfers to a partnership in which the insured is a partner Transfers to a corporation in which the insured is a shareholder or officer Transfers to which carryover basis rules apply

20. Transfer For ValueNON-EXCEPTION Transfers from one shareholder in a corporation to a fellow shareholder!

21. Insurable Interest

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

23. Premium Payments

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

25. Interest on Policy Loans

26. Interest on Policy Loans Interest is deductible only if business-owned policy insures “Key Person” Key person must be either an officer or 20 percent owner of taxpayer/business No business can have more than 20 “Key Persons” Interest deductible only to extent of $50,000 of loan principal per insured “Moody’s” rates must be used

27. Quiz Questions

28. Short Quiz #2 A corporation may take a deduction for premium payments made for insurance on the life of an officer of the corporation if the beneficiary is the corporation. True False

29. Short Quiz #2 An employer who pays the premiums on an individual policy owned by an employee and insuring the employee’s life may deduct these payments as additional compensation to the employee. True False

30. Short Quiz #2 Interest on a life insurance policy loan of $50,000 may be deductible if the insured is a “key person” with respect to the taxpayer. True False