Taxation of life insurance and annuities l.jpg
This presentation is the property of its rightful owner.
Sponsored Links
1 / 48

Taxation of Life Insurance and Annuities PowerPoint PPT Presentation


  • 188 Views
  • Uploaded on
  • Presentation posted in: General

Taxation of Life Insurance and Annuities. Al Kingan, JD, LLM, CLU, ChFC Director, Estate & Business Planning. University of Nebraska School of Law 2006 Estate & Business Planning Program May 12, 2006. # 078730-000. Disclosure.

Download Presentation

Taxation of Life Insurance and Annuities

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript


Taxation of life insurance and annuities l.jpg

Taxation of Life Insurance and Annuities

Al Kingan, JD, LLM, CLU, ChFC

Director, Estate & Business Planning

University of Nebraska School of Law

2006 Estate & Business Planning Program

May 12, 2006

# 078730-000


Slide2 l.jpg

Disclosure

This presentation is not written or intended as specific tax or legal advice and cannot be relied upon for purposes of avoiding any federal tax penalties.

MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from a qualified tax or legal advisor.


Life insurance tax basics l.jpg

Life Insurance Tax Basics

  • Premiums are not tax deductible

  • Death benefits are income tax exempt

  • Cash values are tax-deferred

Life Insurance


No deduction for premiums l.jpg

No Deduction for Premiums

  • IRC 264 – life insurance premiums are not tax deductible expenses.

  • John cannot deduct the premiums he pays on his personal life insurance policy.

  • John’s business or employer cannot deduct the premiums it pays on an insurance policy it owns on his life (e.g., key person insurance).

Life Insurance


Tax free death benefits l.jpg

Tax-Free Death Benefits

  • IRC 101(a) “… gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured.”

    • Must be a life insurance policy

    • Must be paid because the insured died

    • Any type of policy (Term, WL, UL, etc.)

    • To any beneficiary (individual, trust, business)

Life Insurance


Irc 7702 definition of life insurance l.jpg

IRC 7702 Definition of Life Insurance

  • Product must meet Sec. 7702:

    • Must be a life insurance contract under applicable law (state or foreign), and

    • Must meet either of two tests:

      • Cash Value Accumulation Test

      • Guideline Premium Test

    • Also, Mortality & Expense charges must be reasonable

Life Insurance


Irc 7702 failure l.jpg

IRC 7702 Failure

If a policy is a life insurance contract under state or foreign law, but does not qualify under IRC 7702:

  • Investment gain on failed contracts are taxable each year as ordinary income

  • Otherwise, Investment gain is tax deferred

    • Income tax-free if received as death proceeds

Life Insurance


Taxation of life insurance non mecs policy distributions l.jpg

Taxation of Life Insurance (non-MECs)Policy Distributions

Favorable taxation - generally, return of basis first

  • Dividend distributions - reduce “investment in the contract”

  • Special Rule for Withdrawals/Partial Surrenders During 1st 15 Years

    • Pre-7702 (pre-January 1, 1985)

      • reduce “investment in the contract”

    • 7702 Contracts

      • Distribution may be treated as income on contract

      • Separate formulas for years 1-5, 6-10 and 11-15

Life Insurance


Taxation of life insurance non mecs policy distributions cont l.jpg

Taxation of Life Insurance (non-MECs)Policy Distributions (cont.)

  • Policy loans

    • Not a distribution

    • Loan can be repaid out of death proceeds with No tax

    • Policy lapse with loan in excess of basis is taxable

  • Full Surrenders

    • Amount received (including loan forgiveness) in excess of basis is taxable ordinary income

  • Distributions in excess of basis

    • Taxable as ordinary income

Life Insurance


Taxation of life insurance modified endowment contracts mecs l.jpg

Taxation of Life Insurance Modified Endowment Contracts (MECs)

Section 7702A -(applies on or after June 21, 1988)

  • Policy that fails the 7-pay test (but passes definition of life insurance test of Section 7702)

  • Policy’s total premiums exceed the premium limits defined in the legislation:

    • During first 7 years

    • At the date of a “material change”, or

    • At the date of loss of “grandfather” status

Life Insurance


Taxation of life insurance modified endowment contracts mecs11 l.jpg

Taxation of Life Insurance Modified Endowment Contracts (MECs)

“Material Changes”

  • Term rider attachments

  • Conversion of Dividend Accumulations to Paid-up Additions

  • Death Benefit Increases

  • Certain Universal Life corridor increases

Life Insurance


Taxation of life insurance modified endowment contracts mecs12 l.jpg

Taxation of Life Insurance Modified Endowment Contracts (MECs)

Policy Distributions - Section 72(e)

  • Dividends/Withdrawals/Partial Surrenders

    • Taxed Income out first

  • Full Surrenders

    • Amount received (not including loan forgiveness) in excess of basis is taxable ordinary income

  • Loans and Collateral Assignments

    • Taxed same as a surrender or withdrawal

    • Repayment of loan increases “investment in the contract”

Life Insurance


Taxation of life insurance modified endowment contracts mecs13 l.jpg

Taxation of Life Insurance Modified Endowment Contracts (MECs)

Policy Distributions (cont.)

  • Premature Distributions

    • Additional 10% penalty tax applies to taxable income on distributions from a MEC

    • Exceptions:

      • Policyowner has attained age 59 1/2

      • Policyowner has become disabled

      • Distributions taken as a series of substantially equal periodic payments (at least annually) over life expectancy of owner and owner’s beneficiary

Life Insurance


Taxation of annuities l.jpg

Taxation of Annuities

Inside Build-up

  • Generally, Tax Deferred

  • Exception, Deferred Annuities held by Non-natural persons

    • Beginning with investment contributions after 2/28/86 - Sec. 72(u)

Annuities


Taxation of annuities15 l.jpg

Taxation of Annuities

Deferred Annuities

  • Withdrawals/Partial Surrenders (Amounts not received as an annuity)

    • Taxed as distribution of income on the contract first

  • Full Surrender/Loans/Collateral Assignments

    • Amount received in excess of basis is taxable ordinary income

  • Gifts of Annuity Contract

    • Treated as a disposition triggering tax on gain

    • Except between spouses or incident to a divorce

Annuities


Taxation of annuities16 l.jpg

Taxation of Annuities

Deferred Annuity Distributions (cont.)

  • Premature Distributions

    • Additional 10% penalty tax applies to taxable income on distributions from a Deferred Annuity

    • Exceptions:

      • Contract holder has attained age 59 1/2

      • Contract holder has become disabled

      • Distributions taken as a series of substantially equal periodic payments (at least annually) over life expectancy of owner and owner’s beneficiary

Annuities


Taxation of annuities death of contract holder sec 72 s l.jpg

Taxation of AnnuitiesDeath of Contract Holder - Sec. 72(s)

  • If Surviving Spouse named as Beneficiary

    • Spouse replaces Contract holder

  • Mandatory distributions

    • Before Annuity Starting Date

      • Distribute entire amount within 5 years

      • Over life of beneficiary (beginning w/in 1 year)

    • On or After Annuity Starting Date

      • At least as rapidly as method of distributions prior to holder’s death

Annuities


Exchanges of insurance and annuity contracts section 1035 l.jpg

Exchanges of Insurance and Annuity Contracts - Section 1035

No Gain or Loss Recognized

Old Basis Carries over to new contract (unless exchange involves taxable “boot”

Permissible Exchanges:

  • Life Insurance for Life Insurance, Endowment or Annuity

  • Endowment for Endowment or Annuity

  • Annuity for Annuity

    • Note, Endowment Contracts are no longer available

Exchanges


Exchanges of insurance and annuity contracts section 103519 l.jpg

Exchanges of Insurance and Annuity Contracts - Section 1035

Special Rules

  • Contracts must have the same Insured or Insureds

  • Generally believed that owner must be same

  • Exchange may involve multiple contracts

  • New Life Policy will not become a MEC as a result of exchange unless old policy was a MEC

    • Amount transferred from old contract not treated as a premium payment under MEC test

    • It does, however, lower premium limit that would otherwise apply to new policy

Exchanges


Exchanges of insurance and annuity contracts section 103520 l.jpg

Exchanges of Insurance and Annuity Contracts - Section 1035

Life Insurance Exchanges - Boot Anomaly

  • Sec. 1035 refers to 1031 for operational instructions

  • Under Sec. 1031, any debt forgiveness is “boot”

  • Under Sec. 72, no gain on life policy until distributions exceed basis

  • Apparent conflict in IRC? (nah?, can’t be?)

  • Insurance Carriers generally take position that forgiven loan is taxable (preserves business/prevents penalties)

  • Problem can be avoided by first doing a partial surrender that eliminates loan (step transaction?)

Exchanges


Life insurance death proceeds transfer for value l.jpg

Life Insurance Death ProceedsTransfer for Value

Death Proceeds Income Tax Free Unless Transfer for Value Rule Applies

  • Transfer for Value - In the case of a transfer for valuable consideration by assignment or otherwise, of a life insurance contract or any interest therein, proceeds in excess of basis are taxable.

Life Insurance


Transfer for value l.jpg

Transfer for Value

Section 101(a)(2) Transfer for Value Exceptions:

  • Transfer to Insured

  • to Partner of Insured

  • to Partnership in which Insured is a Partner

  • to Corporation in which Insured is a shareholder or officer

  • Transfer where basis in hands of transferee is same as in hands of transferor

Life Insurance


Transfer for value23 l.jpg

Transfer for Value

Caution: Broad application of Transfer for Value Rules - Examples:

  • A, B and C own Corp; they buy policies on each other for Buy/Sell funding

    • A dies

    • B & C collect death proceeds, and buy stock from A’s estate

    • B buys A’s interest in policy on C’s life

    • C buys A’s interest in policy on B’s life

  • Transfer for Value?

Life Insurance


Transfer for value24 l.jpg

Transfer for Value

Examples:

  • A and B are brothers; they own XYZ Corp.

  • Each owns a life insurance policy on his own life

  • Each names his brother as beneficiary of his life insurance policy

  • Transfer for Value?

Life Insurance


Transfer for value25 l.jpg

Transfer for Value

Examples:

  • Mom gifts life insurance policy to daughter. Policy has outstanding loan.

    • Premiums paid$ 8,000

    • Outstanding loan$ 5,000

    • Net Cash Surrender Value$10,000

  • Transfer for Value?

Life Insurance


Transfer for value26 l.jpg

Transfer for Value

Examples:

  • Mom gifts life insurance policy to daughter. Policy has outstanding loan.

    • Premiums paid$20,000

    • Outstanding loan$25,000

    • Net Cash Surrender Value$12,000

  • Transfer for Value?

Life Insurance


Transfer for value27 l.jpg

Transfer for Value

Examples:

  • Policy on A owned by A’s Irrevocable Trust

  • A, concerned about one of trust beneficiary’s ability to handle money, wants to change trust

    Can A create new trust to buy the life insurance policy from old trust?

Life Insurance


Transfer for value28 l.jpg

Transfer for Value

Examples:

  • Can A’s New Trust buy life policy from Old Trust?

    • Under Grantor Trust rules, all assets of New Trust are treated as owned personally by A for income tax purposes

    • The Transfer for Value Rule is an Income Tax rule

    • A transfer directly to A (the Insured) is exempt

  • IRS, after refusing to rule for many years, has issued a number of favorable letter rulings:

    • PLR 200228019PLR 200247006 PLR 200606027

    • PLR 200518061PLR 200514001

IRS Private Letter Rulings are opinions rendered by staff of the IRS relating to a specific case. These opinions do not set legal precedent but do provide some insight concerning the IRS’ attitude toward the relevant tax issue. PLRs cannot be relied on as can published rulings (Revenue Rulings).

Life Insurance


Transfer for value29 l.jpg

Transfer for Value

Examples:

  • Getting A’s Policy from A’s Old Trust to A’s New Trust

  • Any Other Options?

Life Insurance


Transfer for value30 l.jpg

Transfer for Value

Getting A’s Policy from Old Trust to New Trust

  • The Super Conservative Solution:

    • A creates Family Limited Partnership

    • A Transfers FLP interests to New Trust

    • New Trust buys policy form Old Trust

      • Trustee should sell for greater than cash value

      • Avoid any Breach of Fiduciary Duty argument

  • Results:

    • Partner of the Insured Exception Applies

    • No Transfer for Value Problem/No Sec. 2042 Problem

Life Insurance


Transfer value of a life insurance policy rev proc 2005 25 td 9223 regulations l.jpg

Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations

New Insurance Valuation Rules apply to Transfers of Life Insurance from:

  • Employer to Employee

  • Distribution or Purchase from a Qualified Plan

    Value to be used is the Fair Market Value, not the:

  • Cash Value

  • Cash Surrender Value, or

  • Interpolated Terminal Reserve (gift tax value)

Life Insurance


Transfer value of a life insurance policy rev proc 2005 25 td 9223 regulations32 l.jpg

Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations

Rev. Proc. 2005-25 valuation safe harbor for Universal Life policies is the greater of:

  • The Statutory Reserve

  • The product of the PERC amount and the Average Surrender Factor (ASF)

Life Insurance


Transfer value of a life insurance policy rev proc 2005 25 td 9223 regulations33 l.jpg

Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations

PERC Definition: Aggregate of :

  • Cumulative premiums paid

  • Plus earnings credited on contract

  • Minus mortality charges and other reasonable charges actually charges

  • Minus any distributions, withdrawals or surrenders taken prior to valuation date

Life Insurance


Transfer value of a life insurance policy rev proc 2005 25 td 9223 regulations34 l.jpg

Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations

  • Average Surrender Factor (ASE) is an adjustment to account for surrender charges.

    • Expressed as a number between .70 and 1.00

  • Employment Based Transfers - subject to IRC 79, 83 or 402(b), the ASE is 1.00

    • Note: No surrender charges can be taken into account in a transfer from employer to employee

  • Qualified Plan Based Transfers- the ASE is greater of a) .70, or b) fraction of CSV/PERC as if surrender was on first day of policy year

  • Life Insurance


    Transfer value of a life insurance policy rev proc 2005 25 td 9223 regulations35 l.jpg

    Transfer Value of a Life Insurance PolicyRev. Proc. 2005-25; TD 9223 Regulations

    For Whole Life Type Products, the safe harbor value is the greater of:

    • Interpolated Terminal Reserve

      • Plus Unearned Premium, etc.

    • product of the PERC and the ASE

      • (no ASE adjustment if the distribution is from employer to employee)

    Life Insurance


    Gift tax value of life insurance l.jpg

    Gift Tax Value of Life Insurance

    Gift Value is Interpolated Terminal Reserve

    • In early years - close to premiums paid

    • In later years, equal to Cash Surrender Value

      Probably the Account Value of a UL or VUL policy

    Life Insurance


    Estate tax inclusion of life insurance l.jpg

    Estate Tax Inclusion of Life Insurance

    Section 2042

    Death Proceeds includable in Decedent’s Taxable Estate if:

    • Payable to Decedent’s Estate

    • Payable to Others, and decedent possessed at his death any of the policy’s incidents of ownership, exercisable alone or in conjunction with any other person.

    This is a summary only of the tax issues related to federal gift and estate laws and is not intended as tax or legal advice. Specific advice should obtained from a qualified professional.

    Life Insurance


    Estate tax inclusion of life insurance38 l.jpg

    Estate Tax Inclusion of Life Insurance

    Section 2035

    Death Proceeds includable in Decedent’s Taxable Estate if:

    • Decedent transferred or relinquished an interest in property (including any incidents of ownership in a life insurance policy on Decedent’s life) during the 3 year period ending on the date of decedent’s death.

    This is a summary only of the tax issues related to federal gift and estate laws and is not intended as tax or legal advice. Specific advice should obtained from a qualified professional.

    Life Insurance


    Life insurance tax traps l.jpg

    Life Insurance Tax Traps

    Goodman Triangle Problem

    • Dad doesn’t want to pay legal fees to create a trust

    • He names responsible Child A as owner of his life insurance policy

    • Child A and Child B are policy beneficiaries

    • Dad dies – Child A is deemed to have made a taxable gift of ½ of the death proceeds to Child B

    This is a summary only of the tax issues related to federal gift and estate laws and is not intended as tax or legal advice. Specific advice should obtained from a qualified professional.

    Life Insurance


    Life insurance tax traps40 l.jpg

    Life Insurance Tax Traps

    Life Insurance Owned by Multiple Individuals: Present Interest Exclusion Issue

    • Dad doesn’t want to pay legal fees to create a trust

    • He names both Child A and Child B as owners of his life insurance policy

    • Dad pays all policy premiums

    • Dads premium payments are all taxable gifts – They do not qualify for the annual gift tax exclusion

    This is a summary only of the tax issues related to federal gift and estate laws and is not intended as tax or legal advice. Specific advice should obtained from a qualified professional.

    Life Insurance


    Life insurance tax traps41 l.jpg

    Life Insurance Tax Traps

    Life Insurance Owned by Multiple Individuals: Present Interest Exclusion Issue

    • Joint owners must all consent to exercise any policy rights

    • Therefore, no individual owner is deemed to have a present interest in a policy gifted to multiple parties

      • Same with the payment of premiums on a policy owned by multiple parties

    Life Insurance


    Life insurance tax traps42 l.jpg

    Life Insurance Tax Traps

    Life Insurance Owned by a Credit Shelter Trust

    Could be a Great Idea, unless:

    • Insured is named Trustee

    • Insured is given a Limited Power of Appointment over the Credit Shelter Trust

    Life Insurance


    Life insurance tax traps43 l.jpg

    Life Insurance Tax Traps

    Corporate Owned Policy Payable to a Personal Beneficiary:

    • Death Benefit may be taxed as a dividend

    • Death Benefit may be taxed as compensation

    • Death Benefit will be deemed to have been constructively paid:

      • First to corporation

      • Then from corporation to Deceased Employee,

      • Then from Deceased Employee to named beneficiary

    • Depending upon beneficiary, could also be a Transfer for Value

    Life Insurance


    Perspective l.jpg

    Perspective

    • Primary purpose is to provide cash to beneficiary at death of the insured.

      • Income to help support a family, put children through college, pay off mortgages, pay estate taxes, fund a buy-sell plan, or make a charitable bequest.

    • Secondarily, permanent life insurance policies also build up tax deferred cash values.

      • May be used to reduce/skip premiums, help provide cash for emergencies, even help supplement retirement income.

    • Congress provides certain tax benefits for life insurance as a public policy due to its value to society. Let’s keep things in perspective as abusive uses of the tax benefits can lead to loss of those benefits.


    Why life insurance l.jpg

    Why Life Insurance?

    • Provides funds on-time, during period of greatest need, regardless of when death occurs

    • Income tax free death proceeds

    • Potentially Estate tax free death proceeds (with appropriate estate planning)

    • Income tax deferred cash value growth

    • Favorable basis recovery of lifetime distributions

    • Cash value loans in excess of basis also income tax free

    Life Insurance


    Common uses of life insurance proceeds l.jpg

    Common Uses of Life Insurance Proceeds

    • Estate tax transfer costs

    • State death transfer costs

    • Family income maintenance

    • Payment of mortgages and debts (both personal and business)

    • Educational needs for children/grandchildren

    • Equalization of inheritances

    • “Special Needs” situations

    Life Insurance


    Uses of life insurance cont l.jpg

    Uses of Life Insurance (cont.)

    • Multiple marriage situations

    • Income tax issues on Qualified Plans and other IRD items

    • Wealth replacement of assets transferred directly (or indirectly) to charitable institutions

    Life Insurance


    Slide48 l.jpg

    MassMutual Financial Group is a marketing designation (or fleet name) for Massachusetts Mutual Life Insurance Company (MassMutual) and its affiliates.

    Massachusetts Mutual Life Insurance Company and affiliates, Springfield, MA 01111-0001 • www.massmutual.com


  • Login